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F8 Audit and Assurance Question Bank

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About the paper
i - viii
Question
number
Topic
Section A
Name
Marks
Page Numbers
Question
bank
Solution
bank
Audit Framework and Regulation
1
2
3
4
5
6
Independence of auditors
Audit engagements
IAASB
Role of auditor in corporate governance
Professional conduct
Ethics
Abel and Co
Bondi
ISA
ISA 260
Cosby Travel
Watson
30
20
10
10
10
10
1-1
1-2
2-2
2-3
3-3
3-3
53 - 55
55 - 56
57 - 57
58 - 59
59 - 60
60 - 62
7
Ethics
Audit committee and internal and
external auditors
Stark Co
20
3-4
62 - 64
Conoy Co
20
4-4
64 - 66
JHG
Pharmaceuticals
Co
30
5-5
67 - 71
ZX
20
6-6
71 - 74
Cleanco
Roxy Hotels Plc
20
20
20
20
6-6
7-7
7-8
8-8
74 - 76
76 - 78
78 - 81
81 - 83
Pitman
20
9-9
83 - 85
Shoe World Ltd
10
10 - 10
85 - 86
MonteHodge Co
20
10 - 10
87 - 90
8
Section B
9
10
11
12
13
14
15
16
17
Internal audit
Internal audit
Corporate governance and audit
committee
Fraud and error
Internal audit and external audit reports
Operational internal audit assignments
Internal audit function
Control weaknesses and suggested
improvements
Objectives of internal and external
auditors
Internal audit department and
outsourcing
Section C
Planning and risk assessment
18
Audit Plan
19
20
Knowledge of business
Analytical procedures and materiality
Extent of reliance on the work of internal
auditors
Audit risk
Audit risk and control environment
Analytical procedures
Audit documentation
Understanding the entity and its
environment and risk assessment
Audit strategy, audit risks, tests of
control, substantive procedures and
analytical procedures
Fraud, substantive procedures on
inventory valuation and ethics
Auditor’s objective and professional
scepticism
21
22
23
24
25
26
27
28
29
Bridgeford
Products Plc
Earn & Co
-
30
11 - 11
91 - 94
20
20
12 - 12
12 - 12
95 - 96
96 - 99
-
20
13 - 13
99 - 100
Quench Cola
EuKaRe charity
Zak Co
Specs4You Co
10
20
20
20
13 - 13
14 - 14
14 - 15
15 - 16
100 - 101
102 - 104
104 - 107
107 - 109
Rock
10
16 - 16
110 - 111
B- Star
30
17 - 18
111 - 113
Tye Co
20
18 - 18
114 - 117
-
10
18 - 18
117 - 118
Question
number
Topic
Section D
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
Marks
Page Numbers
Question
bank
Solution
bank
Internal control
Substantive procedures and
tests of controls
Evaluation of internal control
systems
Internal control procedures
Objective of audit evidence Test of control / substantive
procedure
Internal control systems of
receivables
Perpetual Inventory
Internal controls
Internal control systems
General Controls
Purchase system and
inventory counting
Despatch and sales system,
direct confirmation of
receivables and internal
control questionnaires
Internal control system of
wages and substantive
analytical procedures
Letter of weakness for sales
system and audit committee
Internal control of petty cash
system and independence of
internal audit
Internal controls and its
weaknesses
Control activity, tests of
control, assertions and audit
opinion
Control environment,
understanding the entity and
substantive procedures
Section E
Name
Atlantis Standard Goods
30
19 - 19
119 - 123
Healthline
30
20 - 21
123 - 125
Bardwell
20
21 - 21
125- 128
Gordon
20
22 - 22
128 - 129
-
20
22 - 23
129 - 133
Pyrmont
Coolex
The Royal Club
Chef Kitchenware
20
20
20
10
23 - 23
24 - 24
24 - 25
25 - 25
133 - 136
137 - 138
139 - 141
141 - 143
DinZee Co
30
25 - 26
143 - 146
Seeley Co
30
26 - 27
146 - 149
Blake Co
30
27 - 28
150 - 152
Rhapsody Co
20
29 - 29
153 - 155
Matalas Co
20
29 - 30
155 - 157
Snu
30
30 - 30
157 - 160
Have a Bite Co
20
31 - 31
161 - 163
31 - 32
164 - 166
Letham
20
Audit evidence
Analytical procedures: ratio
analysis
Audit evidence
Assertions and payroll audit
Audit procedures
Audit of inventory
Audit evidence
Small entities
Not-for-profit organisation
Statistical techniques in
auditing
Hivex
30
33 - 34
167 - 170
Boulder
BearsWorld
IAS 2
Company A
ISA
Ajio
20
20
20
20
20
20
20
34 - 34
34 - 35
35 - 35
35 - 35
36 - 36
36 - 36
36 - 37
171 - 173
173 - 175
175 - 177
177 - 180
180 - 182
183 - 185
185 - 187
-
10
37 - 37
187 - 188
Question
number
56
57
58
59
60
Topic
CAAT
Audit software
Substantive audit procedures
and audit evidence
Audit software and audit
documentation
Substantive procedures, audit
planning and inherent risks
Section F
61
62
63
64
65
66
67
68
69
70
71
72
73
74
Mock paper
Pilot paper
Marks
Page Numbers
Question
bank
Solution
bank
Royal Selection
Delphic Co
10
20
37 - 37
38 - 38
189 - 189
190 - 192
Metcalf
20
38 - 39
193 - 196
Cal & Co
20
39 - 39
196 - 199
Redburn Co
30
40 - 40
199 - 202
Crighton-Ward
20
41 - 41
203 - 204
Calva
20
42 - 42
205 - 207
Chemical Compounds
Posco
EWheels
20
20
20
10
42 - 42
43 - 43
43 - 44
44 - 44
207 - 209
209 - 212
212 - 214
214 - 215
Smithson Co
20
45 - 45
215 - 218
ZeeDiem Co
20
45 - 46
218 - 220
Cliff
Rudra Plc
Corsco
Hood Enterprises
MSV Co
JonArc & Co
30
30
20
20
20
20
100
100
47 - 47
221 - 225
47 - 48
225 - 228
49 - 49
228 - 230
49 - 50
230 - 232
50 - 51
233 - 235
51 - 52
235 - 238
1-6
1 - 14
1-6
1 - 14
Total Page Count: 288
Review
Written representations
Audit finalisation, overall
review and subsequent
events
Written representations
Subsequent events
Going concern
Going concern
Going concern and negative
assurance
Subsequent events
Section G
Name
Reporting
Report to management
Audit reports
Audit reports
Audit reports
Audit reports
Audit reports
Examination structure
The syllabus is assessed by a three-hour paper-based examination, consisting of five compulsory questions. The
bulk of the questions will be discursive but some questions involving computational elements will be set from
time to time.
The questions will cover all areas of the syllabus.
¾ Question 1 will be a scenario-based question worth 30 marks.
¾ Question 2 will be a knowledge-based question worth 10 marks.
¾ Questions 3, 4 and 5 will be worth 20 marks each.
Reading and planning time
For all three hour examination papers, ACCA has introduced 15 minutes reading and planning time.
This additional time is allowed at the beginning of each three-hour examination to allow candidates to read
the questions and to begin planning their answers before they start writing in their answer books. This time
should be used to ensure that all the information and exam requirements are properly read and understood.
During reading and planning time candidates may only annotate their question paper. They may not write
anything in their answer booklets until told to do so by the invigilator.
Effective time management – a key to success
Remember you have 1.8 minutes per mark.
Aim to solve
¾
¾
¾
a 10 mark question in 18 minutes
a 20 mark question in 36 minutes, and
a 30 mark question in 54 minutes
About the GTG Question Bank
This Question Bank of 84 questions covers all important topics of the syllabus. The solution bank provides
both the correct answer as well as supporting explanations to enhance your understanding of the subject.
The Solution Bank has the following features, in addition to solutions to the questions:
strategy
to help you tackle the question
Callouts and tips
to give you additional guidance
Score More
where students lose marks even when they have
the required knowledge and notes how to avoid these
mistakes
Answer plan
to help you plan the answers for longer questions
ACCA RESOURCES
ACCA provides a number of online resources to help students with their studies. They include detailed
syllabus, study guides, examiners’ reports, examiners’ guidance, past exam papers, technical articles. They
can be found at http://www2.accaglobal.com/students/acca/exams/F8/
A detailed syllabus and study guides of paper P1is given in the PDF format on ACCA website:
http://www2.accaglobal.com/pubs/students/acca/exams/f8/syllabus/f8_syllabus2012_int.pdf
Paper F8: past exam paper analysis of the latest FIVE papers
GTG SG No
Jun -11
A1
A2
Dec-10
Jun-10
Dec-09
2(a),(b)
2(a)
4(d)
A3
A4
2(b)
2 (b), 4(a),
4(c)
3(a)
4
Jun-09
4(b)
5b(iii)
B1
B2
4(a),(b)
B3
B4
4(a)
5b(i), (ii)
4(b)
1(d),
4(a),(b)
B5
C1
3(b)
1(a),
(b)
C2
C3
C4
3(b)
1(c)
C5
C6
C7
D1
2(b)
3(a)
1(d)
3(c )
1(a)
2 (c)
4(b)
3(a)
1(a)
3(b)
2 (a)
D2
D3
D4
5(b) i,ii
1(c)
1(a)
D5
D6
E1
1(a),(b)
3(b)
5(a)
2(a),
1(b),(c)
3(a)
E2
5(a)
1(b) , 1(d),
3(a)
E3
1(c),4(c)
1(c ), (d),
3(c)
1e,3c,
4(c ), 5(c )
E4
E5
E6
E7
F1
F2
F3
F4
G1
G2
G3
2(b)
5(a)
1(b),
(c),(d),
3(c )
2(a)
3(a),
(b)
5(b)
5
5(b),(c )
5(a)
5(c)
5(d)
2(c )
SECTION A
QUESTION BANK
AUDIT FRAMEWORK AND
REGULATION
A
1. Independence of auditors – Abel and Co
Abel and Co, Chartered Certified Accountants, recently held a staff training session on quality control. The session
concluded with staff being invited to raise matters from their experience relating to the ethical rules on independence.
Some of these matters are given below.
(i) Shortly before commencing the final audit of a large listed company, a junior staff member on the audit team
inherited a substantial number of shares in that company. No action was taken because, although
representing a large investment for the staff member concerned, the number of shares was totally
immaterial with respect to the company. Moreover; the partner knew that when the company's results were
announced the share price would rise and he did not think it was fair to require the staff member to sell them
now.
(ii) The management accountant of another listed company client had an accident and was away from work for
three months. At the time of the accident the audit senior was winding up the prior year's audit and, because
of his familiarity with the company's management accounting system, it was agreed that he would take over
as management accountant for the three months.
(iii) In its management letter to another audit client, Abel and Co warned the company that their computer
system lacked essential controls. The company decided to install a totally new computer system and Abel
and Co's management consultancy department was appointed to design the new system.
(iv) Abel and Co was recently approached by a large company that was not then an audit client, for a second
opinion. The company was in dispute with its existing auditors who were proposing to issue a modified
auditor's report because of disagreement over inventory valuation. Abel and Co's technical partner reviewed
the evidence provided by the company and advised the company that its accounting treatment was in order.
Shortly afterwards Abel and Co were invited to accept nomination as auditors. The reply to the letter of
enquiry to the existing auditors made it clear that the inventory valuation dispute was not as straightforward
as the company had made it out to be.
Required:
(a) Discuss whether Abel and Co may have impaired their independence or otherwise acted unprofessionally in
each of the situations described.
(20 marks)
(b) Briefly explain the term ‘confidentiality’ and explain the situations where an auditor may disclose confidential
information about a client.
(10 marks)
(30 marks)
2. Audit engagements – Bondi
You are a partner in a firm of Chartered Certified Accountants that has been invited by the board of directors to
accept nomination as external auditors to Bondi, a publicly owned incorporated business. Bondi operates a
number of car dealerships and has grown rapidly over the past two years through an aggressive take-over
strategy.
You are aware that the company's existing auditors, a much smaller firm, qualified their last auditor's report.
Over lunch with a number of your firm's partners, the company's chief financial officer maintained that their
existing auditors could not cope with the audit of a company their size and, in particular, were not equipped to
audit the recently installed sophisticated computer accounting system. He also suggests that they need a firm of
your reputation in order to reassure the market as they intend to seek a public listing within two years.
2: Audit Framework and Regulation
© GTG
The existing auditors, in response to your inquiry, advise against accepting the audit on the following grounds:
(i) Insufficient consideration has been devoted by management to developing the accounting system in line
with the expanding business. In particular there is a lack of concern as to control. They detected a number
of petty employee frauds as a result of control weaknesses. No serious action was taken against the
employees identified as engaged in fraud. The attitude seems to be to encourage risk-taking employees for
whom, making money on the side whilst securing good deals for the company is seen as a legitimate bonus.
(ii) The newly installed computer accounting system is unreasonably complicated. Bondi claims this is
necessary because of the need to maintain records to justify the company's claims for volume rebates, and
bonuses under the complex incentive schemes by which car manufacturers reward dealers.
(iii) They have no evidence of deliberate misrepresentation by the directors but audit staff was hindered in their
audit work by a less than helpful attitude by senior management who adopted an aggressive stance
whenever a query was raised. The chief financial officer was constantly on the phone to the partner claiming
the audit staff was incompetent and accusing them of wasting his time asking unnecessary questions.
At a partner's meeting a majority of partners accepted the story that the existing auditors were out of their depth
and that their complaints were merely an attempt to cover up their own shortcomings. Your firm accepted
nomination and was duly appointed as auditors.
Required:
(a) State factors the partners should have considered for and against accepting nomination.
(7 marks)
(b) Detail the matters to which you would pay particular attention in obtaining the required knowledge of the
business and in developing your audit plan.
(7 marks)
During the first audit, your firm discovers that the reason for the complexity of the computer system is to
falsify records in order to reduce the amount of tax payable to the government.
(c) Describe the action you would take on discovery of the fraud.
(6 marks)
(20 marks)
3. IAASB – ISA
You are a Certified Chartered Accountant who has recently begun work with the International Auditing and
Assurance Standards Board (“IAASB”). Your main responsibility is to design and develop various International
Standards on Auditing (“ISAs”).
You have received a letter from another Certified Chartered Accountant who has a similar job but works for a
national standard setter. He has written to you asking about what the IAASB does and whether the organisation
can assist him in any way with his job.
Required:
(a) Send a reply letter outlining what the main functions and roles of the IAASB are.
(5 marks)
(b) Also state how the IAASB can assist him and the national standard setter he works for in performing their
functions.
(5 marks)
(10 marks)
4. Role of auditor in corporate governance – ISA 260
Given the recent multitude of high profile and worldwide accounting scandals, there has been an increasing
push for adoption of a more stringent, uniform and global set of corporate governance regulations. This
increased emphasis on corporate governance has also placed additional importance on the function of auditing
and the work of auditors. ISA 260 deals with “the auditor’s responsibility to communicate with those charged
with governance in an audit of financial statements.”
© GTG
Question Bank: 3
Required:
(a) Explain the role that auditors play in the overall corporate governance framework.
(5 marks)
(b) Identify examples or instances of matters that auditors would be required to communicate with those
charged with governance of an entity.
(5 marks)
(10 marks)
5. Professional conduct – Cosby Travel
You work for a medium-sized firm of Chartered Certified Accountants with seven offices and 150 employees.
Your firm has been asked to tender for the provision of a statutory audit and other services to Cosby Travel, a
private company providing discounted package holiday services in the Mediterranean. The company is growing
fast and would represent a substantial amount of fee income for your firm. The finance director of Cosby Travel
has explained to you that they would like the statutory auditors to provide a number of different services. These
include the statutory audit and assistance with the preparation of the financial statements. The company is also
struggling with a new computer system and the finance director is of the opinion that a systems review by your
firm may be helpful. Your firm does not have much experience in the travel sector.
Required:
(a) Explain why it is necessary for the statutory auditors to be (and be seen as) independent of their audit
clients.
(2 marks)
(b) With reference to the ACCA's Rules of Professional Conduct, describe the ethical matters that should be
considered in deciding on whether your firm should tender for:
(i) the statutory audit of Cosby Travel.
(ii) the provision of other services to Cosby Travel
(8 marks)
(10 marks)
6. Ethics – Watson
(a) According to the ACCA’s Code of Ethics and Conduct, discuss the fundamental principles of integrity,
objectivity and independence.
(6 marks)
(b) Watson LLP is an accountancy firm based in the UK. It is the auditor for Smart Financers. Watson’s signing
partner has taken a home loan from this bank on the normal commercial terms. At the time of signing the
audit report, last year’s audit fee has still not been paid.
Required:
Does Mr. Watson face a threat to his independence?
(4 marks)
(10 marks)
7. Ethics – Stark Co
You are a manager in the audit firm of Ali & Co; and this is your first time you have worked on one of the firm’s
established clients, Stark Co. The main activity of Stark Co is providing investment advice to individuals
regarding saving for retirement, purchase of shares and securities and investing in tax efficient savings
schemes. Stark is regulated by the relevant financial services authority.
You have been asked to start the audit planning for Stark Co, by Mr. Son, a partner in Ali & Co. Mr. Son has been
the engagement partner for Stark Co, for the previous nine years and so has excellent knowledge of the client.
Mr. Son has informed you that he would like his daughter Zoe to be part of the audit team this year; Zoe is
currently studying for her first set of fundamentals papers for her ACCA qualification. Mr. Son also informs you
that Mr. Far, the audit senior, received investment advice from Stark Co during the year and intends to do the
same next year.
4: Audit Framework and Regulation
© GTG
In an initial meeting with the finance director of Stark Co, you learn that the audit team will not be entertained on
Stark Co’s yacht this year as this could appear to be an attempt to influence the opinion of the audit. Instead, he
has arranged a balloon flight costing less than one-tenth of the expense of using the yacht and hopes this will
be acceptable. The director also states that the fee for taxation services this year should be based on a
percentage of tax saved and trusts that your firm will accept a fixed fee for representing Stark Co in a dispute
regarding the amount of sales tax payable to the taxation authorities.
Required:
(a)
(i) Explain the ethical threats which may affect the auditor of Stark Co.
(6 marks)
(ii) For each ethical threat, discuss how the effect of the threat can be mitigated.
(6 marks)
(b) Discuss the benefits of Stark Co establishing an internal audit department.
(8 marks)
(20 marks)
(December 2008)
8. Audit committee and internal and external auditors – Conoy Co
(a) Contrast the role of internal and external auditors.
(8 marks)
(b) Conoy Co designs and manufactures luxury motor vehicles. The company employs 2,500 staff and
consistently makes a net profit of between 10% and 15% of sales. Conoy Co is not listed; its shares are
held by 15 individuals, most of them from the same family. The maximum shareholding is 15% of the share
capital.
The executive directors are drawn mainly from the shareholders. There are no non-executive directors because
the company legislation in Conoy Co's jurisdiction does not require any. The executive directors are very
successful in running Conoy Co, partly from their training in production and management techniques, and partly
from their 'hands-on' approach providing motivation to employees.
The board is considering a significant expansion of the company. However, the company's bankers are
concerned with the standard of financial reporting as the financial director (FD) has recently left Conoy Co. The
boards are delaying provision of additional financial information until a new FD is appointed.
Conoy Co does have an internal audit department, although the chief internal auditor frequently comments that
the board of Conoy Co do not understand his reports or provide sufficient support for his department or the
internal control systems within Conoy Co. The board of Conoy Co concurs with this view. Anders & Co, the
external auditors have also expressed concern in this area and the fact that the internal audit department
focuses work on control systems, not financial reporting. Anders & Co are appointed by and report to the board
of Conoy Co.
The board of Conoy Co is considering a proposal from the chief internal auditor to establish an audit committee.
The committee would consist of one executive director, the chief internal auditor as well as three new
appointees. One appointee would have a non-executive seat on the board of directors.
Required:
Discuss the benefits to Conoy Co of forming an audit committee.
(12 marks)
(20 marks)
(June 2009)
SECTION B
QUESTION BANK
INTERNAL AUDIT
B
9. Internal audit – JHG Pharmaceuticals Co
JHG Pharmaceuticals Co has 56 factories in different countries worldwide including the USA, Asia, the UK and
in most of the European capitals. The company is engaged in specialised research for the development of
medicines for cancer treatment. The company has an internal audit department whose staff visits the various
factories throughout the year and carries out the required activities.
JHG is facing high employee turnover in the internal audit department. During the last 4 years, at least 14
employees working in the internal audit department left the company. Furthermore, the company also
experienced problems in recruiting staff, mainly on account of the locations of many of the factories. These
factories are located far from any major city and this can make it difficult to recruit staff of the right quality.
The matter was discussed in the audit committee meeting. All the members came to a consensus that in view of
the difficulties in staff recruitment and retention faced by the internal audit department, it would be beneficial to
outsource the internal audit function.
The audit committee requested the chief internal auditor (CIA) to identify the firms which are competent and
efficient.
The CIA explained that his team had identified two firms, as being able to provide the internal audit service:
(i) Wilson Plc, the external auditors of JHG, who have offices in more than 10 countries and employ over
25,000 employees; and
(ii) Perfect Inc which specialises in accountancy and internal audit services.
Required:
(a) Discuss the advantages and disadvantages of appointing Perfect as internal auditors for JHG.
(8 marks)
(b) Discuss the issues Wilson needs to consider before it can accept the appointment as internal auditors for
JHG.
(7 marks)
(c) Assume that an outsourcing company has been chosen to provide internal audit services.
Describe the control activities that JHG should apply to ensure that the internal audit service is being
maintained at a high standard.
(5 marks)
(d) In relation to ISA 610, The Auditor’s Consideration of the Internal Audit Function, explain the factors the
external auditor should consider when evaluating the work of the internal auditor.
(5 marks)
(e) What is meant by an internal audit? Explain the matters which can be included within the scope of an
internal audit.
(5 marks)
(30 marks)
6: Internal Audit
© GTG
10. Corporate governance and audit committee – ZX
You are a recently qualified Chartered Certified Accountant in charge of the internal audit department of ZX, a
rapidly expanding company. Turnover has increased by about 20% p.a. for the last five years, to the
current level of $50 million. Net profits are also high, with an acceptable return being provided for the
four shareholders.
The internal audit department was established last year to assist the board of directors in their control of the
company and to prepare for a possible listing on the stock exchange. The Managing Director is keen to
follow the principles of good corporate governance with respect to internal audit. However, he is also
aware that the other board members do not have complete knowledge of corporate governance or detailed
knowledge of International Auditing Standards.
Required:
Write a memo to the board of ZX that:
(a) Explains how the internal audit department can assist the board of directors in fulfilling their obligations
under the principles of good corporate governance.
(10 marks)
(b) Explains the advantages and disadvantages to ZX of an audit committee.
(10 marks)
(20 marks)
(Paper 2.6 June 2005)
11. Fraud and Error
Fraud and error present risks to an entity. Both internal and external auditors are required to deal with
risks to the entity. However, the responsibilities of internal and external auditors in relation to the risk of
fraud and error differ.
Required:
(a) Explain how the internal audit function helps an entity deal with the risk of fraud and error.
(7 marks)
(b) Explain the responsibilities of external auditors in respect of the risk of fraud and error in an audit of financial
statements.
(7 marks)
Stone Holidays is an independent travel agency. It does not operate holidays itself. It takes commission on
holidays sold to customers through its chain of high street shops. Staffs are partly paid on a commission
basis.
Well-established tour operators run the holidays that Stone Holidays sells. The networked reservations
system through which holidays are booked and the computerised accounting system are both wellestablished systems used by many independent travel agencies.
Payments by customers, including deposits, are accepted in cash and by debit and credit card. Stone
Holidays is legally required to pay an amount of money (based on its total sales for the year) into a central
fund maintained to compensate customers if the agency should cease operations.
(c) Describe the nature of the risks to which Stone Holidays is subject arising from fraud and error.
(6 marks)
(20 marks)
(Paper 2.6 December 2004)
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Question Bank: 7
12. Internal audit and external audit reports
Reports produced by internal auditors are different from audit reports produced by external auditors
performing audits under International Standards on Auditing. The reports are produced for different
purposes, and are directed at different users. They differ substantially in both form and content.
Internal audit reports often comprise the following:
(i)
(ii)
(iii)
(iv)
a cover page;
executive summary;
the main report contents;
appendices.
Required:
(a) List and briefly describe the general categories of information that you would expect to find in an internal
audit report under each of the four headings above.
(4 marks)
(b) List the main contents of most external audit reports.
(4 marks)
Note: you are not required to reproduce a full external audit report.
(c) Explain why the contents of external audit reports prepared under International Standards on Auditing
and internal audit reports are different.
(4 marks)
Some reports produced by internal auditors are similar to the report to management (management letter)
on internal controls and other matters that are produced by external auditors during the course of the
audit. The steps taken by internal and external auditors in drafting, issuing and following up such reports
are also similar.
Required:
(d) Describe the common characteristics of the steps taken by internal and external auditors in producing
reports to management.
(8 marks)
(20 marks)
(Paper 2.6 June 2003)
13. Operational internal audit assignments – Cleanco
Internal auditors often assist management in performing internal review assignments covering, for example,
human resources, procurement (purchasing), marketing and treasury activities. Such reviews involve:
(i)
(ii)
(iii)
(iv)
the identification of risks;
the identification of control systems and procedures implemented to manage those risks;
tests of controls to ensure that internal controls are operating effectively;
an evaluation of the overall effectiveness of the design and operation of controls in managing the risks
identified.
You are the internal auditor for a private company, Cleanco. Cleanco provides cleaning services to shops
and offices and has a reputation for high quality work. You have been asked to review the human resources,
procurement and marketing functions within the company.
Cleanco employs about 500 cleaning staff, all of whom are on the payroll, and most of whom work part-time.
Cleanco does not employ sub-contractors. Cleanco has a high turnover of staff.
The company buys its computers, office stationery and furniture, cleaning materials, equipment and work
clothes for staff, from a variety of different suppliers. It processes its payroll in-house.
8: Internal Audit
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The company has recently decided to out-source its marketing to a large, aggressive, third party company
that will advertise Cleanco's services by means of direct mail, sometimes by offering discounts; this
company has been criticised in the past for breaching advertising regulations. There is growing price
competition in Cleanco's market. Cleanco is struggling to maintain its profitability and would like to expand
its client base.
Cleanco has three main functions:
(i) human resources;
(ii) procurement;
(iii) marketing.
Required:
For each of the three main functions at Cleanco describe the:
(a) risks that you expect the company to face;
(b) controls you expect to be in place to manage the risks you have identified in (a), above;
(c) tests of control you should perform to check that the controls you have identified in (b) above are operating
properly.
Marks will be awarded as follows:
(i) Human resources.
(8 marks)
(ii) Procurement.
(6 marks)
(iii) Marketing.
(6 marks)
You may present your answer in tabular format, if you wish.
(20 marks)
(Paper 2.6 December 2003)
14. Internal audit function – Roxy Hotels Plc
Roxy Hotels Plc is a listed company which runs a chain of some 40 hotels. The company has an established
internal audit department which is based at the head office and which makes regular visits to the hotels.
The hotels provide business and tourist class accommodation. They also provide restaurants, bars, and
conference and leisure facilities which are open to the general public as well as residents. The company
operates a computerised central booking and billing system and an inventory and asset control system, both of
which can be accessed via terminals in the hotels. Access to the system is restricted by the use of passwords
and all significant expenditure is authorised through head office. The payroll is operated through head office.
Hotel and regional managers are actively involved in the setting of budgets and cash flow forecasting. On
average, throughout the year, the chain has a 65% occupancy rate.
Required:
(a) Describe the role of internal audit in ensuring that organisations achieve their corporate objectives.
(5 marks)
(b) List the types of activities normally carried out by internal audit department.
(5 marks)
(c) Describe the areas in which the internal audit department at Roxy might check detailed transactions and
balances
(6 marks)
(d) Describe FOUR areas in which the internal audit department at Roxy might perform reviews of systems or
operational performance.
(4 marks)
(20 marks)
(Paper 2.6 December 2001)
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Question Bank: 9
15. Control weaknesses and suggested improvements – Pitman
Pitman, a privately owned incorporated business, has grown in recent years from a small manufacturing
business to a medium sized business employing over 200 hourly paid staff in the factory. In that period the
payroll system, as described below, has remained basically unchanged, except that certain routines are now
computerised.
Payroll system
(i) On Monday mornings, each employee takes a blank time card from a pile and writes his or her name and
number at the top. Each day of the week, they record their starting and finishing times. The following
Monday, each department supervisor collects the cards and forwards them to the wages clerk.
(ii) Personnel and wages records are maintained by the wages clerk on a personal computer. From the time
cards he calculates the hours worked by each employee and enters them into a payroll program on the
computer. This program, using data from personnel records as to wage rates and deductions, produces the
weekly payroll and a pay-slip for each employee.
(iii) The wages clerk prepares a cheque requisition for the total net pay for the week, which is sent to the
company accountant together with a copy of the payroll. The accountant draws up the cheque, made
payable to cash, and has it countersigned by a director. The wages clerk takes the cheque to the bank and
uses the cash to prepare the wage packets. Wage packets are given to the department supervisors for
distribution to the employees in their department as they see fit.
(iv) There is no personnel department. Each department supervisor has the authority to engage new employees
and to determine changes in wage rates with the verbal consent of a director.
As internal auditors, your firm of Chartered Certified Accountants has not considered it necessary to draw
management's attention to weaknesses in the system in previous years. When it was a small business it was
felt that the directors maintained a reasonable level of supervision over all aspects of the business and your
audit strategy in prior years was to assess control risk and to verify wages transactions by the use of
substantive procedures.
During the planning phase of the audit, it became apparent that reliance on management supervision may no
longer be sufficient. There are now too many employees for them to be personally known to the directors who,
in any event, now rarely find the time to visit the factory. Recognising this, the directors have appointed a factory
manager to oversee the day-to-day running of the factory. The factory manager's job description includes
responsibility for hiring factory staff and determining their rates of pay. Since the company is not sufficiently
large to require a separate personnel department, appropriate functions are to be assigned to the factory
manager.
The audit manager asks you to draft a note to form the basis of a management letter concerning the wages
system. She suggests that the note should identify each of the principal weaknesses of the existing system,
possible consequences if the weakness is not remedied and recommended changes that should be made
including functions to be assigned to the factory manager.
Required:
(a) Draft the note suggested by the audit manager. (You are not required to draft the management letter).
(10 marks)
(b) The audit manager also suggests that you recommend the introduction of access controls and programmed
application controls into the computer system. Further enquiries reveal that gross weekly wages never
exceed $500 for any employee and that total hours including overtime never exceed 50 hours a week. In
addition to that, increases in hourly rates of pay never exceed 10%. She also states that if such controls are
introduced we might be able to place more audit reliance on computer controls.
(i) Describe access and programmed application controls that could be included in the computer system.
(4 marks)
(ii) Explain the use of test data in verifying the computer processing of payroll, including a description of the test
data you would use.
(6 marks)
(20 marks)
10: Internal Audit
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16. Objectives of internal and external auditors – Shoe World Ltd
Shoe World Ltd is a company which sells footwear through retail outlets in seven countries. Shoe World has
almost 200 suppliers, from which it purchases shoes for men, women and children. It sells these shoes under
different brand names to its customers.
Shoe World has outsourced its internal audit function and has appointed a company that employs professionally
qualified people to conduct the internal audit on a regular basis.
Internal and external auditors may carry out the following audit procedures while discharging their duties:
(i) evaluate the internal controls over the procurement system.
(ii) assess the operations of the marketing department
(iii) visit all the stores on a rotational basis. The visits are timed to coincide with the year end inventory count.
One of the directors has questioned the need for internal auditors to carry out these procedures, considering
that the external auditors are already performing the tasks.
Required:
As a student of the ACCA discuss the objectives of internal and external auditors in carrying out the above
mentioned audit procedures.
(10 marks)
17. Internal audit department and outsourcing - MonteHodge Co
(a) Discuss the advantages and disadvantages of outsourcing an internal audit department.
(8 marks)
(b) MonteHodge Co has a sales income of $253 million and employs 1,200 people in 15 different locations.
MonteHodge Co provides various financial services from pension and investment advice to individuals, to
maintaining cash books and cash forecasting in small to medium-sized companies. The company is owned
by six shareholders, who belong to the same family; it is not listed on any stock-exchange and the
shareholders have no intention of applying for a listing. However, an annual audit is required by statute and
additional regulation of the financial services sector is expected in the near future.
Most employees are provided with on-line, real-time computer systems, which present financial and stock
market information to enable the employees to provide up-to-date advice to their clients. Accounting systems
record income, which is based on fees generated from investment advice. Expenditure is mainly fixed, being
salaries, office rent, lighting and heating, etc. Internal control systems are limited; the directors tending to trust
staff and being more concerned with making profits than implementing detailed controls.
Four of the shareholders are board members, with one member being the chairman and chief executive officer.
The financial accountant is not qualified, although has many years experience in preparing financial statements.
Required:
Discuss the reasons for and against having an internal audit department in MonteHodge Co.
(12 marks)
(20 marks)
(June 2008)
SECTION C
QUESTION BANK
PLANNING AND RISK
ASSESSMENT
C
18. Audit Plan – Bridgeford Products Plc
Your firm has been the auditor of Bridgeford Products Plc, a listed company, for a number of years. The
engagement partner has asked you to describe the matters you would consider when planning the audit for the
year ended 31 January 20X9.
During a recent visit to the company, you obtained the following information:
(a) The management accounts for the 10 months to 30 November 20X8 show sales of $130 million and profit
before tax of $4 million. Assume sales and profits accrue evenly throughout the year. In the year ended 31
January 20X8, Bridgeford had sales of $110 million and profit before tax of $8 million.
(b) The company installed a new computerised inventory control system which has operated from 1 June 20X8.
As the inventory control system records inventory movements and current inventory quantities, the company
is proposing:
¾ to use the inventory quantities on the computer to value the inventory at the year end, and
¾ not to carry out an inventory count at the year end
(c) You are aware there have been reliability problems with the company’s products, which have resulted in
legal claims brought against the company by customers, and customers refusing to pay for the products.
(d) The sales increase in the 10 months to 30 November 20X8 over the previous year has been achieved by
attracting new customers and by offering extended credit. The new credit arrangements allow customers
three months credit before their debt becomes overdue, rather than the one month credit period allowed
previously. As a result of this change, the receivables age has increased from 1.6 to 4.1 months.
(e) The chief financial officer (CFO) and purchasing manager were dismissed on 15 August 20X8. A
replacement purchasing manager has been appointed but it is not expected that a new CFO will be
appointed before the year end of 31 January 20X9. The chief accountant will be responsible for preparing
the financial statements for audit.
Required:
(i) In the above scenario, describe the reasons why it is important that the auditors should plan their audit
work. Briefly explain your general strategy while planning the audit of Bridgeford.
(10 marks)
(ii) Describe the matters you will consider in planning the audit and the further action you will take concerning
the matters listed in (1) to (5) above.
(15 marks)
(iii) Why is the documentation of working papers including audit plan necessary?
(5 marks)
(30 marks)
12: Planning and Risk Assessment
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19. Knowledge of business – Earn & Co
Jane, a trainee, has joined an audit firm, Earn & Co. She has been given her first audit assignment and has
been sent to the client with a senior auditor. She has a few doubts which she wants her senior auditor to clear.
Requirements:
(a) What is meant by knowledge of the business?
(2 marks)
(b) Why is knowledge of the business important to the auditor and the members of the audit staff working on an
engagement?
(3 marks)
(c) Why is it relevant to all phases of an audit?
(5 marks)
(d) What are the various sources by which an auditor can obtain knowledge of the client’s business?
(5 marks)
(e) What are the different factors to be considered while developing an audit plan?
(5 marks)
(20 marks)
20. Analytical procedures and materiality
(a) Analytical procedures are an important and powerful tool for auditors for explaining the performance of a
business. They are used at the planning, testing and review stages of the audit.
Required:
Preliminary analytical procedures are often performed on accounting ratios. Explain the possible reasons for the
following changes found at the planning stage of the audit:
(i)
(ii)
(iii)
(iv)
(v)
an increase in the current ratio;
a decrease in the gross profit margin;
an increase in the inventory holding period;
an increase in dividend cover;
an increase in capital gearing (leverage)
(10 marks)
Note: no marks will be awarded for showing the calculation of the ratios, all parts carry equal marks.
(b) The concept of materiality is fundamental to the work of auditors. Matters that are immaterial are not
reported in financial statements.
Required:
(i) Explain the concept of materiality;
(4 marks)
(ii) Describe how materiality affects the audit work performed by auditors;
(4 marks)
(iii) Give an example of qualitative materiality.
(2 marks)
(20 marks)
(Paper 2.6 June 2002)
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Question Bank: 13
21. Extent of reliance on the work of internal auditors
Your firm is the newly appointed external auditor to a large company that sells, maintains and leases office
equipment and furniture to its customers and you have been asked to co-operate with the internal auditors to
keep total audit costs down. The company wants the external auditors to rely on some of the work already
performed by the internal auditors.
The internal auditors provide the following services to the company:
(i) a cyclical audit of the operation of internal controls in the company's major functions (operations, finance,
customer support and information services),
(ii) a review of the structure of internal controls in each major function every four years,
(iii) an annual review of the effectiveness of measures put in place by management to minimise the major risks
facing the company.
During the current year, the company has gone through a major internal restructuring in its information services
function and the internal auditors have been closely involved in the preparation of plans for restructuring, and in
the related post-implementation review.
Required:
(a) Explain the extent to which your firm will seek to rely on the work of the internal auditors in each of the
areas noted above.
(6 marks)
(b) Describe the information your firm will seek from the internal auditors in order to determine the extent of
your reliance.
(6 marks)
(c) Describe the circumstances in which it would not be possible to rely on the work of the internal auditors.
(4 marks)
(d) Explain why it will be necessary for your firm to perform its own work in certain audit areas in addition to
relying on the work performed by the internal auditors.
(4 marks)
(20 marks)
(Paper 2.6 June 2003)
22. Audit risk – Quench Cola
Quench Cola is a beverage company producing cold drinks on a large scale and making them available
throughout the country. The company has warehouses in four regions where the stock is maintained and then
distributed to its regional sales offices. The company has a computerised environment and its staff have
computer knowledge. Previous audits have shown that there is a good system of internal control in place. Fiona
is the auditor of Quench Cola.
This year, sales have been affected by two major law suits, which have been reported in the news, between a
rival company and a consumer regarding the ingredients of the cold drinks and which the consumer claimed
were harmful. Quench Cola has spent a lot of money on marketing and promotion of sales, but this has not
given the desired results. For sales promotion it has relied on the marketing manager who has been working
with the company since its incorporation. There is a possibility that the government may impose a ban on the
production and sale of cold drinks of the type produced by Quench Cola.
Required:
(a) Explain what is meant by the term audit risk, and describe its components and their impact on Quench Cola.
(8 marks)
(b) Suppose the inherent risk is 0.10, the control risk is 0.10 and the detection risk is 0.20. What is the audit
risk? What is the assurance that Fiona will be able to give to the users of financial statements?
(2 marks)
(10 marks)
14: Planning and Risk Assessment
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23. Audit risk and control environment – EuKaRe charity
(a) Explain the term ‘audit risk’ and the three elements of risk that contribute to total audit risk.
(4 marks)
The EuKaRe charity was established in 1960. The charity’s aim is to provide support to children from
disadvantaged backgrounds who wish to take part in sports such as tennis, badminton and football. EuKaRe
has a detailed constitution which explains how the charity’s income can be spent. The constitution also notes
that administration expenditure cannot exceed 10% of income in any year. The charity’s income is derived
wholly from voluntary donations.
Sources of donations include:
(i) Cash collected by volunteers asking the public for donations in shopping areas,
(ii) Cheques sent to the charity’s head office,
(iii) Donations from generous individuals.
Some of these donations have specific clauses attached to them indicating that the initial amount donated
(capital) cannot be spent and that the income (interest) from the donation must be spent on specific activities,
for example, provision of sports equipment.
The rules regarding the taxation of charities in the country EuKaRe is based are complicated, with only certain
expenditure being allowable for taxation purposes and donations of capital being treated as income in some
situations.
Required:
(b) Identify areas of inherent risk in the EuKaRe charity and explain the effect of each of these risks on the audit
approach.
(12 marks)
(c) Explain why the control environment may be weak at the charity EuKaRe.
(4 marks)
(20 marks)
(December 2008)
24. Analytical procedures – Zak Co
(a) With reference to ISA 520 Analytical Procedures explain:
(i) what is meant by the term 'analytical procedures';
(2 marks)
(ii) the different types of analytical procedures available to the auditor; and
(3 marks)
(iii) the situations in the audit when analytical procedures can be used.
(3 marks)
Zak Co sells garden sheds and furniture from 15 retail outlets. Sales are made to individuals, with income
being in the form of cash and debit cards. All items purchased are delivered to the customer using Zak's
own delivery vans; most sheds are too big for individuals to transport in their own motor vehicles. The
directors of Zak indicate that the company has had a difficult year, but are pleased to present some
acceptable results to the members.
© GTG
Question Bank: 15
The income statements for the last two financial years are shown below:
Income statement
Revenue
31-Mar-2010
31-Mar-2009
$000
$000
7,482
6,364
(3,520)
(4,253)
3,962
2,111
(1,235)
(1,320)
Selling and distribution
(981)
(689)
Interest payable
(101)
(105)
145
-
1,790
(3)
253
(950)
Cost of sales
Gross profit
Operating expenses
Administration
Investment income
Profit / (loss) before tax
Financial statement extract
Cash and bank
Required:
(b) As part of your risk assessment procedures for Zak Co, identify and provide a possible explanation for
unusual changes in the income statement.
(9 marks)
(c) Confirmation of the end of year bank balances is an important audit procedure.
Required:
Explain the procedures necessary to obtain a bank confirmation letter from Zak Co's bank.
(3 marks)
(20 marks)
(Adapted from June 2008)
25. Audit documentation – Specs4You Co
ISA 230 Audit Documentation (Revised) establishes standards and provides guidance regarding documentation
in the context of the audit of financial statements.
Required:
(a) List the purposes of audit working papers.
(3 marks)
(b) You have recently been promoted to audit manager in the audit firm of Trums & Co. As part of your new
responsibilities, you have been placed in charge of the audit of Specs4You Co, a long established audit
client of Trums & Co. Specs4You Co sells spectacles; the company owns 42 stores where customers can
have their eyes tested and choose from a range of frames.
Required:
List the documentation that should be of assistance to you in familiarising yourself with Specs4You Co.
Describe the information you should expect to obtain from each document.
(8 marks)
16: Planning and Risk Assessment
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(c) The time is now towards the end of the audit, and you are reviewing working papers produced by the audit
team.
An example of a working paper you have just reviewed is shown below.
Client Name: Specs4You Co
Working paper Payables transaction testing
Year end 30 April
Page xxxxxxx
Prepared by
Reviewed by CW
Date
Date 12 June 2009
Audit assertion: To make sure that the purchases day book is correct
Method: Select a sample of 15 purchase orders recorded in the purchase order system. Trace details to the
goods received note (GRN), purchase invoice (PI) and the purchase day book (PDB) ensuring that the
quantities and prices recorded on the purchase order match those on the GRN, PI and PDB.
Test details: In accordance with audit risk, a sample of purchase orders were selected from a numerically
sequenced purchase order system and details traced as stated in the method. Details of items tested can be
found on another working paper.
Results: Details of purchase orders were normally correctly recorded through the system. Five purchase orders
did not have any associated GRN, PI and were not recorded in the PDB. Further investigation showed that
these orders had been cancelled due to a change in spectacle specification. However, this does not appear to
be a system weakness as the internal controls do not allow for changes in specification.
Conclusion: Purchase orders are completely recorded in the purchase day book.
Required:
Explain why the working paper shown above does not meet the standards normally expected of a working
paper.
Note: you are not required to reproduce the working paper.
(9 marks)
(20 marks)
(Adapted from June 2007)
26. Understanding the entity, its environment and risk assessment - Rock
You are an audit senior responsible for understanding the entity and its environment and assessing the risk of
material misstatements for the audit of Rock for the year ending 31 December 20Y0. Rock is a company listed
on a stock exchange. Rock is engaged in the wholesale import, manufacture and distribution of basic cosmetics
and toiletries for sale to a wide range of stores, under a variety of different brand names. You have worked on
the audit of this client for several years as an audit junior.
Required:
(a) Describe the information you will seek, and procedures you will perform in order to understand the entity
and its environment and assess risk for the audit of Rock for the year ending 31 December 20Y0.
(10 marks)
(December 2004)
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Question Bank: 17
27. Audit strategy, audit risks, tests of control, substantive procedures and analytical
procedures – B- Star
Background information
B-Star is a theme park based on a popular series of children’s books. Customers pay a fixed fee to enter the
park, where they can participate in a variety of activities such as riding roller-coasters, playing on slides and
purchasing themed souvenirs from gift shops.
The park is open all year and has been in operation for the last seven years. It is located in a country which has
very little rainfall - the park is open-air so poor weather such as rain results in a significant fall in the number of
customers for that day (normally by 50%). During the last seven years there have been on average 30 days
each year with rain.
B-Star is now very successful; customer numbers are increasing at approximately 15% each year.
Ticket sales
Customers purchase tickets to enter the theme park from ticket offices located outside the park. Tickets are only
valid on the day of purchase. Adults and children are charged the same price for admission to the park. Tickets
are preprinted and stored in each ticket office.
Tickets are purchased using either cash or credit cards.
Each ticket has a number comprising of two elements - two digits relating to the ticket office followed by six
digits to identify the ticket. The last six digits are in ascending sequential order.
Cash sales
1. All ticket sales are recorded on a computer showing the amount of each sale and the number of tickets
issued. This information is transferred electronically to the accounts office.
2. Cash is collected regularly from each ticket office by two security guards. The cash is then counted by two
accounts clerks and banked on a daily basis.
3. The total cash from each ticket office is agreed to the sales information that has been transferred from each
office.
4. Total cash received is then recorded in the cash book, and then the general ledger.
Credit card sales
1. Payments by credit cards are authorised online as the customers purchase their tickets.
2. Computers in each ticket office record the sales information which is transferred electronically to the
accounts office.
3. Credit card sales are recorded for each credit card company in a receivables ledger.
4. When payment is received from the credit card companies, the accounts clerks agree the total sales values
to the amounts received from the credit card companies, less the commission payable to those companies.
The receivables ledger is updated with the payments received.
You are now commencing the planning of the annual audit of B-Star. The date is 3 June 2009 and B-Star’s year
end is 30 June 2009.
Required:
(a) List and explain the purpose of the main sections of an audit strategy document and for each section,
provide an example relevant to B-Star.
(8 marks)
(b)
(i) For the cash sales system of B-Star, identify the risks that could affect the assertion of completeness of
sales and cash receipts;
(4 marks)
(ii) Discuss the extent to which tests of controls and substantive procedures could be used to confirm the
assertion of completeness of income in B-Star.
(6 marks)
18: Planning and Risk Assessment
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(c)
(i) List the substantive analytical procedures that may be used to give assurance on the total income from
ticket sales for one day in B-Star;
(ii) List the substantive analytical procedures that may be used to give assurance on the total income from
ticket sales in B-Star for the year.
(8 marks)
(d) List the audit procedures you should perform on the credit card receivables balance.
(4 marks)
(30 marks)
(June 2009)
28. Fraud, substantive procedures on inventory valuation and ethics – Tye Co
One of your audit clients is Tye Co, a company providing petrol, aviation fuel and similar oil based products to
the government of the country it is based in. Although the company is not listed on any stock exchange, it does
follow best practice regarding corporate governance regulations. The audit work for this year is complete, apart
from the matter referred to below.
As part of TyeCo's service contract with the government, it is required to hold an emergency inventory reserve
of 6,000 barrels of aviation fuel. The inventory is to be used if the supply of aviation fuel is interrupted due to
unforeseen events such as natural disaster or terrorist activity.
This fuel has in the past been valued at its cost price of $15 a barrel. The current value of aviation fuel is $120 a
barrel. Although the audit work is complete, as noted above, the directors of Tye Co have now decided to show
the 'real' value of this closing inventory in the financial statements by valuing closing inventory of fuel at market
value, which does not comply with relevant accounting standards. The draft financial statements of Tye Co
currently show a profit of approximately $500,000 with net assets of $170 million.
Required:
(a) List the audit procedures and actions that you should now take in respect of the above matter.
(6 marks)
(b) For the purposes of this section assume from part (a) that the directors have agreed to value inventory at
$15/barrel.
Having investigated the matter in part (a) above, the directors present you with an amended set of financial
statements showing the emergency reserve stated not at 6,000 barrels, but reported as 60,000 barrels. The final
financial statements now show a profit following the inclusion of another 54,000 barrels of oil in inventory. When
queried about the change from 6,000 to 60,000 barrels of inventory, the finance director stated that this change
was made to meet expected amendments to emergency reserve requirements to be published in about six
months time. The inventory will be purchased this year, and no liability will be shown in the financial statements
for this future purchase. The finance director also pointed out that part of TyeCo's contract with the government
requires Tye Co to disclose an annual profit and that a review of bank loans is due in three months. Finally the
finance director stated that if your audit firm qualifies the financial statements in respect of the increase in
inventory, they will not be recommended for re-appointment at the annual general meeting. The finance director
refuses to amend the financial statements to remove this 'fictitious' inventory.
Required:
(i) State the external auditor's responsibilities regarding the detection of fraud;
(4 marks)
(ii) Discuss to which groups the auditors of Tye Co could report the 'fictitious' aviation fuel inventory;
(6 marks)
(iii) Discuss the safeguards that the auditors of Tye Co can use in an attempt to overcome the intimidation
threat from the directors of Tye Co.
(4 marks)
(20 marks)
(June 2009)
29. Auditor’s objective and professional scepticism
(a) Explain the general objectives of an auditor.
5 marks
(b) Explain five instances when an auditor needs to maintain professional scepticism.
5 marks
(10 marks)
SECTION D
QUESTION BANK
INTERNAL CONTROL
D
30. Substantive procedures and tests of controls – Atlantis Standard Goods
(a) Explain the control objectives for ordering, despatching and invoicing goods.
(8 marks)
(b) Atlantis Standard Goods (ASG) Co has a year end at 30 June 20X8. ASG retails sports and fitness
equipment like treadmills, racquets, and footballs. All sales are made via the company’s internet site. ASG’s
vehicles are used to despatch and deliver goods to the customers’ homes. Goods are purchased from
different manufacturers.
The process of making a sale is as follows:
(i) Potential customers visit ASG’s website and select an item of their choice. The website ordering system
accesses the inventory specification file to obtain details of the products that ASG sells.
(ii) When the customer chooses an item, the order information, including the price, item and quantity required
are stored in the orders pending file.
(iii) Online authorisation of the credit card details is obtained from the customer’s credit card company
automatically by ASG’s computer systems.
(iv) Following authorisation, the sales amount is transferred to the computerised sales day book. At the end of
each day the total from this ledger is transferred to the general ledger.
(v) Each month, reimbursement of the sales amount, less the appropriate commission charged by the credit
card company, is obtained from each credit card company.
(vi) Following authorisation of the credit card, order details are transferred to a goods awaiting despatch file and
allocated a unique order reference code. Order details are automatically transferred to the despatch
department’s computer system.
(vii) In the despatch department, goods are obtained from the physical inventory, packed, placed on ASG
vehicles and the computerised inventory system is updated. Order information is downloaded on a hand
held computer with a writable screen.
(viii) On delivery, the customer signs for the goods on the hand held computer. On return to ASG’s warehouse,
images of the customer signature are uploaded to the orders file, which is then flagged as ‘order complete’.
This year’s audit planning documentation states that a substantive approach will be taken on the audit.
Required:
Tabulate the audit tests you should carry out on the sales and despatch system, explaining the reason for each
test.
(15 marks)
(c) Differentiate between substantive procedures and tests of controls.
(4 marks)
(d) Describe the audit evidence provided by the direct confirmation of receivables and the alternative audit
evidence available when direct confirmation is not provided.
(3 marks)
(30 marks)
(Adapted from Paper 2.6 June 2006)
20: Internal Control
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31. Evaluation of internal control systems – Healthline
Healthline is a private hospital run in partnership by four surgeons. It employs twelve doctors, sixteen nurses,
six laboratory technicians, one manager and three clerks. The clerks manage the activities at the reception
counter such as billing, cash receipts, bank deposits, correspondence, accounts receivables and appointment
scheduling.
For patients who have medical insurance, the office manager verifies the insurance cover and communicates it
to the clerk. Nearly 75% of the hospital’s patients have insurance cover.
In respect of those patients who do not have insurance cover, most make payments by cash, cheque or credit
card when the services of the hospital are received. The office manager has the authority to extend credit to
patients on a case-to-case basis, and this is done for around 8% of the patients.
When services are rendered to each patient, the attending doctor records the nature of the services on a prenumbered service slip. The slip is handed over to Clerk 1 who enters the amounts payable for each service and
arrives at the total value of the services rendered. The slip is then handed over to the patient and a copy of the
slip is handed over to Clerk 2 who carries out either of the following functions for each patient:
(i) For patients who have insurance cover:
¾ the clerk obtains the approval of the office manager on the slip to confirm the patient’s insurance cover.
¾ the clerk files the insurance claim and records the amount receivable from the insurance company.
(ii) For patients who do not have insurance cover:
¾ if the office manager has approved credit, the clerk records the amount as receivable from the patient; or
¾ for patients who pay by cash, cheque or credit card, clerk 2 receives the payment from the patient and
records the receipt when the patient leaves the hospital.
At the end of each day, Clerk 2 prepares a summary of revenue. All the transactions are recorded in the
computer.
Clerk 1 opens the incoming mail, receives the cheques from the insurance companies and patients and hands
them over to Clerk 2 for deposit.
Clerk 2 posts the receipt of the cheques on the patients’ accounts receivable and the insurance companies’
receivable accounts. Clerk 1 hands over mail that requires correspondence to Clerk 3.
Clerk 2 stamps all cheques with “Account payee only” and prepares a list containing details of cheques and
cash to be deposited into the bank each day. Clerk 2 also receives cheques and cash from patients directly.
These cheques / cash are also included in the list prepared. Clerk 2 keeps a copy of the list and gives the
original to Clerk 3.
Clerk 3 personally deposits the payments in the bank and maintains a file containing the list of daily bank
deposits. Clerk 3 also maintains the list of patients whose insurance coverage has been verified by the
manager. The clerk is also involved in scheduling patient appointments and also handles all types of
correspondence.
When insurance claims or patients’ receivables are not settled within 60 days, Clerk 2 informs the office
manager. The office manager personally inspects the details of each case of non-payment. He also authorises
additions to the patients’ receivable accounts for any amounts of insurance claims that were rejected by the
insurance company. Then Clerk 2 adds these amounts to the patients’ receivables and deletes them from the
insurance companies’ receivable accounts.
For patients without insurance cover, Clerk 2 deletes the patients’ receivables which appear uncollectible after
obtaining approval from the manager. Clerk 2 prepares a list of uncollectible receivables and hands it over to
Clerk 3, who does not allow these patients to make appointments in future.
In the case of payments to be made for expenses, all cheques are authorised by the partners.
Once a month, an external accountant posts Clerk 2’s daily revenue summaries to the general ledger, prepares
the monthly trial balance and financial statements and also accounts for the pre-numbered service slips. He also
files payroll forms, tax returns and reconciles monthly bank statements to the general ledger. This accountant
directly reports to the partners of the hospital.
The computers used by the clerks are connected through a local area network. Each computer is accessible by
a password, known only to the concerned clerk and the partners. The hospital uses standard software which
cannot be modified.
© GTG
Question Bank: 21
Required:
(a) Describe the strengths in the internal controls of the hospital, which the auditor can consider while
assessing the control risk.
(5 marks)
(b) Describe the weaknesses in the internal controls which can lead to material misstatements in the financial
statements. In addition, suggest internal control measures that could help to correct the weaknesses.
(20 marks)
(c) The communication of inaccuracies, redundancies and weaknesses in the internal control system is made
by means of a letter known as a letter of weakness. Explain the points usually contained in a letter of
weakness.
(5 marks)
(30 marks)
32. Internal control procedures – Bardwell
Bardwell is a privately owned incorporated business that operates a garage which repairs and services motor
vehicles. Most customers are required to pay by cash or cheque on collecting their vehicle. Credit accounts are
available to business customers. These customers sign the invoice on collection of the vehicle and their
business is billed monthly. Separate series of pre-numbered invoices are drawn up by the foreman for cash
sales and for credit sales. All customer accounts are maintained by the receptionist. His duties include the
following:
Cash sales
Collect cash or cheques from customers on collecting their vehicle.
At the end of the day, check the numerical sequence of cash sales invoices, add the sales total and agree the
total to the amount of cash and cheques received. Record the total cash sales in the cash receipts book.
Credit sales
Obtain the customer's signature on the copy invoice of business account customers. Enter the invoices in
numerical sequence in the sales journal and post the customer's account in the accounts receivable ledger.
Send monthly statements to credit account customers and follow up overdue accounts. List the balances on the
accounts receivable ledger at the end of the month and reconcile the total with the control account in the
general ledger. Write off uncollectible balances to bad debts.
Cash receipts
Open the mail, extract cheques from credit account customers, record them in the cash receipts book and post
the accounts receivable ledger. Make up the day's banking of cash (and cheques) from both cash and credit
sales, prepare the deposit slip and bank the cash (and cheques). All other accounting duties are the
responsibility of two further accounts clerks and all are subject to supervision by the garage manager.
Required:
(a)
(i) Explain why the functions assigned to the receptionist result in an inadequate segregation of duties. Your
explanation should identify misstatements that could occur and indicate how those duties could be
reassigned to other staff members;
(8 marks)
(ii) Identify other control procedures you would consider necessary to ensure the completeness of the recorded
cash receipts and accounts receivable.
(4 marks)
(b) As a member of the audit staff of the company's external auditors, you visit the garage and make a count of
cash on hand. You subsequently compare details of unbanked cash receipts that you counted with the entry
in the cash receipts book for that date. Although the total in the cash receipts book is the same, the amount
of banknotes and coins is less and there is a cheque from a business customer that had not been recorded.
Required:
(i) Explain the procedures to be followed in making a cash count for audit purposes;
(4 marks)
(ii) Explain the irregularity that the discrepancy between the cash count and cash receipts book might lead you
to suspect, and describe how you would investigate the discrepancy.
(4 marks)
(20 marks)
(Paper 2.6 June 2001)
22: Internal Control
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33. Objective of audit evidence: Test of control / substantive procedure – Gordon
ISA 500 Audit Evidence provides a framework for evaluating the role of evidence in forming an opinion.
Amongst other matters it:
(i)
describes the objectives of audit evidence as being either to test controls or provide substantive evidence.
Tests of controls are further analysed into tests of design and tests of operation. Substantive procedures
are classified as tests of details of transactions, tests of details of balances and analytical procedures;
(ii) identifies financial statement assertions to which evidence relates; and
(iii) discusses the reliability of different kinds of evidence.
The following procedures appear in the accounts payable audit program for Gordon, a listed company.
(i) Select a sample of purchase transactions recorded in the purchase journal during the year and vouch them
to suppliers' invoices.
(ii) Observe the goods received clerk accepting delivery of goods.
(iii) Check the numerical continuity of a sequence of goods received notes and trace them to suppliers' invoices
and to the entry in the purchase journal.
(iv) Select a sample of purchase invoices and see that they have been initialled as being agreed to the goods
received note and to the purchase order.
(v) Consider the reasonableness of the relationship between the year-end accounts payable balance and the
total of credit purchases during the year.
(vi) Add the list of account payable' balances and agree the total to the control account in the general ledger.
(vii) Enquire into the procedures used to ensure the reliability of cut-off.
Required:
For each procedure (2) to (7) inclusive:
(a) Identify its principal objective;
(3 marks)
(b) Explain its objective in terms of the account balance or transaction class involved and the financial
statement assertion(s) to which the evidence principally relates;
(8 marks)
(c) Discuss the reliability of the evidence obtained.
(9 marks)
(20 marks)
(Paper 2.6 June 2001)
34. Internal control systems of receivables
There are many reasons for maintaining internal control systems. These include the need to ensure that:
(i)
(ii)
(iii)
(iv)
transactions are properly authorised
transactions are promptly and accurately recorded
access to assets and records is properly authorised
recorded assets represent actual assets
In the absence of internal controls, errors, omissions and misappropriation of assets are likely, and external and
internal auditors pay particular attention to both the design and operation of internal control systems. Receivable
is an area in which most organisations expect internal controls to be operating effectively.
© GTG
Question Bank: 23
Required:
(a) In the context of receivables, list and describe the types of error, omission and misappropriation of assets
that can occur in practice where internal controls are weak or non-existent.
(4 marks)
(b) Explain why even a good system of internal control will not necessarily prevent or detect errors, omissions
and the misappropriation of assets in a receivables system, and explain why a good system of internal
control is important to auditors.
(4 marks)
(c) List the main internal controls that you would expect to be in operation in the receivables system at a small
manufacturing company with a computerised accounting system.
(9 marks)
(d) Explain why external auditors seek to rely on the proper operation of internal controls wherever possible.
(3 marks)
(20 marks)
(Paper 2.6 December 2001)
35. Perpetual Inventory – Pyrmont
For several years Pyrmont, a listed company, has maintained perpetual inventory records at each of its ten shoe
shops. Nevertheless, it has continued to determine closing inventory by physical count at or near period end. As
the senior in charge of Pyrmont’s external audit for the year ending 31 December 20X8, you are in the process
of planning the audit. In discussions with the company's chief accountant she informs you that the company is
intending to dispense with the annual physical inventory and to rely on the perpetual records in determining
closing inventory.
The company operates a centralised computer system networked to terminals and point of sale registers in
each shop. Last year's audit file indicates that control risks over purchase and sale transactions were assessed
as low for occurrence, completeness and measurement assertions. However, the control risk assessment did
not extend to the recording of sale and purchase transactions into the inventory records since inventory was
determined by physical count. The description of the accounting system shows inventory as being delivered
directly to each shop. The manufacturers attach a bar-coded tag to each pair of shoes. On delivery, shop
personnel physically check each pair of shoes with the description coded on the tag. They then scan the tags.
The networked computer verifies the goods against the order and records them on the shop's inventory. At the
point of sale the tag is again scanned which both, records the sale and removes the item from inventory
records.
During the past year the company's computing department has rewritten the inventory control system to
incorporate inventory costs as well as quantities. The computer system now records cost at the point of delivery;
on sale, the computer determines cost of sale on a first in first out (FIFO) basis and recalculates the cost of
inventory on hand at each shop.
Required:
(a)
(i) Describe the control procedures you would need to identify in order to accept book inventory as the basis
for determining the quantity of inventory on hand at period end.
(5 marks)
(ii) Describe how you would test those controls.
(3 marks)
Assuming your assessment of control risk over recorded inventory is sufficiently low for you to plan substantive
procedures that do not require observation of inventory count at or near the year end.
(b) Describe the substantive procedures you would perform, both during the year and as at the year end, in
order to verify the completeness and existence of inventory.
(8 marks)
(c) State the systems development controls you would expect to find applied to the rewriting of the inventory
control system
(4 marks)
(20 marks)
(Paper 2.6 June 1999)
24: Internal Control
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36. Internal controls – Coolex
Coolex manufactures air conditioners. The company supplies its products to its dealers who, in turn, sell the
products to the customers. The market is highly competitive, so the company has to incur heavy costs on
advertisements.
The company receives its payments through bills of exchange. The bills are sometimes discounted subject to
the needs of the company.
Required:
(a) List the control activities which are required to be in place with respect to:
(i) advertisement expenses; and
(5 marks)
(ii) contingent liabilities.
(5 marks)
(b) List the tests of controls which the auditors of the company would perform to ensure the financial
statements are true and fair with respect to:
(i) advertisement expenses; and
(5 marks)
(ii) contingent liabilities.
(5 marks)
(20 marks)
37. Internal control systems – The Royal Club
Mr. John is the external auditor of the Royal Club. The club maintains its accounts on a cash basis. Mr. John
wants to ensure that there are sufficient internal controls in the following areas of the club’s cash operations so
that cash and cheques received are properly paid into the club’s account.
(i)
Cash is received from the members and their guests at the following nine venues: reception, smoking bar,
non-smoking bar, swimming pool, billiards hall, table tennis court, lawn tennis court, boating club and
cafeteria.
(ii) All staff members working at these venues work in shifts as the club is open until midnight. Computer
entries can be made only at the reception, cafeteria, smoking bar and non-smoking bar.
(iii) The member and guest entry fees are received at the reception. As Royal Club has several different
venues, bills are raised manually at those venues, according to the rate card. Cash received at these
venues is entered into the computer or bills are raised manually, a receipt is issued to the member and a
copy of the receipt is retained by the attendant. When his shift is over, he prints out a cash memo, which
shows the number of receipts during his shift or makes a summary manually from the manual bill book. He
then hands over the copies of cash receipts and the cash collected to the cashier. The cashier verifies the
cash with the documents received.
(iv) Cash received from all venues is deposited by the cashier in the bank daily. For petty cash expenses and
other expenses the cashier places a requisition with the head of the department estimating the costs to be
incurred, the daily routine expenses and the amounts to be withdrawn from the bank. The maximum
withdrawal which the head of the department can authorise at any one time is $3,000. An amount greater
than $3,000 requires the approval of the managing committee.
(v) The person preparing the receipts through the computer can neither delete the receipt nor make changes to
the receipt after it is prepared. Any changes or deletions required on computerised receipts can be carried
out by the accounts officer, after authorisation by the head of the department.
(vi) Manual receipts are not perforated but sequentially pre-numbered. A receipt book with carbon copies is
maintained.
(vii) Internal audit is carried out by an internal auditor appointed by the audit committee. The internal audit report
states that cash in transit is not under insurance cover and cash received during organised events such as
flower decoration, fêtes, Christmas and New Year parties etc. does not have effective controls. Manual
receipts are made during these events at the entrance of the club.
(viii) The club maintains a query file in which it records all the queries of the members regarding accounting
errors, mistakes or grievances. Mostly the grievances were regarding the 2% administrative charges levied
on their outstanding balances in cases where they exceeded the time limit for credit given by the club.
© GTG
Question Bank: 25
Required:
(a) How will Mr. John identify weaknesses in the internal control system?
(10 marks)
(b) State the importance of an effective internal control system to the auditor in the context of Royal Club.
(10marks)
(20 marks)
38. General Controls – Chef Kitchenware
Chef Kitchenware manufactures kitchen utensils such as cutters, plates, dishes, bowls, serving trays, spoons
etc. Recently they attended a catering exhibition where their products proved very popular. As a result they
have received a good finance offer which will enable them to launch their products on a bigger scale and to
install a computerised accounting and administrative system. They have appointed Graham as the auditor to set
up the general controls for the new IT system.
Required:
Explain the general IT controls that Graham should set for Chef Kitchenware.
(10 marks)
39. Purchase system and inventory counting – DinZee Co
DinZee Co assembles fridges, microwaves, washing machines and other similar domestic appliances
from parts procured from a large number of suppliers. As part of the interim audit work two weeks prior
to the company year-end, you are testing the procurement and purchases systems and attending the
inventory count.
Procurement and purchases system
Parts inventory is monitored by the stores manager. When the quantity of a particular part falls below reorder level, an e-mail is sent to the procurement department detailing the part required and the quantity
to order. A copy of the e-mail is filed on the store manager's computer.
Staffs in the procurement department check the e-mail, allocate the order to an authorised supplier and send
the order to that supplier using Electronic Data Interchange (EDI). A copy of the EDI order is filed in the order
database by the computer system. The order is identified by a unique order number.
When goods are received at DinZee, the stores clerk confirms that the inventory agrees to the delivery note
and checks the order database to ensure that the inventory were in fact ordered by DinZee. (Delivery
is refused where goods do not have a delivery note.)
The order in the order database is updated to confirm receipt of goods, and the perpetual inventory
system updated to show the receipt of inventory. The physical goods are added to the parts store and the
paper delivery note is stamped with the order number and is filed in the goods inwards
department.
The supplier sends a purchase invoice to DinZee using EDI; invoices are automatically routed to the
accounts department. On receipt of the invoice, the accounts clerk checks the order database, matches the
invoice details with the database and updates the database to confirm receipt of invoice. The invoice is
added to the purchases database, where the purchase day book (PDB) and suppliers individual
account in the payables ledger are automatically updated.
Required:
(a) List SIX audit procedures that an auditor would normally carry out on the purchases system at DinZee Co,
explaining the reason for each procedure.
(12 marks)
(b) List FOUR audit procedures that an auditor will normally perform prior to attending the client's premises on
the day of the inventory count.
(2 marks)
26: Internal Control
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(c) On the day of the inventory count, you attended depot nine at DinZee. You observed the following
activities:
1. Prenumbered count sheets were being issued to client's staff carrying out the count. The count
sheets showed the inventory ledger balances for checking against physical inventory.
2. All count staff were drawn from the inventory warehouse and were counting in teams of two.
3. Three counting teams were allocated to each area of the stores to count, although the teams were
allowed to decide which pair of staff counted which inventory within each area. Staffs were warned
that they had to remember which inventory had been counted.
4. Information was recorded on the count sheets in pencil so amendments could be made easily as
required.
5. Any inventory not located on the pre-numbered inventory sheets was recorded on separate inventory
sheets which were numbered by staff as they were used.
6. At the end of the count, all count sheets were collected and the numeric sequence of the sheets
checked; the sheets were not signed.
Required:
i.
List the weaknesses in the control system for counting inventory at depot nine.
ii.
For each weakness, explain why it is a weakness and state how that weakness can be overcome.
(3 marks)
(9 marks)
(d)
i. State the aim of a test of control and the aim of a substantive procedure.
ii. In respect of your attendance at DinZee Co's inventory count, state one test of control and one
substantive procedure that you should perform.
(4 marks)
(30 marks)
(December 2007)
40. Despatch and sales system, direct confirmation of receivables and internal control
questionnaires – Seeley Co
1. Introduction - audit firm
You are an audit senior in Brennon & Co, a firm providing audit and assurance services. At the request of an
audit partner, you are preparing the audit programme for the income and receivables systems of Seeley Co.
Audit documentation is available from the previous year's audit, including internal control questionnaires and
audit programmes for the despatch and sales system. The audit approach last year did not involve the use
of computer-assisted audit techniques (CAATs); the same approach will be taken this year. As far as you
are aware, Seeley's system of internal control has not changed in the last year.
Client background - sales system
Seeley Co is a wholesaler of electrical goods such as kettles, televisions, MP3 players, etc. The company
maintains one large warehouse in a major city. The customers of Seeley are always owners of small retail
shops, where electrical goods are sold to members of the public. Seeley only sells to authorised customers;
following appropriate credit checks, each customer is given a Seeley identification card to confirm their
status. The card must be used to obtain goods from the warehouse.
Despatch and sales system
The despatch and sales system operates as follows:
1. Customers visit Seeley's warehouse and load the goods they require into their vans after showing
their Seeley identification card to the despatch staff.
2. A pre-numbered goods despatch note (GDN) is produced and signed by the customer and a member
of Seeley's despatch staff confirming goods taken.
© GTG
Question Bank: 27
3. One copy of the GDN is sent to the accounts department, the second copy is retained in the despatch
department.
4. Accounts staff enter goods despatch information onto the computerised sales system. The GDN is
signed.
5. The computer system produces the sales invoice, with reference to the inventory master file for
product details and prices, maintains the sales day book and also the receivables ledger. The
receivables control account is balanced by the computer.
6. Invoices are printed out and sent to each customer in the post with paper copies maintained in the
accounts department. Invoices are compared to GDNs by accounts staff and signed.
7. Paper copies of the receivables ledger control account and list of aged receivables are also available.
8. Error reports are produced showing breaks in the GDN sequence.
Information on receivables
The chief accountant has informed you that receivables days have increased from 45 to 60 days over the last
year. The aged receivables report produced by the computer is shown below:
Number of
receivables
15
197
153
23
388
Range of debt
Less than $0
$0 to $20,000
$20,001 to 50,000
$50,001 or more
Total debt
$
(87,253)
2,167,762
5,508,077
1,495,498
9,084,084
Current
$
(87,253)
548,894
2 ,044,253
750,235
3,256,129
1 to 2 months old
$
643, 523
2,735, 073
672,750
4,051, 346
More than 2
months old $
975,345
728,751
72,513
1,776,609
In view of the deteriorating receivables situation, a direct confirmation of receivables will be performed this
year.
Required:
(a) Explain the steps necessary to check the accuracy of the previous year's internal control questionnaires.
(4 marks)
(b) Using information from the scenario, list SIX tests of control that an auditor would normally carry out on
the despatch and sales system at Seeley Co and explain the reason for each test.
(12 marks)
(c) State and explain the meaning of FOUR assertions that relate to the direct confirmation of
receivables.
(4 marks)
(d)
i. Describe the procedures up to despatch of letters to individual receivables in relation to a direct
confirmation of receivables.
(5 marks)
ii.
Discuss which particular categories of receivables might be chosen for the sample.
(5 marks)
(30 marks)
(June 2008)
41. Internal control system of wages and substantive analytical procedures – Blake Co
Introduction
Blake Co assembles specialist motor vehicles such as lorries, buses and trucks. The company owns four
assembly plants to which parts are delivered and assembled into the motor vehicles.
The motor vehicles are assembled using a mix of robot and manual production lines. The ‘human’ workers
normally work a standard eight hour day, although this is supplemented by overtime on a regular basis as Blake
has a full order book. There is one shift per day; mass production and around the clock working are not possible
due to the specialist nature of the motor vehicles being assembled.
28: Internal Control
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Wages system – shift workers
Shift-workers arrive for work at about 7.00 am and ‘clock in’ using an electronic identification card. The card is
scanned by the time recording system and each production shift-worker’s identification number is read from
their card by the scanner. The worker is then logged in as being at work. Shift-workers are paid from the time of
logging in. The logging in process is not monitored as it is assumed that shift-workers would not work without
first logging in on the time recording system.
Shift-workers are split into groups of about 25 employees, with each group under the supervision of a shift
foreman. Each day, each group of shift-workers is allocated a specific vehicle to manufacture. At least 400
vehicles have to be manufactured each day by each work group. If necessary, overtime is worked to complete
the day’s quota of vehicles. The shift foreman is not required to monitor the extent of any overtime working
although the foreman does ensure workers are not taking unnecessary or prolonged breaks which would
automatically increase the amount of overtime worked. Shift-workers log off at the end of each shift by
re-scanning their identification card.
Payment of wages
Details of hours worked each week are sent electronically to the payroll department, where hours worked are
allocated by the computerised wages system to each employee’s wages records. Staff in the payroll department
compare hours worked from the time recording system to the computerised wages system, and enter a code
word to confirm the accuracy of transfer. The code word also acts as authorisation to calculate net wages. The
code word is the name of a domestic cat belonging to the department head and is therefore generally known
around the department.
Each week the computerised wages system calculates:
i. gross wages, using the standard rate and overtime rates per hour for each employee,
ii. statutory deductions from wages, and
iii. net pay.
The list of net pay for each employee is sent over Blake’s internal network to the accounts department. In the
accounts department, an accounts clerk ensures that employee bank details are on file. The clerk then
authorises and makes payment to those employees using Blake’s online banking systems. Every few weeks the
financial accountant reviews the total amount of wages made to ensure that the management accounts are
accurate.
Termination of employees
Occasionally, employees leave Blake. When this happens, the personnel department sends an e-mail to the
payroll department detailing the employee’s termination date and any unclaimed holiday pay. The receipt of the
e-mail by the payroll department is not monitored by the personnel department.
Salaries system – shift managers
All shift managers are paid an annual salary; there are no overtime payments.
Salaries were increased in July by 3% and an annual bonus of 5% of salary was paid in November.
Required:
(a) List FOUR control objectives of a wages system.
(2 marks)
(b) As the external auditors of Blake Co, write a management letter to the directors in respect of the shiftworkers wages recording and payment systems which:
(i) Identifies and explains FOUR weaknesses in that system.
(ii) Explains the possible effect of each weakness.
(iii) Provides a recommendation to alleviate each weakness.
Note: up to two marks will be awarded within this requirement for presentation.
(14 marks)
(c) List THREE substantive analytical procedures you should perform on the shift managers’ salary system. For
each procedure, state your expectation of the result of that procedure.
(6 marks)
(d) Audit evidence can be obtained using various audit procedures, such as inspection. Apart from this
procedure, in respect of testing the accuracy of the time recording system at Blake Co, explain FOUR
procedures used in collecting audit evidence and discuss whether the auditor will benefit from using each
procedure.
(8 marks)
(30 marks)
(December 2008)
© GTG
Question Bank: 29
42. Letter of weakness for sales system and audit committee – Rhapsody Co
Rhapsody Co supplies a wide range of garden and agricultural products to trade and domestic customers. The
company has 11 divisions, with each division specialising in the sale of specific products, for example, seeds,
garden furniture, agricultural fertilizers. The company has an internal audit department which provides audit
reports to the audit committee on each division on a rotational basis.
Products in the seed division are offered for sale to domestic customers via an Internet site. Customers review
the product list on the Internet and place orders for packets of seeds using specific product codes, along with
their credit card details, onto Rhapsody Co’s secure server. Order quantities are normally between one and
three packets for each type of seed.
Order details are transferred manually onto the company’s internal inventory control and sales system, and a
two part packing list is printed in the seed warehouse. Each order and packing list is given a random
alphabetical code based on the name of the employee inputting the order, the date, and the products being
ordered.
In the seed warehouse, the packets of seeds for each order are taken from specific bins and dispatched to the
customer with one copy of the packing list. The second copy of the packing list is sent to the accounts
department where the inventory and sales computer is updated to show that the order has been dispatched.
The customer’s credit card is then charged by the inventory control and sales computer. Bad debts in Rhapsody
are currently 3% of total sales.
Finally, the computer system checks that for each charge made to a customer’s credit card account, the order
details are on file to prove that the charge was made correctly. The order file is marked as completed confirming
that the order has been dispatched and payment obtained.
Required:
(a) In respect of sales in the seeds division of Rhapsody Co, prepare a report to be sent to the audit committee
of Rhapsody Co which:
(i) identifies and explains FOUR weaknesses in that sales system;
(ii) explains the possible effect of each weakness; and
(iii) provides a recommendation to alleviate each weakness.
Note: up to 2 marks will be awarded for presentation.
(14 marks)
(b) Explain the advantages to Rhapsody Co of having an audit committee.
(6 marks)
(20 marks)
(June 2007)
43. Internal control of petty cash system and independence of internal audit – Matalas Co
Matalas Co sells cars, car parts and petrol from 25 different locations in one country. Each branch has up to 20
staff working there, although most of the accounting systems are designed and implemented from the
company’s head office. All accounting systems, apart from petty cash, are computerised, with the internal audit
department frequently advising and implementing controls within those systems.
Matalas has an internal audit department of six staff, all of whom have been employed at Matalas for a minimum
of five years and some for as long as 15 years. In the past, the chief internal auditor appoints staff within the
internal audit department, although the chief executive officer (CEO) is responsible for appointing the chief
internal auditor. The chief internal auditor reports directly to the finance director. The finance director also
assists the chief internal auditor in deciding on the scope of work of the internal audit department.
You are an audit manager in the internal audit department of Matalas. You are currently auditing the petty cash
systems at the different branches. Your initial systems notes on petty cash contain the following information:
(i) The average petty cash balance at each branch is $5,000.
(ii) Average monthly expenditure is $1,538, with amounts ranging from $1 to $500.
(iii) Petty cash is kept in a lockable box on a bookcase in the accounts office.
(iv) Vouchers for expenditure are signed by the person incurring that expenditure to confirm they have received
re-imbursement from petty cash.
(v) Vouchers are recorded in the petty cash book by the accounts clerk; each voucher records the date, reason
for the expenditure, amount of expenditure and person incurring that expenditure.
30: Internal Control
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(vi) Petty cash is counted every month by the accounts clerk, who is in charge of the cash. The petty cash
balance is then reimbursed using the ‘imprest’ system and the journal entry produced to record expenditure
in the general ledger.
(vii) The cheque to reimburse petty cash is signed by the accountant at the branch at the same time as the
journal entry to the general ledger is reviewed.
Required:
(a) Explain the issues which limit the independence of the internal audit department in Matalas Co.
Recommend a way of overcoming each issue.
(8 marks)
(b) Explain the internal control weaknesses in the petty cash system at Matalas Co. For each weakness,
recommend a control to overcome that weakness.
(12 marks)
(20 marks)
(December 2007)
44. Internal controls and its weaknesses – Snu
Some organisations conduct inventory counts once a year and the external auditors attend those counts. Other
organisations have perpetual systems (i.e. they conduct continuous inventory counting and do not conduct a
year end count.)
Snu is a family-owned company which retails beds, mattresses and other bedroom furniture. The company's
financial year ends on 31 December 20X3. The only full inventory count takes place at the end of the year. The
company maintains up-to-date computerised inventory records. When the company sells goods to its
customers, a deposit is taken and customers are invoiced for the balance after the delivery. Some goods that
are in stock at the year-end have already been paid for in full - customers who collect goods themselves pay by
cash or credit card. Staff at the company’s warehouse and shops conduct the year-end count. The shop and the
warehouse are open seven days a week except for two important public holidays during the year, one of which
is 1 January. Staff are very busy in the week prior to the inventory count. The shops close at 15.00 hours on 31
December and staff work until 17.00 hours to prepare the inventory for counting. The company has a high
turnover of staff.
The following inventory counting instructions have been provided to the staff at Snu.
(i) The inventory count will take place on 1 January 20X4 commencing at 09.00 hours. No movement of
inventory will take place on that day.
(ii) The count will be supervised by Mr Sneg, the inventory controller. All staff will be provided with preprinted, pre-numbered inventory counting sheets that are produced by the computerised system. Mr Sneg
will ensure that all sheets are issued, and that each one is collected at the end of the count.
(iii) Counters will work on their own, because there is insufficient staff for them to work in pairs, but they
will be supervised by Mr Sneg and Mrs Zapad, an experienced shop manager who will check the work
performed by the counters. Staff will count the inventory which is most familiar to them, in order to ensure
that the count is completed as quickly and efficiently as possible.
(iv) Any inventory that is known to be old, slow-moving or already sold will be highlighted on the sheets.
Staff is required to highlight any inventory that appears to be soiled or damaged.
(v) All inventory items counted will have a piece of paper attached to them, showing that they have been
counted.
(vi) Inventory that has been delivered to the customers but has not yet been paid for in full will be added
back to the inventory, by Mr Sneg.
Required:
(a) Explain why year-end inventory counting is important to the auditors.
(5 marks)
(b) Describe the audit procedures you would perform in order to rely on a perpetual inventory system in a large,
dispersed organisation.
(5 marks)
(c) Describe the importance of the auditor’s attendance at the physical counting in the context of ISA 501.
(5 marks)
(d) Describe the weaknesses in Snu's inventory counting instructions and explain why these weaknesses are
difficult to overcome.
(15 marks)
(30 marks)
(Adapted from Paper 2.6 June 2003)
© GTG
Question Bank: 31
45. Control activity, tests of control, assertions and audit opinion – Have a Bite Co
(a) Identify and explain four assertions relevant to accounts payable at the year-end date.
(6 marks)
You are the audit senior responsible for the audit of Have A Bite Co, a company that runs a chain of fast food
restaurants. You are aware that a major risk of their sector is that poor food quality might result in damage
claims by customers.
You had satisfied yourself at the interim audit that the company's control risk as regards purchases of food and
its preparation in the kitchen was low. However, during your final audit it comes to your attention that one month
before the year-end, a customer has sued the company for personal injury caused by food poisoning, claiming
an amount of $200,000 in compensation. This amount is material to the stated profit of the company, but
management believes that it has good defences against the claim
Required:
(b)
(i) State two controls that the company should have in place to reduce the risk associated with
purchases of food and its preparation in the kitchen; and
(ii) State two audit procedures you should carry out during controls testing to satisfy yourself that control risk in
this area is low.
(4 marks)
(c) In respect of the potential claim state three items of evidence you should obtain and explain how they might
enable you to form a conclusion on the likelihood of the claim being successful.
(6 marks)
Following your audit you have concluded that there is a possibility, but not a probability, that the claim will be
successful. However, management have decided not to make a provision or disclosure in the financial
statements in respect of this matter.
Required:
(d) Describe how the matter should be reported in the financial statements and explain the effect on your
report.
(4 marks)
(20 marks)
(December 2009)
46. Control environment, understanding the entity and substantive procedures – Letham
ISA 315 (Redrafted) Identifying and Assessing the Risks of Material Misstatement through Understanding the
Entity and Its Environment requires auditors to obtain an understanding of the entity and its environment,
including its internal control.
Required:
(a) Explain why obtaining an understanding of the entity and its environment is important for the auditor.
(4 marks)
Letham Co is a large engineering company with ten manufacturing units throughout the country in which it is
located. The manufacturing process is capital intensive and the company holds a wide variety of plant and
equipment.
The finance director is responsible for the preparation of a detailed non-current assets budget annually, which is
based on a five-year budget approved by the whole board of directors after consultation with the audit
committee. This annual budget, which is also approved by the full board, is held on computer file and is the
authority for the issue of a purchase order.
32: Internal Control
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When the item of plant and equipment is delivered to the company, a pre-numbered goods received note (GRN)
is prepared, a copy of which is sent to the accounting department, and used to update the non-current assets
budget to reflect the movement. The equipment is carefully inspected by production personnel and tested for
proper operation. An operational certificate is prepared by the production department and this is used by the
accounting department, together with the GRN, to check against the purchase invoice when it is received.
At the same time as the purchase invoice enters the purchasing system, a computerised non-current assets
register is updated. Access to the non-current assets register is restricted to personnel in the accounting
department. On a rolling basis throughout the year the non-current assets register is compared to plant and
equipment on site by accounting department personnel, using identification numbers in the register and
permanently marked onto each item in the factory.
The internal audit department also tests on a sample basis the operation of the system from budget preparation
to entry in the non-current assets register. Internal audit staff also compares a sample of entries in the noncurrent assets register with equipment on the shop floor.
Required:
(b) Identify SIX STRENGTHS in Letham's control environment in respect of non-current assets and explain why
they may reduce control risk.
(12 marks)
(c) As part of your work as external auditor you are reviewing the non-current assets audit programme of the
internal auditors and notice that the basis of their testing is a representative sample of purchase invoices.
They use this to test entries in the non-current assets register and the updating movements on the annual
budget.
Required:
(i) Explain why this is not a good test for completeness;
(ii) State a more appropriate test to prove completeness of the non-current assets records, including the
non-current assets register.
(4 marks)
(20 marks)
(December 2009)
E
SECTION E
QUESTION BANK
AUDIT EVIDENCE
47. Analytical procedures: ratio analysis – Hivex
You have been presented with the following draft financial information about Hivex, a very successful company
that develops and licences specialist computer software and hardware. Its non-current assets mainly consist of
property, computer hardware and investments, and there have been additions to these during the year. The
company is experiencing increasing competition from rival companies, most of which specialise in hardware or
software, but not both. There is pressure to advertise and to cut prices.
You are the audit manager. You are planning the audit and are conducting a preliminary analytical review and
associated risk analysis for this client for the year ended 31 May 20X9. You have been provided with a
summarised draft income statement which has been produced very quickly and certain accounting ratios and
percentages. You have been informed that the company accounts for research and development costs in
accordance with IAS 38 Intangible Assets.
20X9
20X8
$’000
$’000
15,206
13,524
Cost of sales
3,009
3,007
Gross Profit
12,197
10,517
3,006
1,996
994
1,768
Selling expenses
3,002
274
Profit from operations
5,195
6,479
Revenue
Distribution costs
Administrative expenses
Net interest receivable
995
395
Profit before tax
6,190
6,874
Income tax expense
3,104
1,452
Net profit
3,086
5,422
Retained profits
1,617
3,983
Dividends paid
1,469
1,439
0.43
1.04
0.80
0·78
Distribution costs
0.20
0.15
Administrative expenses
0.07
0.13
Selling expenses
0.20
0.02
Operating profit
0.34
0.48
Accounting ratios and percentages
Earnings per share
Performance ratios include the following:
Gross margin
Expenses as a percentage of revenue:
Required:
(a) Using the information above, comment briefly on the performance of the company for the two years and
identify the areas that are subject to increased audit risk.
(8 marks)
(b) Describe the further audit work you would perform in response to the risks identified in part
(12 marks)
34: Audit Evidence
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(c) ISA 500 has identified seven sources of audit evidence such as observation and reperformance.
For any five ISA 500 sources of audit evidence, choose an audit procedure you described in your answer to part
(b) above, identify the ISA 500 category under which it belongs, and comment on the reliability of the evidence
gathered by that means.
(10 marks)
(30 marks)
(Adapted from Paper 2.6 June 2003)
48. Audit evidence
There are a number of different methods of obtaining audit evidence. Methods include:
(i)
(ii)
(iii)
(iv)
(v)
analytical procedures;
audit sampling;
tests of controls;
detailed testing of transactions and balances;
computer-Assisted Audit Techniques (CAATs).
These methods overlap and may be used for different purposes during an audit of financial statements.
Required:
(a) Explain the advantages and disadvantages of each of the five methods of evidence gathering listed above.
(15 marks)
Note: you are not required to describe the methods listed above.
(b) Describe the relationship between the five methods of evidence gathering described above.
(5 marks)
(20 marks)
49. Assertions and payroll audit – Boulder
ISA 315, Identifying and assessing the risks of material misstatement through understanding the entity and its
environment, states that management implicitly or explicitly makes assertions regarding the recognition,
measurement, presentation and disclosure of the various elements of financial statements and related
disclosures.
Auditors can use these assertions to consider the different types of potential misstatements that may occur fall
into the following three categories and may take the following forms:
(i) classes of transactions,
(ii) account balances,
(iii) presentation and disclosure.
One assertion applicable to all three categories is completeness: that all transactions, events, assets, liabilities,
equity interests and disclosures that should be included, are included in the financial statements.
Required:
(a) List and describe SIX financial statement assertions, other than completeness, used by auditors in the audit
of financial statements.
(6 marks)
(b) Boulder is a small company that manufactures hosiery products. It employs approximately 150 staff, all of
whom are paid by bank transfer.
Temporary factory staff are hired through an agency and are paid on piece rates (i.e. for the number of items
that they produce or process) on a weekly basis. Supervisors at Boulder authorise documentation indicating the
number of items produced or processed by agency staff. The agency is paid by bank transfer and it, not
Boulder, is responsible for the deduction of tax and social insurance.
Permanent factory staff are paid on a weekly basis on the basis of hours worked as evidenced by clock cards.
Administration and sales staff are paid a monthly salary. The two directors of the company are also paid a
monthly salary.
Sales staff are paid a quarterly bonus calculated on the basis of sales. Directors are paid an annual bonus
based on profits.
You will be performing the audit of the financial statements for the year ending 31 December 20X8 and you will
be responsible for the figures in the financial statements relating to payroll.
© GTG
Question Bank: 35
Required:
Describe the substantive audit procedures you will perform on:
(i) the payroll balances in the SOFP of Boulder;
(10 marks)
(ii) the payroll transactions in the income statement of Boulder.
(4 marks)
(20 marks)
(Adapted from Paper 2.6 December 2004)
50. Audit procedures – BearsWorld
You are the auditor of BearsWorld, a limited liability company which manufactures and sells small cuddly toys
by mail order. The company is managed by Mr Kyto and two assistants. Mr Kyto authorises important
transactions such as wages and large orders, one assistant maintains the payables ledger and orders inventory
and pays suppliers, and the other assistant receives customer orders and dispatches cuddly toys. Due to other
business commitments Mr Kyto only visits the office once per week.
At any time, about 100 different types of cuddly toys are available for sale. All sales are made cash with order there are no receivables. Customers pay using credit cards and occasionally by sending cash. Turnover is over
$5.2 million.
You are planning the audit of BearsWorld and are considering using some of the procedures for gathering audit
evidence recommended by ISA500 as follows:
(i)
(ii)
(iii)
(iv)
(v)
analytical Procedures
inquiry
inspection
observation
re-calculation
Required:
(a) For EACH of the above procedures:
(i) explain its use in gathering audit evidence.
(5 marks)
(ii) describe one example for the audit of BearsWorld.
(5 marks)
(b) Discuss the suitability of each procedure for BearsWorld, explaining the limitations of each.
(10 marks)
(20 marks)
(Paper 2.6 June 2005)
51. Audit of inventory – IAS 2
IAS 2 ‘Inventories' requires that inventories are measured at the lower of cost and net realisable value.
Required:
(a) Explain why the audit of inventory is important to auditors.
(5 marks)
(b) Define 'cost' and 'net realisable value' according to IAS 2 'Inventories'.
(6 marks)
(c) Describe the audit evidence that you would obtain for the cost and net realisable value of finished inventory
in a company that manufactures household furniture.
(9 marks)
Note: you are not required to deal with inventory quantities.
(20 marks)
(Paper 2.6 December 2002)
36: Audit Evidence
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52. Audit evidence – Company A
(a) Company A has a number of long and short-term payables, accruals and provisions in its SOFP.
Required:
Describe the audit procedures you would apply to each of the three items listed below, including those relating
to disclosure.
(i) A 10-year bank loan with a variable interest rate and an overdraft (a bank account with a debit balance on
the bank statement), both from the same bank.
(5 marks)
(ii) Expense accruals.
(4 marks)
(iii) Trade payables and purchase accruals.
(6 marks)
(b) Company B has a provision in its SOFP for claims made by customers for product defects under 1-year
company warranties.
Required:
Describe the matters you would consider and the audit evidence you would require for the provision.
(5 marks)
(20 marks)
(Paper 2.6 December 2002)
53. Small entities –ISA
International Standards on Auditing (ISAs) apply equally to the audit of all entities, whatever their size. However,
the manner in which ISAs are applied differs from entity to entity and depends on the use of the auditor's
judgement. The characteristics of smaller entities may include:
(i)
(ii)
(iii)
(iv)
(v)
common ownership and management;
a control framework that is different to the control framework for larger entities;
the use of standardised computer packages;
reliance on the auditor for accounting expertise;
a lack of sufficient appropriate audit evidence to support financial statement assertions relating to income
from cash transactions.
These characteristics have an effect on the way the audits of smaller entities are approached, how audit risk is
assessed, how the audit is conducted, the auditor's report and the relationship between auditor and client.
Required:
Describe the nature and effect of each of the five characteristics listed in (a)-(e) above on the audit of smaller
entities and on the relationship between auditor and client.
Note: the five characteristics (i) - (v) carry equal marks.
(20 marks)
(Paper 2.6 December 2004)
54. Not-for-profit organisation – Ajio
Ajio is a charity whose constitution requires that it raises funds for educational projects. These projects seek to
educate children and support teachers in certain countries. Charities in the country from which Ajio operates
have recently become subject to new audit and accounting regulations. Charity income consists of cash
collections at fund raising events, telephone appeals, and bequests (money left to the charity by deceased
persons). The charity is small and the trustees do not consider that the charity can afford to employ a qualified
accountant. The charity employs a part-time bookkeeper and relies on volunteers for fund raising. Your firm has
been appointed as accountants and auditors to this charity because of the new regulations. Accounts have been
prepared (but not audited) in the past by a volunteer who is a recently retired Chartered Certified Accountant.
© GTG
Question Bank: 37
Required:
(a) Describe the risks associated with the audit of Ajio under the headings inherent risk, control risk and
detection risk and explain the implications of these risks for overall audit risk.
(10 marks)
(b) List and explain the audit tests to be performed on income and expenditure from fund raising events.
(10 marks)
Note: in part (a) you may deal with inherent risk and control risk together. You are not required to deal with the
detail of accounting for charities in either part of the question.
(20 marks)
(Paper 2.6 December 2003)
55. Statistical techniques in auditing
Audit sampling is a technique for drawing conclusions about the characteristics of a population by
testing a sample drawn from it. Internal and external auditors use sampling for both tests of controls and
substantive testing.
Required:
Describe the following:
(i)
(ii)
(iii)
(iv)
(v)
judgement sampling and statistical sampling;
a representative sample;
tolerable error;
two different methods of selecting a representative sample;
the extrapolation of errors.
Note: parts (i) - (v) carry equal marks.
(10 marks)
(Paper 2.6 June 2003)
56. CAAT – Royal Selection
Royal Selection is limited liability company reselling electronic equipment. Most, sales orders are accepted
through the internet. For these orders, payment is made by credit card and the customers are required to
provide their credit card details. 10% of the total sales are in cash. In case of cash sales, goods are handed
over to the customers at the company premises itself.
For the orders received through internet, the processing software processes the orders by checking the credit
card details, order details, customer address and availability of the item. After verifying these details, a serially
pre-numbered sales invoice is printed and then goods are dispatched.
There is a separate computer for cash sales. The person processing cash sales orders is provided with a login
and password. At the end of the day, he takes a print of all the cash sales made during the day and hands over
the cash along with the printout of the sales to the main cashier. The cashier then passes a single entry in which
all cash sales made during the day are recorded. There should be only one cash sales entry in the sales day
book everyday. Once a day is closed, it is not possible to modify entries except using a special code known only
to sales manager. Such modification gets recorded in the exception report. The main cashier also deposits cash
into the bank.
Each item has unique code number. Once the code is selected, the rate for the item automatically gets selected.
A record of the inventory is maintained on-line, which enables the computer system to check the availability of
the item.
Generally orders are placed for one or two items only. For more than two items, the computer system generates
an exception report. These orders require authorisation of a responsible person.
Required:
(a) List the test data you will use in your audit of the financial statements of Royal selection to confirm the
completeness and accuracy of input into the sales system, clearly explaining the reason for each item of
data.
(7 marks)
(b) Also explain why you as an auditor, would choose to use CAATs for the audit of Royal selection.
(3 marks)
(10 marks)
38: Audit Evidence
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57. Audit software – Delphic Co
Delphic Co is a wholesaler of furniture (such as chairs, tables and cupboards). Delphic buys the furniture
from six major manufacturers and sells them to over 600 different customers ranging from large retail
chain stores to smaller owner-controlled businesses. The receivables balance therefore includes
customers owing up to $125,000 to smaller balances of about $5,000, all with many different due dates
for payments and credit limits. All information is stored on Delphic's computer systems although previous
audits have tended to adopt an 'audit around the computer' approach.
You are the audit senior in charge of the audit of the receivables balance. For the first time at this client,
you have decided to use audit software to assist with the audit of the receivables balance. Computer staff
at Delphic are happy to help the auditor, although they cannot confirm completeness of systems
documentation, and warn that the systems have very old operating systems in place, limiting file
compatibility with more modern programs.
The change in audit approach has been taken mainly to fully understand Delphic's computer systems prior
to new internet modules being added next year. To limit the possibility of damage to Delphic's computer
files, copy files will be provided by Delphic's computer staff for the auditor to use with their own audit
software.
Required:
(a) Explain the audit procedures that should be carried out using audit software on the receivables balance at
Delphic Co. For each procedure, explain the reason for that procedure.
(9 marks)
(b) Explain the potential problems of using audit software at Delphic Co. For each problem, explain how it can be
resolved.
(8 marks)
(c) Explain the concept of 'auditing around the computer' and discuss why this increases audit risk for the
auditor.
(3 marks)
(20 marks)
(December 2007)
58. Substantive audit procedures and audit evidence – Metcalf Co
ISA 500 Audit Evidence requires that auditors 'should obtain sufficient appropriate audit evidence to be able to
draw reasonable conclusions on which to base the audit opinion'.
Required:
(a) List and explain the factors which will influence the auditor's judgement concerning the sufficiency of audit
evidence obtained.
(4 marks)
(b) You are the audit senior in charge of the audit of Metcalf Co, a company that has been trading for over 50
years. Metcalf Co manufactures and sells tables and chairs directly to the public. The company's year end is
31 March.
Current liabilities are shown on Metcalf Co's SOFP as follows:
Trade payables
Accruals
Provision for legal
Total
20X9
20X8
$
$
884,824 816,817
56,903
51,551
60,000
1,001,727 868,368
The provision for legal action relates to a claim from a customer who suffered an injury while assembling a chair
supplied by Metcalf Co. The directors of Metcalf Co dispute the claim, although they are recommending an out
of court settlement to avoid damaging publicity against Metcalf Co.
© GTG
Question Bank: 39
Required:
List the substantive audit procedures that you should undertake in the audit of current liabilities of Metcalf Co for
the year ended 31 March 20X9. For each procedure, explain the purpose of that procedure.
Marks are allocated as follows:
(i) Trade payables;
(9 marks)
(ii) Accruals;
(3 marks)
(iii) The provision for legal action.
(4 marks)
(20 marks)
(Adapted from June 2007)
59. Audit software and audit documentation – Cal & Co
Following a competitive tender, your audit firm Cal & Co has just gained a new audit client Tirrol Co. You are the
manager in charge of planning the audit work. TirrolCo's year end is 30 June 2009 with a scheduled date to
complete the audit of 15 August 2009. The date now is 3 June 2009.
Tirrol Co provides repair services to motor vehicles from 25 different locations. All inventory, sales and
purchasing systems are computerised, with each location maintaining its own computer system. The software in
each location is the same because the programs were written specifically for Tirrol Co by a reputable software
house. Data from each location is amalgamated on a monthly basis at TirrolCo's head office to produce
management and financial accounts.
You are currently planning your audit approach for Tirrol Co. One option being considered is to re-write Cal
&Co's audit software to interrogate the computerised inventory systems in each location of Tirrol Co (except for
head office) as part of inventory valuation testing. However, you have also been informed that any computer
testing will have to be on a live basis and you are aware that July is a major holiday period for your audit firm.
Required:
(a)
(i) Explain the benefits of using audit software in the audit of Tirrol Co;
(4 marks)
(ii) Explain the problems that may be encountered in the audit of Tirrol Co and for each problem, explain how
that problem could be overcome.
(10 marks)
(b) Following a discussion with the management at Tirrol Co you now understand that the internal audit
department are prepared to assist with the statutory audit. Specifically, the chief internal auditor is prepared
to provide you with documentation on the computerised inventory systems at Tirrol Co. The documentation
provides details of the software and shows diagrammatically how transactions are processed through the
inventory system .This documentation can be used to significantly decrease the time needed to understand
the computer systems and enable audit software to be written for this year's audit.
Required:
Explain how you will evaluate the computer systems documentation produced by the internal audit department
in order to place reliance on it during your audit.
(6 marks)
(20 marks)
(June 2009)
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60. Substantive procedures, audit planning and inherent risks – Redburn Co
(a) Explain the importance of audit planning and state TWO matters that would be included in an audit plan.
(6 marks)
Redburn Co, a publisher and producer of books of poetry, has been a client of your firm of Chartered Certified
Accountants for a number of years. The manager in overall charge of the audit has been discussing the audit
plan with the audit team, of which you are a member, prior to commencement of the work. The audit manager
has informed the team, among other things, that there has been a growing interest in poetry generally and that
the company has acquired a reputation for publishing poets who are still relatively unknown.
During your audit you determine:
(i) Contracts with the poets state that they are given a royalty of 10% on sales. Free copies of the books are
provided to the poets and to some organisations such as copyright libraries and to others, such as
reviewers an university lecturers. No royalties are given on these free copies.
(ii) The computerised customer master file contains a code indicating whether a despatch is to earn a royalty
for the author. This code is shown on the sales invoice and despatch note when they are prepared.
(iii) A computerised royalties file is held, all entries therein bearing the invoice number and date.
(iv) The company keeps detailed statistics of sales made, including trends of monthly sales by type of customer,
and of colleges where its books are recommended as part of course material, based on reports from sales
staff.
(v) Bookshops have the right to return books which are not selling well, but about 10% of these are slightly
damaged when returned. The company keeps similar records of returns as it does for sales.
Required:
(b) Describe TWO procedures used to ensure that the sales statistics kept by the company may be relied
upon.
(4 marks)
(c) Describe THREE substantive tests you should perform to ensure that the royalties charge is accurate and
complete, stating the objective of each test.
(6 marks)
(d) A material figure in the statement of financial position of Redburn Co is the amount attributed to inventory of
books.
Required:
State TWO inherent risks that may affect the inventory figure and suggest ONE control to mitigate each risk.
(4 marks)
(e) The management of Redburn Co have told you that inventory is correctly valued at the lower of cost and net
realisable value. You have already satisfied yourself that cost is correctly determined.
Required:
(i) Define net realisable value;
(2 marks)
(ii) State and explain the purpose of FOUR procedures that you should use to ensure that net realisable value
of the inventory is at or above cost.
(8 marks)
(30 marks)
SECTION F
QUESTION BANK
REVIEW
F
61. Written representations – Crighton-Ward
(a) Explain the purpose of a management representation letter.
(5 marks)
(b) You are the manager in charge of the audit of Crighton-Ward, a public limited liability company which
manufactures specialist cars and other motor vehicles for use in films. Audited turnover is $140 million with
profit before tax of $7.5 million.
All audit work up to, but not including; the obtaining of management representations has been completed.
A review of the audit file has disclosed the following outstanding points:
Lion's Roar
The company is facing a potential legal claim from the Lion's Roar Company in respect of a defective vehicle
that was supplied for one of their films. Lion's Roar maintains that the vehicle was not built strongly enough
while the directors of Crighton-Ward argue that the specification was not sufficiently detailed. Dropping a vehicle
50 metres into a river and expecting it to continue to remain in working condition would be unusual, but this is
what Lion's Roar expected. Solicitors are unable to determine liability at the present time. A claim for $4 million
being the cost of a replacement vehicle and lost production time has been received by Crighton-Ward from
Lion's Roar. The director's opinion is that the claim is not justified.
Depreciation
Depreciation of specialist production equipment has been included in the financial statements at the amount of
10% p. a. based on reducing balance. However the treatment is consistent with prior accounting periods (which
received an unmodified auditor's report) and other companies in the same industry and sales of old equipment
show negligible profit or loss on sale. The audit senior, who is new to the audit, feels that depreciation is being
undercharged in the financial statements.
Required:
For each of the above matters:
(i) discuss whether or not a paragraph is required in the representation letter, and
(ii) if appropriate, draft the paragraph for inclusion in the representation letter.
(10 marks)
(c) A suggested format for the letter of representation has been sent by the auditors to the directors of
Crighton-Ward. The directors have stated that they will not sign the letter of representation this year on the
grounds that they believe the additional evidence that it provides is not required by the auditor.
Required:
Discuss the actions the auditor may take as a result of the decision made by the directors not to sign the letter
of representation.
(5 marks)
(20 marks)
(Paper 2.6 June 2005)
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62. Audit finalisation, overall review and subsequent events – Calva
You are an audit manager in an audit firm with ten offices and 250 staff. Your firm is the auditor of Calva, a
chain of supermarkets. Your firm has been the auditor of this client for many years.
All of the planning work and tests of control have been completed for Calva for the year ended 31 December
20X8. Staff are still working on substantive procedures. The company operates a continuous inventory checking
system with good records and you have tested this system and will be relying on the records for the year-end
figure.
The company is intending to invest a substantial amount in opening new stores during the next year and it has
been negotiating with both banks and property companies in relation to leases.
Required:
(a) Describe the objectives of the following and how these objectives will be met in the audit of Calva:
(i) overall review of financial statements
(4 marks)
(ii) review of working papers
(6 marks)
(b) Describe the:
(i) auditor's responsibilities with regard to subsequent events.
(6 marks)
(ii) procedures that should be applied during the subsequent events review at Calva.
(4 marks)
(20 marks)
(Paper 2.6 December 2003)
63. Written representations
Towards the end of an audit, it is common for the external auditor to seek a letter of representation (written
representations) from the management of the client company.
Required:
(a) Explain why auditors seek letters of representation.
(5 marks)
(b) List the matters commonly included in the letter of representation.
(6 marks)
(c) Explain why it is important to discuss the content of the letter of representation at an early stage during the
audit.
(3 marks)
(d) Explain why management is sometimes unwilling to sign a letter of representation and describe the actions
an external auditor can take if management refuses to sign a letter of representation.
(6 marks)
(20 marks)
(Paper 2.6 June 2002)
© GTG
Question Bank: 43
64. Subsequent events – Chemical Compounds
(a) You are the auditor of Chemical Compounds, a limited liability company that researches and prepares
chemical compounds for industrial use.
The audit for Chemical Compounds for the year ended 30 June 20X7 revealed the following subsequent events:
Date
17 August 20X7
23 September 20X7
24 September 20X7
4 November 20X7
25 November 20X7
29 November 20X7
Event
One of the major customers, who represented 15% of the total trade receivables on
the SOFP, went bankrupt.
Financial statements approved by directors.
Audit work completed and auditor’s report signed.
Accidental release of toxic fumes in the atmosphere from the company’s chemical
plant resulting in severe damage to the environment. Management had made
adequate disclosure of this in the financial statements to year end 30 June 20X7 and
made proper amendments wherever necessary.
Financial statements issued to Chemical Compounds.
Flooding of a nearby river destroyed the machinery and equipment at one of the
company’s locations. Repairs to the entire set-up are required that will take eleven
months. This will result in production losses.
Required:
(a) For each of the following three dates:
(i) 17 August 20X7
(ii) 4 November 20X7
(iii) 29 November 20X7
State whether the events occurring on those dates are adjusting or non-adjusting according to IAS 10 Events
occurring after the Reporting Period, giving reasons for your answer.
Explain the auditor’s responsibility and the audit procedures that should be carried out.
(15 marks)
(b) ISA 560 describes the audit work to be carried out for any subsequent events.
Required:
List the audit procedures that can be used prior to the signing of the auditor’s report to identify events that may
require adjustment or disclosure in the financial statements.
(5 marks)
(20 marks)
(Adapted from Paper 2.6 December 2005)
65. Going concern – Posco
(a) Describe management's responsibilities and the work that it should perform in relation to the going concern
status of companies.
(5 marks)
(b) Describe the possible procedures to be followed by the auditor according to ISA 570 during the review of
the going concern status of an entity.
(5 marks)
Posco is a large thermal power generation company that is listed on a stock exchange. It is highly geared
because, like many such companies, it borrowed a large sum to pay for permission to operate in a disputed
area. It has suffered huge losses due to non-production because the area has been the subject of litigation for
many years. The company's share price has dropped by 60% during the last two years and there have been
several changes in the senior management during that period. There has been considerable speculation in the
press over the last six months about whether the company can survive without being taken over by a rival. Four
companies have approached the company regarding a possible takeover but all have failed, mainly because the
bidders pulled out of the deal as a result of a drop in share prices generally.
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The company has net assets, but has found it necessary to severely curtail its capital investment programme.
Some commentators consider this to be fundamental to the future growth of the business; others consider that
the existing business is fundamentally sound. It has also been necessary for the company to restructure its
finances. Detailed disclosures of all these matters have always been made in the financial statements. No
reference has been made to the going concern status of the company in the previous auditors’ reports on
financial statements and the deterioration in circumstances in the current year is no worse than it has been in
previous years.
Required:
(c) On the basis of the information provided above, describe the audit report that you consider is likely to be
issued in the case of Posco, giving reasons.
(4 marks)
(d) Explain the difficulties that would be faced by Posco and its auditors if Posco’s audit report made reference
to going concern issues.
(6 marks)
(20 marks)
66. Going concern – EWheels
Your firm has recently been appointed as external auditor to EWheels. EWheels is a private 'dot.com' company
that operates an internet auction service for the sale of used motor vehicles. You are planning the audit of the
financial statements. The company has been in existence for four years and has grown rapidly. It was founded
by three individuals who are a former car auctioneer, an internet specialist with an interest in cars, and an
accountant. The company now has three offices and some 100 employees. The on-line car auction market is
very competitive. The company is the biggest provider of the service in the south of the country, but the
directors have ambitious plans which include an aggressive marketing campaign, the take-over of a number of
target competitors and additional office space and staff, all of which will require considerable additional
finance.
The company is financed partly by private capital brought in by the three founders, and partly by bank loans.
The three founders were all directors, but the accountant resigned six months ago and has commenced a legal
action against the company for a considerable amount of money, claiming that he has effectively been excluded
from management by the other two directors. The company's SOFP shows net liabilities. The company has not yet
made a profit although preliminary figures indicate that it has reached break-even point in the current year. Your
firm has discovered that the previous auditors were not re-appointed because they refused to issue an
unmodified audit opinion on the previous year's financial statements, and instead made reference to the going
concern status of the company in their audit report.
Your firm has made it clear to the directors that it may be necessary to make reference to the going concern
status of the company again in the current year, but they have indicated that they would prefer an unmodified
report if at all possible. You are also aware that loan facilities for this type of company are becoming scarce, as
there are too many companies seeking such finance.
The director who resigned six months ago was responsible for the day to day accounting function and for the
preparation of the financial and management accounts.
The company has been unsuccessful in recruiting a permanent replacement and has used a number of
temporary accountants. Your initial investigations have highlighted a number of weaknesses in the operation
of the accounting and internal control systems.
Required:
(a) List the enquiries you will make and the procedures you will perform in deciding whether to make reference to
the going concern status of EWheels in your audit report on the financial statements.
(5 marks)
(b) Describe the different ways in which your audit report might refer to the going concern status of the company.
(5 marks)
(10 marks)
(Paper 2.6 December 2001)
© GTG
Question Bank: 45
67. Going concern and negative assurance – Smithson Co
Smithson Co provides scientific services to a wide range of clients. Typical assignments range from
testing food for illegal additives to providing forensic analysis on items used to commit crimes to assist law
enforcement officers.
The annual audit is nearly complete. As audit senior you have reported to the engagement partner that
Smithson is having some financial difficulties. Income has fallen due to the adverse effect of two high
profile court cases, where Smithson's services to assist the prosecution were found to be in error.
Not only did this provide adverse publicity for Smithson, but a number of clients withdrew their contracts. A
senior employee then left Smithson, stating lack of investment in new analysis machines was
increasing the risk of incorrect information being provided by the company.
A cash flow forecast prepared internally shows Smithson requiring significant additional cash
within the next 12 months to maintain even the current level of services. Smithson's auditors have been
asked to provide a negative assurance report on this forecast.
Required:
(a) Define 'going concern' and discuss the auditor's responsibilities in respect of going concern.
(4 marks)
(b) State the audit procedures that may be carried out to try to determine whether or not Smithson Co is a going
concern.
(8 marks)
(c) Explain the audit procedures the auditor may take where the auditor has decided that Smithson Co is
unlikely to be a going concern.
(4 marks)
(d) In the context of the cash flow forecast, define the term 'negative assurance' and explain how this
differs from the assurance provided by an audit report on statutory financial statements.
(4 marks)
(20 marks)
(June 2008)
68. Subsequent events – ZeeDiem Co
The date is 3 December 2010. The audit of ZeeDiem Co is nearly complete and the financial statements and the
audit report are due to be signed next week. However, the following additional information on two material
events has just been presented to the auditor. The company’s year end was 30 September 2010.
Event 1 – Occurred on 10 October 2010
The springs in a new type of mattress have been found to be defective making the mattress unsafe for use.
There have been no sales of this mattress; it was due to be marketed in the next few weeks. The company’s
insurers estimate that inventory to the value of $750,000 has been affected. The insurers also estimate that the
mattresses are now only worth $225,000. No claim can be made against the supplier of springs as this company
is in liquidation with no prospect of any amounts being paid to third parties. The insurers will not pay ZeeDiem
for the fall in value of the inventory as the company was underinsured. All of this inventory was in the finished
goods store at the end of the year and no movements of inventory have been recorded post year-end.
Event 2 – Occurred 5 November 2010
Production at the Sham Eve factory was halted for one day when a truck carrying dye used in colouring the
fabric on mattresses reversed into a metal pylon, puncturing the vehicle allowing dye to spread across the
factory premises and into a local river. The Environmental Agency is currently considering whether the release
of dye was in breach of environmental legislation. The company’s insurers have not yet commented on the
event.
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Required:
(a) For each of the two events above:
(i) Explain whether the events are adjusting or non-adjusting according to IAS 10 Events After the Reporting
Period.
(4 marks)
(ii) Explain the auditors’ responsibility and the audit procedures and actions that should be carried out
according to ISA 560 (Redrafted) Subsequent Events.
(12 marks)
(b) Assume that the date is now 20 December 2012, the financial statements and the audit report have just
been signed, and the annual general meeting is to take place on 10 January 2013. The Environmental
Agency has issued a report stating that ZeeDiem Co is in breach of environmental legislation and a fine of
$900,000 will now be levied on the company. The amount is material to the financial statements.
Required:
Explain the additional audit work the auditor should carry out in respect of this fine.
(4 marks)
(20 marks)
(Adapted from December 2008)
SECTION G
QUESTION BANK
REPORTING
G
69. Report to management – Cliff
Your firm has recently been appointed as auditor to Cliff, a private company that runs a chain of small
supermarkets selling fresh, frozen, canned and dry food. Cliff has very few controls over inventory
because the company trusts local managers to make good decisions regarding the purchase, sale and
control of inventory, all of which is done locally. Pricing is generally performed on a cost-plus basis.
Each supermarket has a stand-alone computer system on which monthly accounts are prepared. These
accounts are mailed to the head office every quarter. There is no integrated inventory control, sale or
purchasing system and no regular system for inventory counting. Management accounts are produced twice
a year.
Trade at the supermarkets has increased in recent years and the number of supermarkets has also
increased. However, the quality of employees that have been recruited has fallen. The senior management
at Cliff is now prepared to invest in more up-to-date systems.
Required:
(a) Describe the problems that you might expect to come across at Cliff resulting from poor internal controls.
(10 marks)
(b) Make FOUR recommendations to the senior management of Cliff for the improvement of internal controls
and explain the advantages and disadvantages of each recommendation.
(12 marks)
(c) Discuss when, to whom and how should the auditor communicate the weaknesses in the internal
control system. Briefly explain the contents of a letter of weakness.
(8 marks)
(30 marks)
(Adapted from Paper 2.6 December 2004)
70. Audit reports – Rudra Plc
An auditor issues an unqualified audit report in circumstances where the financial statements show a true and
fair view of the affairs of the entity. However, an auditor sometimes modifies the audit report by including an
emphasis of matter paragraph in his audit report.
Required:
(a) Explain the circumstances in which an auditor needs to include an emphasis of matter paragraph in his
audit report and give reasons for its inclusion.
(8 marks)
Sia is appointed as the auditor of Rudra Plc for verification of the records relating to the period ending
December 20X7. While auditing the records, Sia observed that the records of inventory were not up-to-date.
The records for the last six months from July 20X7 to December 20X7 were not available for verification
purposes. Sia was not allowed to attend the physical verification of inventory on the cut-off date.
Management has also not updated the records of the receivables for the same period.
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This has caused severe difficulty to Sia’s audit since she was not able to confirm the position of the inventory
and receivables as on the reporting date. She is of the opinion that this may make the financial statements
materially misstated since sufficient supporting documents have not been maintained to confirm the two main
figures on the SOFP.
The amount of receivables is $150,000 and inventory is worth $250,000. These together constitute 45% of the
assets of Rudra Plc.
Required:
(b) State what kind of audit report Sia will issue in this case. Give an illustrative paragraph of how she will frame
the report that includes the description of the limitations on the audit and the opinion paragraph.
(8 marks)
(c) State the purpose of the Auditor's Responsibility paragraph in the audit report.
(4 marks)
Sia is also the auditor of Network Cables Plc. Network Cables is a company engaged in manufacturing electric
cables used in digital devices.
For the period ending 31 December 20X8, the value of inventory as shown in the SOFP was $450,000.
While auditing the valuation of inventory, Sia came to know that the company is following the ‘LIFO’ method for
valuation. However, International Accounting Standards 2 suggests that ‘FIFO’ method should be followed to
value the inventory.
Therefore, Sia drafted the following extracts for the proposed audit report:
(i)
We have audited the accompanying financial statements of Network Cables Plc, which comprise of the
statement of financial position as at December 31 20X8, the statement of changes in income, the statement
of changes in equity and the statement of cash flow statement for the year then ended, a summary of
significant accounting policies and other explanatory notes.
(ii) We conducted our audit in accordance with the International Standards on Auditing. These Standards
require that we comply with ethical requirements and plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement.
(iii) As discussed in Note 2 to the financial statements, the LIFO method is used to value the closing inventory
which in practice, in our opinion, is not in accordance with the International Accounting Standards.
(iv) Using the FIFO method, which is in accordance with the International Accounting Standards, the value of
inventory will be $375,000 as against the reported amount of $450,000.
(v) Accordingly, the current assets should be reduced by $75,000 and the profit for the year and accumulated
reserve should be decreased by $75,000.
(vi) In our opinion, except for the effect on the financial statements of the matter referred to in the preceding
paragraph, the financial statements give a true and fair view of the financial position of Network cables Plc
as at December 31, 20X8, and of its financial performance and its cash flows for the year then ended in
accordance with the International Financial Standards.
Required:
(d) Explain the meaning and purpose of each of the above extracts in your draft audit report.
(10 marks)
(30 marks)
© GTG
Question Bank: 49
71. Audit reports – Corsco
(a) Describe external auditor’s responsibilities and the work that the auditor should perform in relation to the
going concern status of companies.
(5 marks)
(b) Describe the possible audit reports that can be issued where the going concern status of a company is
called into question; your answer should describe the circumstances in which they can be issued.
(5 marks)
Corsco is a large telecommunications company that is listed on a stock exchange. It is highly geared because,
like many such companies, it borrowed a large sum to pay for a licence to operate a mobile phone network with
technology that has not proved popular. The company’s share price has dropped by 50% during the last three
years and there have been several changes of senior management during that period. There has been
considerable speculation in the press over the last six months about whether the company can survive without
being taken over by a rival. There have been three approaches made to the company by other companies
regarding a possible takeover but all have failed, mainly because the bidders pulled out of the deal as a result of
the drop in share prices generally.
The company has net assets, but has found it necessary to curtail its capital investment program severely.
Some commentators consider this to be fundamental to the future growth of the business; others consider that
the existing business is fundamentally sound. It has also been necessary for the company to restructure its
finances. Detailed disclosures of all of these matters have always been made in the financial statements. No
reference has been made to the going concern status of the company in previous auditor’s reports on financial
statements and the deterioration in circumstances in the current year is no worse than it has been in previous
years.
Required:
(c) On the basis of the information provided above, describe the audit report that you consider is likely to be
issued in the case of Corsco, giving reasons.
(4 marks)
(d) Explain the difficulties that would be faced by Corsco and its auditors if Corsco’s audit report made
reference to going concern issues.
(6 marks)
(20 marks)
(Paper 2.6 December 2003)
72. Audit reports – Hood Enterprises
You are the audit manager of Hood Enterprises a limited liability company. The company's annual turnover is
over $10 million.
Required:
(a) Compare the responsibilities of the directors and auditors regarding the published financial statements of
Hood Enterprises.
(6 marks)
(b) An extract from the draft audit report produced by an audit junior is given below:
Basis of Opinion
'We conducted our audit in accordance with Auditing Standards. An audit includes examination, on a test basis,
of evidence relevant to the amounts and disclosures in the financial statements. It also includes an assessment
of all the estimates and judgements made by the directors in the preparation of the financial statements, and of
whether the accounting policies are appropriate to the company's circumstances, consistently applied and
adequately disclosed.’
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'We planned and performed our audit so as to obtain as much information and explanation as possible given the
time available for the audit. We confirm that the financial statements are free from material misstatement,
whether caused by fraud or other irregularity or error. The directors however are wholly responsible for the
accuracy of the financial statements and no liability for errors can be accepted by the auditor. In forming our
opinion we also evaluated the overall adequacy of the presentation of information in the company's annual
report.'
Required:
Identify and explain the errors in the above extract.
Note: you are not required to redraft the report.
(10 marks)
(c) The directors of Hood Enterprises have prepared a cash flow forecast for submission to the bank. They
have asked you as the auditor to provide a negative assurance report on this forecast.
Required:
Briefly explain the difference between positive and negative assurance, outlining the advantages to the directors
of providing negative assurance on their cash flow forecast.
(4 marks)
(20 marks)
(Paper 2.6 June 2005)
73. Audit reports – MSV Co
(a) ISA 700 The Independent Auditor’s Report on a Complete Set of General Purpose Financial Statements
indicates the basic elements that will ordinarily be included in the audit report.
Required:
List SIX basic elements of an auditor’s report. Briefly explain why each element is included in the report.
(6 marks)
(b) You are the audit manager in charge of the audit of MSV Co for the year ended 28 February 2010. MSV Co
is based in a seaside town and hires motor boats and yachts to individuals for amounts of time between one
day and one week. The majority of receipts are in cash, with a few customers paying by debit card.
Consequently, there are no trade receivables on the SOFP. The main non-current assets are the motor
boats and yachts.
The company is run by four directors who are also the major shareholders. Total income for the year was about
$10 million.
The following issues have been identified during the audit:
Issue 1
Audit tests on sales indicate a weakness in the internal control system, with a potential understatement of
income in the region of $500,000. The weakness occurred because sales invoices are not sequentially
numbered, allowing one of the directors to remove cash sales prior to recording in the sales day book. This was
identified during analytical procedures of sales, when the audit senior noted that on the days when this director
was working, sales were always lower than on the days when the director was not working.
(8 marks)
© GTG
Question Bank: 51
Issue 2
During testing of non-current assets, one yacht was found to be located at the property of one of the directors.
This yacht has not been hired out during the year and enquiries indicate that the director makes personal use of
it. The yacht is included in the non-current assets balance in the financial statements.
(6 marks)
Required:
For each of the issues above:
(i) List the audit procedures you should conduct to reach a conclusion on these issues;
(ii) Assuming that you have performed all the audit procedures that you can, but the issues are still unresolved,
explain the potential effect (if any) on the audit report.
Note: the mark allocation is shown against each of the two issues.
(20 marks)
(Adapted from June 2007)
74. Audit reports – JonArc & Co
(a) You are the audit manager in JonArc & Co. One of your new clients this year is Galartha Co, a
company having net assets of $15 million. The audit work has been completed, but there is one
outstanding matter you are currently investigating; the directors have decided not to provide
depreciation on buildings in the financial statements, although International Accounting Standards
suggest that depreciation should be provided.
Required:
State the additional audit procedures and actions you should now take in respect of the above matter.
(6 marks)
(b) Unfortunately, you have been unable to resolve the matter regarding depreciation of buildings; the
directors insist on not providing depreciation. You have therefore drafted the following extracts for your
proposed audit report.
1. We conducted our audit in accordance with International Standards on Auditing. Those Standards
require that we comply with ethical requirements and plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement
(remaining words are the same as a normal unmodified report).
2. As discussed in Note 15 to the financial statements, no depreciation has been provided in the
financial statements which practice, in our opinion, is not in accordance with International
Accounting Standards.
3. The charge for the year ended 30 September 2007, should be $420,000 based on the straight-line
method of depreciation using an annual rate of 5% for the buildings.
4. Accordingly, the non-current assets should be reduced by accumulated depreciation of $1,200,000
and the profit for the year and accumulated reserve should be decreased by $420,000 and
$1,200,000, respectively.
5. In our opinion, except for the effect on the financial statements of the matter referred to in the
preceding paragraph, the financial statements give a true and fair view (remaining words are the
same as for an unmodified opinion paragraph).
The extracts have been numbered to help you refer to them in your answer.
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Required:
Explain the meaning and purpose of each of the above extracts in your draft audit report.
(10 marks)
(c) State the effect on your audit report of the following alternative situations:
(i) Depreciation had not been provided on any non-current asset for a number of years, the effect of which
if corrected would be to turn an accumulated profit into a significant accumulated loss.
(ii) JonArc & Co were appointed auditors after the end of the financial year of Galartha Co. Consequently,
the auditors could not attend the year end inventory count. Inventory is material to the financial
statements.
Note: you are not required to draft any audit reports.
(4 marks)
(20 marks)
(December 2007)
SECTION A
SOLUTION BANK
AUDIT FRAMEWORK AND
REGULATION
A
1. Independence of auditors – Abel and Co
This question is designed to test your understanding on the topic of ethical principles in relation to
independence and confidentiality. You can earn good marks easily in this question by showing your knowledge
about the five ethical principles and its application in a practical situation.
To score good marks in part (a), you must demonstrate your understanding about what constitutes
independence for accountants, why it is important and how it can be compromised in real life situations.
There are four situations outlined and 20 marks available. The presumption is therefore five marks per situation
examined, equating to about 9 minutes for each (5 x 1.8 minutes/mark = 9 marks).
(a)
(i) Shareholding by staff
This situation poses a self interest threat to Abel and Co. A self interest threat is said to exist when an
accountant has a personal link or a financial interest in an organisation he is auditing or working for. This
naturally leads to the danger that the accountant may not be completely independent and objective in his work
and may be influenced to deliver a more favourable picture of the organisation’s financial performance and
position than is justified.
Given that the shares held by the junior staff member represent “a large investment for the staff member” his
working on the audit assignment jeopardises the objectivity of the whole audit team. In addition, advising the
staff member to hold onto the shares because their share price is expected to rise, involves Abel and Co
capitalising on privileged information. This would violate the corporate governance requirements of many
countries and may even be classified as insider trading.
Lastly, it should be noted that the ACCA Rules of professional ethics prohibits partners from holding shares in
audit client companies and many audit firms have taken the extra step of extending this ruling to all their audit
staff. Furthermore, the ACCA Rules of professional ethics recommend that the audit team must not include
members who have a financial interest in the audit client.
Therefore in this situation the firm has compromised on its independence.
5 marks
(ii) Management of accounting services
Having the audit senior become the management accountant jeopardises Abel and Co’s independence with
their client. This is because Abel can no longer assert that the firm has no relationship with the party or parties
that prepared the data, which will be audited by the firm. In addition, it also creates a self review threat for the
firm. A self review threat occurs when an accountant has to review and regulate his previous judgments. The
risk that exists here is the temptation for an accountant to “cover up” any mistakes he may have made.
Given that in this scenario, Abel and Co, at the time of the next audit, will be auditing the work of “one of their
own”, this threat may well come into existence as the senior senior for all practical purposes became a member
of the organisation’s management team for three months.
However, in emergencies, the ACCA rule permits its members to perform the function of a management
accountant, provided it is for a short period and the management accepts full responsibility for the work of the
audit firm's staff member. In the absence of any declaration from the management, it can be concluded that the
firm has compromised on its independence.
5 marks
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(iii) Advice on controls
The situation that Abel and Co faces in this scenario can be divided into two parts. The first is that the firm
advised its client on the weaknesses in their MIS. The second part is that the firm was then subsequently
offered a computer consultancy assignment from this audit client.
Regarding the first part, reporting any deficiencies or weaknesses in an organisation’s internal controls or
systems is a standard part of any audit. Therefore their independence was not comprised by providing this
information in the management letter. In addition, it is also fairly routine for clients to offer their auditors work
assignments not related to audit (clients often cite the reason for this as the familiarity their auditors have with
the business’s workings, systems, procedures etc). The ACCA rules of ethics and conduct do not prevent audit
firms from accepting non-audit assignments from their clients subject to the provision that no one client provides
more than 15% of the firm’s revenue (or 10% for a public interest company).
However, accepting this assignment would lead Abel and Co into a “grey area”. It is generally said that when an
auditing firm starts generating additional revenue from non audit services from a client, its independence
becomes compromised. The concern is that auditors will become less inclined to disagree with management, or
even to provide a qualified report for fear of losing the additional business. With this particular scenario, given
that Abel and Co would be designing the system, it could lead to a threat of self review at the time of the next
audit.
Therefore accepting this assignment has compromised Abel and Co’s independence.
5 marks
(iv) Advice to non-audit clients
The situation that Abel and Co faces in this scenario can again be divided into two parts. The first is that the firm
accepted a non-audit assignment from a non-audit client. The second part relates to how the firm actually
completed the assignment.
Abel and Co did not compromise their independence in any way by accepting the assignment. They were asked
to provide a second opinion on a subject matter they were adequately qualified to report on (i.e. inventory
valuation). However, the way Abel and Co carried out this assignment broke protocol and professional rules on
how second opinions should be provided.
The firm should have contacted the company’s auditors to ensure that their advice would be based on all
available facts. Given that Abel did not do this, their reported opinion may now be erroneous. Therefore,
accepting the appointment as the company’s new auditor will compromise their independence as it will give rise
to an advocacy threat. An advocacy threat occurs when “a professional accountant promotes a position or
opinion to the point that subsequent objectivity may be compromised”. Abel has already formally stated that the
organisation’s “accounting treatment was in order”, so the threat is that they may be reluctant to contradict their
former statement.
Therefore, accepting this assignment would compromise the firm’s independence.
5 marks
Maximum marks 20
(b) Confidentiality comprises of the following
(i) Non-disclosure of information. However, such information can be disclosed to a third party if the
accountant has the specific authority to do so, or the accountant has a legal and professional right to
do so.
(ii) Non-utilisation of information to the advantage of the accountant, e.g. the auditor sells shares in the
client’s company after receiving confidential information about the company which will reduce the price of
the company’s shares.
(iii) Confidentiality of information received from a prospective client or employer.
(iv) Confidentiality of information received from a prospective client or employer, within the firm /
organisation where the accountant is employed.
(v) Confidentiality of information within the firm or client organisation.
(vi) Professional accountants should ensure that staff and associates respect this duty of confidentiality.
(vii) Professional accountants must maintain confidentiality even at a future date, when the relationship
with a client or employer ends.
1 mark for each valid point
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Solution Bank: 55
The following are the situations where an auditor may disclose confidential information about a client:
The concept of confidentiality is one of the five fundamental principles of professional ethics that accountants
are meant to abide by. It requires that accountants never disclose any confidential information of their clients or
organisations to any other third party except in certain very restricted circumstances.
1 mark
Therefore, alongside their duty to their clients, accountants also have a duty to serve and protect the best
interests of their profession and the public. These two duties constitute a “higher” obligation for accountants.
1 mark
Therefore, there are situations where accountants can be required to violate this principle and disclose their
client’s confidential information. These situations typically arise when such disclosure is in the public interest
and / or when the accountant is required to do so for legal or professional reasons.
3 marks
Examples of these instances include:
¾ if the accountant becomes aware of / suspects that his client has committed a crime that goes against the
public interest (e.g. treason, drug trafficking). Then the accountant becomes duty bound to inform the
relevant authorities;
¾ if the accountant has received a court order to release such information and the accountant or another
member of the profession is involved in a legal dispute with the client (e.g. suing for unpaid fees).
3 marks
Maximum marks 10
2. Audit engagements – Bondi
This question is designed to test your understanding of the concept of audit engagements. You are required to
describe the evaluations that an auditor must follow before accepting an audit assignment. In addition to that
you must also demonstrate that you understand what constitutes appropriate behaviour for an auditor in
connection to the detection and reporting of fraud.
(a) An audit engagement is defined by the Code of Ethics for Professional Accountants as an assurance
engagement which provides a high level of assurance that the financial statements are free from any
material misstatement.
Therefore, when deciding whether to accept an audit engagement, the auditor needs to gauge the level of risk
that will go with the assignment. That is to say, they need to ascertain whether there are factors present that
increase the possibility of material misstatement going undetected and thereby cause them to incorrectly
declare the financial statements of the organisation to be true and fair. If these factors point to the risk of
material misstatement being too high then the assignment should be declined.
1 mark
(i) Arguments for declining the assignment
¾ The previous auditors have advised against accepting the assignment with supporting rationale (although
the majority of partners do not accept the reasons why the concerns highlighted by Bondi’s previous
auditors cannot be simply dismissed);
¾ Management, by not taking any serious action against employees guilty of fraud, is encouraging a system
and culture of unethical behaviour;
¾ The danger that the growth the organisation is undergoing is not being well controlled (inadequate
accounting systems that cannot keep pace with business expansion, increase the risk of inadequate and /
or inaccurate financial reporting);
¾ Management seems to be following an aggressive take over strategy without devoting the necessary
attention and effort to develop stronger internal controls (again this increases the risk of inadequate and / or
inaccurate financial reporting);
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¾ Any unnecessarily complicated operation or MIS is often a warning signal that fraud or accounting
malpractice may be taking place;
¾ This also applies to having a management that is unable or unwilling to cooperate with their auditors and the
planned upcoming public listing indicates that management may well be over-aggressive in seeking good
results and in pushing and fighting for an unqualified audit report which may improve their public image.
1 mark for each valid point
(ii) Arguments for accepting the assignment
¾ The previous auditors may be biased in their reports and may be covering up their own shortcomings;
¾ Since Bondi has already received one qualified audit report they are more likely to cooperate and work with
their auditors this time around;
¾ These factors may well lead to a justifiably clean audit report being published which would benefit both the
organisation and all their stakeholders.
1 mark for each valid point
Maximum marks 7
(b) With regard to the planning of the audit, the areas I would pay particular attention to include:
¾ determining how and why frauds took place in the past. More specifically I would try and ascertain the
lapses or deficiencies in Bondi’s internal control systems that allowed employees to commit fraud. As
importantly, I would also ascertain from management why no severe disciplinary action was taken against
these employees;
¾ the entire internal control system is another area that needs to be carefully examined and evaluated
especially since the organisation is in a growth phase;
¾ examining and evaluating the organisation’s MIS also needs to be a priority especially since the previous
auditors have labelled it as being “unreasonably complicated” and if need be, enlisting the services of a
computer audit systems specialist and
¾ scrutinising and understanding the “complex incentive schemes” offered by car manufacturers and if
necessary, enlisting the services of an industry specialist.
1.5 marks for each valid point
Focusing on the above factors would give me a thorough understanding of Bondi’s business thereby helping me
to identify high risk areas (and therefore areas where I should concentrate my audit). In addition it would also
put me in a better position to be able to evaluate whether the organisation’s previous auditors were justified in
their comments or not.
2 marks
Maximum marks 7
(c) As a Chartered Certified Accountant, I cannot associate myself with fraud or fraudulent behaviour of any
kind. This would not only cause me to violate the ethical principle of integrity but also bring disrepute to my
profession.
2 marks
Therefore my first and immediate step would be to notify either Bondi’s audit committee or board of directors in
writing of the fraud taking place. The next step would be to determine whether appropriate corrective action was
being taken.
2 marks
If appropriate corrective action was not being taken, I would then take legal advice to determine whether I am
legally bound to take any further action (e.g. whether I am required to break my duty of confidentiality and inform
the relevant tax authorities or if I am required to inform the shareholders of the organisation).
2 marks
At this point I would have to evaluate carefully whether I wish to continue with the assignment as it would
require working with an unethical organisation which inevitably will be associated with high risk. In the event
decide to continue, I would however not provide a clean audit if the amounts of tax withheld were material. I
would provide a qualified report detailing the amount of tax payments withheld and outlining penalties that might
be raised by the government.
2 marks
Maximum marks 6
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Solution Bank: 57
3. IAASB – ISA
To score high marks in this question you must demonstrate your understanding of the functions and roles
played by the IAASB. You must also discuss how this organisation can help and benefit local standard setters in
performing their functions. You should put your answer into a letter format.
(a)
Dear Sir,
Thank you for your letter of X / X / 200X enquiring about the functions of the IAASB and how it might be able to
assist national standard setting bodies.
The International Auditing and Assurance Standards Board (“IAASB”) is a specialised committee created by the
International Federation of Accountants (“IFAC”). The main function and role of the IAASB is to produce a set of
basic principles and procedures regarding auditing coupled with guidance on how they should be applied in
practical audit situations.
We term these principles and procedures International Standards on Auditing or “ISAs” for short. Our main aim
is to write and promote a uniform set of auditing standards or ISAs to serve as a benchmark for professional
accountants around the world when they are conducting their audits.
The main goal of the IAASB is to serve the public by setting high quality auditing, assurance, quality control and
related services standards and by facilitating the convergence of international and national standards.
However please note that ISAs are not meant to override or supersede any local laws or regulations. Rather
they are heavily promoted to help ensure that audits the world over are conducted in accordance with a set of
uniform international standards thereby enhancing the quality and uniformity of auditing throughout the world
and strengthening public confidence in our profession.
1 mark for each valid point
Maximum marks 5
(b) Today, over 100 countries have either adopted or are in the process of adopting / incorporating ISAs into
their national auditing framework. Part of the reason for our success in this regard is that we work closely
with many national standard setters. By cooperating and working in conjunction with national standard
setters when developing ISAs we have managed to help minimise duplication of effort as well as gaining
maximum support and acceptance of our standards during the early stages of their development.
2 marks
Therefore, we would be able to assist you and the national standard setter you work for in developing quality
policies and procedures for your auditors to follow whilst they are performing their audits. Furthermore these
policies and procedures would offer the added benefit of being part of an accepted set of international standards
being followed on an almost global scale.
1.5 marks
Overall it can be said that the relationship that the ISAs share with the national standards is one of
co-existence. By working closely with various local standard setters, the IAASB has helped to make
adoption / integration of ISAs an almost seamless process in many countries.
1 mark
The development process of ISAs contains a stage relating to discussion with the public at large. After the
basic research is complete and the exposure draft is prepared, it is discussed and debated at an open
IAASB meeting in which the public is free to comment on the draft.
The exposure draft is then placed on the IAASB website for at least 120 days and public comments are
invited. The national standard setter can also give his comments, favourable or unfavourable, about the
IAASB standards. IAASB finalises the standards taking the public comments into consideration.
If I can be of any further assistance, please do not hesitate to contact me.
Yours faithfully,
Ivan S Atkins (imaginary name)
Maximum marks 5
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4. Role of auditor in corporate governance – ISA 260
This question tests your knowledge and understanding on the concept of corporate governance. To score good
marks in this question, you should demonstrate what the main purpose and elements of a good corporate
governance framework are. In addition to that, you must explain the role that auditing and auditors are required
to play in this framework. Part (b) is more open-ended. It does not specify how many examples to give, but
assume that 5 marks imply 5 examples.
(a) Corporate Governance represents the set of policies and procedures that determine how an organisation is
directed, administered and controlled. One of the main aims of corporate governance is to align the interests
of an organisation’s board of directors, executives and managers with those of its shareholders. To help
ensure this, good corporate governance requires organisations to set up a system of “checks and
balances”.
1.5 marks
The audit function is a key component of this system as it provides an assurance about the information
published in the financial statements to the shareholders of an organisation. This assurance is presented in the
form of a report in which the auditor states that the organisation’s financial statements truly and fairly portray the
financial position and performance of the organisation over a given period of time.
1.5 marks
Shareholders can then with reasonable confidence use this information to determine if the organisation is being
run with their best interests in mind (e.g. is management pursuing activities that maximise shareholder value).
This information can also be used by shareholders to evaluate the financial condition and performance of the
organisation and consequently the performance of the organisation’s board of directors (the group ultimately
responsible for the performance of the organisation).
1.5 marks
Corporate governance codes insist that the directors must have procedures for identifying risk and that they
must also implement a satisfactory system of internal control. As part of the audit function, the auditors will also
be very interested in how directors assess the major risks that the company faces and auditors are, of course,
closely involved with evaluating the system of internal control that is in place.
They report weaknesses in the internal control system to management and if these shortcomings lead to the risk
of material misstatement in the financial statements, the problem will also be reported to shareholders in a
qualified audit report.
1.5 marks
If shareholders are dissatisfied with the performance of the organisation, they can opt to elect a new board of
directors. In this way the audit function becomes a tool that can be used by the shareholders of the organisation
to help ensure that their interests are protected on an on-going basis. Overall corporate governance involves
organisations being transparent and honest in all their dealings.
1.5 marks
Maximum marks 5
(b) “Those charged with governance” are defined as the person(s) “with responsibility for overseeing the
strategic direction of the entity and obligations related to the accountability of the entity. This includes
overseeing the financial reporting process.”
Although not a universal rule, “those charged with governance” for most organisations typically represent their
board of directors and / or audit committees. Instances or matters of interest that may arise during the course of
the audit that auditors need to communicate to this group include:
(i) Whether there have been any changes made to the accounting policies and practices being used by the
organisation (e.g. if a different depreciation rate will be used to value the organisation’s assets).
(ii) Whether any potential risks or exposures need to be included in the statements (e.g. disclosure of any
pending litigation).
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Solution Bank: 59
(iii) Whether there is any material risk present that may affect the organisation’s ability to continue as a going
concern and whether the risk should be reported in the financial statements (e.g. if the organisation’s total
debt has reached an unserviceable level).
(iv) If the internal control systems are not sufficient for the nature and complexity of the organisation’s
transactions (e.g. when there is no proper segregation of duties with the handling and recording of cash
payments and collections in a large organisation as the same person is doing the receiving and recording of
all cash payments).
(v) Whether the auditors have come across any occurrences of fraud or any other management impropriety
(e.g. an auditor has discovered that certain managers are using their corporate credit cards to pay their
personal bills).
(vi) Any material disagreements with the management on the financial statements / reporting process (e.g.
disagreements over which inventory valuation method should be used).
1 mark for each valid point
Maximum marks 5
5. Professional conduct – Cosby Travel
This question is designed to test your knowledge and understanding of the concept of ethics. To score good
marks, you must demonstrate your knowledge of the ethical principles that auditors are required to always
comply with as well as how they can be applied in a practical situation.
The question says “With reference to the ACCA’s Rules of professional conduct…”, so it would probably be a
good idea to note what these are at the start of your answer to part (b).
(a) An audit is an engagement that provides a high level of assurance that financial statements are free of any
material misstatement. An audit is defined as being an independent examination of financial information,
with a view to expressing an opinion on this information (i.e. with regards to how true and fair the presented
financial information is).
1 mark
Therefore, in order to successfully complete an audit, an auditor must be independent of the organisation he is
auditing. That is he should not have been involved in preparing the financial statements of the company nor
should he have any relationship with any of the parties who have prepared these financial statements, nor any
financial interest in the client.
1 mark
In addition, he must also at all times be viewed as being independent of the entity he is auditing by all outside
parties. This is because if the independence of an auditor is questioned then the opinion of the auditor will be of
less value and the entire purpose of conducting an audit will be defeated.
1 mark
Maximum marks 2
(b)
(i) ACCA’s rules of professional conduct state than an auditor must always be in compliance with the five
fundamental principles of ethics whilst performing any audit assignment. If an auditor believes that
accepting and subsequently working on an audit will cause him to violate any of these five principles then
the assignment should be declined.
These five principles are:
¾
¾
¾
¾
¾
integrity
objectivity
professional competence and due care
confidentiality
professional behaviour
1 mark
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Regarding the acceptance of the Cosby Travel assignment, the two principles that may be compromised are
professional competence and due care as well as the objectivity principle. The professional competence and due
care principle requires auditors to have the necessary knowledge and skill set as well as resources (e.g. time,
staff) to satisfactorily complete any audit assignment they accept.
Given that my firm “does not have much experience in the travel sector” I should very carefully study and evaluate
whether my firm has the necessary expertise needed to complete this audit. In addition, given that the
assignments would represent “a substantial amount of fee income” and that the company is “growing fast”
indicates that the number of transactions is substantial and my firm may not have the necessary staff or time to
diligently complete the assignment.
2 marks
The objectivity principle requires that auditors should have no personal bias or conflict of interest in their work.
Again, given that the assignment represents substantial revenue for the firm, there is a danger that my firm might
become too dependent upon this income, thereby impairing the ability to be objective (e.g. this dependence may
result in providing a more favourable audit report than what is justified). Therefore, given that Cosby is a privately
held company it should be determined that the total revenue from both assignments does not exceed 15 percent of
my firm’s total billing. If it does, then either one or both of the assignments should be declined.
2 marks
It is 10% for a public listed company.
(ii) Although it is permitted by the ACCA for auditors to assist in the preparation of an entity’s financial statements
(provided that the client accepts full responsibility for the accounting records and financial statements) it is
generally not considered a good practice for a number of reasons.
Firstly, it highlights a weakness in the organisation’s internal control and accounting systems that they are not able
to prepare their own financial statements. Secondly, given that the role of the statutory auditor is to express an
independent opinion on the financial statements, he should ideally have had no part in preparing them (even if his
role was limited to providing only assistance). This factor may also cause other stakeholders to view the auditor as
not being entirely independent and thereby question the value of the audit. If help in preparing the accounts is
given by the audit firm, then the audit must be carried out by a different team from the firm so as to minimise the
self-review threat.
2 marks
The same rationale applies to accepting the assignment for reviewing the MIS of the organisation. Part of an
auditor’s responsibilities is to review and evaluate the effectiveness of an organisation’s internal control systems. If
the auditor has had a hand in designing the very systems he is evaluating, it may cause a conflict of interest
(as the auditor may not wish to later criticise his own work).
2 marks
The firm must also keep track of the total recurring fees received from one client and refuse work which would take
those fees over 15% of their total fees (or 10% in the case of a special interest or listed company).
1 mark
Therefore, given the above factors, I feel my firm should either accept only the statutory audit assignment from
Cosby or instead accept the assignments to assist in preparing the financial statements and computer review, but
not both.
1 mark
Maximum marks 8
6. Ethics - Watson
In this question you are required to discuss three of the ethical principles in detail.
When you are asked to describe or to define something, it can be difficult to do this in an abstract way. Always
consider giving a practical example to illustrate your answer and to help convey your knowledge to the
examiner
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Solution Bank: 61
(a) Fundamental ethical principles
(i) Integrity
Any person acting in the public interest must have integrity. Integrity implies qualities related to honesty,
fairness, candour and intellectual probity.
This principle requires members to be “straightforward and honest in all professional and business
relationships”. In addition, members also must not be associated with or “sign off” on any fraudulent or
inaccurate financial reports and / or statements.
1 mark
For example, accountants are expected either to terminate an assignment or resign from an organisation if they
are ever given an ultimatum by their client or employer to produce financial statements / reports that do not
provide a “true and fair” view.
1 mark
(ii) Objectivity
Objectivity can be defined as giving fair and impartial consideration to all matters that are relevant to the task.
This means that there should be no bias, prejudice or compromise while taking a decision.
An accountant needs to be objective because several questions relating to an opinion on a set of financial
statements relate to judgement rather than fact. Hence, accountants have to be unbiased and impartial in
making their decision. This will help them in challenging assumptions made by the directors.
Accountants are always expected to keep any personal bias or conflict of interest out of their work. Therefore all
of their findings and judgments should be based solely upon sound rationale and research.
1 mark
For example, an internal auditor cannot say that the implementation of systems and controls for a particular
department is weak solely because he does not like the head of the department.
1 mark
(iii) Independence
Independence ensures that no circumstances and associations exist which could make a rational and informed
third party conclude that objectivity is impaired or might be impaired. Hence, independence is closely related to
objectivity.
1 mark
For example, an accountant must not accept gifts or entertainment which may impair his judgment. He must
refrain from participating in any activity which will impair, or appear to impair, his judgment.
1 mark
Maximum marks 6
(b) Threat to independence
(i) Home loan taken by Watson
Under normal circumstances, auditors are not permitted to receive either loans or loan guarantees from clients.
However, if the auditor receives a loan from a client whose normal business is to make loans,(such as a bank),
and if the loans are sanctioned according to the standard lending procedures and on normal terms, the auditor
does not face a threat to his independence.
1 mark
On the other hand, if the auditor receives a loan which is not in accordance with the standard terms applicable
for home loans (i.e. loan amount given is higher than the loan which is normally sanctioned or the rate of
interest charged on the loan is less than the normal interest charged, etc) the auditor would face a threat to his
independence. His independence could be impaired due to intimidation or self-interest and the auditor might not
act objectively since he has received a favour from the client.
1 mark
Considering the fact that Watson was offered a loan at the normal commercial terms, there appears to be no
threat to his independence.
1 mark
Maximum marks 2
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(ii) Fees not paid
In situations where the fees received from the assurance client ware significant, the auditor would face a threat
to his independence. The reason for this is that the auditor would be under a threat that his fees will continue to
remain unpaid if he acts in public interest by reporting objectively. For example, a qualified audit report might
lead to the collapse of the client and the auditor would then simply be an unsecured creditor.
1 mark
In this scenario, Mr. Watson bills were unpaid for a long time as of the date of signing the audit report.
Therefore, he faces an intimidation threat and a self-interest threat to his independence. In fact, he should not
have started this year’s audit whilst last year’s fees were outstanding: when you are in a hole, stop digging!
1 mark
Maximum marks 2
7. Ethics – Stark Co
For part (a) explain ethical threats from the scenario provided and then for each threat, explain how that threat
could be mitigated.
The question is worth 12 marks. The mark allocation would be 0.5 for identifying the threat, 0.5 for explaining
the threat and then 1 mark for showing how the threat could be mitigated. Therefore to get maximum marks, at
least six valid points need to be made.
For part (b) students are required to discuss the benefits to the company in the scenario of establishing an
internal audit department.
The question was worth 8 marks. The marking scheme allows 1 point for explaining one benefit of internal audit
and a further mark for relating this to the scenario information.
(a) Ethical threats
¾ Letting the daughter of the engagement partner, Zoe, be involved in the audit may give an impression of
lack of independence of the audit firm. Zoe may deliberately refrain from identifying errors in an effort to
avoid problems for her father in dealing with the client. i.e. it would cause a self-interest threat. Not allowing
Zoe to be a part of the audit team will avoid this threat. However, if Mr. Son is no longer the engagement
partner, Zoe could be a part of the audit team without affecting the independence of the firm.
¾ As the engagement partner, Mr. Son is working with the client for the last nine years. He may be too familiar
with the client. This would pose a familiarity threat. The long working relationship could affect his objectivity
in making decisions. This threat could be mitigated by rotating Mr. Son from being an engagement partner.
¾ A balloon flight is announced for the audit team on completion of the audit. Independence of the firm could
be in danger, if this balloon flight is accepted. It makes no difference whether the flight costs less or more
than the yatch expense. It would cause a self-interest threat. To avoid this threat, the flight should not be
accepted, and previous cases of such hospitality should be investigated.
¾ Accepting a contingent fee (based on the percentage of tax saved) is not acceptable, as there might be a
temptation to achieve the highest possible tax refund by resorting to illegal methods. This would also cause
a self-interest threat. In order to mitigate this threat, the fee should be based on the time taken for the job
and/or the experience and knowledge needed to carry out the task.
¾ Mr. Far, the audit senior, seeks investment advice from Stark Co. Audit independence could be threatened
by continued use of the services of Stark Co, especially if Stark Co offers any concessions in fees to Mr.
Far. This again poses a self-interest threat. To mitigate this threat, Mr. Far should be discouraged to use the
services of Stark Co.
¾ The firm should not represent Stark Co in court, as it could lead to an advocacy threat. The firm may be
seen as endorsing the position of the client in court.
2 marks for each valid point
Maximum marks 12
© GTG
Solution Bank: 63
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Stating “The auditor should not accept the balloon ride from the client.” The answer is incomplete as it
identifies the ethical threat but does not explain why it is a threat. Therefore it would be more appropriate to
mention the point as “The auditor should not accept the balloon ride from the client as the ride would impair
the team’s judgment’.
(ii) Other points:
¾ not explaining the ethical threat (as noted above). Simply stating a threat was “intimidation”, for example, is
insufficient as an explanation.
¾ mentioning non-relevant points. Firstly, in this situation Zoe being part-qualified would not bar her from
being on the audit team as this is how auditors obtain “on the job” training.
(b) Benefits of Stark Co establishing an internal audit department
¾ Effectiveness of internal control: the internal audit department would review the effectiveness of the
internal controls of the company and in areas where the controls are weak, suggest ways to improve them.
Considering the fact that Stark would be handling significant cash balances belonging to their clients and
also the fact that Stark is regulated, the review of effectiveness of internal controls relating to its cash
operations would significantly benefit the company.
¾ Value for money audit: such audits can be undertaken internally by the company. For example, to
ascertain the cost effectiveness of the investment advice in relation to the income / commission generated.
¾ Regulation: stark might be required to produce certain reports, and comply with certain conditions, as the
company might be under the supervision of a regulatory authority. To ensure compliance with the regulatory
requirements, the internal audit reports will prove to be helpful. Moreover, even though an internal audit is
not mandatory by law, it is strongly recommended for the smooth working of an organisation.
¾ Taxation services: from the scenario it is clear that Stark requires specialist assistance for preparation of
taxation computations and assistance in court proceedings regarding a dispute. Therefore if the internal
audit department contains persons with this expertise, it would definitely benefit Stark. Furthermore,
provision of these services would also remove any conflict of interest between Stark’s auditors.
¾ Risk assessment: internal audit would help in risk assessment for the clients, involving portfolios
recommended for them. This will ensure that clients’ risk profile would match the portfolio they own.
Furthermore, if any weaknesses in this area were observed, a recommendation to amend the investment
portfolios would be made.
¾ Liaisons with the external auditors: the time and costs of the external audit decrease in cases where the
external auditors can rely on the internal controls of the company while conducting the audit. Moreover, the
internal auditors can monitor the work of the external auditors, and confirm whether they carry out an
efficient service.
¾ Reports to the board: the internal audit department can help to gauge the accuracy of the reports
submitted to the board. This is especially important considering the fact that Stark is a financial service
provider. The internal audit department’s review will confirm the accuracy of the reports and make them
more reliable.
2 marks for each valid point
Maximum marks 8
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Stating, “Internal audit can help establish the internal control system for management.” This point is
technically incorrect. It would be more appropriate to write this point as ‘Internal audit helps to monitor and
recommend improvements to the system; establishing the system immediately provides a self-review
threat’.
(ii) Stating, “Internal audit will help decrease the cost of external audit”.
The point is not complete as there is no explanation of how the cost reduction will actually happen.
Additional detail is therefore needed to discuss this benefit.
Continued on the next page
64: Audit Framework and Regulation
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(iii) Other common errors
¾ Explaining the work of an audit committee such as recommending auditor appointment.
¾ Explaining the problems of establishing an internal audit department.
¾ Explaining the benefits of internal audit rather than outsourcing.
These points do not meet the question requirement and so are not relevant.
8. Audit committee and internal and external auditors – Conoy Co
This question, carrying 20 marks, has two requirements.
Part (a) worth 8 marks is quite straightforward as you are required to contrast the role of an internal and external
auditor. You can score good marks by including four valid points in your answer relating to objectives, scope of
work, relationship with the company and reporting. This question can also be presented in a tabular format.
Part (b), carrying 12 marks, requires you to discuss the benefits of forming an audit committee using information
from the scenario. As the verb in the question is ‘discuss’, in order to score the maximum marks, you need to
write at least 6 valid points. For each point, you can score up to one mark for explaining the benefit of an audit
committee and 1 mark for showing how this can be applied to the scenario.
(a) Role of internal and external auditors – differences
Objectives
The main objective of internal audit is to improve a company's operations, primarily in terms of validating the
efficiency and effectiveness of the internal control systems of a company.
The main objective of the external auditor is to express an opinion on the truth and fairness of the financial
statements, and other jurisdiction specific requirements such as confirming that the financial statements comply
with the reporting requirements included in legislation.
2 marks
Reporting
Internal audit reports are normally addressed to the board of directors, or other people charged with governance
such as the audit committee. Those reports are not publicly available, being confidential between the internal
auditor and the recipient.
External audit reports are provided to the shareholders of a company. The report is attached to the annual
financial statements of the company and is therefore publicly available to the shareholders and any reader of
the financial statements.
2 marks
Scope of work
The work of the internal auditor normally relates to the operations of the organisation, including the transaction
processing systems and the systems to produce the annual financial statements. The internal auditor may also
provide other reports to management, such as value for money audits which external auditors rarely become
involved with.
The work of the external auditor relates only to the financial statements of the organisation. However, the
internal control systems of the organisation will be tested as these provide evidence on the completeness and
accuracy of the financial statements.
2 marks
Relationship with company
In most organisations, the internal auditor is an employee of the organisation, which may have an impact on the
auditor's independence. However, in some organisations the internal audit function is outsourced.
The external auditor is appointed by the shareholders of an organisation, providing some degree of
independence from the company and management.
2 marks
Maximum marks 8
© GTG
Solution Bank: 65
In order to score the maximum marks, your answer must:
¾ provide a clear contrast between the two sets of auditors (i.e. avoid presenting the answer in one long
paragraph by making individual points difficult and sometimes impossible to identify).
¾ include only those points that relate to the role of internal or external auditors.
¾ explain the points. For example:
9 state that both sets of auditors are responsible for detecting fraud; and
9 explain that the main responsibility rests with internal audit while external audit is concerned with
material fraud only.
(b) Benefits of forming an audit committee in Conoy Co
Assistance with financial reporting (no finance expertise)
The executive directors of Conoy Co do not appear to have any specific financial skills - as the financial director
has recently left the company and has not yet been replaced. This may mean that financial reporting in Conoy
Co is limited or that the other non-financial directors spend a significant amount of time keeping up to date on
financial reporting issues.
An audit committee will assist Conoy Co by providing specialist knowledge of financial reporting on a temporary
basis - at least one of the new appointees should have relevant and recent financial reporting experience under
codes of corporate governance. This will allow the executive directors to focus on running Conoy Co.
2 marks
Enhance internal control systems
The board of Conoy Co does not necessarily understand the work of the internal auditor, or the need for control
systems. This means that internal control within Conoy Co may be inadequate or that employees may not
recognise the importance of internal control systems within an organisation.
The audit committee can raise awareness of the need for good internal control systems simply by being present
in Conoy Co and by educating the board on the need for sound controls. Improving the internal control 'climate'
will ensure the need for internal controls is understood and reduce control errors.
2 marks
Reliance on external auditors
Conoy Co's internal auditors currently report to the board of Conoy Co. As previously noted, the lack of financial
and control expertise on the board will mean that external auditor reports and advice will not necessarily be
understood - and the board may rely too much on external auditors
If Conoy Co’s external auditors, report to an audit committee this will decrease the dependence of the board on
the external auditors. The audit committee can take time to understand the external auditor's comments, and
then via the non-executive director, ensure that the board takes action on those comments.
2 marks
Appointment of external auditors
At present, the board of Conoy Co appoints the external auditors. This raises issues of independence as the
board may become too familiar with the external auditors and so appoint on this friendship rather than merit.
If an audit committee is established, then this committee can recommend the appointment of the external
auditors. The committee will have the time and expertise to review the quality of service provided by the external
auditors, removing the independence issue.
2 marks
66: Audit Framework and Regulation
© GTG
Corporate governance requirements - best practice
Conoy Co does not need to follow corporate governance requirements (the company is not listed). However, not
following those requirements may start to have adverse effects on Conoy. For example, Conoy Co's bank is
already concerned about the lack of transparency in reporting.
Establishing an audit committee will show that the board of Conoy Co is committed to maintaining appropriate
internal systems in the company and providing the standard of reporting expected by large companies.
Obtaining the new bank loan should also be easier as the bank will be satisfied with financial reporting
standards.
2 marks
Given no non-executives - independent advice to board
Currently Conoy Co does not have any non-executive directors. This means that the decisions of the executive
directors are not being challenged by other directors independent of the company and with little or no financial
interest in the company.
The appointment of an audit committee with one non-executive director on the board of Conoy Co will start to
provide some non-executive input to board meetings. While not sufficient in terms of corporate governance
requirements (about equal numbers of executive and non-executive directors are expected) it does show the
board of Conoy Co are attempting to establish appropriate governance systems.
2 marks
Advice on risk management
Finally, there are other general areas where Conoy Co would benefit from an audit committee. For example,
lack of corporate governance structures probably means Conoy Co does not have a risk management
committee. The audit committee can also provide advice on risk management, helping to decrease the risk
exposure of the company.
2 marks
Maximum marks 12
In order to score the maximum marks, you must avoid the following mistakes:
¾ listing the benefits of an audit committee with little or no reference to the details in the scenario. These
answers will provide you with only 1 mark per point for identifying and explaining the benefit.
¾ explaining the constitution of the audit committee or the work of other committees rather than the benefits of
an audit committee.
¾ making some of the following inappropriate points:
(i) “The audit committee will comprise non-executive directors (NEDs) who will review the work of executive
directors ensuring they are working in the best interests of shareholders.”
The above point is a general comment on the role of NEDs in a company rather than a benefit of internal audit.
Hence, it is not relevant to the question.
(ii) “The audit committee assesses the need for new directors on the board of Conoy, such as the finance
director, and assists in identifying and recruiting those directors”.
The above point is not valid as it applies to a nomination committee rather than an audit committee.
SECTION B
SOLUTION BANK
INTERNAL AUDIT
B
9. Internal audit – JHG Pharmaceuticals Co
The answer to this question is very lengthy. When attempting this question in the examination, managing the
time effectively to complete the answer is challenging.
Part (a) requires you discuss the advantages and disadvantages of appointing Perfect as internal auditors for
JHG. It seems to be relatively straightforward, but remember to cover all the points in detail to score high marks
in this part of your answer.
Part (b) requires you to discuss the issues Wilson needs to consider before it can accept the appointment as
internal auditors for JHG. The points you need to cover are independence, training, skills and time, fee pressure
and knowledge
Part (c) requires you to discuss the control activities that JHG should apply to ensure that the internal audit
service is being maintained at a high standard. The points to be considered are having separate team members
for internal and external audit, adherence to ISAs etc.
Part (d) requires you to explain the factors the external auditor should consider when evaluating the work of the
internal auditor. The points that need to be covered are evaluating the objectivity of the internal audit function,
assessing the technical competence of the internal auditors, evaluating whether the work of the internal auditors
is likely to be carried out with due professional care and assessing whether there is likely to be effective
communication between the internal auditors and the external auditor
Part (e) is a direct question where you have to explain internal audit and the matters which can be included
within the scope of an internal audit.
(a) Benefits to JHG from outsourcing the internal audit function to Perfect
(i) A higher level of efficiency and, at the same time, a reduction in cost can be achieved. This is because
the outsourcing company needs to be efficient in order to quote a competitive price and take advantage of
economies of scale, as they will specialise in internal audits. For example, a senior internal auditor
specialising in IT can work on several audits in an outsourcing company. However, an individual company
may not find such an IT expert cost effective.
(ii) The outsourcing firm’s broad range of expertise can be accessed which otherwise would be too expensive
to develop internally. The audit staff in an outsourcing firm receives versatile exposure because these firms
undertake the audit of organisations with varied types of operations. On the other hand, the internal auditor
who is an employee of the company may only have exposure to auditing that particular company.
(iii) Risk of employee turnover is passed to the outsourcing firm since the company outsourcing the internal
audit function continues with only a skeleton department.
(iv) Fixed employee costs may be replaced by variable fees for services. Through outsourcing, the
company eliminates the costs incurred towards the salaries of the internal audit team and instead may hire
value-added services from an outsourcing firm, in consideration of the variable nature of fees.
(v) May improve the independence of the internal audit function since personal relationships of the
employees and reporting relationships would not come in the way of conducting an internal audit.
(vi) Latest technologies / software for auditing can be accessed without incurring the associated costs.
Outsourcing firms can afford to buy the audit software that is needed for their varied clients. However, it is
cost-prohibitive for a company to procure such software (e.g. audit methodology software) for its own
internal audit department.
(vii) Saving management time required for administering an internal audit department.
(viii) Employee training costs to educate them about the principles, methods and techniques of an internal
audit can be saved by way of outsourcing.
(ix) Though no information has been given about Perfect’s staff, Perfect is expected to employ independent
staff. The staff should have appropriate qualifications to provide an appropriate level of service.
1 mark for each valid point
68: Internal Audit
Problems with outsourcing from Perfect
(i) The independence of the internal audit function may be
jeopardised if the management unduly influences the outsourcing
firm (e.g. if the management threatens not to renew the contract).
This will be reflected in the form of reports from the outsourcing firm
which may not be objective.
© GTG
Differentiate each point with the
help of bullets. This will improve
your presentation and help you
to score good marks
(ii) There will always be a risk that the firm’s staff may be ignorant of the organisation’s objectives,
culture or business. Hence, the audit staff would have to acquaint themselves with the accounting policies
and controls at JHG prior to the commencement of the internal audit. Furthermore, they may not be aware
of the areas in which there are weaknesses in the internal controls, which will be a disadvantage.
(iii) Outsourcing decisions are sometimes taken based on cost considerations ignoring the possibility that
the effectiveness of the function will be adversely affected. In order to minimise this risk, regular reviews of
the quality of audit work performed would be essential.
(iv) The flexibility and availability of the audit personnel may be adversely affected when the audit function is
outsourced.
(v) Lack of control over the audit staff of the outsourced firm may make it difficult to maintain the audit
standard. This can be overcome by monitoring the internal audit function by having a detailed discussion
with Perfect about the work carried out, the documents reviewed, the irregularities noticed, etc. Also,
Perfect’s system of reviewing the work done by the audit team would have to be reviewed further by JHG.
(vi) The loyalty or trustworthiness of the internal auditor is one of the major considerations when deciding on
whether or not to outsource the function. It is difficult to ascertain whether or not the accounting firm will be
loyal enough to examine the internal control system of the company diligently.
1 mark for each valid point
Maximum marks 8
(b) Issues to be considered by Wilson
(i) Independence
Wilson needs to ensure that its independence is maintained in the following areas:
Sometimes the internal audit function will require offering a recommendation on systems or maintaining
working papers. If the internal auditors are also the external auditors, they may have to subsequently check
the systems or working papers recommended by the internal auditors. This will cause a threat of self-review
which will affect Wilson’s independence. In order to mitigate the risk of self-review, the staff conducting the
internal and external audits must not be the same.
1 mark
Wilson would have to follow the ethical guidance of the ACCA. For this it must ensure that there are no
situations of conflict of interests. Because Wilson is already the auditor of JHG’s, then accepting the internal
audit assignment of JHG could well lead to a conflict of interest. In this situation Wilson would have to follow the
ethical guidance of the ACCA to mitigate the risk of a conflict of interest. Furthermore, Wilson must ensure that
its independence is not affected because of personal interest, financial interest, etc. in JHG. For example, total
fee income from JHG might arise above the recommended maximum level. The importance of maintaining
independence stems from the fact that any threats to independence, real or perceived, will lower the overall
trust that can be placed in the internal report produced by Wilson.
2 marks
(ii) Training
As a firm of auditors, Wilson will train its staff in auditing. This will ensure in-house compliance with association
regulations (e.g. compulsory CPD was introduced from January 20X5). Wilson will have to train its staff in
internal auditing. Wilson will have to make sure that the staff providing the internal audit function to JHG are
aware of the relevant guidance for internal auditors.
1 mark
(iii) Skills and time
To undertake internal audit work with JHG, Wilson needs to make sure that it has staff with necessary and
sufficient skills and the time available to carry out the work properly. As a firm of auditors, the staff at Wilson
must be well-versed in audit procedures.
1 mark
© GTG
Solution Bank: 69
(iv) Fee pressure
Wilson will face fee pressure to maintain the cost effectiveness of the internal audit department. Furthermore, it
may be under pressure to maintain a high quality of audit work, bearing in mind the fees which are offered.
1 mark
(v) Knowledge
As JHG’s external auditor, Wilson will have knowledge about JHG. The systems documentation will already be
available. Wilson will already be aware of potential weaknesses in the control systems. This will help in
establishing the internal audit department.
1 mark
Maximum marks 7
(c) Controls to maintain the standard of the internal audit department
(i) If Wilson is appointed as the internal auditor, the internal and external audits need to be managed by
different partners of the firm. In addition, the team members for both the functions must not be the
same.
(ii) The internal auditors must be asked to report directly to the audit committee, made up of
independent non-executive directors. The audit committee must define the scope of work to the internal
auditors and also monitor the functioning of the internal audit department by reviewing the internal audit
reports and discussing the observations of the internal auditors with the operations staff.
(iii) The firm conducting the internal audit must use the appropriate audit methodology. This will include
clear documentation of the audit work carried out, adequate review and drawing of conclusions. The firm
must also set up controls while conducting the audit, like reviewing performance measures e.g. cost, areas
reviewed, etc. Explanations must be obtained for any significant variance from the performance measures.
(iv) Ensure adherence to International Standards on Auditing or any in-house standards for auditing by
filling checklists and sending out questionnaires to the operations staff.
(v) Furthermore, the outsourced firm must carry out a second partner review of the function. This will
ensure that a high audit quality is maintained.
1 mark for each valid point
Maximum marks 5
(d) According to ISA 610 the external auditor should consider the following points while evaluating the
work of the internal auditor:
The external auditor should check the reliability of the internal auditor’s work by:
1. Evaluating the objectivity of the internal audit function
Objectivity is a combination of impartiality, intellectual honesty and a freedom from conflicts of interest. When
using the work of others, the independence of that person is of prime concern. The external auditor should
satisfy themselves that the work of the internal auditor is unbiased; otherwise the work of the internal audit will
be unreliable. For example, if the internal auditor reports to the finance director, they could be biased in their
work and not report on matters which indicate weaknesses in the area of finance.
2. Assessing the technical competence of the internal auditors
The external auditor should be satisfied that the internal auditors are technically qualified to carry out the
internal audit. Furthermore, they need to verify that the staff have participated in the continuous development
programmes, and whether or not the staff conducting the internal audit function have the required skills and
current knowledge of all the relevant laws.
3. Evaluating whether the work of the internal auditors is likely to be carried out with due professional
care
Work carried out with due professional care means that the work performed maintains the standards of the
profession. The internal auditor should keep their professional knowledge and skills updated. In other words,
they should have up-to-date knowledge of developments in practice, legislation and techniques.
4. Assessing whether there is likely to be effective communication between the internal auditors and
the external auditor
Once the external auditor has decided to rely on the work of the internal auditor, the internal auditors must be
free to communicate with the external auditors. For example, in order to have effective communication,
meetings of the internal and external auditor should be held at regular intervals to discuss various matters
including the findings of the internal auditor and decisions on the basis of such findings regarding the nature,
timing, and extent of audit procedures to be carried out by the internal auditor.
70: Internal Audit
© GTG
This evaluation includes determining the following:
(i) Whether the internal auditors (who carried out the internal audit) have adequate technical training
and proficiency. (Discussed above).
(ii) Whether the work was properly supervised, reviewed and documented. This could be achieved by
reviewing the internal auditors’ working papers.
(iii) Whether the internal auditor’s conclusions were supported by adequate audit evidence. For example,
the audit working papers relating to the area of sales must mention the sample of sales invoices verified, the
invoice number, customer name, invoice value etc. of invoices where weaknesses were observed.
(iv) Whether the internal audit reports were consistent with the results of the work performed. For
example, if the working papers give details of the weaknesses in the internal controls, then the internal audit
report must mention the existence of the weaknesses in this area. This can be checked by reviewing the
audit report and the work performed.
(v) Whether the exceptions or unusual matters disclosed by the internal auditors are properly resolved.
For example, if the internal audit report mentions that depreciation on a non-current asset is calculated on
an ad-hoc basis i.e. without taking into account the useful life of the asset, the external auditor would
confirm that the company has rectified the entry after recalculating the depreciation.
1 mark for each valid point
Maximum marks 5
(e) An internal audit is defined by the Institute of Internal Auditors, USA as, “an independent appraisal function
established within an organisation to examine and evaluate its activities as a service to the organisation.
The objective of internal auditing is to assist members of the organisation in the effective discharge of their
responsibilities. To this end, internal auditing furnishes them with analysis, appraisals, recommendations,
counsel and information concerning the activities reviewed.”
The scope of an internal audit is not confined to the routine checking of accounting records but also includes an
appraisal of the various operational functions and provides advice and recommendations on the activities and
operations reviewed.
2 marks
The scope of the internal audit varies from assignment to assignment, but will normally include:
(i) examination and evaluation of the adequacy and effectiveness of the internal control system of an
entity.
(ii) review of reliability, integrity, adequacy, timeliness of the financial and operating information, and also
the mechanism employed for identifying, measuring, classifying and reporting such information.
(iii) review of the system established for ensuring compliance with the applicable laws and regulations,
and also management policies.
(iv) review of the system for ensuring that the assets of the entity are safeguarded from various losses like
theft, fire, misappropriation etc.
(v) determination of the effectiveness, efficiency and also the economy of the operations of the entity.
3 marks
Apart from the above mentioned areas, suggestions of improvements to the entity’s operations are also
expected from the internal auditor. This can be achieved by evaluating and improving the effectiveness of the
following:
¾
Risk management: the internal auditor may design and perform further audit procedures whose nature,
timing and extent are responsive to the assessed risk of material misstatement at the assertion level.
¾
Internal control process: the internal auditor’s primary duty is to examine and evaluate the adequacy and
effectiveness of the system of internal control and assess the quality of performance in carrying out
assigned responsibilities.
¾ Corporate governance: it consists of four elements, namely, the external auditor, the audit committee,
management, and the internal audit function. According to the Combined Code of Corporate Governance,
management has to consider the need for an internal audit. The internal audit function serves as a resource
for each of the other three parties responsible for corporate governance. Accordingly, the nature and value
of corporate governance depends on the quality of the internal audit function.
2 marks
Maximum marks 5
© GTG
Solution Bank: 71
You can score high marks by avoiding the following common mistakes:
While answering part (a) of the question, many students do not cover the points in detail. Covering the points in
brief without sufficient explanation will not fetch you good marks. For example, in point (i) of part (a), if you write
the benefit only as ‘A higher level of efficiency and, at the same time, a reduction in cost can be achieved’,
this is not sufficient to earn good marks. Instead, it should be properly explained with example wherever
necessary as given in the model answer above.
You should not repeat the same points while answering part (b) and (d). You should use your knowledge of ISA
610 to answer part (d) and give its reference in the answer. Remember to relate the knowledge to the given
scenario to avoid a bad answer.
10. Corporate governance and audit committee – ZX
In the first part of the question you have to emphasise on the need for an internal audit function in the context of
the company ZX. In the second part of the question you are asked to focus on the advantages and
disadvantages of an audit committee in the context of the company ZX. You are required to answer the question
in a memorandum format.
Memo
From: Chief Internal Auditor
To:
Board of ZX
Subject: Implementation of good corporate governance and role of audit committee
Date: December 2007
An effective internal audit function plays an essential role in assisting the board to discharge its corporate
governance responsibilities. The key role that an internal audit can play is to support the board in ensuring
adequate design, implementation and functioning of internal controls and, in doing so, forms an integral
part of an organisation’s corporate governance framework. Under the Combined Code of Corporate
Governance, with which listed companies are expected to comply, the directors have a duty to ensure that
there is an adequate system of internal control and must keep the need for an internal audit department
under review.
(a) Areas where the internal audit department can assist the directors with the implementation of good
corporate governance in an organisation include:
(i) Board reports
The internal audit department possesses good knowledge about the operations of the company and it has
access to detailed accounting information. Accordingly, it can review the reports prepared by and for
management to inform the board about operational performance in order to provide a more balanced, useful
and easily understandable assessment of the performance of the company.
The internal audit department can also assist the board in preparing reports by ensuring the accuracy of the
contents of the reports.
2 marks
(ii) Internal controls
One of the greatest concerns of the board of directors is to ensure that a good system of internal control is in
place so that the operations of the organisation are efficient and effective, and that assets are safeguarded.
This could mean, for example, that the cheapest purchases of the best quality are made and that the
purchasing department approaches at least three suppliers for quotes. Also, good internal controls should
ensure that the information in the financial statements is complete, accurate and valid. The internal audit
department can review the effectiveness of the internal control system and recommend improvements in
order to ensure that the objectives of the board regarding good corporate governance are fulfilled.
2 marks
72: Internal Audit
© GTG
(iii) Application of ISAs and IASs
Particularly as the company might be seeking a stock exchange listing, the board must ensure that the
international accounting standards (IASs) are followed during the preparation of the financial statements
and international statements on auditing (ISAs) are followed in the course of its audit.
It is expected that the internal audit department should be aware of new accounting and auditing standards
and amend the financial accounting systems and the control systems to comply with up-to-date standards.
2 marks
(iv) Communication with external auditors
The internal auditor and the external auditor are considered to be two of the four pillars of the corporate
governance mechanism; the other two being the audit committee and management.
Accordingly, in order to ensure that the internal control system is effective enough for efficient performance
of the organisational functions, the internal and external auditors may work together. However, both the
auditors will send their reports on the internal control system to the audit committee of the board
separately.
2 marks
(v) Communication to the board by external auditor
The internal auditor can co-operate with the external auditor to provide appropriate information to the board.
ISA 260 (Communications of audit matters with those charged with governance) provides a list of
matters which should be communicated to the board and the internal auditor can work with the external
auditor to ensure that this information is provided.
According to ISA 260, the matters that an auditor needs to
communicate to the board include the following:
Answering at least a few of the following
will help you to score good marks.
¾ the general approach and overall scope of the audit, including any expected limitations thereon, or any
additional requirements.
¾ the selection of or changes in, significant accounting policies and practices that have, or could have, a
material effect on the entity’s financial statements.
¾ the potential effect on the financial statements of any material risk and exposures, such as pending
litigation, that are required to be disclosed in the financial statements.
¾ audit adjustments, whether or not recorded by the entity that have, or could have, a material effect on the
entity’s financial statements.
¾ material uncertainties related to events and conditions that may cast significant doubt on the entity’s ability
to continue as a going concern.
¾ disagreements with management about matters that, individually or in aggregate, could be significant to the
entity’s financial statements or auditor’s report. These communications include consideration of whether the
matter has, or has not, been resolved and the significance of the matter.
¾ expected modifications to the auditor’s report.
¾ other matters warranting attention by those charged with governance, such as material weakness in internal
control, questions regarding management integrity, and fraud involving management.
¾ any other matters agreed upon in the terms of the audit engagement.
3 marks
(vi) Special investigations
Management can ask internal audit to carry out special investigations. For example, if there has been as
incident of fraud, management might ask internal audit to report on the extent and value of the fraud and to
recommend how it could be prevented in the future.
2 marks
Maximum marks 10
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Solution Bank: 73
(b) The advantages and disadvantages of an audit committee
The advantages of an audit committee include:
(i) Public confidence
It is important to try to boost public confidence in the credibility and objectivity of public financial
information. When ZX is listed on the Stock Exchange it is very important that the public (investors) are
confident in it otherwise it will be difficult to raise capital and the company’s share price will be damaged.
The audit committee can enhance the confidence level of the investors regarding the correctness of the
financial statements, the effectiveness of the internal control function, compliance with regulations and
norms, etc., so that ZX will be considered to be an attractive investment option by investors.
The functions of audit committee are to assist the board in fulfilling its responsibilities for:
¾
¾
¾
¾
¾
the correctness of the company’s financial statements (true and fair).
the company’s compliance with legal and regulatory requirements.
the external auditor’s qualification and independence.
the performance of the company’s internal and external auditor.
ensuring that there is an adequate system of internal control in place.
2 marks
(ii) Compliance programmes
The audit committee ensures that all the regulatory provisions, ethical pronouncements, accounting and
auditing standards are complied with by the organisation, and accordingly provides assurance about the
compliance to the board. The audit committee ensures this compliance through the internal and external
audit functions.
Since the audit committee comprises of non-executive directors who have in depth knowledge of
corporate governance, IASs, ISAs and applicable regulatory provisions, having an audit committee in
place directly helps the organisation to follow the principles of good corporate governance.
2 marks
(iii) Financial reporting and disclosure practices
The audit committee assists the board in fulfilling their financial reporting obligations. The directors need
to prepare financial statements for ZX. The committee can assist by checking the financial statements to
ensure that they comply with appropriate reporting requirements. This is especially important when the
board of ZX do not have detailed knowledge of accounting requirements.
1.5 marks
(iv) Risk management
A risk is the threat or possibility that an action or event will adversely affect an organisation’s ability to
achieve its objectives. Risk management is the systematic application of management policies, practices
and procedures to the task of analysing, assessing, treating, monitoring and reporting on risk.
In corporate governance parlance, the audit committee will have an independent appreciation of what
constitutes good practice in risk management. In order to assess risks in ZX, the audit committee will
examine the reports of the external auditor and the internal auditor and, if needed, will communicate with
them to strengthen the risk assurance mechanism.
This role of the audit committee will be of great advantage to the board.
2 marks
(v) Assisting the board
The audit committee may also assist the board by monitoring the work of the board and providing helpful
guidance, where corporate governance requirements appear not to have been met. The audit committee
should have detailed knowledge of corporate governance requirements and can share this with the other
members of the board who may not have the time to obtain detailed information.
2 marks
74: Internal Audit
The disadvantages of an audit committee include:
(i) Lack of understanding of function
© GTG
Don’t forget the disadvantages!
Read the question!
As the directors in ZX do not have much knowledge of corporate governance, they may perceive the
additional involvement of the audit committee as a threat to their authority or as taking away some of their
responsibilities and letting other people run the company.
2 marks
(ii) Role of non-executive directors
As the audit committee will be made up mainly of non-executive directors, the board may take this opportunity
to appoint non-executive directors who possess knowledge of corporate governance and of the applicable
rules and regulations in place of the non-executive directors who do not have complete knowledge of
corporate governance or detailed knowledge of Internal Auditing Standards. Again, the audit committee
must be seen as fulfilling a supporting role to the main board. It will utilise their special knowledge of
accounts preparation and internal controls from the external auditor and internal auditor to provide
appropriate information to the board.
2 marks
(iii) Cost
The introduction of the audit committee will increase the company’s costs as the non-executive directors
will require some remuneration for their additional responsibilities.
2 marks
Maximum marks 10
11. Fraud and error
(a) Internal audit function: risk of fraud and error
Your answer should start with a brief introductory paragraph. You should complete your answer within 12
minutes in the examination. This is a knowledge-based question in which you have to explain the use of
an internal audit in relation to the risks of fraud and error.
The Institute of Internal Auditors, USA, defines internal auditing as an independent appraisal function
established within an organisation to examine and evaluate its activities as a service to the organisation.
The term fraud refers to the intentional misrepresentation of financial information by one or more
individuals among management, employees or third parties.
2 marks
On the other hand the term error refers to unintentional mistakes in financial information.
1 mark
In order to prevent fraud, an internal auditor can design an effective internal audit programme and
implement it.
For example, Robert, an internal auditor, plans to conduct cash vouching selectively. However, by
conducting a surprise check of the cash balance he finds that unrecorded cash is available to the
cashier. This raises his suspicion about the possibility of fraud and he changes his plan so as to perform
vouching extensively.
1 mark
An internal auditor can assist management in the prevention and detection of fraud and error in the
following ways:
¾ by assessing the risks and control strategies of an entity. This includes reviewing the risks
associated with the safeguarding of assets (ensuring that the assets are protected from theft,
misappropriation, fire etc.). To do this, the auditor should assess the adequacy and effectiveness of
the internal control system.
1 mark
¾ by providing suggestions for improvement of risk management and control strategies. However,
many significant cases of fraud may not be revealed by the normal internal control systems. In the
case of management fraud in particular, higher level controls (those relating to the high level
governance of the entity) need to be reviewed by the internal audit in order to detect the nature of the
risks, and to manage them effectively.
1 mark
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Solution Bank: 75
The steps that an internal auditor takes to manage risks in relation to fraud and error include:
(i) Analysing and reporting on the process adopted by management to identify and classify the specific
fraud and error risks to which the entity is subject (and in some cases helping management develop
and implement that process).
(ii) Commenting on the appropriateness and effectiveness of the existing risk management process in an
organisation.
(iii) Periodically auditing or reviewing systems or operations to determine whether the risks of fraud and
error are being effectively managed.
(iv) Monitoring the incidence of fraud and error, investigating serious cases and making recommendations in
order to prevent the subsequent occurrence of similar fraud or error.
0.5 marks for each valid point
Maximum marks 7
(b) External auditors: fraud and error in an audit of financial statements
If you do not have sufficient time in the examination to write this part of the answer, you may attempt the first
three paragraphs which will enable you to secure substantial marks out of the total.
An external auditor needs to express an opinion on whether or not the financial statements have been prepared,
in all material respects, in accordance with an applicable financial reporting framework and whether they provide
a true and fair view of the financial position of an entity. It is not the primary responsibility of the external auditor
to prevent or detect fraud or error in the financial statements. However, in the course of conducting the audit, if
he comes across a situation where he has reason to believe that fraud or error might exist to a material extent,
he should modify his audit programme or perform additional procedures to confirm or dispel his suspicion of
fraud or error.
2 marks
In the case of Kingston Cotton Mills Company (1896), it was held that an auditor is not bound to be a detective
or to perform his audit work with the suspicion that there is something wrong.
However, at the same time, this does not mean that it is not the duty of the auditor to detect fraud if situations
give indications of fraud. The auditor should exercise due care and diligence to uncover the fraud.
1 mark
The following summarises the steps that an external auditor
needs to take to consider fraud or error in an audit of financial
statements:
In order to secure better marks,
answer the question point-by-point.
(i) ISA 240 (The Auditor's Responsibility to Consider Fraud in an Audit of Financial Statements)
requires an external auditor to consider the risks of material misstatements in the financial
statements due to fraud. Although, in the absence of any indication of fraud, the auditor does not
need to engage himself to detect fraud, he needs to maintain an attitude of professional scepticism
while conducting an audit.
(ii) The auditor should enquire about management's assessment of fraud risk, its process for dealing
with risk, and its communications with those charged with governance and employees. He should
enquire into the supervision process with those charged with governance.
(iii) The auditor should also enquire of those charged with governance i.e. board of directors about any
suspected or actual instance of fraud.
(iv) The auditor should assess fraud risk and error risk factors (e.g. by trying to identify unusual results of
ratio analysis), and assess the risk of misstatements due to fraud, if any significant risk is identified.
He should evaluate the relevant internal controls, and assess their effectiveness.
(v) The auditor should determine an overall response to the assessed risk of material misstatements due to
fraud or error and develop appropriate audit procedures, including testing certain journal entries,
reviewing estimates for bias, and obtaining an understanding of the business rationale of significant
transactions outside the normal course of business. Appropriate management representations should be
obtained in this regard.
76: Internal Audit
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(vi) The auditor is only concerned with risks that might cause material error in the financial statements. He
might therefore pay less attention than internal auditors to small cases of fraud (and errors), although
he must always consider whether evidence of single instances of fraud (or error) are indicative of
more systematic problems.
(vii) Where an auditor has reason for suspicion or he encounters actual instances of fraud (or error), he must
consider the effect on the financial statements, which will usually involve further investigations. He
should also consider the need to report to management and those charged with governance.
(viii) Where material fraud (or error) is detected, the auditor also needs to consider the effect on the going
concern status of the entity, and the possible need to report externally to the stakeholders, either in the
public interest, or for regulatory reasons. Many entities in the financial services sector are subject to
this type of regulatory reporting and many countries have legislation relating to the reporting of money
laundering activities.
(ix) An audit conducted in accordance with ISAs may not always detect a material misstatement in the financial
statements arising from fraud due to the hidden nature of fraud. In practice, routine errors are much easier
to detect than frauds.
1 mark for each valid point
Maximum marks 7
(c) Nature of risks arising from fraud and error: Stone Holidays
Stone holidays can face the risk of fraud or error arising from the use of
computerised systems if the controls on the systems are not maintained
properly. A person who knows how to operate the system can
manipulate the data stored in order to hide the misappropriation of
assets. It is, for example important to ensure good password discipline.
Remember to direct your
answer towards the details
given in the mini-scenario. For
example, why has the examiner
stated that staff are paid partly
on a commission basis?
1 mark
The networked systems may also lead to risk of error because of the chances of the loss or corruption of data in
transit. If transmission of data is not securely encrypted it may be subject to risk of fraud.
1 mark
All entities that employ staff who handle company assets (such as receipts from customers) are subject to the
risk that staff may make mistakes (errors) or that they may misappropriate those assets (fraud) and then seek to
hide the error or fraud by falsifying the records. Here, some payments are made by cash and this is an obvious
risk area.
2 marks
There is a risk of fraud perpetrated by senior management who might seek to reduce the amount of money
payable to the central fund (and the company’s tax liability) by falsifying the company’s sales figures, particularly
if a large proportion of holidays are paid for in cash.
1 mark
Stone holidays also faces a high risk from staff members. Staff can try to maximise the commission which they
are paid by entering false transactions into the computer system and will reverse them after the commission has
been paid.
1 mark
Maximum marks 6
12. Internal audit and external audit reports
This is a straightforward question which can earn you good marks if answered well.
(a) Information in internal audit reports
(i) Cover of report: it contains the subject of the report, the period covered by the audit, the date of issue and
the list of copies distributed.
1 mark
(ii) Executive summary: it summarises the whole report. It is intended to draw the attention of the reader to
main the contents of the report. By reading the executive summary, even if the reader is too busy to go
through the whole report, he will be in a position to reach the same conclusions as he would have reached
by reading the whole report and can take a decision accordingly.
1 mark
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Solution Bank: 77
(iii) Main report contents
¾ Major observations / findings and recommendations: these are stated in brief, point-wise first, and are
then described at length. The major findings may be listed under the headings:
9 problems
9 breaches in procedures
9 ineffective procedures
After the problems have been stated, point-wise recommendations are made regarding each of the problems.
¾ Comments of those who were audited: this section of the report should contain a description of the
findings and the specific replies of the relevant staff and managers with respect to each of the observations
of the auditor. The report should set out the agreed actions and the timescale for actions to be taken.
2 marks
(iv) Appendices
This part of the report contains analytical statements explaining the parts of the main report and sometimes
contains excerpts of evidence, as far as possible. It also includes tables, internal control questionnaires, tests
performed and any other relevant information.
1 mark
Maximum marks 4
(b) Contents of external audit reports
According to ISA 700, external audit reports should include the following basic elements, ordinarily in the
following layout:
(i) Title;
(ii) Addressee;
(iii) Opening or introductory paragraph:
¾ identification of the financial statements audited;
¾ a statement of the responsibility of the entity’s management and the responsibility of the auditor.
(iv) Scope paragraph (describing the nature of an audit):
¾ a reference to the ISAs or relevant national standards or practices;
¾ a description of the work the auditor performed (test basis, reasonable assurance, material misstatements
only).
(v) Opinion paragraph containing:
¾ a reference to the financial reporting framework used to prepare the financial statements (including
identifying the country of origin of the financial reporting framework when the framework used is not the
International Accounting Standards); and
¾ an expression of opinion on the financial statements.
(vi) Date of the report;
(vii) Auditor’s address; and
(viii) Auditor’s signature
0.5 marks for each valid point
Maximum marks 4
(c) Differences - internal and external audit reports
(i) The definition of an external audit report is laid down in ISA
700 ‘The Auditor's Report on Financial Statements’. It includes
references to financial statements, applicable audit standards and the
audit opinion in terms of truth and fairness and compliance with an
identified financial reporting framework. The external audit report is
addressed solely to the members of the company.
It may be a good idea to
answer this part of the
question in tabular form,
considering the time
constraint in the exam.
On the other hand, no statute or standards have outlined the definition or meaning of an internal audit
report. Moreover, it is created for different purposes and is directed at management or the audit
committee. On the basis of the nature of assignments, the internal audit report changes substantially e.g.
an internal audit report regarding general controls on cash will be entirely different from the report on the
physical verification of inventory.
1.5 marks
78: Internal Audit
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(ii) The main distinction between external and internal audit reports is that external reports are very precise in
nature. They also do not contain any action plan in relation to internal controls or other matters. However,
internal audit reports are normally detailed in nature. They pertain to analysis, findings in relation to the
control system, suggestions for improvement, etc.
1.5 marks
(iii) The similarity between internal and external audit reports is that they both state what has been done to
carry out the audit, the overall parameters and the overall findings. However, their subject matter is not
the same.
1 mark
Maximum marks 4
(d) Common characteristics of the steps taken by internal
and external auditors in producing their respective reports
This should be answered
keeping in mind the statement
made in part (b) of the question.
(i) Reports are drafted by both the internal and external auditors
on the basis of the findings of their work. Although the audit report issued by the external auditors will
refer to material misstatements appearing in the financial statements, the management letter will
report on weaknesses in and departures from, the system of internal control which have been
discovered during their audit. Weaknesses will be referred to even if they have not yet led to material
misstatements: the aim will be to reduce the likelihood of material misstatement occurring in the
future. Similarly in the case of internal auditors findings will be primarily relating to weaknesses in the
internal control system.
(ii) Both the reports are normally split into three main sections - the issues, the consequences or
implications and the recommendations. It is further split into major and minor matters and some sort of
summary or overall evaluation of the relatively important matters.
(iii) The draft reports are often discussed with management, partly to confirm the findings and partly to
establish management's likely responses - these can be incorporated into the report itself.
(iv) In large organisations, reports usually go through several redrafts before they are issued. It is assumed
that if management does not give a comment at an earlier stage, it may do so at a later stage.
2 marks for each valid point
Maximum marks 8
13. Operational internal audit assignments – Cleanco
The format of the answer is different for this question. The answer should be given in a tabular form as
suggested in the question, combining all the three parts in one table for better presentation. Do note that you
are in the role of internal auditor.
HUMAN RESOURCES
Experience
and
competence
Risks
There is a risk of employing
staff who do not have
proper experience and
training as they may cause
damage to client property).
Controls
Staff should be asked to fill
in application forms which
will give details of their
qualifications,
experience
and skill.
Tests of control
The auditor should test
check the application forms
to ensure that they are duly
filled in.
Staff should be asked to
give
references
which
should be checked before
allowing them to join.
All
inexperienced
staff
should be given proper
training before starting their
job.
He should inspect the
references given by the staff
selectively.
He should review the
mechanisms in place for
ensuring that staff receive
proper training
Marks
3
Continued on the next page
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Solution Bank: 79
HUMAN RESOURCES
Criminal
record
Risks
Some workers may be
employed
without
enquiring
into
any
criminal records they
might have.
A staff member with a
criminal record relating
to a dishonesty offence
might be more likely to
misappropriate
company
or
client
property.
Pay
calculation
There is a risk that
proper time sheets are
not maintained or not
consulted
while
calculating pay and
accordingly
amounts
could be paid for hours
not worked. Again,
there is a risk that
incorrect
payroll
calculations are made.
Staff
turnover
A high turnover of staff
leads
to
increased
probability of employing
inexperienced staff.
Controls
Staff should be asked to
provide details of any
criminal convictions.
Tests of control
The documents evidencing
the procedures relating to
investigating criminal records
should be test checked.
If possible, criminal records
of the personnel should be
investigated
before
employing them (though
not all countries have
legislation which permit
this).
The
company
should
regularly consult clients
about their levels of
satisfaction
with
the
service provided (and have
investigative
and
disciplinary procedures in
place where allegations of
misappropriation
are
made).
All normal payroll controls
such as the use of
timesheets, reconciliations
and regular reviews of
payroll costs should be in
place. Personnel control
should ensure that new
staff can only be entered
into the payroll system with
appropriate authorisation.
Any
allegations
of
misappropriation made by
clients should be noted and
investigated.
Marks
3
Staff should be given
feedback
on
their
performance
and
be
rewarded
for
quality
performance and long
service.
The
existing
employees should be given
appropriate
benefits,
salaries, opportunities and
internal growth so that they
don’t
leave
the
organisation.
The auditor should review the
results of client satisfaction
surveys and establish if
appropriate
management
responses have been made.
The
auditor
should
selectively recalculate payroll
calculations to ensure that
they have been made
correctly. He should also
verify
that
appropriate
authorisation has been given,
review the overall level of
payroll cost and identify the
reasons for variations, if any.
3
The documentary evidence
of staff reviews should be
inspected by an auditor. He
should review and assess the
processes by which quality
performance
and
long
service are rewarded and for
a sample of staff with good
reviews and/or long service
records, determine whether
rewards
have
been
forthcoming.
3
Maximum marks 8
80: Internal Audit
© GTG
PROCUREMENT
Risks
There is a risk of
amounts being paid
to fictitious suppliers.
Controls
A list of vendors should be
maintained and it should be
ensured that purchases are
made only from these
vendors. Payments should
be made for authorised
purchases only.
Orders
should be placed in writing
for
financially
material
purchases.
There is a risk that
unauthorised
purchases are made.
All purchases should be
supported by an authorised
purchase requisition note.
There is a risk that
inappropriate
purchases are made.
(so that, for example,
too much inventory of
cleaning materials is
ordered)
There
should
be
procedures for recognising
when orders need to be
placed.
The auditor should review
the procedures in place that
allow the company to
identify when purchases are
required.
Incorrect and
delayed
payment
There is a risk of
incorrect and delayed
payments.
The invoices and the prices
agreed should be checked
by an authorised person.
There should be proper
controls over the purchase
ledger to make sure that
discounts are obtained for
genuine
payments
i.e.
payments made within the
due date.
The auditor should review a
representative sample of
invoices, purchase orders
and other documents in
order to check the payment
terms. He should verify
selectively the payments in
the purchase ledger in order
to be sure that they are
made following the payment
terms.
Best
value
for money
The risk here is that
the company will not
get the best value for
money
by
using
existing suppliers.
There
should
be
discussions with alternative
suppliers
and
regular
negotiations with existing
suppliers. This needs to be
documented properly for
future reference.
An auditor’s responsibility is
to review and critically
assess the documentation
and confirm that there are
regular negotiations and
discussions.
Fraudulent
payments
Unauthorised
and
inappropriate
purchases
Tests of control
The auditor should check
the list of vendors and
examine whether it is
updated periodically. He
should also test check to
ensure that the policy of
purchasing from enlisted
vendors has not been
violated.
Moreover,
he
should enquire whether or
not all material purchases
are made through written
purchase orders.
The auditor should review a
selection
of
purchases
orders and ensure that each
is
supported
by
an
appropriately
authorised
requisition note.
Marks
2.5
2.5
2.5
2.5
Maximum marks 6
© GTG
Solution Bank: 81
MARKETING
Breach
of
advertising
regulations
Risks
Outsourcing
the
marketing function to
a third party may run
the risk of breaching
advertisement
regulations.
There is a risk of
excessive marketing
expenditure
not
resulting
in
new
business.
Controls
The
contract
between
Cleanco and the advertising
company should require that
all
advertising
is
in
accordance with regulations
and any best practice
guidance
(since
the
company wishes to maintain
a high reputation). There
should be clauses in the
contract
requiring
the
outsourcing company to
indemnify Cleanco against
any costs arising from such
breaches. Cleanco should
take legal advice on the
wording of such clauses.
Tests of control
The auditor should review
the
contract
with
the
company and the advertising
material produced in order to
ensure
that
it
is
in
accordance with regulations
and any guidance on best
practice. The auditor should
ensure that appropriate legal
advice was taken with
regard to indemnities and
other important elements in
the contract. The auditor
should
review
correspondence
with
lawyers,
customers,
competitors and regulators
to identify if complaints
about advertising have been
received.
The outsourcing company
should submit all advertising
material to Cleanco for
approval,
and
Cleanco
should have final control
over the design and content
of the advertising material.
The auditor should obtain
documentary evidence in
order to verify that the
advertising material has
been
approved
at
an
appropriate
level
within
Cleanco.
To minimise the risk of
excessive
expenditure,
monthly / quarterly budgets
should be prepared and
they should be regularly
reviewed to ensure that the
costs are under control.
The auditor should review
budgets and management
accounts to ensure that
advertising costs have been
controlled and are resulting
in an appropriate level of
increased
business
at
appropriate prices.
Marks
2.5
2.5
2.5
Maximum marks 6
14. Internal audit function – Roxy Hotels Plc
Your answer should be succinct and specific and must pay attention to the marks (and therefore time) available
for each part. This will help you to secure good marks and, at the same time, to manage your time effectively
during the exam. Remember, part (c) and (d) of the question should be answered in the context of Roxy Hotels.
(a) Role of internal audit
Internal audit should provide management with a dynamic, value-added tool which makes a positive contribution
to the achievement of the organisation’s corporate objectives. More formally, internal audit is defined by the
Institute of Internal Auditors as ’an independent, objective assurance and consulting activity designed to add
value and improve an organisation’s operations. It helps an organisation accomplish its objectives by bringing a
systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and
governance processes.’
1 mark
82: Internal Audit
© GTG
It should therefore assist the board and management to discharge their corporate governance responsibilities by
helping them to identify and manage risks and providing:
¾ an objective evaluation of business risk
¾ a regular evaluation of the organisation’s system of control
¾ effective reviews of operational and financial performance
3 marks
Therefore, the role of internal auditing within an organisation is broad and includes internal control issues such
as the efficacy of operations, the reliability of financial reporting, deterring and investigating fraud, safeguarding
assets, and compliance with laws and regulations.
1 mark
Moreover, the role of internal audit has expanded considerably in recent years and the scope of internal audit
work is no longer routine or low level. Internal audit takes place at all levels of management and internal audit
work includes non-routine matters such as assisting the board in setting corporate objectives and assessing
performance against them. Under the Combined Code of Corporate Governance, the board has to consider the
need for an internal audit department.
1 mark
Maximum marks 5
(b) The types of activities normally carried out by an internal audit department are:
(i) an objective evaluation of the existing risk and internal control framework.
(ii) recommendation for improvements top the internal control system.
(iii) systematic analysis of business processes, related risks and associated controls.
(iv) reviews of existence and value of assets.
(v) reviews of the compliance framework and specific compliance issues.
(vi) reviews of operational and financial performance.
(vii) recommendations for more effective and efficient use of resources.
(viii) assessment of the accomplishment of corporate goals and objectives.
(ix) feedback on adherence to the organisation’s values and code of conduct / code of ethics.
(x) performing value for money (economy, efficiency and effectiveness), best value and similar audits.
(xi) special investigations, such as fraud investigations.
0.5 marks for each valid point
Maximum marks 5
(c) The areas where the internal audit department at Roxy might check detailed transactions and balances.
(i) The department might concentrate on selective checking by taking representative samples of room
bookings and bookings of conference facilities from source documentation through the system, to ensure
that the correct amounts are billed, that the amounts due are received and facilities are paid for within the
time limits agreed and that the correct amounts have been recorded in the correct accounting period.
(ii) The department might check the orders for food and other consumables selectively through the system to
ensure that authorised suppliers are used where necessary, that the correct prices have been billed by
suppliers, that payment has been made according to the agreed terms and that the correct amounts have
been recorded in the correct accounting period.
(iii) The department might check the additions to and disposals of assets as recorded in the accounting system,
physically verify the assets periodically to ensure that the assets recorded in the books are in existence, in
good condition and are kept in the right place, check whether or not the procurement and disposal of the
assets are properly recorded in the books and check whether all assets acquired / disposed of are properly
authorised.
(iv) The department might select representative samples of receivables and payables for direct confirmation.
(v) The department might check the existence of certain employees on the payroll and test the accuracy of the
payroll calculations with reference to records of hours worked kept at the hotels.
1.5 marks for each valid point
Maximum marks 6
© GTG
Solution Bank: 83
(d) The four areas in which the internal audit department at Roxy might perform reviews of systems.
(i) The internal audit department might review the documentation of the centralised booking systems and
evaluate it. They might then review the actual operation of the system in practice and make
recommendations for improvements or change.
(ii) The department might review the integrity of the systems by checking the effectiveness of computer system
access procedures. The use of dummy data and false passwords might be used in such an assessment.
(iii) Analytical procedures might be performed to evaluate the relative financial and operational performance of
individual hotels, hotels in certain regions and the performance of the various segments of the business
(tourist and business accommodation, conference and leisure facilities, restaurants and bars etc.) and
moreover of the whole hotel chain. Performance could be also evaluated against budgets, on a seasonal
basis and by comparison with prior years and periods.
(iv) Analytical procedures could be performed on relationships such as those between drinks and meals
consumed, and those between occupancy rates and other facilities used. This will highlight the comparative
efficiency / inefficiency of each segment.
1 mark for each valid point
Maximum marks 4
15. Control weaknesses and suggested improvements – Pitman
Part (a) of the question should preferably be answered in a tabular format in order to highlight the control
weaknesses and suggested improvements. This is a very standard format for management letters.
The answers to both parts of question (b) should be brief, considering the marks allotted to them. The answers
should be broken down into small paragraphs.
(a) Note of control weaknesses and suggested improvements
Weakness
Inadequate
timekeeping
arrangements
Possible misstatement
Employees could record fictitious
hours.
No independent
personnel
function
Supervisors and wages clerk
could add fictitious employees to
the payroll and misappropriate
their wages.
No control over
weekly payroll
Hours worked could be incorrectly
entered.
Proposed change
Use properly designed time cards prepared in
advance for each employee.
Use an automated time recording system.
Require supervisors to check and sign all time
cards.
Observe employees clocking-in and out to
ensure that employees use the correct card
and do not also clock-in / out friends.
All personnel changes to be approved, in
writing, by the factory manager.
Restrict access to personnel data held on the
computer such that changes can only be made
by the factory manager.
Wages clerk should prepare a statement
reconciling net pay with the previous week's
net pay. This should accompany the copy of
the weekly payroll and be given to both the
factory manager and accountant.
Reconciliation of net pay as above.
Accountant should periodically check the
payroll against personnel records and time
cards.
Marks
Continued on the next page
84: Internal Audit
© GTG
Poor control over
cash withdrawn
for wages
Cash could be misappropriated
either before reaching the wages
clerk or by the wages clerk.
Use a security company to collect cash and
make up wage packets.
Poor control over
wages
distribution
Supervisors could submit time
cards for absent or terminated
employees and collect their
wages.
Employees could claim not to
have been paid.
Wage packets should be delivered to accounts
personnel and distributed jointly by that staff
member and the department supervisor.
No procedure for
unclaimed wages
Unclaimed wages
misappropriated.
could
be
2
Employees should be required to produce
identification and to sign for their wages.
Employees should not be allowed to collect
wages on behalf of others unless authorised
by the original recipient in writing.
Unclaimed wages should be recorded in a
register.
All unclaimed wages should be returned to the
accounts department which should reconcile
unclaimed wages with the payroll and with the
list of signatures for collected wage packets.
2
Unclaimed wages should be deposited in the
bank, if not claimed within a couple of days.
2
Maximum marks 10
(b) Programmed application controls and test date
(i) Access and programmed application controls.
Access controls
Due to the sensitivity of information on personnel and wages records, data held on the personal computer
should be protected by passwords to prevent unauthorised attempts to access sensitive data or to alter payroll
data.
Knowledge of access codes to amend personnel information should be restricted to the factory manager and a
director. There should be a separate code for reading but not amending personnel data that should, additionally,
be known to the wages clerk. Knowledge of access codes to the payroll program should be restricted to the
wages clerk and the accountant.
The computer used by the wages clerk should be networked with the factory manager's computer to enable the
wages program to access up-to-date personnel data when preparing the payroll.
2 marks
Program controls
The payroll program should include edit controls as part of the weekly payroll run. These should reject data
entered by the wages clerk as follows:
¾ employee names (or numbers) not on the personnel file
¾ weekly hours worked exceed 50 (this should require special authorisation)
¾ duplication of employee names (or numbers)
A further report (exception report) should be produced for director approval where:
¾ gross pay exceeds $500 (say)
¾ hourly rate increase is greater than 10%
¾ employee names (numbers) are on the personnel file but not on payroll (to query reasons for omission)
The personnel program should also include a control to prevent acceptance of a wage rise greater than 10%
entered by the factory manager. The director who has access to personnel records could have programmed
access to override this control.
2 marks
Maximum marks 4
© GTG
Solution Bank: 85
(ii) Test data
I would prepare a set of test data using actual employees. I would ascertain, from personnel records, the wage
rates and deductions for these employees and would manually determine the gross and net pay for each and
the totals for the week. I would then enter typical hours worked for each of the employees and obtain a printout
of the payroll in order to compare it with my manual calculations.
This would confirm that the program is working correctly in calculating gross and net pay.
I would then attempt to enter data that would breach the program controls including fictitious and former
employees; hours in excess of 50; and duplicate entries for the same employee. In each case, I would expect
the computer to reject the entry. In order to examine the reasonableness test of $500 gross pay I would
probably need, first, to amend the personnel records to increase the hourly wage rate to over $10 ($500 / 50
hours) otherwise the 50-hour limit would prevent me from testing the operation of this control.
I would also test personnel records using the factory manager's password. I would first enter routine changes to
personnel data, i.e. additions, terminations and changes in wage rates, to ensure the output is the same as my
manually amended personnel data. I would also attempt to increase wage rates by more than 10% to ensure
that the program control over such changes is effective.
In performing these tests I would need to download a copy of the programs used by the company to avoid
corrupting live data, particularly year to date totals. I would need to take reasonable precautions to ensure that
the copy I take is of the version actually used by the company, such as by downloading it immediately after
observing a payroll run by the wages clerk.
2 marks for each valid point
Maximum marks 6
16. Objectives of internal and external auditors – Shoe World Ltd
You need to understand the question by reading it thoroughly. The answer to this question is a little lengthy for
the marks allotted to it. You need to elaborate the objectives of internal as well as those of external auditors and
then relate these to the audit procedures set out in the question.
(a) While conducting the internal audit of Shoe World’s procurement system, operation of the marketing
function and inventory counting, the following audit objectives should form the part of the internal audit plan:
(i) Work: audit of internal controls over procurement system
Internal auditor’s objectives
The key objective is to ensure that the procurement system is efficient and effective.
This means that:
¾ the goods procured are actually required by the organisation i.e. the purchase of items is linked to projected
sales and items are not over-stocked.
¾ procurement is responsive to demand so that stock-outs are avoided.
¾ purchases are made at the most optimum prices i.e. excessive amounts are not paid for the items.
¾ goods meet with the quality standards set by Shoe World.
¾ goods are correctly recorded in the books of Shoe World.
¾ purchases are paid for, in accordance with the terms of payment.
2 marks
(ii) Work: reviewing the operations of the marketing department
Internal auditor’s objectives
The key objective is to ensure that the marketing function is effective.
¾ Assess the efficiency of the marketing function, whether the marketing department is well-organised with
clear responsibilities being assigned to the entire team.
¾ The review of the availability of information to the marketing managers and team as and when required by
them.
¾ Identification of deficiencies in the information system and recommendation of measures for its
improvement.
2 marks
86: Internal Audit
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(iii) Work: year end inventory count
Internal auditor’s objectives
To ensure that the quantities of inventory recorded in the financial statements are accurate.
The internal auditor has to ensure that the control system over the inventory count is working properly. He
should ensure that it is well-organised and effective in detecting any unusual matters. For example, if the
inventory recorded in the inventory ledger is not physically present, he will need to investigate why, and take
corrective action, after discussing it with the appropriate authority. An example of the corrective action would be
writing off the loss (if necessary).
The internal auditor has to ensure that the physical inventory count has actually been carried out, and would
need to be present while the inventory is physically verified.
The internal auditor should also ensure that teams of two or more people have counted the inventory. This is
necessary to ensure the segregation of duties. This should be followed by counting the test counts to determine
the accuracy of the test results.
2 marks
Maximum marks 5
(b) While conducting the audit of Shoe World’s procurement system, operation of the marketing
function and inventory, the following audit objectives should form a part of the external audit plan:
(i) Work: audit of internal controls over procurement system
External auditor’s objective
To ensure the accuracy of the purchases and accounts payable figures stated in the financial statements.
This can be done by performing various types of tests to evaluate the effectiveness and efficiency of the
controls on recording purchases and liabilities. These tests are aimed at ensuring the audit assertions of
accuracy, completeness, occurrence, cut-off and classification of the purchase transactions and liabilities in the
financial statements.
2 marks
(ii) Work: reviewing the operations of the marketing department.
External auditor’s objective
Reviewing the operations of the marketing department falls outside the scope of the external auditor’s work. The
external auditor’s work is to verify the correctness and accuracy of the financial statements. The marketing
department’s operations are not related to what is presented in the financial statements.
2 marks
(iii) Work: year end inventory count
External auditor’s objectives
To ensure that:
¾ the physical inventory count stated in the financial statements is materially correct and that the assertions of
existence, ownership, valuation, cut-off, accuracy and completeness are supported.
¾ the inventory counters correctly record items which are either slow moving or damaged. This will be
necessary to address the valuation assertion.
2 marks
Maximum marks 5
© GTG
Solution Bank: 87
17. Internal audit department and outsourcing – MonteHodge Co
This question has two parts.
Part (a) is worth 8 marks. You need to discuss the advantages and disadvantages of outsourcing an internal
audit department. This is a knowledge based question, so you need to use your knowledge relating to internal
audit and outsourcing while writing this answer. The verb in the requirement is “discuss”. Therefore, to score
maximum marks, you need to identify and explain each point in the context of outsourcing. As the question is
worth 8 marks, you need eight valid points.
Part (b) of the question is worth 12 marks. This is a scenario-based question where you need to discuss the
reasons for and against having an internal audit department at MonteHodge Co. The scenario contains many
pointers relating to the usefulness of an internal audit department. You need to identify them in your answer.
The verb in the requirement is “discuss’. Therefore, you need to identify and explain each area of usefulness
and also show how it is applicable to MonteHodge. You can score 2 marks for each valid point.
1.
(a) Outsourcing internal audit
Advantages of outsourcing internal audit
Staff recruitment
There will be no need to recruit staff for the internal audit department; as the outsourcing company will provide
all staff and ensure staff is of the appropriate quality.
Skills
The outsourcing company will have a large pool of staff available to provide the internal audit service. This will
provide access to specialist skills that the company may not be able to afford if the internal audit department
was run internally.
Set up time
The department can be set up in a few weeks rather than taking months to advertise and recruit appropriate
staff.
Costs
Costs for the service will be agreed in advance. This makes budgeting easier for the recipient company as the
cost and standard of service expected are fixed.
Flexibility (staffing arrangements)
Staff can be hired to suit the workloads and requirements of the recipient company rather than full-time staff
being idle for some parts of the year.
Disadvantages of outsourcing internal audit
Staff turnover
The internal audit staff allocated to one company may change frequently; this means that company systems
may not always be fully understood, decreasing the quality of the service provided.
External auditors
Where external auditors provide the internal audit service there may be a conflict of interest (self-review threat),
where internal audit work is then relied upon by external auditors.
Continued on the next page
88: Internal Audit
© GTG
Confidentiality
Knowledge of company systems and confidential data will be available to a third party. Although the service
agreement should provide confidentiality clauses, this may not stop breaches of confidentiality e.g. individuals
selling data fraudulently.
Control
Where internal audit is provided in-house, the company will have more control over the activities of the
department. Therefore there is less need to discuss work patterns or suggest areas of work to the internal audit
department.
1 mark for each valid point
Maximum marks 8
In order to score maximum marks, you must avoid the following common errors:
Avoid writing the following
points in your answer
“Potential reduction in cost.”
What is inappropriate
Here, matter is only identified without
an explanation. So you can score
only 0.5 marks rather than 1 mark
“The internal audit department will
be able to provide detailed reviews
of the control systems in the
company and recommendations for
improvements in those controls.”
This point is inappropriate as it is a
general point relating to internal
audit department rather than the
outsourcing element of internal audit
“An outsourced internal audit
department will be more
independent”
Matter is only identified without an
explanation.
Appropriate way of writing
the point
“Potential reduction in
cost because recruitment fees
and training costs will be
avoided”
An outsourced internal audit
department will be more
independent because they
don’t work full
time at the company and have
fewer self-interest or
association risks
(b) Need for internal audit
(i) For establishing an internal audit department
Value for money (VFM) audits
MonteHodge has some relatively complex systems such as the stock market monitoring systems. Internal audit
may be able to offer VFM services or review potential upgrades to these systems checking again whether value
for money is provided.
Accounting system
While not complex, accounting systems must provide accurate information. Internal audit can audit these
systems in detail ensuring that fee calculations, for example, are correct.
Maintenance of computer systems is critical to MonteHodge’s business. Without computers, the company
cannot operate. Internal audit could review the effectiveness of backup and disaster recovery arrangements.
Internal control systems
Internal control systems appear to be limited. Internal audit could check whether basic control systems are
needed, recommending implementation of controls where appropriate.
© GTG
Solution Bank: 89
Effect on audit fee
Provision of internal audit may decrease the audit fee where external auditors can place reliance on the work of
internal audit. This is unlikely to happen during the first year of internal audit due to lack of experience.
Image to clients
Provision of internal audit will enable MonteHodge Co to provide a better ‘image’ to its clients. Good controls
imply client monies are safe with MonteHodge.
Corporate governance
Although MonteHodge does not need to comply with corporate governance regulations, internal audit could still
recommend policies for good corporate governance. For example, suggesting that the chairman and chief
executive officer roles are split.
Compliance with regulations
MonteHodge is in the financial services industry. In most jurisdictions, this industry has a significant amount of
regulation. An internal audit department could help ensure compliance with those regulations, especially as
additional regulations are expected in the future.
Assistance to financial accountant
The financial accountant in MonteHodge is not qualified. Internal audit could therefore provide assistance in
compliance with financial reporting standards, etc. as well as recommending control systems.
(ii) Against establishing of internal audit department
No statutory requirement
As there is no statutory requirement, the directors may see internal audit as a waste of time and money and
therefore not consider establishing the department.
Accounting systems
Many accounting systems are not necessarily complex so the directors may not see the need for another
department to review their operations, check integrity, etc.
Family business
MonteHodge is owned by a few shareholders in the same family. There is therefore not the need to provide
assurance to other shareholders on the effectiveness of controls, accuracy of financial accounting systems, etc.
Potential cost
There would be a cost of establishing and maintaining the internal audit department. Given that the directors
consider focus on profit and trusting employees to be important, then it is unlikely that they would consider the
additional cost of establishing internal audit.
Review threat
Some directors may feel challenged by an internal audit department reviewing their work (especially the
financial accountant). They are likely therefore not to want to establish an internal audit department.
2 marks for each valid point
Maximum marks 12
90: Internal Audit
Avoid writing the following
points in your answer
To
examine
financial and
accounting information
© GTG
What is inappropriate
This point is incomplete as it does
not explain why this function is
necessary at MonteHodge.
“Montehodge is a family owned
company with four of the six
shareholders
being
board
members.”
This statement only repeats the
matters provided in the scenario
without explaining why it will be
useful to have an internal audit
department.
To evaluate and test the design
and implementation of controls at
Montehodge Co.
This is a valid reason to establish
an internal audit department.
However, the point is incomplete
as it does not relate to
Montehodge.
Appropriate way of writing the
point
To
examine
financial and
accounting
information
as
MonteHodge does not have a
qualified financial accountant.
Therefore, it would be useful for
the internal audit department to
conduct a review of the accounts
to confirm the appropriateness of
application
of
accounting
standards.
Montehodge is a family owned
company with four of the six
shareholders
being
board
members. The internal audit
department would provide the
two shareholders with some
confidence regarding the controls
and financial statements of the
company.
To evaluate and test the design
and implementation of controls at
Montehodge Co.
Montehodge is faced with issues
such as lack of controls (due to
directors
trusting
staff).
Furthermore, Montehodge has
15 locations. Therefore, the
entity would benefit from having
a common control system.
SECTION C
SOLUTION BANK
PLANNING AND RISK
ASSESSMENT
C
18. Audit Plan – Bridgeford Products Plc
You need to concentrate on part (b) of the question as you are required to focus on the problems highlighted in
the question. You should plan your answer before starting as there is sufficient information given and it is time
consuming to compile your answer with this information.
You can score well in part (a) as the question is straightforward and easy to answer.
(i) The need and importance of planning an audit and the subsequent control of the work cannot be overemphasised.
Planning assists an auditor in conducting the audit in an effective manner as it enables the auditor to:
(a) Identify the important areas that require more attention
In planning the audit, an auditor obtains knowledge of the entity and its environment including the internal
control system. He also identifies the significant transactions and those areas which need more attention. For
example, the scenario indicates that inventory is an important area because the company proposes to value its
inventory on the reporting date based on the inventory quantities recorded in the inventory system without
taking an inventory count on 31 January 20X9. Furthermore the inventory system was installed only in the
current year and the auditor has no idea how reliable the system is.
(b) Identify potential risks which have an effect on the audit as well as the financial statements
The auditor also identifies the potential risks associated with the financial statements. Risks can arise from
many causes, which include the sudden dismissal of the CFO, without reason. Furthermore, there is no
replacement CFO from 15 Aug 20X8 to 31 Jan 20X9. The auditor analyses the areas of potential risk and
prepares his audit plan accordingly.
(c) Conduct an effective audit in an efficient and timely manner
Having an audit plan will enable the auditor to estimate the time required for each section of the audit and to
decide on the appropriate grades of staff needed. For example, if the auditors plan to take an inventory count on
the reporting date, the audit plan will estimate the time taken for the inventory count and also the type of the
staff required for the inventory count. This comes from past experience and also looking at the inventory ledger,
the number of items and making a rough analysis of the items which are of a high value, etc. The company’s
year end accounting timetable and the deadlines for the completion of the audit should be reviewed with the
company’s chief financial officer (or in this case the chief accountant) to ensure that all deadlines can been met.
A detailed audit timetable should then be prepared, giving the dates on which schedules are due from the client
and the dates when various sections of the audit are to be completed.
(d) Allocate work to assistants in such a manner that they will be best utilised
Planning the audit enables the allocation of individuals to the various audit clients. This will be decided based on
the experience of each staff member and the degree of skill required for the particular assignment concerned. It
is preferable that the audit team contains members of staff who have visited the client previously, not only to
maintain good relationships but also because they will have gained detailed knowledge of the client and the
industry in which the client operates. However, care needs to be taken that staff are also rotated so that there is
no familiarity threat faced by the auditor.
92: Planning and Risk Assessment
© GTG
(e) Identify the need for experts and co-ordination of the work of others
To ensure that an audit is carried out effectively and efficiently, the work is controlled and recorded at each
stage of its progress. The most important elements of control are the direction and supervision of the audit staff
and the review of the work they have done.
For example, the audit plan will specify the exact work which will have to be carried out at the planning stage of
the audit - like analytical procedures. While the audit planning stage is in progress, the audit senior will be able
to verify whether the analytical procedures are actually carried out. He will then review the findings of the
procedures and decide on the areas which are high risk in nature. In certain specialist industries, it is desirable
that some members of the audit team have previous audit experience in that industry. For example, Bridgeford
has installed a new inventory system, so it will be ideal to ensure that the audit team includes audit staff with
experience in working on computerised inventory systems. An audit plan enables such kind of allocation.
(f) Determine the nature, timing and extent of the audit procedures
The auditor also determines the nature, timing and extent of the audit procedures that he should perform to
carry out the audit work in an effective and timely manner. Once the procedures, their timing and extent are
decided, it will be easy for an auditor to perform the audit according to the plan.
For example, the audit plan will specify analytical procedures which have to be carried out at the planning stage
of the audit. After the audit planning stage is complete, the audit senior will be able to verify the results of the
test of controls. For areas where the internal controls are weak, the auditor will carry out extensive substantive
procedures.
1.5 marks for each valid point
The general strategy I, as an auditor, will adopt, would be similar to the previous year’s audit as it is a recurring
audit. However, it will be modified to handle the problems experienced in the previous year’s audit and
significant factors that take place in the current year.
In the case of Bridgeford Products, the scenario has not stated about any problem areas relating to the previous
years.
However, the significant matters which will have to be taken into account in the current audit are testing the
reliability of the new inventory system, the quality of the company’s products, and the dismissal of two senior
members of staff.
2 marks
Maximum marks 10
(ii)
Remember to explain how
you will plan your audit in
these situations.
(a) In point (1), the management accounts for the 10 months show sales
of $130 million and profit before tax of $4 million. The expected sales for
12 months would be $156 million and profit before tax of $4.8 million. However, the actual sales for the year
ended 31 January 20X8 are $110 million and profit before tax of $8 million. This indicates that the ratio of
sales to profit has fallen from 7.28% ($8/$110x100) to 3.08% ($4.8/$156x100) which appears
disproportionate.
1 mark
I will try to analyse the reasons for the variance between the actual and the expected. The variations could be in
relation to sales or the various expense heads. In the case of sales, it could be due to a change in the sales mix
in 20X8 and 20X9 or due to a fall in the sales price. If this is the case, I will investigate the reasons for the
change in the sales price and also whether it is authorised. For the expense accounts, I will obtain the trial
balance as at 30 November 20X9 and find out the ratio of the various expenses to sales, make enquiries with
the clients and also obtain audit evidence and try to determine whether there are misstatements in the financial
statements.
I will also try to find out the basis on which the projections were made. Therefore, my audit plan will include the
reasons for the variance and the basis of the projections. This information will be reported to management so
that next year the projections will be closer to the actual figures.
2 marks
(b) The company proposes to avoid an
inventory count on the reporting date and,
with the help of the new computerised
inventory control system, to use the
inventory quantities on the computer to
value the inventory at the year end.
Remember, not to copy the sentences as they are from
the question. E.g. – Do not write ‘The company installed
a new computerised inventory control system which has
operated from 1 June 20X8’. It would be considered as a
bad answer. Instead, you can summarise the situation in
your own words.
1 mark
© GTG
Solution Bank: 93
I will not recommend this approach. The reason is that I will not have an assurance on the existence assertion.
This assertion is very important because inventory is a very important component of the financial statements
since a misstatement in the inventory will have a direct impact on the profit and also on the composition of the
SOFP. Furthermore, the new inventory system has not even been tested by the auditors. Therefore, my audit
plan will include physical verification of the inventory and reconciliation with the inventory quantities on the
computer.
2 marks
(c) We are informed that customers are refusing to pay for the products on account of reliability problems, and
also that there are legal cases filed by the customers against the company. These are important matters
because they affect not just the reputation, but also the going concern status of the company. Furthermore,
it will also affect the amount of provisions or contingent liabilities which need to be disclosed in the financial
statements and the valuation of inventory.
1 mark
I will enquire into the reasons for the problems relating to the quality of the company’s products, i.e. whether the
problems are on account of insufficient quality tests prescribed for the products / raw materials or on account of
inability to carry out the prescribed quality tests. I will enquire the management whether corrective actions were
taken, and if so, I will look into the corrective actions taken. For example, if the company has introduced
additional quality tests then I will verify the reports of the quality department to confirm that the new tests are
now being conducted. It is essential to estimate the reliability of items in closing inventory as this will affect their
values.
I will ask the client to take professional and legal advice on matters related to the legal claims. I will make a note
to make a provision for such claims.
2 marks
(d) The sales increase in the current year appears to be on account of the extension of the credit period from
one month to three months. This appears to be the reason for the change in the age of receivables from 1.6
to 4.1 months. This is an important matter because it can affect the liquidity position of the company and it
can also increase the changes of bad debts if the debts become irrecoverable. Also if tight controls on
recovery are not maintained it can affect the going concern status of the company.
1 mark
First of all, I will find out whether the extension to the credit period has the approval of the management. If the
management has approved the extension then I will also enquire whether the company has introduced the
system of fixing credit ratings to customers before deciding on extending the original credit terms. Furthermore, I
will verify whether the company has a system of monitoring the recoveries and taking timely action in case of
non-recovery of debts. I will review the receivables ledger (with the help of an aged receivables analysis) to
confirm that customers are paying their debts on time. This will help me to find out whether there are any bad
debts. If there any customers who have not paid for more than six months, I will ask my client to send reminders
to them. There is also a chance that the company is facing liquidity problems due to the large increase in
receivables.
2 marks
The CFO and purchasing manager were dismissed on 15 August. Furthermore, even though a replacement
purchasing manager has been appointed a new CFO will be appointed before the year end only. The Chief
Accountant will be responsible for preparing the financial statements for audit. This is an important matter
because the reasons for the dismissals of the personnel are not known; it could be also on account of fraud.
This can lead to material misstatement in the financial statements.
2 marks
The reasons for the removal of the chief financial manager and purchasing manager will have to be ascertained.
I will check whether they have been involved in any fraud which has material financial consequences. If fraud
has occurred, I will look into the circumstances which led to the fraud and the officials involved and then try to
determine the extent of fraud. I will determine whether the management has introduced additional safeguards to
avoid the repetition of fraud. Furthermore, if the fraud occurred during the previous year, I will look into the
reasons as to why my firm’s quality control procedures could not detect the fraud. If required, I will introduce
additional quality checks such as second partner review (if non-existent) within my firm.
1 mark
In addition, I will have to consider the consequences of the company being without a purchasing manager for a
long time. There is a risk of controls getting weaker during this period.
2 marks
Maximum marks 15
94: Planning and Risk Assessment
© GTG
(iii) Documentation means the records maintained by the audit team during the course of audit.
Audit documentation should contain sufficient information to enable an experienced auditor, who has had no
previous connection with the audit, to ascertain from the audit documentation the evidence that supports the
auditors’ conclusions.
For example, audit documentation for verification of overtime payments will mention the employee code
numbers and month of payments of employees whose overtime wages were checked, a copy of the company’s
policy relating to overtime payment, the employee code numbers where irregularities were noticed, the actual
amount/ hours which should have been paid / recorded, the amount which was actually paid, etc.
1 mark
Necessity of audit documentation:
(a) Provides defence against negligence of actions
An auditor may be charged with negligence in a court of law for not detecting a material fraud or error in the
financial statements. The suit may come up a long time after the audit is completed. The working papers will
enable him to defend himself by proving that he had taken reasonable care and skill while carrying out his audit
and drafting his report.
(b) Facilitates adequate planning
Documentation helps to ensure that:
¾ planning is completed in an organised manner
¾ planning decisions are followed during the conduct of audit
¾ an appropriate reference point is available for review both during and upon completion of the audit
In short, working papers make the auditor aware of the work performed. This helps the auditor in designing and
deciding the nature, timing and extent of the audit procedures. It also saves time required for training the audit
staff as well as avoiding the repetition of work. Audit projects are often repeated or extended to cover additional
areas or used as a basis for the planning of other assignments.
(c) Facilitates supervision and review of the audit work
An audit is performed by the audit team, as it is not possible for the senior auditor to perform all the procedures.
Working papers provide efficient means for the audit team to communicate the results of their work to their
senior auditors.
(d) Provides the basis of audit report
Working papers provide a vital link between the audit examination procedures and the auditor’s work. Working
papers represent evidence of the work done.
(e) Allows discussion of audit findings with management
Audit working papers are effective means of discussing major audit findings with the management. The auditor
is also able to discuss the audit plan with the audit team and the management before commencing the audit, if
the audit working papers contain the audit plan which specifies the nature, timing and extent of audit
procedures.
(f)
Serves as guide for succeeding auditors
Good working papers contribute to the quality of subsequent audits by providing a good starting point for
succeeding auditors to:
¾
¾
¾
¾
reduce time spent in understanding the nature of the business operations
identify areas of audit risks
determine the scope of audit required
determine, with a greater degree of accuracy, the time and staff required
(g) Serves as a data bank
Working papers help in accumulation of information for the final report. The various lists, statements and
schedules supply a lot of information on different aspects of the company. This information is useful for both, the
current as well as future audits.
1 mark for each valid point
Maximum marks 5
© GTG
Solution Bank: 95
19. Knowledge of the business – Earn & Co
The question is very straightforward and easy to understand. Your answer should be to the point.
(a) Concept: knowledge of the business
Knowledge of the business is a frame of reference within which the
auditor exercises professional judgement. The auditor’s knowledge of
the business for an audit engagement would include:
Give explanations in
accordance to the marks
allotted. As it is a 2 mark
question, give fewer details.
¾ general knowledge of the economy and the industry in which the client operates
¾ a more detailed knowledge of how the entity operates
2 marks
Maximum marks 2
(b) Purpose of knowledge of business
The auditor and the members of the audit staff should have knowledge of the business for the following
reasons:
(i) to enable them to identify and understand the events, transactions or practices so that the auditor’s
judgement can be applied to the financial statements.
(ii) to assess the inherent and control risks.
(iii) to determine the nature, timing and extent of audit procedures.
(iv) to evaluate audit evidence.
(v) to make judgement on various matters throughout the course of audit.
1 mark for each valid point
Maximum marks 3
(c) Relevance of knowledge of business to all phases of audit
Knowledge of business is relevant to all phases of an audit.
(i) At the planning stage it helps the author in:
¾ assessing inherent risk and control risks.
¾ identifying fraud risk factors.
¾ developing the overall audit plan and audit programme.
¾ setting the materiality level.
0.5 marks for each valid point
(ii) At the time of performing the audit, it helps the auditor in:
¾ assessing audit evidence regarding its appropriateness and the validity of the related financial statement
assertions.
¾ evaluating accounting estimates and management representations.
¾ identifying related parties and related party transactions.
¾ recognising conflicting information.
¾ recognising unusual circumstances.
¾ making informed enquiries and assessing the reasonableness of answers.
0.5 marks for each valid point
At the time of review, it helps the auditor in considering the appropriateness of the accounting policies and the
financial statement disclosures.
Maximum marks 5
96: Planning and Risk Assessment
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(d) Sources of knowledge of business
Apart from interviews and discussions with the client’s management and staff, the auditor can obtain knowledge
of the client’s business from the following sources:
(i)
(ii)
(iii)
(iv)
(v)
annual reports of the client which are given to the shareholders.
minutes of meetings of shareholders, Board of Directors and important committees.
internal financial management reports for the current and previous periods.
the previous year’s working papers and other relevant files.
firm personnel responsible for non-audit services to the clients who may be able to provide information on
matters that may affect the client.
(vi) the client’s policy and procedure manual.
(vii) trade journals or magazines.
(viii) consideration of the state of the economy and its effect on the client’s business.
(ix) visits to the client’s premises and plant facilities.
0.5 marks for each valid point
Maximum marks 5
Visits to the client’s premises and plant facilities which will assist the auditor in familiarising himself with the
physical realities behind the entries in the books of accounts. For example, inspection of plant and storage
facilities will enable the auditor to understand inventory movements from which he may appraise the stage of
production of work in progress. In addition, the auditor will be able to gain knowledge of the sources of
documentary evidence of the movements, which may cause duplication unless all movements are stopped at
the time of such stocktaking.
(e) Developing an audit plan
In developing an overall audit plan, the following matters
should receive the careful consideration of the auditor:
You don’t need to write all the
points in the exam. Extra points
have been given only for your
understanding.
(i) the terms of the auditor’s engagement.
(ii) the statutory responsibilities of the auditor.
(iii) the nature and timing of reports or other communications with the client that are expected under the
engagement.
(iv) the client’s accounting policies.
(v) deviations from accounting policies followed by the client in the past.
(vi) the effect of new accounting or auditing pronouncements – both national and international – on the audit.
(vii) the identification of significant risk areas.
(viii) the setting of materiality levels for risk areas.
(ix) the extent of reliance on the accounting system expected by the auditor and related internal control
arrangements in force in the client organisation.
(x) conditions requiring special attention, such as the possibility of material error or fraud.
(xi) rotation of audit emphasis on specific audit areas.
(xii) the nature and extent of audit evidence to be obtained.
(xiii) possible areas of cooperation with the internal auditors.
0.5 marks for each valid point
Maximum marks 5
20. Analytical procedures and materiality
In this question you are required to elaborate the concepts of analytical procedure and materiality.
Each element of part (a) is worth 2 marks, so give at least two potential reasons for the changes. Note that there
is little point in explaining that an increase in the current ratio is because current assets have risen and current
liabilities have fallen: that is a truism! You have to give reasons why that change might have taken place.
Note that where a ratio depends on a SOFP figure, changes in ratios can always be caused by accidents in
timing.
Part (b) is again a straightforward knowledge-based question with a well-defined mark allocation.
© GTG
Solution Bank: 97
(a) Analytical procedures
Note: in all cases the changes could have been caused by misstatement in the accounts. Set out below are
potential legitimate reasons for the changes.
(i) Increase in current ratio
Although you are told that there
are no marks for showing how a
ratio is calculated, a sentence
explaining this can help you to
focus on possible reasons for
changes.
The current ratio is calculated by dividing the total current assets by
the total current liabilities. The reasons why current assets have
increased more than current liabilities include:
¾ an increase in inventory, perhaps because the company is over
stocked.
¾ an increase in cash, perhaps because of additional finance being raised.
¾ an inability to collect receivables or a change in the collection period, or a change in the mix of customers
(e.g. export customers generally take more credit).
¾ a decrease in the trade payables or other current liabilities. This could simply be an artefact of the timing of
a payment. For example, if a large amount is paid to a accounts payable just the day before year-end,
liabilities will be greatly decreased at the reporting date compared to what they would be if payment were
made just after year-end.
2 marks
(ii) A decrease in gross profit margin
Gross profit ratio is calculated by dividing gross profit by sales revenue.
A change in this ratio could indicate the following:
¾
¾
¾
¾
change in sales / sales mix to less profitable items.
price pressure from competitors.
a rise in purchase cost which cannot be passed on to customers
in a manufacturing business, an increase in other direct expenses, such as wages, which cannot be passed
on.
2 marks
(iii) An increase in inventory holding period
This measure is calculated by dividing the inventory at the end of the year by the average daily cost of goods
sold. Possible causes are:
¾ inventory has increased because it cannot be sold and has become slow-moving.
¾ inventory has been deliberately increased to prepare for a marketing initiative, or to reduce the occurrence
of stock-outs.
¾ a large order was received just before year-end (a timing effect).
¾ inventory unit costs have increased just before year end so that recently acquired inventory looks large
compared to cost of sales in the year.
2 marks
(iv) Increase in dividend cover
Dividend cover is calculated by dividing profit after taxes and interest by the amount of dividend. An increase in
this ratio could indicate the following:
¾ the directors are following a stable dividend growth policy, not directly linked to profit growth. For example,
the directors plan for dividends to grow at 5% p.a. irrespective of the profits earned.
¾ a deliberate cut in dividends, perhaps to fund capital expenditure.
¾ legal restrictions on the amount of profits that can be paid as dividends.
2 marks
(v) Increase in the gearing ratio
The gearing ratio measures the relationship between equity and borrowing. Reasons for a possible increase in
gearing include:
¾ additional borrowing in advance of capital expenditure or acquisition.
¾ additional borrowing forced on the company because of liquidity difficulties.
¾ buy-back of shares (this will reduce the company’s equity).
2 marks
Maximum marks 10
98: Planning and Risk Assessment
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(b) Materiality
(i) Concept
Information is material if its omission or misstatement could influence the economic decisions of users taken on
the basis of the financial statements. Materiality depends on the size and incidence of an item. Materiality is a
matter of judgement.
1.5 marks
Materiality is not an absolute term and must be decided in a relative context only. This means that the same
item, of the same magnitude, may be material to one company but immaterial to another. It also means that the
incidence of the item (i.e. its likely effect on a user of the accounts) has to be considered. For example, a
relatively small which turns a small loss into a small profit might be regarded as material because the financial
statements now might give the impression that the company is on the road to recovery after a loss-making
period.
1.5 marks
The following examples will clarify the concept of materiality:
¾ an amount of $7,000 received from export sales would
usually be regarded as material if the total amount of income
from sales is $25,000, as its omission will affect the income
considerably.
An answer followed by an example
shows that you have thoroughly
understood the concept.
¾ an error or fraud of $50,000 is detected - is this material? If the company’s turnover is $400,000, then the
error would usually be regarded as material. If the company’s turnover is $2,000,000, then the error is
probably immaterial.
1.5 marks
Maximum marks 4
(ii) An auditor considers materiality both, at the overall financial information level and in relation to individual
account balances and classes of transactions. According to ISA 320, there is an inverse relationship
between materiality and the level of audit risk. This is because if the auditor gathers the same amount of
audit evidence and does not modify the audit strategy, and decreases / increases the materiality level, the
audit risks increases / decreases. If materiality decreases, the possibility of an inappropriate audit opinion
increases thereby increasing the audit risk. Likewise, if materiality increases, the possibility of an
inappropriate audit opinion decreases, decreasing the audit risk.
1.5 marks
The auditor considers this inverse relationship when he determines the nature, timing and extent of his audit
procedures. If, after planning for specific audit procedures, the auditor concludes that the level of materiality is
low (meaning that relatively small amounts are material), the audit risk is increased. He would try to reduce the
audit risk to an acceptable level by:
¾ carrying out extended or additional tests of control; or
¾ modifying the nature, timing and extent of his substantive procedures.
1.5 marks
For example, if we decrease our level of materiality from $1,000,000 to $100,000, our audit risk increases if we
gather the same amount of audit evidence (as we did at the $1,000,000 materiality level). This is because when
auditing without complete evidence, the auditor will find it hard to be confident about the absence of errors or
frauds of lower amounts as they are usually harder to detect. So, if the auditor does not change his audit
procedures and accordingly, the amount of audit evidence obtained the chances (risk) of being falsely confident
increases.
The auditor’s assessment of materiality at the time of initial planning may change at the time of evaluation of the
results of the audit procedures.
This could be due to:
¾ changes in circumstances; or
¾ changes in the auditor’s knowledge.
1.5 marks
For example, the auditor at the time of initial planning may have thought that a bad debt of $1,000 is immaterial
and it does not matter if this amount is not written off or provided for. However, the terms of a bank loan
obtained during the year require the company to maintain a current ratio of 2:1 otherwise the loan will be
recalled (i.e. the loan becomes repayable immediately on the banker giving notice of the recall). If this bad debt
is written off and, consequently, the current ratio falls below 2:1, this may result in recall of the bank loan and its
reclassification as a current liability in the SOFP. Therefore, the auditor’s initial assessment of materiality at the
planning stage will change.
1.5 marks
Maximum marks 4
© GTG
Solution Bank: 99
(iii) The auditor’s materiality decision is a multi-factor decision involving both quantitative and qualitative
aspects. It is important to consider both the amount (quantity) and nature (quality) of misstatements in order
to judge the materiality of the misstatements. An example of a qualitative misstatement is as follows:
1 mark
The disclosure of accounting policy is a qualitative aspect of materiality. Disclosure of accounting policies is
necessary to make the financial statements understandable. An inadequate or improper description of
accounting policy is likely to mislead a user of the financial statements. Non-disclosure of the method of
depreciation will prevent the financial statements from presenting a true and fair view of the financial position of
the entity.
1.5 marks
Maximum marks 2
21. Extent of reliance on the work of internal auditors
Remember that the question is divided into four parts, and allocating your time appropriately will help you score
good marks as they carry more marks. Explaining only theory without relating it to the given scenario will be
considered as a bad answer. This is a scenario-based question and you can answer it well if you have sufficient
knowledge of the concept of internal audit.
(a) Reliance on work of internal auditors
Management wants our firm to co-operate with the internal auditors to avoid unnecessary duplication of work.
The internal auditors operate largely in the same field and have a common interest in ascertaining that there is
an effective system of internal control to prevent / detect errors and fraud. They both aim to provide an adequate
accounting system for preparation of true and fair financial statements.
1 mark
In order to determine whether and to what extent we might be able to rely on the work performed by the internal
auditors, we will have to ascertain the extent to which such work has been carried out with objectivity,
competence and due professional care by the internal auditors. In other words, the quality of the internal audit
personnel, their degree of independence, their work performance and the scope of the internal audit function are
important factors which we would consider.
2 marks
(i) We, as an external auditor, may be able to rely on the
Identify the requirements of
work of the internal auditors in relation to the cyclical
the question and write your
audit of internal controls.
answer to each accordingly.
1 mark
(ii) In relation to the four-year review of internal controls, the extent of reliance on the work of internal audit
depends on how long ago the last review was conducted. If it was conducted recently, it will help us in the
areas of accounting and the internal control system.
2 marks
(iii) In relation to risk management, the relevance of the internal audit work depends on the extent to which the
effects of risks in reporting and the financial statements in particular, have been addressed separately by
management. This work will help us in risk assessment and planning.
2 marks
Maximum marks 6
(b) Information required
Our firm will ask the internal auditors to document all the work carried out by them along with the reasons
supporting their decisions. Such documentation should include the examination and assessment of the quality
of the internal audit personnel, the degree of their independence, the objectivity with which their work is
performed, the scope of the internal audit function and also the details of any specific tests of transactions,
balances or working papers. In addition, the extent of the internal audit work on which our firm has relied and
the conclusions arrived at should be documented.
3 marks
100: Planning and Risk Assessment
© GTG
External auditors can rely on the internal auditor’s work by scrutinising:
¾ the internal auditor’s audit plan – this will help the external auditor to know the risk areas, tests of controls
and substantive procedures implemented by the internal auditor.
¾ the systems documentation of internal audit – the information system of the company may include the
documentation of the company’s accounting and internal control systems.
¾ the results of tests of control and substantive procedures
¾ the supervision and review of the internal audit team
¾ to whom the internal auditors report. For example, reporting to the audit committee is likely to make them
more independent
¾ the documentation on the four year review of internal controls
3 marks
Maximum marks 6
(c) Circumstances in which our firm will not be able to rely on the work of internal auditors
¾ If the internal auditors do not possess adequate qualifications, training, experience and competence.
¾ If they are not aware of the developments in the field of accounting and auditing, especially internal auditing.
¾ If they do not perform their duties with professional care and pay due attention to the role assigned to them
by the management.
¾ If, within the limits of being employees of the organisation, they do not discharge their duties with
independence in attitude.
¾ If they do not possess the qualities of integrity and objectivity in their approach to the work assigned to
them.
¾ If they do not document or plan their work.
1 mark for each valid point discussed
Maximum marks 4
(d) Additional work taken by our firm
(i) Regardless of relying on the work of the internal auditors, our firm will wish to perform work independently in
all areas that are material to the financial statements. It may be possible to rely on the work of the internal
auditors for immaterial areas in which the internal audit work can be verified by testing.
1.5 marks
(ii) We will want to review internal audit working papers to ensure that their work has been properly carried out
and that any problems followed up.
1.5 marks
(iii) Areas material to the financial statements are likely to be long and short-term leases with customers, noncurrent assets, receivables and inventory. We will wish to see if proper accounting policies are applied to
leases. In addition, the valuation of inventory has a direct effect on the financial statements and this is an
area that is easy to manipulate. Therefore, proper verification of valuation of inventory is needed.
1.5 marks
(iv) We will also wish to perform our own risk analysis based on analytical procedures in order to ensure that no
high risk areas have been overlooked.
1.5 marks
Maximum marks 4
22. Audit risk – Quench Cola
You need to go through the question thoroughly and mark the audit risks. You should then divide them into
inherent, control and detection risks. Remember to explain WHY it is a risk, by mentioning its possible impact on
the financial statements.
Part (b) requirements will help you with part (a) as the components of audit risk are set out there!
© GTG
Solution Bank: 101
(a) Audit risk is the risk that the auditor expresses an inappropriate audit opinion
for example, giving an unqualified audit report when the financial statements
are, in fact, materially misstated.
Start by explaining
the audit risks and
their types
There are three components of audit risk:
¾ inherent risk
¾ control risk
¾ detection risk
2 marks
(i) Inherent risk
Inherent risks are the risks that organisations face because of the business they are in and the nature of their
industry, the skill of their staff and so on. Inherent risk is the susceptibility of an account balance or class of
transactions to material misstatement assuming that there were no related internal controls. Some account
balances are more prone to errors or fraud than others. The term inherent is used here because these types of
risks will always be present for the organisation and are an inevitable part of its business environment.
1 mark
In the case of Quench Cola, sales depend on the outcome of the law suit and the government’s decision
regarding the potential ban on the production and sale of soft drinks. Fiona cannot estimate the extent of risk but
the risk could affect the going concern status of Quench Cola.
1 mark
(ii) Control risk
Control risk is the risk that an organisation’s internal control systems do not adequately protect the organisation
because they have not been properly designed and/or implemented. Control risk is the risk that a material
misstatement that could occur in an account balance or class of transactions will not be prevented or detected
and corrected on a timely basis by the accounting and internal control systems.
1 mark
Previous audits have found that there is a good system of internal control. If that system is still in operation then
control risk will be low.
1 mark
(iii) Detection risk
Detection risk is the risk that an auditor’s substantive procedures will not detect a material misstatement that
exists in an account balance or a class of transactions. This covers the risk that an auditor’s checking and
sampling procedures will not reveal any existing irregularities or misrepresentations. As a result, the auditor may
unwittingly end up using inaccurate or fraudulent information while conducting his audit.
1 mark
Fiona can observe from the financial statements of Quench Cola that the sales have not shown a significant rise
compared to the rise in expenditure on sales promotion and marketing. It is not possible for Fiona to check each
and every transaction as sales take place throughout the country and the volume of sales is huge. Fiona will
have to rely on the test checks’ result. Therefore, there is a possibility that she may miss an instance of fraud or
an error. Detection risk can be decreased by performing more extensive testing.
1 mark
Maximum marks 8
(b)
Inherent risk = 0.10
Control risk = 0.10
Detection risk = 0.20
Audit risk = Inherent risk x Control Risk x Detection risk
= 0.10 x 0 .10 x 0.20 = 0.002
Of course, these figures are difficult to assess
with much accuracy in practice. They will be
used more subjectively, so that if inherent and
control risks are judged to be high, the auditor
will have to make detection risk low (by
carrying out more testing) to end up with a low
audit risk.
1 mark
Therefore, audit risk = 0.20%
Therefore, assurance = 100 - 0 .20 = 99.80%
1 mark
Maximum marks 2
102: Planning and Risk Assessment
© GTG
23. Audit risk and control environment – EuKaRe charity
Part (a) of the answer requires you to explain the term audit risk and the three elements of risk that contribute to
total audit risk. The question is worth 4 marks. The question requirement is to provide four explanations for the
four points.
Part (b) requires you to identify areas of inherent risk in the charity scenario provided and then to explain the
effect of each risk on the audit approach. The question is worth 12 marks. There are two verbs in the
requirement, i.e. ‘list’ and ‘explain’, which need to be linked to the scenario. Therefore the mark allocation is 2
marks per point made. One mark is for identifying the inherent risk and one for explaining its effect on the audit
approach.
Part (c) requires you to explain why the control environment may be weak in the charity. The question is worth 4
marks. To obtain maximum marks, you need 4 points. Here, you need to think about the bigger “control
environment” issues within the entity. This question is comparatively difficult because the scenario does not
provide detailed control weaknesses.
(a) ‘Audit risk’ and the three elements of risk that contribute to total audit risk
The risk to the organisation is that the auditor will not competently or diligently perform the audit. The audit risk
is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially
misstated. Therefore audit risk can be defined as the risk that arises when an auditor furnishes an erroneous
opinion on the financial statements which are audited. The three elements of audit risk are as follows:
¾ Detection risk
Detection risk is the risk that an auditor’s substantive procedures will not detect a material misstatement that
exists in an account balance or a class of transactions or in the disclosures made in the financial statements.
This type of risk covers the risk that an auditor’s checking and sampling procedures will not uncover any existing
irregularities or misrepresentations. As a result, the auditor may unwittingly end up using inaccurate or
fraudulent information while conducting their audit.
For example, being aware of the existence of these risks, EuKaRe’s auditor first checks the effectiveness of the
cash system in place. The auditor also undertakes a few surprise cash counts to satisfy himself that the cash
balances are accurately recorded. In addition, the auditor also performs a routine sample check of a few
donations where he checks to see if the donations are accurately recorded in the cash records. However,
despite these procedures the auditor may still not discover that cash has been either stolen or misappropriated.
This then becomes one of the main detection risks of the audit.
¾ Inherent risk
Inherent risk is the susceptibility of an account balance or class of transactions or disclosures to material
misstatement assuming that there were no related internal controls. Some account balances are more prone to
errors or fraud than others e.g. cash balances at EuKaRe are more vulnerable to fraud than account balance of
non-current assets. This is because the charity generates income purely from voluntary donations.
Inherent risks are the risks that organisations face because of the business they are in and the nature of their
industry. The term inherent is used here because these types of risks will always be present for the organisation
and are an inevitable part of its business environment. Organisations cannot eliminate these types of risks.
However, they can take steps and precautions to mitigate them. One of the most common methods is to
mitigate the risks is by implementing a system of internal controls. However, this rarely mitigates all inherent
risks.
¾
Control risk
Control risk is the risk that a material misstatement that could occur in an account balance or class of
transactions or disclosures will not be prevented or detected and corrected on a timely basis by the accounting
and internal control systems. Control risk is the risk that an organisation’s internal control systems do not
adequately protect the organisation because they have not been adequately designed and/or implemented.
For example, if the internal controls relating to opening of mail and handling of donation cheques is not clearly
spelt out EuKaRe will face the control risk that a material misstatement could occur in the cash balance .
1 mark for each valid point
Maximum marks 4
© GTG
Solution Bank: 103
Common errors which must be avoided are:
¾ explaining audit risk as errors in the financial statements instead of inappropriate audit reports
¾ not linking inherent risk to the nature of the entity
¾ stating that control risk arises on account of not identifying the risk
(b) Areas of inherent risk in the EuKaRe charity and their effects:
¾ If there are insufficient controls to ensure that the income received is complete, money could be stolen, and
audit tests would not be able to identify the theft. For example, if donation receipts are not issued while
accepting donations, there will be no track of income. In these cases, the audit report may have to be
modified to explain the lack of evidence, stating that completeness of income cannot be confirmed.
¾ Since the whole of income of the charity is made up of voluntary donations, an inherent risk is that if the
donors face recession or a credit crunch, the amount of donations is bound to fall. Hence, future income
cannot be estimated, in turn making audit on the principle of “going concern” very difficult.
¾ Donations may not be spent according to the donor’s wishes. This especially applies to the donations which
have specific clauses attached to them e.g. provision of sports equipment. During audit, appropriateness of
expenditure should be confirmed with the terms and conditions of the donations. Any discrepancy will have
to be reported to management.
¾ Correct analysis of the income and expenditure, depending upon the relevant taxation rules governing
charities, needs to be done. For this, the auditor should ensure that appropriate staff, familiar with these
rules, are part of the audit team.
¾ Charities have specific objectives, and funds received by them are supposed to be spent in accordance with
those objectives. Hence, there is a risk of funds being spent outside the scope of the objectives. To avoid
this, the auditor will need to scrutinise the constitution of the charity. Furthermore, utilisation of funds outside
the scope of the objectives will have to be reported to management.
¾ The constitution of the charity says that administration expense can be no more than 10% of the total
income. Here, there is a risk of the income being overstated, to allow for expenses to be overstated. Audit
procedures, focusing on the allocation and recording of expenditure, should be undertaken to be assured of
the accuracy.
2 marks for each valid point
Maximum marks 12
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Stating that “There are very few staff meaning that the control system will be weak”.
This point relates to control risk rather than inherent risk.
(ii) Stating that “Additional substantive procedures will be required.”
This point is very general rather than scenario based.
(c) Control Environment:
The control environment may be weak at the charity EuKaRe on account of:
¾ Lack of qualified staff: in the case of charities, people volunteer to work, so the charity has very little
choice while selecting the staff. Mostly, the volunteers have little or no formal qualifications and/or
experience required for the job.
104: Planning and Risk Assessment
© GTG
¾ Attitude of the trustees: the trustees may not stress on the importance of controls for the charity due to
lack of time that they can devote, or due to lack of professional training. Hence, the overall controls may be
weak.
¾ No segregation of duties and responsibilities: segregation of duties cannot be implemented, probably
due to lack of staff. The staff also may be ignorant about their intended role in the charity, as they are not
formal employees, but volunteers.
¾ Lack of internal control: as the charity is not likely to have an internal audit department, the internal
controls may not be formally monitored.
¾ Lack of full time staff: the staff might be working voluntarily, and on an occasional basis. So, the control
environment will suffer as controls will be performed irregularly, and by different staff every time.
1 mark for each valid point
Maximum marks 4
24. Analytical procedures – Zak Co
Part (a) of the question is knowledge based. You are required to explain:
¾ analytical procedures;
¾ the types of procedures that could be used; and
¾ the situations in the audit when analytical procedures could be used.
The question is worth 8 marks. Therefore you need eight valid points.
In part (b) you are required to identify and explain the unusual changes in the income statements provided in the
scenario. Therefore a careful analysis of the income statements is required. While analysing the financial
statements you need to remember that the results appear to be good although the directors thought the
company had had a difficult year.
The question is worth 9 marks. The requirement verbs are ‘identify’ and ‘explain’. Therefore you would score 0.5
marks for identifying each unusual change and a further mark for explaining the change. So in order to score
maximum marks, you need six valid points.
For part (c) you are required to explain the procedures to obtain a bank confirmation letter. The question is
worth 3 marks and is knowledge based and straightforward. You need to write three valid points in order to
score maximum marks.
(a)
(i) Explanation of analytical procedures
'Analytical procedures' means evaluation of the financial and other information, and the review of plausible
relationships among both financial and non-financial data. For example, sales have a direct relationship with
royalty expenses, provided royalty payments are based on the number of units sold. Therefore analytical
procedures will include determining whether the sale for a period has a direct relationship with the royalty
expenses incurred during the same period.
1 mark
The analytical procedure also includes investigation of identified fluctuations and relationships that are
inconsistent with other relevant information or deviate significantly from predicted amounts. For example if the
relationship between sales and royalty expenses is not direct, then the auditor would have to investigate the
reasons for the deviations because it indicates a possibility of a misstatement of either sales or royalty expenses
in the financial statements.
Analytical procedures help in understanding an entity and its environment and its overall review at the end of the
audit. They are also used as substantive procedures when their use can be more effective or efficient than tests
of details, in reducing the risk of material misstatement at the assertion level to an acceptably low level.
1 mark
Maximum marks 2
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Solution Bank: 105
(ii) The different types of analytical procedures available to the auditor are as follows:
Comparison with prior periods
Comparable information of the current year is compared with information relating to prior periods. This
comparison helps to identify unusual changes or fluctuations in amounts. For example a comparison of revenue
and gross profits of the current year with the amounts of the previous year will help determine the percentage of
growth in sales and whether the gross profit margin was similar as in the previous year.
Comparison with anticipated resulted
Actual results are compared with anticipated results of the entity or budgets and/or forecasts. Unusual
discrepancies identified by the comparisons indicate a possibility of misstatement in the area where the
discrepancy is noticed. This would have to be investigated by further audit procedures. For example a
comparison of sales will be made with budgeted sales and if major deviations are noticed, these would have to
be investigated. In fact if the actual results show a significant fall as compared to the budgeted results, the
auditor may have to investigate whether the going concern status of the entity is affected.
Comparison with industry information
Client information is compared with industry information either for the industry as a whole or by comparison with
entities similar in size to the client. For example, receivable days of a client are compared with the receivable
days of the industry.
1 mark for each valid point
Maximum marks 3
(iii) The situations in the audit when analytical procedures can be used are as follows:
Risk assessment procedures
Analytical procedures can be used at the beginning of the audit (as risk assessment procedures):
¾ to obtain an understanding of the entity and its environment so as to determine the audit strategy. This will
help the auditor to understand those aspects of the entity, of which they were unaware and will assist them
in determining the nature, timing and extent of further audit procedures.
¾ to assess the risk of material misstatement.
For example, the auditor performs ratio analysis based on the previous year’s financial statements. He
compares them with the company’s prior period results as well as with the results of the industry. The ratio
analysis indicates that there is a drastic fall in the gross margin ratio. This indicates that further audit procedures
are needed in the area of sales and direct expenses as there is a possibility of material misstatement.
Substantive procedures
The auditor can perform substantive procedures when their use can be more effective than tests of details in
reducing the risk of material misstatement at the assertion level. For example, comparisons of aggregate
salaries paid with the number of personnel may indicate unauthorised payments that may not be apparent from
testing individual transactions. Therefore analytical procedures can be used as substantive procedures in
determining the risk of material misstatement at the assertion level during work on the income statement and
statement of financial position.
Analytical procedures in the overall review
Analytical procedures help the auditor at the end of the audit to determine whether the financial statements as a
whole are consistent with the auditor's understanding of the entity. The auditor should apply analytical
procedures at or near the end of the audit that will enable them to form an overall conclusion as to whether the
financial statements are true and fair. For example, the auditor carried out ratio analysis on the financial
statements of the entity at the end of the audit and compared the ratios with the industry ratios. This enabled
them to determine whether the financial statements were true and fair.
1 mark for each valid point
Maximum marks 3
106: Planning and Risk Assessment
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Common errors and reasons why those errors will not obtain marks are as follows:
(i) “Analytical procedures can be used at the end of the audit as part of risk analysis.”
It would be more appropriate to state ‘Analytical procedures can be used at the end of the audit as they enable
the auditor to compare their overall knowledge of the business with the financial statements’.
(ii) Explaining different methods of collecting audit evidence such as enquiry, computation, observation, etc.
(iii) These methods of collection are not relevant to analytical procedures.
(b) Net profit
There is an overall change in the income statement of Zak Co i.e. the result has changed to a net profit from a
net loss. Although the sales have increased by 17%, the expenses, especially administration expenses, appear
to be low; they have fallen by 6%. Therefore there is the possibility that expenditure may be understated.
Sales: increase by 17%
Although Zak Co has faced a very difficult year (as stated by the directors), there is an increase in sales
amounting to 17%. The reasons for an increase in the sales income must be ascertained as the change is not in
line with the directors' comments. The reason for Zak’s favourable results as to sales may be growth in the
industry as a whole.
Cost of sales: fall by 17%
A fall in the cost of sales is unusual given that sales have increased significantly. The fall in the cost of sales
may be due to incorrect valuation of inventory or use of cheap substitutes from the market. However, this can
cause problems such as poor quality products, during the next year.
Gross profit (GP): increases by 88%
The GP percentage has changed significantly i.e. from 33% to 53% in 2008. It is necessary to determine the
reason for this drastic change. It could be either due to change in the sales mix or change in the direct
expenses. If the matter is not investigated, there can be material misstatements in the financial statements.
Administration expenses: fall by 6%
A fall is unusual given that sales have increased. Administration expenses should increase in order to support
the increased sales. There is a possibility of misstatement in the area of administration expenses.
Selling and distribution expenses: increase by 42%
Selling and distribution expenses would be expected to increase in line with sales, but the disproportionate
increase may be due to incorrect classification of expenses between administration expenses and selling and
distribution expenses or due to the age of Zak's delivery vans increasing, resulting in additional servicing costs.
Interest payable: decreases by 3%
Given that Zak has considerable cash surplus this year the company continues to pay interest, which is
surprising. The amount may be overstated; the reasons for lack of fall in interest payment (e.g. loans that cannot
be repaid early) must be determined. Therefore there is a possibility of misstatement in the financial statements
in this area.
Investment income: appears for the first time
This is expected in view of the existence of cash surplus during the current year. However, the amount is very
high indicating a possibility of errors in the amount of income or the existence of other income generating assets
not disclosed in the balance sheet extract.
1.5 marks for each valid point
Maximum marks 9
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Solution Bank: 107
Example comments provided and reasons why those comments will not obtain a pass standard are as follows:
(i) “An increase in turnover shows that sales have increased.”
The above comment is not relevant as sales and turnover mean the same thing. Instead, the comment must
provide an explanation for the increase in turnover on account of more intensive marketing or changes in the
weather (perhaps more sunny days meaning people were outside more in their gardens, cheaper shed prices
increasing demand, etc.)
(ii) “Selling and distribution costs increased by 20%.”
Although the comment has rightly identified the unusual change in the expenditure, it does not explain the cause
of the change. For this, the selling cost needs to be linked to the sales increase.
(iii) ‘Cost of sales falling due to stock being undervalued’.
The above point indicates a lack of understanding of the basic accounting principles.
(c) The procedures necessary to obtain a bank confirmation letter from Zak Co’s bank are as follows:
(i) Based on the results of the preliminary risk assessment, decide the need to obtain a bank letter from Zak
Co’s bankers.
(ii) Prepare a standard letter in which the confirmation of balance will be asked. The format needs to agree
with banks in your jurisdiction.
(iii) Obtain authorisation on that letter from the director of Zak to provide information to the auditors.
(iv) Include a reference to the director’s permission to provide the information to the auditors, in the letter
which is sent out to the bank.
(v) Send the letter to Zak's bank with a request to send the reply directly to the auditors.
1 mark for each valid point
Maximum marks 3
Common errors and reasons why those errors will not obtain marks are as follows:
(i) “Decide whether to obtain a positive or negative confirmation request and seek client’s approval
accordingly”
Bank balances are significant to financial statements. Therefore the auditor must obtain only positive
letters.
(ii) “Obtain the cash book; trace all deposits to the bank statement and cheques issued to the supplier’s
ledger accounts.”
This point is not relevant as it relates to testing of transaction systems rather than obtaining a bank letter.
25. Audit documentation – Specs4You Co
Part (a) of the question is designed to test your knowledge of ISA 230. You need to identify two or three
purposes of audit working papers. Keep the answers brief and clear. The question is quite straightforward.
Part (b) is based on a short scenario. You need to identify the documentary evidence that could be obtained,
and a description of the information contained in that evidence, when taking over the audit of an established
client. Your answer can include a review of the previous year’s audit file, company brochures, etc.
Part (c) is another scenario based question. You are provided with a typical audit working paper. You need to
explain why that working paper does not meet the characteristics of a good audit working paper. The question
carries nine marks, indicating that you need nine valid points in order to score maximum marks.
108: Planning and Risk Assessment
(a) The main purposes for making audit working
papers are as follows:
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Other valid points
¾ Allows discussion of audit
¾ It helps in recording the audit evidence resulting
findings with management
from the audit work performed to support the
¾ Provides defence against
auditor's opinion: working papers provide a vital link
negligence charges
between the audit examination procedures and the
auditor’s work. They facilitate the preparation of a report
since everything noticed during the audit, queries raised and responses received are recorded here. An
auditor refers to the audit working papers before preparing their audit report.
¾ It helps in planning and performance of the audit: it provides evidence to confirm that planning of the
audit was carried out in an organised manner and planning decisions were followed during the conduct of
the audit.
¾ It helps in the supervision and review of the audit work: working papers provide an efficient means for
the audit team to communicate the results of their work to the audit seniors and partners. They are a means
by which the auditor supervises and maintains a control over the audit work already done and the work yet
to be done.
1 mark for each valid point
Maximum marks 3
Common errors which need to be avoided are as follows:
¾ Listing the types of audit test (analytical procedures etc.).
¾ Listing the different types of audit working papers (permanent file, current file, etc).
The above points do not explain the main purpose of making audit working papers. Therefore they are not valid.
(b) Documentation and information to be obtained:
(i) Memorandum and Articles of Association: will provide information relating to the objectives of
Specs4You, its permitted capital structure and the internal constitution of the company. This will be
contained in the permanent file.
(ii) Latest published financial statements: will provide details of the size of the company, profitability etc. In
addition, they also provide details on any unusual factors such as loans due for repayment.
(iii) Organisation chart: will enable identification of the key management personnel, the persons authorised for
carrying out important functions, the people who need to be contacted during the audit, etc.
(iv) Latest management accounts / budgets / cash flow information: will help to determine the current
status of the company including ongoing profitability, deviations from budget, etc. as well as identify any
potential going concern problems.
(v) Specs4You industry data on revenue: will help to understand Specs4You’s performance compared to
the industry standards. For example, lower than expected cost of sales will require further investigation by the auditor.
(vi) Financial statements of similar companies: will be used to compare the accounting policies of
Specs4You with other companies in the industry and also acquire additional information on industry
standards.
(vii) Prior year audit file will be reviewed in order to:
¾ identify the problems encountered in that year (such as weaknesses in internal controls), and how those
problems were resolved. This information is especially useful while planning the current year’s audit.
¾ determine other areas on which the auditor needs to concentrate while auditing. This can be
determined by analysing the performance of Specs4You in comparison to the industry standards; by
reviewing the analytical ratios which were analysed by the audit partner and the final conclusions drawn.
(viii) Internet news sites: will help to know whether they carry any significant news stories, (favourable or
unfavourable) which may affect the audit approach.
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Solution Bank: 109
(ix) The permanent audit file will be reviewed to understand the competition for the client in the market, the
supplier and customer relationship i.e. whether they are related parties, technological and other
developments in the industry and their impact on the entity, e.g. whether the entity is on the same level as
its competitors relating to technological development.
1 mark for each valid point
Maximum marks 8
Common errors which need to be avoided are as follows:
¾ Not explaining the information to be obtained from each document.
¾ Listing non-documentary sources of evidence rather than documentary sources of evidence.
¾ Focusing on the documentation without explaining the information contained therein. For example, ‘prior
year financial statements’ could be the document identified and the information contained therein would be
that ‘the auditor would use this to identify financial trends or risk areas’.
(c) The audit working papers do not meet the standards normally expected because:
(i) The working papers do not contain page reference. This would make them extremely difficult to file in the
audit file and also to locate them when there are queries on them.
(ii) The year end of the client is also not mentioned on the working papers. This could lead to filing of working
papers in the wrong working paper file.
(iii) The working papers are not signed. This means that:
¾ It is not possible to find out the names of the team members who raised the queries. Therefore queries
relating to the contents of the working papers also cannot be addressed.
¾ The authenticity of the queries can be doubted by the client in view of the absence of names of persons
who raised the queries.
(iv) There is evidence of a reviewer's signature. However, given that the reviewer did not raise any queries
relating to the absence of the preparer's signature or other omissions mentioned in the following points, the
effectiveness of the review is subject to doubt.
(v) The ‘objective’ of the audit procedure is vague – the audit assertion is mentioned as ‘To make sure that the
purchases day book is correct’. Here the meaning of the word ‘correct’ is not clear. Rather it would be better
to state the objective in terms of assertions such as completeness or accuracy.
(vi) The test objective is given the heading ‘test assertion’. This is incorrect because no audit assertions are
actually listed here.
(vii) It is unclear how the sample size which is tested was determined. Therefore the sufficiency of the size of the
sample cannot be ascertained. This will make it difficult to ensure the adequacy of audit evidence.
(viii) The working paper file states that the details of the testing are saved in another file. However, in the
absence of proper cross reference of the working paper file and the page number where the details are
filed, plenty of time will be wasted in searching for the working papers.
(ix) Information on the results of the test is vague. The working papers do not appear to state the result of the
test without bias, i.e. the opinion appears to be based on speculation (the personal judgement of the
preparer).
(x) The results of the test and the conclusion also appear inconsistent. This is because although five errors
were found, the results indicate that there are no weaknesses in the system.
1 mark for each valid point
Maximum marks 9
Common errors and reasons why those errors will not obtain marks are as follows:
Not explaining the points made. For example, stating that the working papers do not contain a page reference is
not valid as the requirement verb is ‘explain’.
110: Planning and Risk Assessment
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26. Understanding the entity, its environment and risk assessment - Rock
(i)
Understanding the entity and its environment involves knowing the following:
Understanding Rock and risk assessment is likely to involve a review of prior year risk assessments as a
starting point and the identification of changes during the year from the information gathered that may alter that
assessment.
Factors to be considered
Industry conditions
Nature of the entity
Entity’s selection and
application of accounting
policies including the
reasons for changes
thereto
Objectives and strategies
and significant business
risks of the entity
Measurement and review of
the entity’s financial
performance
Internal control
Explanation
I will obtain basic knowledge of the industry in which Rock operates. This
includes knowledge of:
i. Competition in the market
ii. Cyclical or seasonal activity
iii. Technological and other developments in the industry and their impact on
Rock
iv. Regulatory environment and external factors such as an understanding of the
laws and regulations those are applicable to Rock.
I will understand Rock’s operations, its ownership and governance and the types
of investments it is planning to make. Furthermore I will also obtain an
understanding of the investment and financing activities.
This includes an understanding of :
¾ The methods Rock uses to account for significant and unusual transactions:
¾ Appropriateness of changes in the Rock’s accounting policies.
Business risks result from significant conditions, events, circumstances, actions
or inactions that could adversely affect Rock’s ability to achieve its objectives.
They may also arise from a change, although a failure to recognise the need for
change may also lead to risk.
An understanding of the measurement and review of Rock’s financial
performance includes analysis of the performance of Rock. This audit procedure
is important as performance measures create pressures on Rock to either
improve business performance genuinely or misstate the financial statements.
Therefore by understanding the pressures it is possible to achieve performance
targets. Furthermore auditors will also be able to determine the areas in the
financial statements where there is an increased risk of material misstatement.
I will also obtain an understanding of the control environment, Rock’s process for
identifying and dealing with business risk, information systems, control activities
and monitoring of controls.
1 mark each valid point
(ii) Procedures I will perform in order to understand Rock and its environment and assess risk for the
audit of Rock
According to ISA 315, an auditor should perform the following risk assessment procedures to obtain an
understanding of the entity and its environment, including its internal control:
¾ Inquiry of management and others within Rock
Members of the engagements team should discuss the susceptibility of the financial statements to material
misstatements.
Information sought would relate to the following matters:
Inquiry from
Those charged with governance
Internal audit personnel
Employees
Legal counsellors
Marketing or sales personnel
Information sought
The environment in which the financial statements are prepared
The internal auditor’s evaluation of the adequacy and effectiveness of the
internal control system.
Identification of problems of the employees while actually implementing the
policies of management.
Inquiry regarding legal matters relating to compliance with applicable laws
and regulations.
The objectives of Rock, its marketing strategy and the risks associated with
the sale of Rock’s products.
2 marks
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Solution Bank: 111
¾ Analytical procedures
Analytical procedures are often used to highlight areas warranting particular audit attention. In the case of Rock,
they are likely to focus on inventory which is likely to have a significant effect on profit (there may be slow
moving or obsolete inventory that needs to be written down) and on property, plant and equipment which (as a
manufacturer and distributor) is likely to be a significant item on the SOFP.
1 mark
¾
Observation and inspection
Observation is regarded as the best method of obtaining an understanding of Rock and its environment
because, through observation, an auditor personally observes a procedure when it is actually performed.
However, sometimes it may happen that personnel may work cautiously when they know that they are being
observed by the auditor.
1 mark
¾ Inspection is examining records and documents (whether internal or external) or examination of tangible
assets.
1 mark
(iii) Risk assessment will facilitate the determination of materiality and tolerable error (calculations are normally
based on sales, profit and assets) that will be used in dertermining the sample sizes and in the evaluation of
errors.
1 mark
Maximum marks 10
27. Audit strategy, audit risks, tests of control, substantive procedures and analytical
procedures – B- Star
This question is based on a sales system in a theme park. You are expected to use information from the
scenario for all sections of the answer, except for section (a).
Part (a) of the question carrying 8 marks requires you to list and explain the main sections of an audit strategy
document and then provide an example of that section for B-Star. This question is quite challenging. Your
answer must include the following main points:
¾ understanding the entity’s environment,
¾ Understanding the accounting and internal control systems,
¾ risk and materiality,
¾ consequent nature, timing and extent of audit procedures and
¾ co-ordination, supervision and review of audit work
Part (b) of the question has two sub parts:
¾ Under Part (i) you require to identify the risks that could affect the assertion of completeness of sales and
cash receipts. This question carries 4 marks. Therefore you require 4 valid points. Each point must relate to
the scenario. In order to suggest valid points, you can think of how cash could be stolen or visitors to the
park could obtain entry without paying. Other valid points could be ticket staff giving away free tickets to
family members and lack of sufficiency of two security guards to guard the cash.
¾ Under Part (ii) you need to discuss how tests of control and substantive procedures could be used to
confirm the assertion of completeness. This question carries 6 marks. The verb in the question is ‘discuss’’.
Points will be valid if you explain the effectiveness of audit testing in a cash based environment focusing on
areas such as the need for clear segregation of duties and authorisation of cash / ticket reconciliations in the
company to be confirmed in tests of control.
Part (c) of the question carrying 8 marks, is scenario based. It also has two sub parts:
You need to list substantive analytical procedures that could be used to give assurance regarding total income
for one day (under part (i)) and then for one year (under part (ii)). In order to score maximum marks, you need to
list 8 valid points.
Part (d) of the question carrying 4 marks, requires you to explain audit procedures on the credit card receivables
balance. You require at least 4 valid procedures, to score maximum marks.
112: Planning and Risk Assessment
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(a)
Audit strategy document
Section of document
Understanding the
entity’s environment
Purpose
Provides details of the industry area that
the company is in along with specific
information about the activities and
strategies of the individual client.
Example from B-Star
Size of the theme park sector and
expected growth over the next few
years.
Accounting policy for sales – sales
are stated net of sales taxes.
Reliance on control systems in BStar may be limited due to lack of
documentation of controls.
The assessment of risk for the client and Materiality for sales to be 5% of
risk of fraud and error and the identification turnover.
of significant audit areas.
B-Star receives cash sales – audit
Risk and materiality
work required to determine the
The materiality level for audit planning
purposes.
completeness of sales.
Details of the focus on audit work on
Audit software could be used to
Consequent nature,
specific areas. Detail on the extent of use
provide analytical procedures on the
timing and extent of audit
of audit software and possible reliance on
sales of B-Star.
procedures
internal audit.
Details the extent of involvement of
B-Star has only one location – audit
Co-ordination,
staff will be required to work there
supervision and review of experts, client locations and staffing
requirements for the audit.
for X weeks.
audit work
2 mark for each valid point
Maximum marks 8
(b)
Understand the
accounting and internal
control systems
Details of accounting policies of the client
and previous assessments of internal
control systems indicating the expected
extent of reliance on those systems.
(i) Risk affecting completeness
¾ The computer system does not record sales accurately and/or information is lost or transferred incorrectly
from the ticket office computer to the accounts department computer.
¾ Cash sales are not recorded in the cash book; cash is stolen by the accounts clerks.
¾ Tickets are issued but no payment is received – i.e. the sale is not recorded.
¾ Cash is removed by the ticket office personnel, by the security guards or by the account clerks.
¾ The account clerks miscount the amount of cash received from a ticket office.
1 mark for each point
Maximum marks 4
(ii) Use of tests of controls and substantive procedures
Tests of controls
Tests of control are designed to ensure that documented controls are operating effectively. If controls over the
completeness of income were expected to operate correctly, then the auditor would test those controls.
In B-Star, while controls could be in operation, e.g. the account clerks agreeing physical cash to computer
summaries, there is no indication that the control is documented; that is the computer summary is not signed to
show the comparison has taken place. The auditor could use the test of inquiry - asking the clerks whether the
control has been used, and observation - actually watching the clerks carry out the controls. As noted above
though, lack of documentation of the control does mean relying on tests of control for the assertion
completeness of income has limited value.
Substantive procedures
Substantive procedures include analytical procedures and other procedures.
Analytical procedures include the analysis of significant ratios and trends and subsequent investigation of any
trends or relationships that appear to be abnormal. These procedures can be used effectively in B-Star as an
approximation of income that can be obtained from sources other than the cash receipt records.
Other procedures, or tests of detail, are normally used to verify statement of financial position assertions and
include obtaining audit evidence relevant to specific assertions. However, they could be used in B-Star to trace
individual transactions through the sales/cash systems to ensure all ticket sales have been recorded
(completeness assertion). The use of other procedures will be time consuming.
Maximum marks 6
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Solution Bank: 113
(c)
(i) Substantive analytical procedures - completeness of income for one day
¾ Obtain proof in total. Tickets sold times price should equal day’s income.
¾ Compare daily sales to budgeted daily sales (for example weekends and bank holidays would expect more
income).
¾ Compare sales with previous days and account for changes such as variations for weather.
¾ Compare sales to souvenirs sales (more people in park means more souvenir sales).
¾ Compare ticket offices day-by-day and staff rotation to see if sales lower someday and confirm staff rotation
(attempt to identify fraud also).
¾ Compare the expected sales from ticket numbers to the total sales amount from cash and credit sales for
each ticket office.
(ii) Substantive analytical procedures - completeness of income for the year
Obtain the sales income from the previous year. Multiply this by 115% to provide
a rough estimate of the income for this year. Obtain information on the number
of days with rain during the last year. Where this is more or less than 30:
9 adjust the income estimate by 1/730 down for each day of rain
above 30 or
9 1/730 up for each day of rain less than 30.
¾ Compare actual income to budgeted income for the year. Ask the directors
B-Star only attracts
50% of the normal
number of customers
on a rainy day; hence
one day of rain
decreases total
customers by 1/730 in
the year
to explain any significant deviations.
¾ Obtain industry information on the popularity of theme parks, and change in customer numbers. Compare
these trends to the results obtained by B-Star. Where B-Star performed significantly better or worse than
average, obtain explanations from the directors.
Maximum marks 8
(d) Audit of year end credit card receivable
¾ Agree the balances on each credit card company’s ledger account to the list of receivables.
¾ Cast the list of receivables and agree the total to the total on the receivables ledger control account.
¾ For the last day of the financial year and the first day of the new financial year, agree total sales income
from ticket office records to the cash book and receivables ledger ensuring they are recorded in the correct
period.
For a sample of material balances and a random sample of immaterial items,
¾ Obtain direct confirmation from the credit card company of the amount due to B-Star using a receivables
confirmation letter.
¾ Where direct confirmation is not possible, obtain evidence of cash receipt after the end of the financial year.
Agree the amount on the bank statements post year end of B-Star to the amount due in the receivables
ledger (less any commission due).
¾ Review after date sales day book for debit notes indicating that sales may have been overstated in the prior
year.
¾ Obtain the financial statements of B-Star and ensure that the receivables amount is disclosed as a current
asset net of commission due to the credit card companies.
Maximum marks 4
114: Planning and Risk Assessment
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28. Fraud, substantive procedures on inventory valuation and ethics – Tye Co
This question relates to a company providing petrol, aviation fuel and similar oil based products to the
government of the country it is based in. The question carries 20 marks and has two requirements. The
directors of the entity have decided to revalue some of its inventory to a potentially unrealistic amount. In part
(a) you are required to list the audit procedures on this matter. The question carries 6 marks. As the requirement
verb is ‘list’, you can score marks by including 6 relevant procedures in your answer. Some of the valid points
would relate to:
¾
¾
¾
¾
¾
the need to discuss the matter with the directors,
the effect on materiality
the need to modify the audit opinion
obtaining written representation
reviewing the proposed policy against GAAP to see if it actually was valid
In part (b), you are required to state and discuss various responsibilities, reporting options and safeguards
regarding fraud affecting the external auditor. This question, carrying 14 marks, has three sub-sections.
In part (i), worth 4 marks, you are required to state the responsibilities of the external auditor regarding fraud.
Considering that the verb in the question is ‘state’, you should write at least 4 valid points in order to score the
maximum marks.
In part (ii) (carrying 6 marks), you need to identify (and discuss) the groups who could be informed regarding the
fictitious inventory. You need to provide 3 valid points in order to score the maximum marks.
There are two key issues that can limit the marks obtained in this question:
¾ Identification of appropriate groups: the group of directors is inappropriate as the directors are already
aware that the inventory is to be revalued; other groups such as banks or payables are also not appropriate
as it would lead to confidentiality issues.
Therefore, the probable groups would include the audit committee, regulatory authorities, etc.
¾ Discussion of why each group was being reported to: most of the students who had appeared for the
exam found this discussion element of the question difficult. Most candidates therefore obtained marks for
identifying groups, but few marks were obtained for stating why those groups were being reported to.
In part (iii), carrying 4 marks, you are required to discuss the safeguards protecting the auditor from the
intimidation threat of being removed from office for qualifying the audit report. You can score up to 2 marks per
valid point i.e. 1 mark for explaining the safeguard and 1 for the effectiveness of the safeguard.
(a) Valuation of aviation inventory
¾
Review GAAP to ensure that there are no exceptions for aviation fuel or inventory held for emergency
purposes which would suggest a market valuation should be used.
¾
Calculate the difference in valuation. The error in inventory valuation is $105 X 6,000 barrels or $630k,
which is a material amount compared to profit.
¾
Review prior year working papers to determine whether a similar situation occurred last year and ascertain
the outcome at that stage.
¾
Discuss the matter with the directors to obtain reasons why they believe that market value should be used
for the inventory this year.
¾
Warn the directors that in your opinion, aviation fuel should be valued at the lower of cost or net realisable
value (that is $15/barrel) and that using market value will result in a modification to the audit report.
¾
If the directors now amend the financial statements to show inventory valued at cost, then consider
mentioning the issue in the weakness letter and do not modify the audit report in respect of this matter.
¾
If the directors will not amend the financial statements, quantify the effect of the disagreement in the
valuation method - the sum of $630,000 is material to the financial statements as TyeCo's income statement
figure is decreased from a small loss to a loss of $130,000 although net assets decrease by only about
0·3%.
© GTG
Solution Bank: 115
¾
Obtain a written representation letter from the directors of Tye Co confirming that market value is to be used
for the emergency inventory of aviation fuel.
¾
If the directors will not amend the financial statements, draft the relevant sections of the audit report,
showing a qualification on the grounds of disagreement with the accounting policy for valuation of inventory.
1 mark for each valid procedure or action
Maximum marks 6
The following matters must be avoided as they are not relevant to the answer:
¾ audit inventory from the beginning of the audit: this is not relevant as the requirement in the question
clearly states that the audit was complete
¾ stating audit procedures regarding existence (attending inventory count)
¾
treating the issue as an event after the reporting period and thus discussing the going concern
status of the company: this is not relevant as no inventory had actually been destroyed
¾ stating the following inappropriate points such as:
9 “Amend the financial statements to show the net realisable value of oil at $15 / barrel.”
This is a common error; auditors cannot amend the financial statements. They only present an opinion on
the financial statements provided to them by the directors.
9 Considering resignation if the directors refuse to amend the inventory value: this is normally considered
too extreme in this situation; a qualification of the audit report being sufficient.
9 Considering every possible type of audit report modification/qualification without clearly explaining that:
(i) the directors’ amendments needed to be reviewed, and then
(ii) the appropriate report needed to be produced depending on those amendments.
(b)
(i) External auditor responsibilities regarding detection of fraud
Overall responsibility of auditor
The external auditor is primarily responsible for the audit opinion on the financial statements following the
international auditing standards (ISAs). ISA 240 (Redrafted) The Auditor's Responsibilities Relating to Fraud in
an Audit of Financial Statements is relevant to audit work regarding fraud.
The main focus of audit work is therefore to ensure that the financial statements show a true and fair view. The
detection of fraud is therefore not the main focus of the external auditor's work. An auditor is responsible for
obtaining reasonable assurance that the financial statements as a whole are free from material misstatement,
whether caused by fraud or error.
The auditor is responsible for maintaining an attitude of professional scepticism throughout the audit,
considering the potential for management override of controls and recognising the fact that audit procedures
that are effective for detecting error may not be effective for detecting fraud.
Materiality
ISA 240 states that the auditor should reduce audit risk to an acceptably low level.
Therefore, in reaching the audit opinion and performing audit work, the external auditor takes into account the
concept of materiality. In other words, the external auditor is not responsible for checking all the transactions.
Audit procedures are planned to have a reasonable likelihood of identifying material fraud.
Discussion among the audit team
A discussion is required among the engagement team placing particular emphasis on how and where the
entity's financial statements may be susceptible to material misstatement due to fraud, including how fraud
might occur.
116: Planning and Risk Assessment
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Identification of fraud
In situations where the external auditor does detect fraud, then the auditor will need to consider the implications
for the entire audit. In other words, the external auditor has a responsibility to extend testing into other areas
because the risk of providing an incorrect audit opinion will have increased.
1 mark for each valid point
Maximum marks 4
You must avoid the following errors:
¾ providing a general answer such as explaining the responsibilities of management, internal audit and
even the audit committee rather than external auditors.
¾ providing comments that were not quite correct. For example, stating that external auditors were
responsible for detecting all fraud, or in some cases, stating that they had no responsibility at all.
¾ providing lengthy explanations of actual watchdogs and bloodhounds rather than auditor responsibilities.
(ii) Groups to report fraud
Report to audit committee
Disclose the situation to the audit committee as they are charged with maintaining a high standard of
governance in the company.
The committee should be able to discuss the situation with the directors and recommend that they take
appropriate action e.g. amend the financial statements.
2 marks
Report to government
As Tye Co is acting under a government contract, and the over-statement of inventory will mean Tye Co
breaches that contract (the reported profit becoming a loss), then the auditor may have to report the situation
directly to the government. The auditor of Tye Co needs to review the contract to confirm the reporting required
under that contract.
2 marks
Report to members
If the financial statements do not show a true and fair view then the auditor needs to report this fact to the
members of Tye Co. The audit report will be qualified with an except for or adverse opinion (depending on
materiality) and information concerning the reason for the disagreement given. In this case the auditor is likely to
state factually the problem of inventory quantities being incorrect, rather than stating or implying that the
directors are involved in fraud.
2 marks
Report to professional body
If the auditor is uncertain as to the correct course of action, advice may be obtained from the auditor's
professional body. Depending on the advice received, the auditor may simply report to the members in the audit
report, although resignation and the convening of a general meeting is another reporting option.
2 marks
Maximum marks 6
(iii) Intimidation threat – safeguards
In response to the implied threat of dismissal if the audit report is modified regarding the potential fraud/error,
the following safeguards are available to the auditor.
Discuss with audit committee
The situation can be discussed with the audit committee. As the audit committee should comprise non-executive
directors, they will be able to discuss the situation with the finance director and point out clearly the auditor's
opinion. They can also remind the directors as a whole that the appointment of the auditor rests with the
members on the recommendation of the audit committee. If the recommendation of the audit committee is
rejected by the board, good corporate governance requires disclosure of the reason for rejection.
2 marks
© GTG
Solution Bank: 117
Obtain second partner review
The engagement partner can ask a second partner to review the working papers and other evidence relating to
the issue of possible fraud. While this action does not resolve the issue, it does provide additional assurance
that the findings and actions of the engagement partner are valid.
2 marks
Resignation
If the matter is serious, then the auditor can consider resignation rather than not being re-appointed.
Resignation has the additional safeguard that the auditor can normally require the directors to convene a
general meeting to consider the circumstances of the resignation.
2 marks
Maximum marks 4
29. Auditor’s objective and professional scepticism
(a) General objectives:
The overall objectives of the external auditor are:
¾
to obtain reasonable assurance about whether the financial statements as a whole are free from material
misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether
the financial statements are prepared, in all material respects, in accordance with an applicable financial
reporting framework; and
2 marks
¾ to report on the financial statements, and communicate as required by the ISAs, in accordance with the
auditor’s findings.
1 mark
In all cases when reasonable assurance cannot be obtained and a qualified opinion in the auditor’s report is
insufficient in the circumstances for purposes of reporting to the intended users of the financial statements, the
ISAs require that the auditor disclaim an opinion or withdraw (or resign) from the engagement, where withdrawal
is possible under applicable law or regulation.
2 marks
Maximum marks 5
(b) Instances when an auditor needs to maintain professional scepticism
1. An attitude of professional scepticism should especially prevail under the following situations:
a) When audit evidence contradicts other audit evidence obtained: For example if the auditor notices that
the list of related party transactions provided by the management is not exhaustive as there are more
transactions which came to light while carrying out the audit, it would be an instance of contradictory
evidence. At such times, the auditor will take more care while conducting the audit on this area.
b) When information that brings into question the reliability of documents and responses to inquiries
to be used as audit evidence. For example when an auditor receives the organisation’s closing year end
closing bank balance, the auditor should cross verify the figure with an official confirmation from the
organisation’s banker and fully investigate any differences.
c) Conditions may indicate possible fraud: For example when an auditor notices that purchases of raw
materials for a particular period is much higher than the average purchases for that period, fearing
misappropriation or fraud, the auditor investigates further and discovers that the organisation had received a
very large one-off order from a new customer earlier that month.
d) Circumstances that suggest the need for audit procedures in addition to those required by the ISAs:
In the case of asset valuation, as a general rule, the larger the value of the asset the more important it is that
the auditor obtain an independent verification of the asset’s value.
In the case of ownership of assets, the auditors should independently verify the title deeds or other
relevant legal documentation regarding assets claimed to be owned by the entity. This will ensure that the
business has a free and clear title.
118: Planning and Risk Assessment
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When receiving information directly from the management / employees of the organisation, auditors should
not blindly accept and then rely upon information and data that is provided to them. They should conduct
checks on random and very important items of information.
To conclude an auditor needs to adopt an attitude of professional scepticism whilst both planning and
performing an audit. For the end objective of an audit is for the auditor to certify that the financial statements
of an organisation are true and fair after they have taken every reasonable precaution.
1 mark for each valid point
Maximum marks 5
D
SECTION D
SOLUTION BANK
INTERNAL CONTROL
30. Substantive procedures and tests of controls – Atlantis Standard Goods
The question contains 4 parts, out of which part (b) is a scenario based question carrying 15 marks. Parts (a)
and (c) are relatively straightforward and knowledge based.
To answer part (a), you should be familiar with the sale cycle and the control objectives for that. Part (c) requires
you to have knowledge of the substantive procedures and tests of control.
Part (b) needs to be answered carefully. While answering this, think about the reasons for testing with the help
of different assertions. Make sure that the audit tests are specific to the given scenario and not vague.
(a) The following are the control objectives relating to:
(i) Ordering of goods
Set out your points clearly. This will
improve your presentation and make it
is easy for the examiner to check and
allot the marks to each correct point.
¾ Authorisation: Orders need to be received through proper
channels according to the company policy. This may be by mail, the internet or any other mode decided by
the company.
¾ The goods are despatched only to authorised customers. Authorised customers are the people who have
been authorised by the sales department to place an order. The authorised customers may be identified by
the sales or credit control department assessing their credit-worthiness.
¾ To ensure that goods are quoted at the correct, authorised prices.
¾ To ensure that orders are recorded using correct part codes (i.e. items which are actually ordered, correct
quantities (i.e. the quantities which are actually ordered), correct prices (according to the company’s price
list), and for the correct customers (i.e. the customers who actually raised the orders).
¾ New orders are promptly recorded in the records of the company to ensure that every order will lead to a
despatch and an invoice.
3 marks
(ii) Invoice of goods
¾ Correct rates: Invoices are raised at the correct rates and prices. If there is a difference in the rate from
the price list, it needs to be approved by the authorised official of the company.
¾ At proper terms: Invoices raised must be on correct terms and conditions, for instance, credit period,
discounts, etc. according to the company policy
¾ Authorised customers: Invoices must be raised only on authorised customers.
¾ Invoice correctly raised: An invoice can only be raised for goods sold by the company. i.e. no invoice can
be raised for goods distributed under promotional offers or free of charge.
¾ Accounting for goods sold: Invoices raised must be correct, and promptly recorded in the financial
statements.
¾ An invoice for every despatch: Every despatch should result in an invoice being raised and a debit entry
to the customer’s account in the receivables ledger.
3 marks
120: Internal Control
© GTG
(iii) Despatch of goods
¾ Authorised official: Goods are despatched by an authorised person i.e. warehouse keeper
¾ Correct customer and destination: Goods are despatched to the correct customer at the right destination
¾ Relate to goods ordered: Goods which are despatched, must relate to the goods which are genuinely
ordered.
¾ Every approved order should result in a despatch: Otherwise sales will be lost.
¾ Properly documented: Goods which are despatched need to be documented e.g. accompanied by an
invoice,
¾ Correctly and promptly recorded: All despatches are correctly and promptly recorded in the books of the
company.
4 marks
Maximum marks 8
(b) Audit tests on sales and despatch system
Read the requirement of the question carefully. It asks you to tabulate the audit tests and explain the reason
behind carrying them out. You are expected to give the answer in a structured way i.e. in the form of a table.
This would help you to cover all the points from the scenario
Marks
Audit test
Reason for test
Test ASG’s input ordering system by entering
dummy data. (ASG’s staff must be informed that
they must not procure or despatch goods based
upon this data).
To ensure that an order placed through the
website is promptly and accurately recorded by
the e-commerce system.
1.5
Also, confirm that the test data simultaneously
updates the order pending files.
From the test data stored in the orders pending
file:
Check the ‘order awaiting despatch’ file. Ensure
the details of the order in the file match the
actual order. The nature (like item description)
and quantity of the goods ordered should be the
same.
To ensure that the orders recorded match with
the inputs which were input to the web-site.
1.5
To ensure that there is no discrepancy between
the order placed on the website and processed
by the company.
1.5
Check the invoice generated at the point of sale
to ensure all customers are billed correctly.
To ensure accurate production of invoices for
each order.
1.5
Confirm that the sales details for the customer
(like customer name, invoice number, invoice
amount, period of credit) match with the monthly
reimbursement from the credit card company.
Also, ensure that the amounts received from the
credit card company are at par with the terms of
the agreement signed with the credit card
company. The amount received must be equal to
the sale price less the fees and commission
charged by the credit card company to ASG.
To ensure that there exists a system whereby
payment is correctly received for all the goods
sold. Moreover, the amount is received within
the timeframe and for the full amount.
1.5
Verify that the sales amounts tallies with entries
in the sales ledger file for each credit card
company.
To ensure that amounts owing from credit card
companies are correctly recorded.
1.5
Verify that the correct postings are made to the
sales account, commission account and VAT
account (if any)
To ensure the sales are recorded completely
and accurately in the sales day book, general
ledger, financial statements or other books of
accounts.
1.5
Continued on the next page
© GTG
Solution Bank: 121
Marks
Audit test
Reason for test
Check if there are any sales orders awaiting
despatch, which are not processed. If any such
orders are found, an enquiry must be made. A
proper reason must be ascertained regarding the
orders which are not processed.
To ensure the various reasons for orders not
processed or being improperly processed are
obtained. A large number of unprocessed
orders may point towards problems in the credit
card authorisation system. If there are any
other factors which affect the proper processing
of a sales order, they need to be investigated.
1.5
Take a random sample of days. Cast the sales
day book file and agree the total sales to the
general ledger account for those days.
To ensure the numerical accuracy
completeness of the day book.
and
1.5
Take a sample of items
despatch’ file. Check
information on ‘orders
despatch’ with the
computer.
To ensure that the order details are complete
and are correctly transferred to the despatch
department.
1.5
To ensure that the despatch information
available to the company is complete and
accurate. Moreover, the despatch record must
match with a valid sale.
1.5
Match the information with the inventory records,
and confirm that the correct record was updated.
To ensure that the inventory system correctly
records the goods ordered and that the
inventory system remains up to date and
accurate.
1.5
Verify whether the records contain signatures
confirming the acceptance of goods by the
customer.
To ensure that evidence is available for the
receipt of the goods dispatched. i.e. the
customer has received goods which are
mentioned in the order, in good condition and
at the desired destination.
1.5
From the sample of items which were
dispatched, on the despatch department
computer, a review of the evidence of delivery
needs to be made. Obtain reasons when no
delivery records were available or customers
have refused to accept delivery.
To ensure that the goods are being delivered to
the correct customer and the procedure for
investigating non-delivery of goods is
functioning properly.
Review the despatch department computer files
and verify for orders not complete.
An investigation must be made into the reasons
for non-completion of the orders.
To ensure that the despatch process is
functioning as per the company’s rules and
policies. Further, incomplete items are
investigated promptly and proper attention is
paid to avoid them.
from ‘the goods awaiting
if it agrees with the
which are pending for
despatch department
From a sample of items on the despatch
department computer (i.e. orders pending
dispatch):
Check the details of orders pending dispatch,
(i.e. the product code, quantity, customer name,
etc.) add comparing them with the goods
awaiting despatch file. There should be no
discrepancy in the terms and conditions offered
and the product quality or quantity.
1.5
1.5
1.5 marks are split as 1 mark for audit test and 0.5 marks for the explanation as to why the test is
required.
Maximum marks 15
122: Internal Control
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(c)
Meaning
Substantive procedures
A substantive procedure is an audit
procedure which is designed to
detect material misstatements at the
assertion level.
E.g. in the case of ASG, the auditor
takes a random sample of days, casts
the sales day book file and agrees the
total sales to the general ledger
account for those days.
Purpose
Relationship
This audit procedure will enable
numerical accuracy and completeness
of the day book, thereby enables to
detect material misstatements at the
assertion level
Substantive procedures are carried
out to establish directly whether or
not system objectives are being
achieved.
System objectives include controlling
the system by segregating the duties,
preparing and following the control
policies manual. Policies should be
designed to ensure that the process is
complete and accurate at each stage.
The relationship between tests of
control and substantive procedures is
that if controls are operating
properly, auditors may reduce the
extent of substantive procedures
necessary to provide an opinion on
the adequacy of output.
However, to prove the reliability of the
controls,
some
substantive
procedures
will
always
be
necessary.
Tests of control
Tests of controls are tests performed to
obtain audit evidence about the
operating effectiveness of controls in
preventing, or detecting and correcting,
material misstatements at the assertion
level i.e. they provide audit evidence
that internal control procedures are
being applied properly and consistently
and that the controls are operating as
they should.
Marks
E.g. enquiry into the procedures used
for sales authorisation.
2
Tests of control focus on how
controls
were
applied,
the
consistency with which they were
applied, and by whom or by what
means they were applied.
2
Tests of controls performed in
previous years may be relevant to
the current year, if they have not
changed.
However, operating effectiveness
may be retested at least once every
third year. Controls related to
significant risks should be tested
every year.
2
Maximum marks 4
(d) Audit evidence provided by direct confirmation of receivables
Direct confirmation is the process of obtaining a representation of information or of an existing condition directly
from the third party. During the course of an audit, the auditor often demands for a direct confirmation of
receivables i.e. statement of account present in the books of a third party i.e. customers, due to the following
reasons:
(i) Confirmation provides reliable audit evidence since it is received directly from an independent source. The
auditor has to match the transactions recorded in the client’s accounts i.e. sales and payments received,
with the extract of the account obtained from the third party.
(ii) The auditor, on matching the transactions in the said two statements, will come to know if the client’s
account is overstated with some fraudulent entries. There is also a possibility that the client has forgotten to
record some transactions. In this way, confirmation provides the evidence in relation to quality of internal
control and also for fraud, if any.
0.5 marks for each valid point
© GTG
Solution Bank: 123
Alternative evidence when the confirmations are not provided by the customers
(i) Sometimes, the customer can provide a reconciliation statement, particularly if the matter relates to a timing
difference i.e. cheque in transit or goods in transit. The auditor should review and match the entries with that
customer’s ledger account obtained from the client’s books. This will ensure the completeness and accuracy
assertions.
(ii) Reviewing the original contracts can help the auditor to understand the agreed terms of trade between the
client and the customer. The auditor should confirm with the help of sample data whether the terms are
followed by the client. This will provide a primary assurance to the auditor about the genuineness of the
operations of client.
(iii) The auditor should obtain an aging analysis for the customer’s accounts. He should enquire the reasons for
the old outstanding balances i.e. amount unpaid for more than a year. This will provide evidence in relation
to the quality of internal controls. For example, if the old outstanding amount in the customer’s account is
because of his bankruptcy, it is the duty of the management to charge the loss to SOCI (income statement)
and write off the balance in the customer’s account. This depicts poor internal control regarding the
receivables ledger.
(iv) Review cash received from accounts receivable after the year end. This gives evidence about the existence,
valuation and cut-off assertions.
1 mark for each valid point
Maximum marks 3
In the answer to part (a), students generally make the common mistake of explaining the system of ordering,
invoicing and despatching the goods. This is not the requirement of the question. You can score good marks if
you explain the objectives clearly in each case without emphasising on the system.
In part (b), the common mistake is discussing audit tests which are not relevant to the given scenario. You
should focus on the basic audit work and explain how the systems are tested, but only in relation to the scenario
given in the question. For example, here the customers are not accounts receivable, but the credit card
companies are.
31. Evaluation of internal control systems - Healthline
The scenario in the question is complicated. You can answer the question well if you read it carefully and
understand it completely. While reading, mark the strengths and weaknesses in the internal control.
In part (b) of the answer, along with the weaknesses and suggestions regarding control activity, do not forget to
include the implications of the weaknesses in the financial statements. This will help you to justify your answer why is it a weakness?
(a) Following are the strengths in the internal control systems of the hospital:
(i) The doctor who renders the services, records the nature of the services on a pre-numbered slip. This slip is
used for recording the revenue and also as a receipt of cash.
(ii) Before medical services are rendered, the manager verifies the insurance cover and conveys this
information to the clerk.
(iii) Patients with uncollectible balances cannot avail future services, since the same clerk (Clerk 3) makes the
appointments and also receives the list containing the uncollectible balances.
(iv) Computers have restricted access by use of passwords.
(v) The software used cannot be modified.
(vi) The pre-numbered slips are accounted for once a month by an external accountant, who is independent of
the company. He is not involved in the receipt of cheques and cash and recording of receipts in the ledger.
(vii) The bank reconciliation statement is prepared by the external accountant who is independent. He is not
connected, in any way, to the person collecting the revenue and recording the revenue collection.
1 mark for each valid point
Maximum marks 5
124: Internal Control
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(b) Following are the weaknesses in the internal control systems, the implication of the weaknesses in the
financial statements and the recommended internal controls which will strengthen the internal control
system of the hospital.
Weakness
Clerk 1 calculates the amount
payable
for
the
services.
However the accuracy of the
amount
payable
is
not
independently verified by another
person.
The office manger does not
follow any formal system of
determining the creditworthiness
of the patient, before approving
credit to patients.
Implication of weakness
This can lead to incorrect
amounts being billed to the
patient or the insurance
company
and
the
understatement of revenue
in the financial statements
of the entity.
Receivables
can
be
converted into bad debts.
The office manager extends
credit to patients and also
approves the write offs of
uncollectible patients’ balances.
Receivables
can
be
converted into bad debts.
Unsettled / rejected insurance
claims pending for more than 60
days are automatically converted
into patients’ receivables without
apparent notification being given
to the patients or any further
follow up.
Receivables
are
not
notified to patients and can
be converted into bad
debts.
An aged statement of patients’
receivables is not prepared and
reconciled with the general
ledger.
Uncollectible
patients’
receivables are not determined
based on a formal system. In
addition, there is no follow up of
uncollectible balances by making
phone calls, emails, letters etc.
Clerk 2 performs too many
functions such as:
¾ receiving cash and cheques
from patients
¾ receiving cheques through
mail from patients and
insurance companies
¾ preparing the daily revenue
summary
¾ maintaining the accounts
receivables
records
and
adding
and
deleting
information
¾ preparing
a
list
of
uncollectible balances
Incorrect
recording
of
revenue in the financial
statements.
Receivables
can
be
converted into bad debts.
Non-segregation of duties
can lead to loss of revenue
through error or fraud.
Internal controls recommended
The calculation done by Clerk 1 should be
checked by another clerk such as Clerk 3.
The hospital must lay down a formal
system of checking the creditworthiness of
the patients such as asking for the patient’s
income statement, asking for a bank
reference, etc. A formal policy must be set
out and all credit given to patients must be
on the basis of the assessment of their
creditworthiness.
The tasks of extending credit to patients
and also approving the write offs of
uncollectible patients’ balances need to be
separated. One of the partners should be
assigned the task of selecting the patients
whose balances are to be written off.
Rejected claims and claims unpaid for over
60 days, should be reviewed by a partner
and a formal follow up procedure should be
implemented to discover why claims were
rejected or unsettled.
Patients should be sent invoices for
outstanding amounts transferred from
insurance companies
Each month an aged statement of
receivables needs to be prepared. This
statement must be reconciled with the
general ledger by the accountant.
There must be a system of regular follow
up by making calls, sending out letters and
emails. The aged statement should be
marked with information showing what
follow-up procedures have been carried out
and must be reviewed by the partners.
The employee who receives the cash and
cheques should be different from the
employee who prepares the summary.
The cheques received through the mail
should be stamped by Clerk 1 who opens
the mail
The recording of accounts receivable and
the deleting of the uncollectible amounts
should be assigned to the employee who
does not receive the cash and cheques.
The accounts manager should be notified
of insurance policies which have not been
realised within sixty days.
The list of uncollectible amounts must be
prepared by a person who does not
maintain the accounts receivable ledger.
3 marks for each point (1 for identification of weakness, 1 for implication and 1 for internal control suggested)
Maximum marks 20
© GTG
Solution Bank: 125
(c) The following points should be taken into account while preparing a letter of weakness:
The letter must be divided into the following three parts for each weakness identified in the system:
¾ details of the weakness,
¾ the implication of the weakness in relation to the financial statements and
¾ the recommendation to eliminate the weakness
(i) Weakness in the system
Weaknesses must include:
¾ instances of departure from the prescribed procedures e.g. the company’s policy specifies that purchase
orders are to be signed by the purchase manager but the auditor observes that purchase orders are signed
by the purchase executive, this is a deviation from the prescribed policy.
¾ weaknesses in the design of existing policies and procedures which are followed. For example, if the
purchase procedure does not specify the method by which the company will finalise the purchase order, this
is a weakness in the system.
1.5 marks
(ii) Implication of the weakness
The implication of the weakness must include the possible dangers of the weakness due to departure from
prescribed procedure, non implementation of the procedure and the design of the existing policy and procedure.
Auditors must not assume that managers are able to understand all the implications of shortcomings in controls
and must point these out to encourage management to take action.
For example, due to purchase orders not being signed by the purchase manager, the risk of purchases being
made at uncompetitive prices exists. Or due to receipt of materials without a valid purchase order in hand, there
is a danger of making unnecessary purchases.
1.5 marks
(iii) Recommendation to eliminate the weakness
Recommendations to eliminate the weakness must suggest the remedial actions to be taken to correct the
weaknesses (in design or execution) which have been observed by the auditor e.g. all purchase orders should
be signed by the purchase manager according to the policy of the company.
1.5 marks
The letter of weakness must be drafted with care to ensure that the weaknesses are presented in the order of
materiality e.g. a weakness involving inventory will be more important than a weakness involving petty cash.
The letter should also clearly mention that the weaknesses reported may not be the only weaknesses. However,
the weaknesses reported were found in the course of evaluation of the system.
1 mark
Maximum marks 5
32. Internal control procedures – Bardwell
In order to get high marks, you need to ensure that you answer all the parts. Allocate your time: you will get 1
mark for each completed point. 1 mark usually means 1.8 minutes of writing.
In the question under subsection (i), your answer should include the following points:
¾ “why the functions assigned to the receptionist result in an inadequate segregation of duties”,
¾ “identify misstatements that could occur” and
¾ “how those duties could be reassigned to other staff members”
The question under subsection (ii) is a straightforward question.
(a)
(i) Segregation of duties is critical to the internal control system. Segregation of duties means that one person
should not be responsible for more than one key activity in a transaction. In other words, one person should
not be responsible for the approval and recording of the transaction, the reconciliation and the security of
assets. A proper segregation of transactions will lead to effective internal controls.
1 mark
Proper segregation of duties will ensure that, if an error or misstatement is made by one employee, the error will
come to light when another employee carries out his duties. For example, if the cashier prepares a cheque for
$500 instead of $5,000, the error will be detected by the accountant who will sign the cheque after crosschecking it with the payment voucher, vendor’s invoice, etc. which are attached to the cheque.
1 mark
126: Internal Control
© GTG
Segregation of duties also reduces the risk of fraud because, if more than one person is involved in a
transaction, it is likely that collusion would be needed for a fraud to be successfully carried out.
1 mark
The following table will explain why the functions assigned to the receptionist will result in an inadequate
segregation of duties, the likely misstatements that could occur and the method by which those duties could be
reassigned to other staff members.
Segregation of duties
Cash sales
The receptionist:
¾ collects the cash / cheque,
¾ cross-checks the cash sales
invoices with the cash /
cheque received and
¾ records the cash sales in
the cash receipt book
Reason for inadequate
segregation of duties and likely
errors and misstatements
The receptionist collects the cash
from the customer. Although the
invoices raised by the foreman are
numerically pre-numbered, because
the receptionist is responsible for
checking that the sequence is the
receptionist could discard some of
the invoices and pocket the cash
relating to them.
Therefore the above inadequate
segregation of duties can lead to:
¾ understatement of sales, and
¾ understatement
of
cash
balance
Credit sales
The receptionist :
¾ obtains
the
customer's
signature on the copy of the
invoice
¾ enters the invoices in
numerical sequence in the
sales journal
¾ posts
the
customer's
account in the accounts
receivable ledger
¾ sends monthly statements
to credit account customers
¾ follows up overdue accounts
¾ lists the balances on the
accounts receivable ledger
at the end of the month
¾ reconciles the total with the
control account in the
general ledger
¾ writes
off
uncollectible
balances to bad debts
The receptionist can intentionally
record a lower amount of sales
since the receptionist records the
sales in the journal and also into the
customer’s account.
This will go undetected since the
receptionist
sends
monthly
statements to customers, follows up
for overdue amounts, reconciles the
accounts ledger with the general
ledger and also writes off
uncollectible balances.
The above will lead to:
¾ understatement
of
sales
amount
¾ incorrect presentation of
receivables accounts in the
financial statements
¾ overstatement of bad debts
Recommended
reassignment of duties
Marks
The receptionist can collect
the cheques / cash against
the sales.
The receptionist should
hand over the cash and
cheques to the accounts
clerk who will cross verify
the cash / cheque amounts
with the invoices at the end
of each day and record the
cash / cheque receipt in the
books.
3
The receptionist should not
be responsible for recording
the sales into the sales
journal and posting the
customers’ accounts in the
accounts receivable ledger.
These tasks should be
carried out by the accounts
clerk 1.
Instead, the receptionist
may
be
involved
in
obtaining the customers’
signatures on the invoices.
Clerk 2 must be involved in
sending monthly
statements of customers’
accounts and follow up for
overdue amounts and
reconciliation of customers
control account with the
general ledger.
Also, the write-off of old
balances must be the
responsibility of the garage
manager, who will crosscheck the ledger account
with customers’ statements
of accounts and follow up
files before sanctioning the
write offs.
3
Continued on the next page
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Cash receipts
The receptionist:
¾ opens the mail
¾ extracts cheques from credit
account customers
¾ records them in the cash
receipts book
¾ posts
the
accounts
receivable ledger
¾ makes up the day's banking
of cash (and cheques) from
both cash and credit sales
¾ prepares the deposit slip
and deposits the cash (and
cheques) in the bank.
Solution Bank: 127
Since the receptionist is responsible
for all actions, right from opening
the mail to preparing the bank
deposit slip, he can intentionally
record cheques received from some
customers as having been received
from other customers. On a future
date he may show the receipt of
cheque from another customer as
having been received from the first
customer.
This could allow cheques to be paid
into an account set up by the
receptionist
without
detection
(“teeming and lading”)
One of the accounts clerks
must be involved in
recording the cheques in
the cash receipt book and
banking the cheques while
the other clerk must be
involved in preparing the
deposit slip.
In the process, there will be:
¾ theft of cash and incorrect
representation of accounts
receivable balances in the
financial statements.
3
Maximum marks 8
(ii) Other control procedures required
¾ Monthly bank reconciliation should be prepared by an accounts clerk. This will confirm that all amounts
recorded in the books match the amounts actually deposited into the bank accounts. Furthermore, the bank
reconciliation statement must be verified by the garage manager.
¾ Each month the garage manager should verify the reconciliation of the control accounts with the balances in
the receivables ledger. This will ensure that accounts are correctly recorded.
¾ The garage manager should also review the list of account balances with the follow up file to ensure that all
follow ups are done promptly.
¾ Each write off should contain the approval of the garage manager who takes decisions on the write off of
accounts receivable only after scrutinising the ledger accounts, party statements of accounts and follow up
files.
¾ Internal control systems are designed, amongst other things, to prevent error and misappropriation.
1 mark for each valid point discussed
Maximum marks 4
(b)
(i) Procedures to be followed in making a cash count for audit purposes
If material, it is very important for an auditor to have a cash count as there is a high chance of fraud and error in
cash transactions. The main objective of cash transactions (receipts) is to ensure that all the cash receipts are
recorded, the cash received is properly safeguarded and the payments are recorded against the correct invoice
or person.
Following is the procedure that is required to be followed in making cash count:
¾ The auditor is required to have a control on all the cash until the completion of the cash count and there
should be no cash movements. This is necessary to prevent the mix up of the counted cash with the
uncounted cash to conceal the deficiency.
¾ The cash count should be carried out in the presence of a custodian. This is very important because in the
case of shortage, the custodian should not argue that cash was not short until handed over to the auditor.
¾ The auditor should prepare a list of each item in the cash fund. The list should contain the denomination of
notes and the number of notes in each denomination, details of cheques in hand, petty cash vouchers in
hand etc. Auditor should subsequently agree these with the bank deposit slips (for cheques in hand) and
other accounting records (for vouchers in hand).
¾ He should confirm the observations of the cash count with the custodian and take his signature on the
record of cash count as being in agreement. This would be adequate audit evidence in the event of any
subsequent disagreement.
1 mark for each valid point discussed
Maximum marks 4
128: Internal Control
(ii)
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Discrepancy
If the cash available in the cash box does not agree with the cash recorded in the cash book, there is a
possibility of misappropriation of cash by failing to record a receipt from a accounts receivables.
To conceal this fact from the account receivables, the cashier will credit the cash received from another
customer against the first customer’s account. Failure to credit payment by the second customer will be
concealed by using the payment received from a third customer and so on.
In this way, the person-in-charge can conceal the fraud for a long period. Such a fraud is only possible if there is
no proper segregation of duties amongst the employees. If the person responsible for maintaining the accounts
receivable ledger also has access to cash received from customers, he can easily play with the cash in absence
of any control.
3 marks
The auditor can investigate this fraud by comparing the bank deposit slips with the details recorded in the cash
receipts book. Posting to the accounts receivable ledger can also be investigated continuously for a series of
consecutive days. If a pattern of differences emerges which is consistent with the pattern associated with this
type of fraud, then the existence of fraud should be suspected.
1 mark
Maximum marks 4
33. Objective of audit evidence: Test of control / substantive procedure – Gordon
This question will lend itself to efficient answering by using a tabular approach with one column for each
requirement.
Marks
Test
2
0.5 marks per
objective:
Maximum = 3
Objective
Test of operation of
controls
1 mark per assertion:
Maximum = 8
1 mark per valid point:
Maximum = 9
Assertions
The auditor observes the
procedure followed by the
company official to receive
goods i.e. whether the clerk
verifies the contents of the
deliveries as meeting the
terms of the purchase order
in respect of quality and
quantity.
Reliability
This is reliable evidence since the
auditor observes the procedure of
receiving the goods.
Such an observation will
enable an auditor to assert
the
occurrence
of
the
purchase transaction.
3
Substantive test of
detail for purchase
transactions
The auditor verifies whether
all goods received result in
invoices which are recorded
in the books of accounts.
Such verification will enable
an auditor to assert the
completeness
of
the
purchase transactions and
payables balances in the
books of accounts.
However this method has the following
drawbacks:
(i) The official of the company may
perform the function of receiving the
goods properly, since he is being
observed.
However,
such
a
procedure may not always be
followed by the clerk.
(ii) The auditor can verify this activity
only
for
few
consignments.
Therefore he cannot get assurance
about whether this procedure is
followed for all consignments.
This is reliable evidence since the
auditor verifies the numeric continuity of
the goods received notes and also
traces it to the suppliers’ ledger.
However, such a transaction has the
following drawback:
If there is no cross-checking of the
delivery notes with the goods received
notes there may be some unrecorded
purchases leading to understatement of
purchases in the financial statements.
Continued on the next page
© GTG
Marks
Test
4
6
7
Solution Bank: 129
0.5 mark per objective:
Maximum = 3
1 mark per assertion:
Maximum = 8
1 mark per valid point:
Maximum = 9
Objective
Test of operation of
control
Assertions
The auditor verifies whether
there is evidence of verification
of goods received notes with
purchase orders.
Reliability
This is reliable audit evidence since it is
documentary evidence of the control
procedure followed.
Substantive test of
details of accounts
payable balance
Test of
control
design
of
Such verification will enable the
auditor to assert the occurrence
of the control procedure for
purchases recorded in the
financial statements.
The auditor verifies whether
there are errors in:
¾ recording purchases in the
purchase journal, recording
cash payments in the cash book
or in the accounts payable
ledger;
¾ additions made in the
purchase journal and the
posting of the totals to the
payable ledger;
¾ arriving at the closing
balances
With the help of this audit
evidence, the auditor can assert
the accuracy of the accounts
payable ledger.
The auditor enquires about the
cut-off procedure for purchase
transactions.
The auditor can assert the
completeness and existence of
purchases which are recorded
in the financial statements and
ensure that purchases and
inventory are consistent with
one another.
Furthermore, if errors are found in the
transactions which are initialled by the
personnel, as found to be in order, the
person who has initialled the transaction
can be held responsible.
The auditor will have to ensure that the list
of accounts payable balances matches the
ledger.
This is reliable evidence since it is
evidence of accuracy of transactions.
This audit evidence assesses the
effectiveness of the design of cut-off
procedures. Therefore it reliable.
This audit evidence has the following
drawbacks:
(i) The officials of the company may
deliberately misinform the auditor
about the cut-off procedure.
(ii) The cut-off procedure which the
auditor is told about may not be
actually implemented so the auditor
should perform tests of controls to
confirm that the company implements
the cut-off procedures which are
informed to the auditor.
34. Internal control systems of receivables
(a) In your answer, include both list and describe the problems.
(b) Do not forget to answer both parts of the question i.e. “why even a good system of internal control will not
necessarily prevent or detect all errors as well as omissions and the misappropriation of assets in a
receivables system” and “why a good system of internal control is important to auditors”.
(c) List the risks that would be faced by the company along with the main internal controls required for
receivables. Once again, a tabular approach will be efficient in some parts.
130: Internal Control
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(a) The types of errors, omissions and misappropriations which can occur in the area of receivables due to
weak or non-existent controls are listed below:
1.
2.
3.
4.
5.
6.
Type of error, omission or misappropriation of
receivables
Invoices can be issued to incorrect customers
(i) New customers without verifying their
creditworthiness.
(ii) Blacklisted customers. If invoices are raised on
blacklisted customers, again there is a greater
possibility of the invoices being converted into bad
debts.
Invoices may be raised for incorrect amounts
Invoices may be raised at rates which are lower than the
rates given in the price list. This error can occur when
the official from the sales department raising the invoice
colludes with the customer and raises the invoice at a
lower rate.
Incorrect recording of invoice
The invoice prepared by the official from the sales
department may not be recorded incorrectly in any of
the following ways:
(i) Invoices may be recorded under the names of
different customers in the sales journal, accounts
receivable ledger and general ledger.
(ii) Invoices may be recorded with incorrect amounts in
the sales journal, accounts receivable ledger and
general ledger.
Failure to record invoice
The invoices raised by the sales department may not be
recorded in the sales journal, accounts receivable ledger
and general ledger. This is an error of omission.
Failure to record amounts received from customers
This error occurs under the following situations:
(i) When amounts are received in cash and the amount
is either not recorded, or is recorded at amounts
which are lower than the invoice amount, in the cash
book or accounts receivable ledger. This is either an
error of omission or misappropriation.
(ii) When an amount is not received in cash but is
recorded as having been received in the cash book
or accounts receivable ledger.
(iii) When payments received are recorded at higher
amounts in the cash book or accounts receivable
ledger.
Insufficient follow up for recovery of amounts due
from customers:
Impact on the financial statements
In such cases, there is a high probability
that the customers will not pay the dues
and the amounts invoiced will be
converted to bad debts.
Sales may be understated.
This error will lead to incorrect
representation of receivables in the
financial statements.
This error will lead to understatement of
sales
and
receivables
and
an
overstatement of inventory in the financial
statements (if the sale recorded is lower
than the invoice amount). Or it will lead to
overstatement of sales and receivables
and understatement of inventory in the
financial statements (if the sale recorded
is higher than the invoice amount).
This error will lead to understatement of
sales and receivables and overstatement
of inventory in the financial statements.
This will lead to understatement of the
cash balance and overstatement of
receivables in the financial statements.
This will lead to overstatement of the cash
balance
and
understatement
of
receivables in the financial statements.
This will lead to conversion of amounts
receivable into bad debts.
Due to insufficient follow up for recovery of amounts due
from customers, the amounts may be written off as bad
debts.
1 mark for each valid point discussed
Maximum mark 4
(b) The internal control systems of any entity are designed so that the entity can ensure an early detection and
prevention of fraud and error. However, the internal control system, even if well-designed and wellimplemented, does not completely eliminate the possibility of fraud or error. No internal control system can
be perfect due to its inherent limitations.
© GTG
Solution Bank: 131
The internal control system of receivables, however well-designed, would have the following weaknesses
leading to errors, omissions and misappropriation of assets.
Impact on the
financial
statements
Weaknesses in internal control systems
Non-implementation of the policies regarding acceptable business practice, in
the true spirit of the policy.
An entity may have a very well-designed internal control system relating to
receivables. However, if the principles and procedures laid down in the policy are not
properly implemented, there may be errors and omissions. Some of the errors and
omissions are as follows:
(i) The policy will specify the level of authority responsible for:
¾ determining whether the order is to be accepted and converted to sales
¾ raising the sales invoice
(ii) The sales order may be raised by the authorised official and the documents such
as the sheet for assessing the creditworthiness of customers before raising the
sales invoice may be filled in. However, even if the information in the sheet would
not permit the customer to obtain credit, the sales invoice may be raised on the
customer. This indicates that the document was not verified before raising the
invoice. The above could be on account of an error or misappropriation.
The sales will be
overstated and the
inventory will be
understated.
(iii) Credit notes may be raised to record sales returns. However, the rejected
materials may not have been returned. The records may be manipulated to show
that the credit note contains the party’s rejection challan and the materials have
been received by the company. In this case, the inventory records would also be
updated.
The sales will be
understated and the
inventory will be
overstated.
(iv) The above would be on account of a misappropriation.
Ineffective commitment to competence due to human inefficiencies
The company may have a well laid down internal control system. However, the
person responsible for carrying out the various activities in the transaction cycle for
receivables may not be sufficiently qualified and trained leading to errors, omissions
and misappropriations. This can occur when the company assigns the task of
preparation of sales invoices on the computer to a person who does not have any
training of operating the computer. As a result, there will be errors in the invoices
raised by the entity.
This will lead to
incorrect
representation of
sales and
receivables in the
financial statements
of the entity.
Unauthorised access to sensitive data (IT system) leading to fraud and errors:
Even if the software for making transactions relating to receivables has proper access
security there can be fraud and errors as follows:
This will lead to
incorrect
representation of
sales and
receivables in the
financial statements
of the entity due to
raising unnecessary
sales invoices or
credit notes.
The person responsible for raising the sales invoice has a separate access password
to ensure that no other person can raise a sales invoice. However, if the official does
not log out from the system when the software is not being used, the software can be
misused by other people who could fraudulently raise invoices and credit notes, when
the sales manager is not at his workstation.
1 mark for each valid point discussed
A good system of internal control is important to auditors for the following reasons:
(i) Avoidance of fraud, errors, waste and inefficiency
Answer this question with
reference to receivables
Internal controls involve control over losses that may arise due to:
¾ fraud e.g. due to recording of incorrect invoices as sales
¾ carelessness of staff e.g. incorrect recording of sales to one customer as sales to another customer
¾ unforeseen losses on dispatches made to customers such as fire, earthquake, theft, riots etc.
Auditors are required to state whether the financial statements present a true and fair view of the financial status
of the entity. If the entity has a good internal control system, the auditors can be reasonably assured that the
financial statements provide a true and fair view.
0.5 marks
132: Internal Control
© GTG
(ii) Internal controls ensure the maximum accuracy of all records, data and statements which lead to accurate
policy decisions i.e. due to good internal controls, the various activities in the transaction cycle for
receivables will be carried out according to the policies and procedures leading to the maximum accuracy of
information contained in the financial statements.
0.5 marks
(iii) Auditors are required to form an opinion regarding the truth and fairness of financial statements. Internal
controls enable auditors to determine the extent to which they can rely on the various systems and this will
enable the auditors to assess the correctness, truth and fairness of the financial statements.
0.5 marks
(iv) Planning the audit: a study of the internal control activities enables the auditors to plan the audit and to
determine the nature, timing and extent of tests to be performed. In other words, based on the functioning of
the internal controls, the auditor will plan the audit. If the controls function well, the auditor will plan to carry
out less extensive substantive procedures. However, if the controls do not function effectively, the auditor
will plan to carry out more extensive substantive procedures.
0.5 marks
Maximum marks 4
(c) The following are the main internal controls which should be in place, for receivables for a small
manufacturing company with a computerised system. The risks associated with each activity are mentioned
alongside.
Risk
Sales invoices may be raised
on new customers or existing
customers without assessing
the credit limits.
2.
Orders may not be processed
or may be processed twice.
3.
Some invoices may not contain
dispatch advice or contain two
dispatch advices.
Some goods may be dispatched
without invoices.
Goods sent to customers may
not be received by them.
4.
5.
6.
7.
Invoices may be made for
incorrect amounts.
Customers’ invoices and credit
notes may be recorded at
incorrect amounts.
Internal control
(i) The software must be programmed to enable sales invoices to be
raised on new customers only if the credit limits are updated for the
customer. Furthermore, access to the module to update the master
file containing credit limits must be entrusted to the EDP manager,
who will do so only on receipt of approval from the credit controller.
The credit controller needs to keep a record of all credit rating sheets
which are duly authorised by him before telling the EDP manager to
update the master information.
(ii) Exception reports should be generated which contain the details
of customer balances which exceed the assigned credit limits.
(iii) If possible, the system must have a control to ensure that
invoices will not be raised unless the customer has a sufficient credit
limit.
(iv) There should be proper segregation of duties as follows:
¾ the salesman will receive enquiries.
¾ the sales executive will accept the order.
¾ the sales manager will verify the creditworthiness of customers.
All orders to be recorded on sequentially arranged stationery.
Processed orders should be marked as such. There should be a
review of the completeness of orders submitted.
Each invoice to contain supporting dispatch advice.
All dispatch advice slips to be sequentially arranged.
All materials leaving the premises to be verified by the security.
Security personnel to be instructed not to dispatch goods unless they
are accompanied by sales invoices and dispatch advice slips.
Customers to acknowledge receipt of materials. Copies of the
acknowledgement to be preserved by the dispatch section.
All invoices to be numbered sequentially.
Invoice to be cross-referenced with customer’s order and dispatch
advice.
Dispatch advice slips to be prepared by the staff from the planning
department.
Periodic verification of invoices for arithmetical accuracy needs to be
carried out by the staff in the accounts department.
(i) Cash to be received by the cashier only. The recording of the
sales journal to be undertaken by the accounts clerk, recording of
accounts receivable ledger to be handled by a different clerk and the
general ledger to be handled by a third clerk.
(ii) Every month the company should send a statement of account to
each of its customers and any customer queries investigated.
(iii) Every month the company must tally the accounts receivable
ledger with the general ledger control account.
Continued on the next page
© GTG
Solution Bank: 133
Risk
invoices
against
Internal control
8.
Customers’
recorded
customers.
may be
incorrect
9.
Amounts received from customers
may not be recorded in the cash
book.
10. Amount received from customers
may be recorded at incorrect
amounts.
11. Amounts recoverable may be
converted into bad debts without
proper assessment.
12. Errors may occur in recording of
dispatch advice slips, customer
orders, sales invoices, receipt of
cash from customers, etc.
(i) The sales manager must take an age-wise report of accounts
receivables. All overdue payments must be rigorously followed up
by the staff members from the sales department. The details of
each follow up needs to be recorded in the customers’ files.
(ii) Bad debts to be written off only if authorised by the chief
accountant and the VP Sales.
All input data must have controls such as batch totals, hash total,
document count, sequence checks and check digits. This will
ensure the accuracy and completeness of the data.
1 mark for each valid point discussed
Maximum marks 9
(d) Even though the auditor can carry out an audit using only substantive procedures, it is practically impossible
for the auditor to carry out an extensive check of transactions in large businesses.
Moreover, extensive substantive procedures would not only be time-consuming but also expensive for the
company and the auditor. Therefore auditors seek to rely on the internal controls of the entity since proper
management of modern business undertakings is not possible unless there are adequate internal controls.
Internal controls are likely to operate throughout the whole financial period. If there is a poor system of control,
much can go wrong in the client company between visits by the auditor. Indeed, the company could fail if
internal control is not good.
Additionally, companies are often under pressure to release their results quickly. If internal controls cannot be
relied upon, it will take the auditor a considerable time to carry out sufficient substantive tests.
1 mark for each valid point
Maximum marks 3
35. Perpetual Inventory – Pyrmont
You are required to describe the control and substantive procedures which will help an entity in better inventory
management. There is no limit to the number of procedures that could be mentioned in the answer. There are
many potential points you can make about control procedures and testing inventory counts, so it should be easy
to achieve close to 8 marks if you bother to put down simple points.
(a)
(i) The main control objective for accepting book inventory as the basis for year end inventory is as follows:
¾ perpetual inventory verification to be carried out.
¾ transactions to be properly processed and recorded into the inventory software.
The control procedures required for verification of inventory by the perpetual inventory method are explained
below, giving the appropriate control procedure to be followed, the reasons for adopting this control procedure
and the risks involved.
134: Internal Control
Risk
The perpetual inventory
system for verification of
inventory may not be carried
out according to the policy set
out by the company.
During the year :
¾ some inventories may not
be verified.
¾ even though inventory is
not verified, records may be
updated indicating that
perpetual inventory
verification was carried out.
© GTG
Control procedure
Perpetual inventory verification
The company must have a written procedure for conducting
perpetual inventory verification. The policy must specify the
following:
Marks
(i) The persons who would be responsible for conducting the
perpetual inventory verification.
(ii) The classification of inventory under “A”, “B” and “C” classes. “A”
class items are important and expensive items in the inventory
such as leather, soles, artificial leather, etc. “B” class items
would include items which are less expensive than “A” class
items such as thread, plastic, lace, etc. “C” class items would
include the least expensive items such as padding material,
beautification materials etc
(iii) The frequency for conducting the perpetual inventory verification
should be mentioned in the policy i.e. For “A” class items,
perpetual inventory verification will be carried out at least 2 to 3
times each year; for “B” class items the perpetual inventory
verification will be carried out at least twice a year and for C
class items the perpetual inventory verification will be carried
out once a year.
(iv) The levels of authority who will review the entire process of
perpetual inventory verification i.e. storekeeper and materials
manager.
(v) The nature of records which are to be maintained to document
the verification of inventory. i.e. inventory register mentioning
the date of verification, item code, name of item, quantity
according to inventory ledger, physical quantity, quantity of
discrepancy, reason for discrepancy, corrective action taken,
signature of person who verified the stock, etc.
(vi) Verification should take place during the hours when the stores
are shut for movement of inventory to and from the stores.
(vii) All inventories which are verified need to be tagged so that the
persons carrying out the verification will be able to identify the
stocks.
(viii) The stores need to be provided with appropriate counting /
weighing machines so that the physical verification can be
carried out smoothly.
0.5
The control procedures specified above need to be adhered to so
that all inventories are verified by the stores department.
Periodically, when perpetual inventory verification is scheduled to be
carried out, the accounts manager must make a surprise visit to the
stores to verify whether the perpetual inventory verification is
conducted according to schedule.
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
All inventory verification registers should be authorised by the
materials manager.
Persons from the accounts department, the planning department,
the marketing department, etc. must be involved in conducting the
perpetual inventory verification on a rotation basis i.e. persons from
stores must not be involved in this activity.
0.5
0.5
Each quarter, a summarised report of the perpetual inventory
verification conducted needs to be prepared and reviewed by
management.
The report must contain the following details: Period of verification,
class of items verified, number of items verified, number of items
showing discrepancies, number and value of items where shortages
were found, corrective action taken, etc.
0.5
0.5
Continued on the next page
© GTG
Solution Bank: 135
Recording of transactions in the inventory ledger
Purchases made might not be
Purchases vouchers, sales invoices and issue slips are to be
recorded.
numbered sequentially and control over these documents
established and checked
Purchases may be recorded
at incorrect quantities in the
Each month, an exception report of purchase voucher numbers,
inventory ledger.
sales invoices and issue slips, which are not recorded, needs to
be generated. This report must be reviewed by the stores
Sales might not be recorded.
manager and all purchases, sales and issues which have been
missed out need to be recorded in the inventory ledger.
Sales may be recorded at
incorrect quantities in the
inventory ledger
Periodically the accounts clerk must cross-check the inventory
ledger with the purchase vouchers, sales invoices and issue slips to
Issues from stores might not
make sure that quantities are correctly recorded in the inventory
be recorded in the inventory
ledger.
ledger.
0.5
0.5
0.5
Issues from stores may be
recorded at incorrect
quantities in the inventory
ledger.
Maximum marks 5
In the answer to part (a) (i), describe both the control procedures and the reason for the procedure i.e. the risk
associated. The risk is needed to justify the procedure.
(ii) Based on the assumption that control risk over recorded inventory is sufficiently low, the tests of control
I would carry out for perpetual inventory verification are as follows:
1. Verification of policies and procedures: are laid down by the company for carrying out perpetual
inventory verification.
1 mark
2. Testing the design of the policies and procedures: critically analyse whether the policy does have
irregularities such as improper segregation of duties i.e. the stores personnel conducting the perpetual
inventory verification.
1 mark
3. Confirmation of verification according to the policy of the company:
¾ for a representative sample of the inventory ledger, check the documentation of the actual physical
verification conducted and confirm that all the columns of the register are properly updated.
¾ verify whether there was a review of the perpetual stock take by the accounts manager i.e. ascertain
whether the accounts manager has authorised the register during his visits.
¾ confirm that the register is authorised by the materials manager.
¾ verify the quarterly report and confirm that all the inventories in the “A”, “B” and “C” classes were counted
during perpetual inventory verification. In addition, determine the nature of any discrepancies, the reasons
for these discrepancies and the corrective action taken.
¾ confirm that the persons involved in the perpetual inventory were as specified in the policy.
¾ confirm that verification of inventory was carried out when the stores were shut for movement of inventory to
and from the stores.
¾ confirm that the stores are provided with appropriate counting / weighing machines so that the physical
verification can be carried out smoothly.
1 mark per valid point
4. Surprise visit: pay a surprise visit to the premises of the client to confirm that all inventories which are
verified are tagged so that the persons carrying out the verification will be able to identify the inventories and
that the procedure laid down is actually implemented.
1 mark
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5. Verification of reports: prior year audits have already identified the existence and completeness of
purchase and sales transactions. Take a sample of purchases and sales and confirm that the controls still
exist in the current year. To do this, list out the purchase and sales invoices as well as issue slips which are
missing from the inventory ledger and confirm that all records are updated.
1 mark
6. Verification of perpetual inventory records: verify the perpetual inventory register and gain assurance
that the reasons for the discrepancies were not on account of non-recording of purchases and sales.
1 mark
7. Verification of inventory ledger: for a sample of entries recorded in the inventory ledger, verify the ledger
with the GRNs and issue slips and confirm whether the ledger is updated with all the entries in respect of
receipt and issue of materials.
1 mark
Maximum marks 3
(b) Substantive procedures are audit procedures designed to detect material misstatements at the assertion
level. They are the tests designed to obtain evidence as to the completeness, accuracy and validity of the
data produced by the accounting system.
For performing the substantive procedures during the year, I would:
¾ make test counts of inventory when attending periodic physical inventory counts. I am not only required to
check the perpetual inventory records with the agreed counts made by the company’s personnel but also
see that all the differences are noted and investigated in order to adhere to the accuracy assertion.
¾ compare the book records with the physical count and also verify explanation of the difference. This will
provide assurance that the differences are genuine and they are not the result of fraud.
¾ check the inventory adjustments and see that the differences are properly approved.
¾ vouch the entries of sales and purchase transactions to test the arithmetical accuracy of the perpetual
inventory records and properly approve corrections arising from differences in the inventory counting.
¾ ensure that all the physical inventory is counted once a year review the records of test counts and
differences detected.
¾ discuss with management regarding evidence as to the reliability of perpetual inventory records and whether
it might be necessary to carry out a full physical inventory at or close to the year-end.
1 mark for each valid point discussed
Analytical procedures followed at the end of the year:
¾ to confirm the reasonableness of the records of the inventory it is necessary to perform analytical procedure
at the end of the year.
1 mark
At the end of the year, I would need to:
¾ check the inventory listing to and from the perpetual inventory records.
¾ check that the balance of inventory according to the perpetual inventory records agrees with the control
account in the general ledger.
¾ verify sales and purchases cut-off including entries to perpetual inventory records.
1 mark for each valid point
Maximum marks 8
(c) The systems development controls that I would expect to find applied to the rewriting of the inventory control
system are as follows:
¾ to identify the requirements of the new system, a feasibility study is required.
¾ the accounts department is required to approve the specified system requirements.
¾ proper testing and written approval by the accounting department regarding the new system with the results
of tests recorded.
¾ documentation of the new system including test results and approvals should be maintained in the
company's files.
¾ appropriate file conversion procedures including the initial determination of cost at FIFO.
1 mark for each valid point discussed
Maximum marks 4
© GTG
Solution Bank: 137
36. Internal controls - Coolex
You are required to list the risks, control activities and tests of control for advertising expenses and contingent
liabilities. This may be efficiently answered in a tabular form. The mark allocation is clear and aim for 1 point to
earn each mark.
(a)
(i) Advertising expenses
The principal control objectives are:
¾ advertisements to be made at the correct time.
¾ advertisements to be made with the correct agency.
¾ advertisements to be made at the correct rates.
1 mark
The main risks for the advertisements, the control activities which should be in place and the tests of controls
which would be carried out by the auditor are as follows:
Risk
General points
Advertisement
s may be made
unnecessarily
Control activity
1 mark per point to a maximum of 5
The company must have policies and
procedures laid down for advertising
expenses.
Purchase orders for advertisements to be
raised only if there is a valid requisition.
Test of control
1 mark per point to a maximum of 5
The auditor will critically appraise the
design of the policies and procedures to
confirm that all the practices are covered.
The auditor will take a sample of
advertisements raised during the review
period and confirm that all advertisements
put up were supported by valid requisitions.
(i.e. duly authorised by the relevant
persons).
The auditor will verify on a test basis
whether all the advertisements have
properly authorised price comparative
sheets.
All advertisements need to be supported by
purchase orders. Purchase orders need to
be authorised and need to have a separate
series which is sequentially arranged.
The auditor must verify the MIS and
ascertain whether the actual expenses
have exceeded the budgeted expenses.
Rates of
advertisements
may be
expensive.
All advertisements to be supported by
price comparative sheets and quotations.
The price comparative sheets need to
include the justification for raising the
advertisement through the agency. The
price comparative sheets need to be
authorised by the appropriate authority.
Advertising
expenses may
be in excess of
the budget.
Each month the MIS must contain a
comparison of the actual expenses with
the budgeted expenses. The reasons for
variances in the expenses need to be
mentioned therein.
Advertisement
expenses may
be recorded
incorrectly i.e.
at incorrect
rates and
under incorrect
account heads.
All advertisement expenses recorded
should to contain a voucher number. Each
voucher must contain a copy of the
purchase order, a copy of the
advertisement and a copy of the invoice.
The auditor will verify a sample
representative of the vouchers and confirm
that they contain all the supporting papers
which are mentioned alongside (i.e.
purchase order and copy of advertisement.)
All vouchers need to be cross-referenced
with the respective PO numbers and
invoice numbers.
The auditor will verify the vouchers and
confirm that they are properly crossreferenced.
Each month the accounts department
must verify the purchase order register
and confirm that the advertising expenses
are fully recorded.
All expenses need to be paid on or before
the due dates as mentioned in the
purchase orders.
The auditor will check the register and
confirm that it is being properly updated.
Advertising
expenses may
be paid before
the due dates.
Payments before due dates must be
made only if cash discounts were
received.
The auditor needs to take a report of the
advertising vouchers recorded which should
contain the due dates and the actual dates
of payment. If payments are made before
the due dates the auditor should confirm
that the company was given a cash
discount.
138: Internal Control
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(ii) Contingent liabilities
A contingent liability is:
¾ a possible obligation that arises from past events and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the
entity.
¾ a present obligation that arises from past events but is not recognised because it is not probably that it will
cause an outflow of economic benefits or the amount of the obligation cannot be measured sufficiently
accurately.
Some examples of contingent liabilities are:
¾ a litigation which may amount to payment of damages
¾ a bills receivable which has been discounted may be dishonoured on the due date and hence it may amount
to a liability because the amount will have to be paid to the bank with whom the bill was discounted
How they are treated in the financial statements depends on how probably it is that there will be an outflow of
funds.
The control objectives of contingent liabilities are as follows:
¾ all possible future liabilities need to be considered.
¾ the values of the liabilities must be as accurate as possible.
(b) The main risks for the contingent liabilities, the control activities to be in place and the tests of controls
which will be carried out by the auditor are as follows:
Risk
Some of the contingent
liabilities may not be
taken into account.
The value of the
contingent liabilities may
not be estimated
properly.
Control activity
1 mark per point to a maximum of 5
The company must have the
following
records
relating
to
contingent liabilities:
A file containing papers relating to
all litigation / court cases in which
the company is involved.
Files containing details of disputes
with customers
All litigation needs to be taken up in
the board meetings and the latest
status of the cases needs to be
recorded in the minutes of the
meeting.
All guarantees given for loans taken
by other companies need to have
the approval of the board.
The company must maintain a bills
receivable register. The register
must contain details such as bill
number / date of invoice / due date
/ amount / date of discounting, etc.
Test of control
1 mark per point to a maximum of 5
The auditor must verify the file
containing the details of the
litigation cases.
The
auditor
should
review
correspondence with customers
The auditor must ask for legal
advice to assess the accuracy of
the liability.
The auditor must verify the minutes
of board meetings and confirm that
all the guarantees given are
included in the contingent liabilities.
Where bills have been discounted,
the auditor must enquire from the
bank as to the number of bills which
have not matured at the end of
reporting period. The auditor must
tally the register details with the
details received from the bank.
The auditor must receive a letter of
representation form management
which states that all known liabilities
have been disclosed.
The auditor must
management and,
company’s lawyers,
liability is to cause
funds.
discuss with
perhaps, the
how likely the
an outflow of
© GTG
Solution Bank: 139
37. Internal control systems – The Royal Club
Part (a) requires you to explain the method of identifying the weaknesses in the internal control system with the
context of the given scenario. Avoid giving generalised points to score good marks.
The answer to this question is lengthy. Remember to answer the complete question as students generally miss
one or two parts.
(a) Methods of identifying the weaknesses in the internal control system
In order to evaluate the internal control system, Mr. John will prepare an audit strategy to decide the extent of
reliance on the internal controls in the area of the club’s cash operations:
(i) Examination of organisational chart
He will ask for the organisational chart and confirm that:
Giving the points in bullets and numbered
format indicates a good presentation.
¾ there is a proper flow of responsibilities i.e. cash payments up to $3,000 are authorised by the head of the
department and for amounts exceeding $3,000, the approval of the audit committee is required.
¾ duties are properly segregated i.e. the persons accepting cash at the various counters are different from the
cashier, who records the entries in the cash book.
This ensures that control is not vested in any single authority and there is a proper system of internal checks
i.e. the work of one person is checked by another person.
Therefore the organisational chart is well prepared such that the duties and responsibilities are properly
delegated and there is no concentration of duties and responsibilities in any individual. The organisational chart
shows that the internal auditor reports to the audit committee. This will increase the reliability of the internal
audit report.
2 marks
(ii) Examination of written policies and procedures of the organisation
Mr. John will obtain the written accounting procedures of the organisation to try to evaluate and obtain an
understanding of the organisation's procedures for cash transactions.
He will be satisfied with the policies and procedures as they are well laid out and every amendment or any new
policy introduced is first discussed and approved in the meetings of the managing committee and minuted.
2 marks
(iii) Examination of various reports
The auditor will seek information from various reports about weaknesses in the internal control system for cash
e.g. the previous year’s external auditor’s report or the internal auditor’s report.
In the given case, the internal auditor’s report states that the cash in transit is not insured and, in the case of fun
events, cash receipts are prepared manually, and the control over such receipts is not effective.
The auditor will also ask management for the internal audit compliance report. Based on the compliance
report, the auditor will confirm whether the club has brought in preventive measures to ensure that, in future, the
controls will be more effective in the area of cash received at the entrance. This could be possible by carrying
out periodic surprise verification of the collection and billing process at the entrance by a managing committee
member, rotation of duties of the employee collecting cash at the entrance and so on.
Furthermore, in the case of fun events, the auditor should carry out further procedures to ensure that the
recommendations suggested by the internal auditor to make the controls more effective have been implemented
by the club. In the case of cash in transit, the auditor will verify whether the cash in transit is insured, as
recommended by the internal auditor.
2 marks
(iv) Examination of feedback from suppliers and customers
To discover the types of errors taking place or recurring, the auditor will check the query file, and find that most
of them are regarding the 2% administrative charges levied on members’ outstanding balances when they
exceed their credit limit. The auditor then verifies the policy for levying administration charges and is satisfied
that the charges levied are according to the club’s policy.
2 marks
140: Internal Control
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(v) Carry out tests of controls
The auditor will take a sample of the cash transactions and confirm that the transactions are initiated and
recorded according to the policies and procedures of the club.
The auditor will also evaluate the internal control system by observing the procedure of changing shifts. He
may check various calculations already performed by the system, to evaluate the correctness of the system.
2 marks
(vi) Discussion with audit committee
Mr. John will report his observations to the audit committee and hold discussions with them about the
weaknesses noticed in the system. The audit committee should provide explanations and clarifications on all the
issues raised by Mr John. This will give Mr. John a broader understanding of actual events and the
implementation of the suggestions made by the internal auditor.
From this discussion, he can confirm that the controls are well designed and have been implemented effectively.
In this case, Mr. John finds that the club's internal controls are reasonably good and functioning effectively,
except in the case of cash transactions during fun events and insurance cover for cash in transit.
2 marks
Maximum marks 10
(b) Importance of an effective internal control system to the auditor in the context of the Royal Club
Mr. John has concluded, based on his findings that the internal control system in the Royal Club is functioning
well, except in the cases of the insurance cover for cash in transit and cash transactions during fun events.
The auditor therefore decides to rely on the internal control system over the cash transactions of Royal Club and
to carry out a basic level of substantive testing. In the case of fun events however, he decides to carry out
extensive substantive testing. The effective internal controls of Royal Club will help Mr. John to perform his audit
by:
1 mark
(i) Providing reasonable assurance
The effective controls of the club provide reasonable assurance to Mr. John
regarding the following:
You are expected to
relate every point in the
context of the given
scenario.
1. All transactions are valid and authorised by a responsible person
Generally an effective internal control system provides reasonable assurance that all transactions are valid and
properly authorised. Here, the clerk in the accounts department does not record an unauthorised transaction in
the books of accounts of the entity. Therefore, this provides assurance to the auditor that all transactions
recorded are valid and all transactions are authorised by responsible persons.
2. All transactions are recorded without omission
The internal control system of the club is quite effective. The person entering a receipt is not able to delete the
transaction. Therefore, there is no possibility for omission in the case of computerised receipts.
In the case of manual receipts, the receipts are not perforated but sequentially pre-numbered. In addition, a
receipt book with carbon copies is maintained. Therefore, the possibility of omission is reduced. Hence the
objectives of audit to ensure that all the transactions are recorded correctly and completely are met by the
auditor.
3. All the assets and records are safeguarded
The auditor obtains assurance that all cash receipts during the day are deposited in the bank and not used for
payments i.e. the cash is safeguarded. The internal audit report also states that all assets are safeguarded,
except cash in transit.
4 marks
© GTG
Solution Bank: 141
(ii) Determination of nature, timing and extent of audit procedures
The internal control system helps the auditor to determine the nature, timing and extent of the audit procedures
in the following way:
1. Timing
On the basis of the effectiveness of the internal control system, the auditor decides the time to be spent for the
audit of a class of transactions or an account balance. If the controls are effective, the auditor decides to spend
less time on the transaction cycle or account balance. Here, he found that the controls on cash collection are
effective therefore he may decide to spend less time on the audit of the cash collection system.
2. Nature
If the controls on a particular transaction cycle or account balance are not effective, the auditor has to perform
extensive substantive testing but if the internal control system is effective, the auditor will perform less extensive
substantive testing.
In Royal Club, the system is ineffective in the case of fun events therefore the auditor will decide to carry out
more extensive substantive procedures on receipts related to fun events. The auditor will rely on controls for the
rest of the transactions and perform less extensive substantive procedures on those transactions.
3. Extent
Mr. John finds the internal controls effective for transactions other than cash received at the entrance.
The extent of audit procedures will be as follows:
¾ for receipts at the entrance - A representative sample of receipts will be verified with the receipts issued and
the recording of those transactions.
¾ for other receipts - A small sample of receipts will be verified with the receipts issued and the recording of
those transactions
4 marks
(iii) Other
When the internal control system is effective, it is beneficial to the auditor in the following ways:
¾ it saves cost as the extent of audit procedures required will be reduced.
¾ it saves time as there is no need for extensive procedures. Time saved can be best utilised for high risk
areas.
2 marks
Maximum marks 10
38. General Controls – Chef Kitchenware
This question tests your knowledge about the general controls for an IT system. As always, you should try to
aim for 1 point per mark
There are two types of control found in IT systems:
¾ general controls and
¾ application controls, which relate to individual processing applications.
General controls include the organisational and administrative structure of the information systems function, the
existence of policies and procedures for the day-to-day operations, availability of staff and their skills and the
overall control environment. It is important for the IT auditor to obtain an understanding of these as they are the
foundation on which other controls reside. A general controls review would also include the infrastructure and
environmental controls.
1 mark
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The general controls that Graham should set for Chef Kitchenware are:
(i) Organisation and management controls
Graham should set controls related to Chef Kitchenware’s policies and procedures. These controls are related
to the authority and responsibility given – who does what. For example, who is permitted to alter certain data in
the IT system.
These controls will also cover who is responsible for taking back-ups, reviewing transaction and run logs,
monitoring internet use, and so on.
1 mark
(ii) Segregation of duties
Graham should see that there is proper segregation of duties, which means that no one person should have
exclusive control over two or more key activities. Segregation of duties is highly desirable in manual accounting
systems and no less so in computerised systems.
1 mark
(iii) Application systems development and maintenance controls
Graham should set these controls to provide reasonable assurance that the system is designed, tested,
implemented and maintained in a proper and efficient manner. Controls on testing the system, changes made to
the system and access to the system documentation should be in place. This will ensure that whenever
changes are made to the system, there will be proper controls and no unauthorised changes take place.
For any new system which is put to use, Graham should verify the documentation to confirm that the system
was actually tested before using. The documentation should contain the reason for procuring / developing the
new system, the nature of the test runs carried out, the nature of any errors which were detected, the corrective
action taken and the authorisation for use of the system by the official responsible for system design.
For any changes made to the system, Graham should check that old versions of the system are archived and
that all users are converted to the updates software release.
1 mark
(iv) Documentation
Graham should also verify that the changes made to the system are properly documented. The documentation
should contain the following details: the reason for the change, the nature of the change, authorisation for the
change, etc.
Graham should see that the system documentation is safeguarded and kept up-to-date. Access to some parts
of the documentation should be restricted to authorised persons (for example documentation relating to file
structures should not generally be disclosed as this could facilitate unauthorised changes to data. The company
should employ a librarian who will have custody of the system documentation and who will ensure that the
system documentation can be accessed only by authorised persons.
1 mark
(v) Computer operation controls
Graham should set these controls to ensure that the system is used only for authorised purposes and not for
illegal or personal purposes, and also to ensure that only authorised programs are used. The system should be
safeguarded; access to computers should be restricted to authorised persons. The system should be such that
errors can be processed, detected and corrected. The computers should be protected by passwords. Anti-virus
software should be installed. Run-logs and transaction logs should be produced and regularly reviewed.
1 mark
(vi) Data entry and program controls
Graham should set the control for access to data on “need to know” and “need to do” basis. Access should be
given only to a person who needs it for discharging his duties.
Such a control is required so that there is no unauthorised access to data.
1 mark
© GTG
Solution Bank: 143
(vii) Disaster recovery controls
Graham should set controls for disaster recovery i.e. if the computer is attacked by a virus and the data is lost;
there should be a back-up of the data stored in a safe place outside the office premises.
Adequate measures should be taken to protect the equipment from fire, flood, theft and other disasters. All the
equipment should be adequately insured.
Such a control is required so that the software, programs and data are not lost and that the company’s
operations are not put at risk by IT failure.
1 mark
(viii)
Physical access controls
Graham should set adequate safeguards to secure the equipment from theft or fire or any kind of
misappropriation. Equipment should be stored in a room which is kept under lock and key and access to the
room should only be granted to authorised persons. Biometric door locks should be used. With this type of lock,
individual features such as a person’s fingerprints, hand geometry, retina, voice etc. are compared with the
features already stored and access is only allowed if the features match.
Such a control is required so that there are no financial losses on account of damage to computer equipment or
to data held.
1 mark
(ix) Network security
Graham should adopt network security because it is very important to ensure the completeness, accuracy,
integrity and availability of the data passed through the internet. It is important to ensure that unauthorised
access from outside the organisation is prevented. The software which can be used by the company to ensure
network security includes firewall, call-back, anti-virus and encryption.
1 mark
Maximum marks 10
39. Purchase system and inventory counting – DinZee Co
The scenario relates to the work of an auditor in attending the inventory count at a client that has a
computerised procurement and purchases system. For part (a), you are required to list SIX audit procedures
that an auditor would normally carry out on the purchases system and explain the reason for each procedure.
The question carries twelve marks. Therefore you need to include six audit procedures along with the
explanation for each procedure in order to score the maximum marks.
For part (b) you need to list four audit procedures that the auditor would perform prior to attending the inventory
count at a client. This is a straightforward question as you needn’t refer to the scenario in the answer. The
question carries two marks therefore you are required to write four valid points. As the requirement relates to
procedures prior to the inventory count it would not be relevant to include procedures relating to attending the
actual inventory count.
Part (c) provides a scenario relating to the inventory counting system. You need to list and explain the
weaknesses in the control system. Furthermore, for each weakness identified, you need to state how the
weakness can be overcome. In other words, the question is based on a letter of weakness, although the
specific format for that letter is not required. This is a very easy answer considering that the scenario provides
plenty of inputs.
In order to score the maximum marks, you are required to list the weaknesses (1 mark for each weakness) and
explain (1.5 marks for each explanation) three procedures along with recommendations for the ways of
overcoming each weakness (1.5 marks for each explanation) identified.
Part (d) is a knowledge based question. You should state the aim of a test of control and substantive procedure
and then provide examples of those tests / procedures with reference to the inventory count attendance. The
marking scheme for this question is one mark for each test / procedure and one mark for each explanation.
Remember, you need to know the difference between a test of control and a substantive procedure in order to
score the maximum marks.
144: Internal Control
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(a) Audit procedures procurement and purchases system
(i) Obtain a sample of e-mails from the store manager's computer. Trace the details of the emails to the
order database. This is done to confirm that all orders and their details are recorded correctly.
(ii) To ensure that goods ordered are received, obtain a sample of orders, verify the order details which are
recorded and trace them to the copies of the paper delivery note filed in the goods inwards department.
(iii) For the sample of orders verified under the earlier point, trace the details to the inventory database. This
will ensure that goods received are completely and accurately recorded in the inventory database.
(iv) To ensure that inventory received has been recorded in DinZee's accounting system and liabilities are
therefore not understated, obtain a sample of delivery notes and trace them to the order module and
inventory module of the purchases system.
(v) For a sample of orders in the orders database, trace the details to the payable ledger after confirming
the details with the purchase invoice too. This will ensure completeness and accuracy of recording of
the inventory liability in the payables database. Care needs to be taken to include only orders which
have been executed within the sample.
(vi) From the purchase database, obtain a sample of invoices recorded in the purchase day book, agree
the details of prices of the purchase invoices recorded in the database with the purchase orders and also
confirm that the details of the purchase invoices have been rightly recorded in the payables database.
This will ensure that the purchase invoice details have been correctly recorded in the payables
database.
(vii) For confirming that purchase liability has been recorded only for goods actually received, obtain a
sample of purchase invoices and trace the details to the delivery notes for items in the invoice.
(viii) For a sample of supplier invoices, cast and cross cast invoice price and quantities confirming
arithmetical accuracy of invoices. Furthermore, also verify the price charged to the original order. This
will ensure that the company has charged the correct price for the goods received.
(ix) To confirm the completeness and correctness of the liability recorded in the general ledger using
computer-assisted audit techniques, cast the purchase day book and match the total.
2 marks for each valid point
Maximum marks 12
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Testing the controls over the computer system such as passwords and backup systems.
These are not relevant as they relate to tests of the general controls over the computer system rather than tests
on the purchases system.
(ii) Procedures relating to the payment of suppliers including recording of transactions in the cash book and
supplier ledger accounts.
These procedures relate to the payments system rather than the purchases system.
(iii) Procedures relating to cut-off.
These procedures are not relevant as the scenario is dated prior to the year-end, whereas this assertion
relates to year-end testing of account balances of inventory.
(iv) Just stating an assertion word as a reason for performing a procedure.
This is not sufficient for an answer as it must contain a few words of explanation e.g. “confirming occurrence
of purchases by agreeing purchase invoice details to the delivery notes” provide useful and relevant
explanation.
(v) ‘Check the invoice’, ‘Check the goods received note’, ‘Check return of goods’.
These are not valid audit procedures as they neither explain what was being checked, nor why.
(b) Audit procedures prior to inventory count attendance
The requirement verb
is list: no explanation
of the individual
procedures is
required to obtain the
0.5 mark for each
procedure.
(i) Review prior year working papers relating to inventory count and confirm
whether there were weaknesses mentioned therein. If so, find out how the
weaknesses have been attended to in the current year.
(ii) Obtain stocktaking instructions, which the client has circulated amongst its staff.
(iii) Find out whether any inventory is held by third parties.
(iv) Book audit staff who will be involved in the inventory counts.
(v) Prepare a detailed audit programme relating to the count. The programme must mention the location where
the staff would visit for the inventory count, the contact persons, the cut-off procedures which will be
followed, etc.
0.5 marks for each valid point
Maximum marks 2
© GTG
Solution Bank: 145
Common errors and reasons why those errors will not obtain marks are as follows:
Not stating the procedure in sufficient detail.
Writing significant amounts of text in providing an answer
This is not relevant as the question carries two marks with 0.5 marks for each procedure.
(c) Weaknesses in counting inventory:
Weakness
Reason for the weakness
How to overcome the
weakness
Count sheets should not
state the quantity of
items so as not to prejudge how many units
will be found.
Inventory sheets
contain the book
inventory i.e. the
quantity of items
expected to be found
in the store.
When numbers of items of inventory
are not correct the count teams will
focus on finding the inventory and the
teams will stop counting when 'correct'
numbers of items are found. This can
cause undercounting of inventory.
Count staff included
were all from the stores
Count staff are responsible for the
inventory. Hence they could be
tempted to hide errors or missing
inventory that they have removed from
the store illegally.
To ensure independence
to the count team, it is
recommended that the
count
teams
should
include staff that are not
responsible
for
inventory.
Count teams allowed
to decide which areas
to count
Due to lack of precise instruction on
which team members would be
involved in counting inventory from
specific locations of the stores, there is
a danger that teams will either miss
out inventory from the count or even
count inventory twice.
In absence of the signatures it is
difficult to raise queries regarding items
counted as the actual staff carrying out
the count is not known. Furthermore
the audit staff may act carelessly in
view of the fact that they are not held
responsible for their actions.
A precise area of stores
should be given to each
team to count.
Again, there is a chance that inventory
will be either missed out or included
twice in the count.
To avoid this, inventory
should be marked /
tagged to identify that it
has been counted.
Count sheets must be
filled in ink only.
Marks
4
While carrying out the
count, the count sheets
are not signed by the
staff.
Counted inventory is
not tagged in order to
indicate it has been
counted.
The information on the
count sheet has been
recorded in pencil.
Inventory count sheets
were not prenumbered. The count
sheets were only
numbered when used.
Recording in pencil means that the
count sheets could be amended after
the count has taken place, not just
during the count.
As there is no overall control over the
sheets actually being used there is a
possibility that some inventory sheets
could be lost. Furthermore the teams
may miss out numbering some of the
sheets which again gives rise to the
possibility
of
undervaluation
of
inventory.
4
4
In order to confirm who
actually carried out the
count
of
individual
items, all count sheets
should be signed by the
staff involved in the
inventory count.
4
4
4
There should be proper
pre – numbering on all
inventory sheets.
4
Maximum marks 12
146: Internal Control
© GTG
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Not linking the explanation of the weakness to the weakness itself. For example, stating that the
inventory count sheets are not pre-numbered and then stating that this did not provide an adequate
segregation of duties.
To obtain marks there has to be a clear link between the weakness and the reason for that weakness.
(ii) Not linking the method of overcoming the weakness with the weakness itself.
For example, recommending that a precise area of store should be assigned to each team to count, without
explaining the weakness that count teams are allowed to decide which areas to count.
To obtain marks for explaining the method of overcoming a weakness, there has to be a clear link between the
weakness and the method of alleviating that weakness.
(d) Test of control and substantive procedures
(i) The aim of a test of control is to make sure that the internal control systems of the audit client are
functioning effectively.
The aim of a substantive procedure is to ensure that there are no material errors at the assertion level in
the client's financial statements.
(ii) Inventory count:
Test of control
In order to ensure that counting of inventory items is done by the count teams in accordance with the
client's inventory count instructions, an auditor should observe the counting carefully.
Substantive procedure
To ensure the valuation of inventory items is correct record the conditions of the inventory items on the
inventory count sheet.
1 mark for each valid point
Maximum marks 4
40. Despatch and sales system, direct confirmation of receivables and internal control
questionnaires – Seeley Co
This scenario based question relates to a sales and despatch system at Seeley. Part (a) of the question
requires you to explain the steps necessary to check the accuracy of the previous year’s control questionnaires.
Remember, the question requirement is checking the accuracy and not the specific content or production of the
control questionnaires. The question is worth 4 marks. You need to provide around 4 valid points to get
maximum marks.
This question does not appear to be one of the easiest introductory questions to an examination. Therefore
students are advised to use their basic auditing knowledge for verifying something where possible in order to
obtain marks in this type of questions.
Part (b) requires candidates to use the scenario to list and explain the purpose of different tests of control. The
question is worth 12 marks. As the requirement explicitly states that six tests are required, the marking scheme
is one mark for the test and one for the explanation. Do not get confused between a test of control and a
substantive procedure. Remember, tests of control are ‘inspection’, ‘observation’, ‘enquiry’ and ‘reperformance’.
Part (c) requires you to state and explain how audit assertions relate to the audit of accounts receivables. The
question is worth 4 marks. Therefore you need four valid points; each point must state the assertion and explain
its relevance to the audit of receivables.
Part (d) (i) requires you to describe the audit procedures leading up to the dispatch of confirmation letters to
accounts receivables. The question is for 5 marks. Therefore at least three to five points are needed.
Part (d) (ii) requires you to discuss the categories of receivables that would be included in a receivables
circularisation sample. The scenario includes an analysis of account receivables balances which can be used as
examples of the different categories of receivables. The question is worth 5 marks. Therefore you need to
include at least five categories in your answer.
© GTG
Solution Bank: 147
(a) Prior year internal control questionnaires
(i) From last year's audit working papers, obtain the audit file. Verify the documentation relating to the
sales system and ensure that the documentation is complete i.e. the documentation must mention the
results of the test of control, the extent of substantive procedures carried out and the results of the test.
Review the document to identify the weaknesses in the sales system. Make a note of these findings to
carry out further audit procedures in the current year.
(ii) In order to identify any changes made to the systems during the last 12 months, an auditor has to
obtain system documentation from the client. This documentation would have to be reviewed to
understand the areas where changes in systems took place.
(iii) Interview client staff to determine the extent of changes made to the sales system during the
current year. Furthermore, also verify with the client the matters contained in the previous year’s
questionnaire to confirm the accuracy of the previous year’s questionnaire.
(iv) Perform a walk through test. For this, select a few transactions and trace them through the sales
system. This will provide assurance that the internal control questionnaires on the audit file can be
relied upon to produce the audit programmes for this year.
(v) While carrying out the walk through tests it must be ensured that the controls documented in the
system actually function. For example, confirming that documents are approved by authorised
officials as indicated in the system documentation.
1 mark for each valid point
Maximum marks 4
Common errors and reasons why those errors will not obtain marks are as follows:
(i)
Explaining how the whole dispatch and sales system could be audited. This approach was inappropriate for
two reasons:
Firstly, there are only 4 marks available for the question. Explaining how to audit an entire system will
correspond to more than 4 marks.
Secondly, explaining how to audit a system is not relevant to the question requirement of checking the
accuracy of the documentation.
(ii) “The questionnaire does not need to be reviewed because systems have not changed”
The scenario actually states “as far as you are aware” the systems have not changed, indicating some
uncertainty. Furthermore, just accepting prior year documentation without some basic checking to determine its
accuracy is inappropriate as reliance would be being placed on essentially untested material.
(iii) “The most cost effective method of checking systems is the use of CAATs”.
This comment is inappropriate as the scenario specifically rules out the use of CAATs.
(b) Tests of control
(i) To ensure that the goods despatched are correctly recorded on the goods despatch notes (GDNs), an
auditor has to check a sample of GDNs and confirm that they are approved by authorised staff of the goods
despatch section and the customer.
(ii) The auditor has to check a sample of GDNs to confirm that the GDN details have been entered in the
computer system. Furthermore, it needs to be confirmed that the GDNs are authorised by the accounts
department staff too.
(iii) The auditor has to observe the despatch system to confirm that goods are despatched to the
authorised customers only after verifying the customers' identification cards before the goods are
loaded.
(iv) In order to ensure that the series of GDNs is complete, the auditor has to verify the error report on
numerical sequence of GDNs and enquire into the action to be taken regarding omissions.
(v) To ensure that goods are not despatched to customers having poor credit ratings, the auditor has to
carefully observe the despatch process to confirm that the customer credit limits are verified before
the goods are despatched.
(vi) To ensure accurate transfer of goods despatched information from the GDN to the invoice, an auditor needs
to select invoices on a sample basis and confirm that they have been authorised by the accounts staff.
2 marks for each valid point
Maximum marks 12
148: Internal Control
© GTG
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Stating, ‘Inspect the goods received note (GRN) for signature of the customer. To confirm that the
GRNs are signed for completeness’.
This comment is vague as it does not explain the control the signature is achieving. It would be more
appropriate to state ‘Inspect the goods received note (GRN) for signature of the customer. This will verify that
the customer confirms that they have taken the goods listed on the GRN.
(ii) Test all orders, delivery notes and invoices to ensure the correct goods and amount has been recorded in
the ledgers and correct invoice is sent.
This is an inappropriate procedure as:
¾ It is not a test of control.
¾ All documents appear to be tested. However, auditors need to check documents on a sample basis.
¾ The documents, i.e. invoices or ledgers which are tested, are not mentioned.
(c) Assertions receivables
Assertion
Existence
Rights and
obligations
Valuation and
allocation
Cut-off
Application to direct confirmation of receivables
The existence of the receivable is proved when it is confirmed by the
customer replying to the receivables confirmation request. This applies
when the auditor sends a positive confirmation request to the customers.
On the other hand when the auditor seeks a negative confirmation request
from the customer the customer not sending out a reply means that the
customer’s account balance exists in the clients’ financial statements.
The assertion of ‘rights and obligations’ means that the entity has a right to
the asset. It is free to use or dispose of the asset as it sees fit. The
receivable belongs to Seeley Co. The receivable confirms that they owe
the amount to Seeley by replying to the confirmation.
Any receivable amount which does not relate to the financial accounts will
be disputed and the correct amount of receivables will have to be
incorporated in the financial statements. This means that any allocations or
valuation adjustments required (due to discrepancies in the recording of
entries) have been made correctly.
Transactions and events have been recorded in the correct
accounting period. In other words, the transactions that are recorded in the
current financial year do not include any transactions relating to any other
year. The circularisation will identify reconciling items such as sales
invoices / cash in transit. The auditor then confirms that the transactions
are recorded correctly.
Maximum marks 4
Marks
1
1
1
1
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Existence: this is to ensure that accounts receivable exist and a transaction has occurred. As such the
account receivables would confirm the amount owing in writing.
The comment offers an explanation for ‘occurrence’ and ‘valuation’ rather than ‘existence’. Therefore the point
needs to be explained as follows: ‘Existence of the account receivables is confirmed when the account
receivables replies to the confirmation letter’.
(ii) Valuation – that amount has been appropriately disclosed in the accounts.
Clear example of confusion between the assertion and the meaning of that assertion – nil points.
(iii) Explaining the assertion “measurement”. This is no longer a relevant assertion since the revision of
ISAs 500 / 505, and so no marks can be awarded for points made regarding this assertion.
(iv) Listing four assertions without explaining the assertions.
The answer would be incomplete as it does not fulfil the primary requirement of the question, which is ‘state’ and
‘explain’.
© GTG
Solution Bank: 149
(d)
(i) Receivables circularisation – procedures
The following are the procedures up to despatch of letters to individual receivables in relation to a direct
confirmation of receivables:
Obtain a list of receivables balances, cast this and agree it to the receivables control account total at the end
of the year. Matured receivables may also be verified at this time. Furthermore, agree the list with the
ageing of receivables.
The auditor selects a sample of receivables from which confirmation of balances will be sought. To decide
the sampling, the auditor has to decide upon a suitable sampling method such as cumulative monetary
amount, value-weighted selection, random, etc.
Ensure that the sample includes receivables included in the following categories viz. negative balances,
receivables in the range of $0 to $20,000, receivables with balances more than two months old and large
and material items.
Extract details of each receivable selected from the ledger and prepare circularisation letters. At Seeley Co
the auditor should ask the chief accountant or any other responsible person to sign the letters. Then the
letters should be posted or faxed to the individual receivables by the auditor.
1 mark for each valid point
Maximum marks 5
(ii) Specific receivables for selection
The following categories of receivables might be chosen for the sample:
1. Large or material balances: materiality is one of the most important criteria applied for sampling.
Choosing receivables that have large or material balances will ensure that there are no material
misstatements in the financial statements. Furthermore, it will also increase the overall value of the
items tested.
2. Negative balances: in Seeley's list of receivables, 15 negative balances have appeared. Some of these
will be tested to ensure the credit balance is accurate and payments have not been posted to the wrong
ledger account.
3. Receivables in the range $0 to $20,000: the range $0 to $20,000 of the receivables is an unusual
group because it has a relatively higher proportion of older debts. Testing the receivables will confirm
the existence of receivables and also confirm that Seeley is not overstating sales income.
4. Receivables with old balances: a review of the receivables with balances more than two months old
may indicate the need to make a provision for doubtful debts, if the probability of recovery of debts is
doubtful. A lack of analysis of Seeley Co's receivable information indicates a high risk of non-payment,
as the period of several debts is unknown.
5. Random sampling: to provide an overall view of the accuracy of the receivables balance, checking a
random sample of the remaining balances is essential.
1 mark for each valid point
Maximum marks 5
Common errors and reasons why those errors will not obtain marks are as follows:
(i) “Receivables more than 3 months old”
This point is not complete as it does not state why these balances will be chosen. It would be more appropriate
to mention that ‘Receivables more than 3 months old should be chosen in the sample as the balances are more
likely to result in bad debts. Therefore it would enable determination of the accuracy of the bad debt provision
which needs to be made.
(ii) Focusing the entire answer on explaining the use of statistical sampling technique to extract a
sample of accounts receivable.
This is just one point as it explains a method of determining the category of accounts receivable. Therefore you
cannot score more than 1 mark for this point.
150: Internal Control
© GTG
41. Internal control systems of wages and substantive analytical procedures – Blake Co
Part (a) of the question requires you to list four control objectives relating to the wage system at Blake. This is a
straightforward question. Do not get confused between the control objective with the audit procedure. The
question is worth 2 marks. As the verb in the question is “list”, no explanation of the control objective is needed.
Part (b) of the question is worth 14 marks. You need to identify and explain four weaknesses in the wage
system given in the scenario. Furthermore, for each weakness identified you need to explain the probable
weakness and also provide a recommendation to mitigate the weakness. The marking scheme is therefore 3
marks for 4 groups of weakness. You can score an additional two marks for presentation.
Part (c) of the question requires you to list three substantive analytical procedures you should perform on the
shift managers’ salary system and state their expectation of the result of each procedure. In other words, you
need to provide valid substantive analytical procedures. Therefore do not provide tests of detail. The question
carries 6 marks. So for each procedure, two marks are available; 1 mark for identifying the procedure and 1
mark for explaining the expectation from that procedure.
Part (d) of the question requires you to explain four procedures (other than inspection) used for collecting audit
evidence and then discuss whether the auditor will benefit from that evidence. You need to relate your answer
to the wage system at Blake.
The question is worth 8 marks. Two marks are therefore available for each procedure; 0.5 marks for stating the
procedure, 0.5 for explaining the procedure and 1 mark for discussing the benefit of the procedure to the
auditor.
(a) Control objectives of a wage system
Control objective is not the same
as audit procedure.
The following controls should be in place for a wages system:
¾ Wages and salaries are paid at the correct rates i.e. the rates fixed by management.
¾ Wages and salaries are paid to the right people i.e. to genuine employees of Blake.
¾ Wages and salaries are paid on time, i.e. without delays.
¾ Employees are paid for work that they have actually done.
¾ Gross pay has been authorised i.e. unauthorised salary payments are not encouraged, since this may lead
to fraudulent payments.
¾ Net pay has been calculated correctly i.e. all the relevant deductions are taken into consideration before
arriving at the net pay.
¾ Gross and net pay have been recorded accurately in the general ledger.
0.5 marks for each valid point
Maximum marks 2
Common errors and reasons why those errors will not obtain marks are as follows:
(i) “The auditor will confirm the accuracy of the wages calculation”
The above stated point relates to audit procedures rather than a control objective of the wages system.
(ii) Provide detailed explanation of each control. This is not relevant as the verb in the question is ‘list’.
© GTG
Solution Bank: 151
(b) Management Letter
The Directors
Blake Co
1302 Some Street
Old City 5499
Somecountry
Don’t miss the
presentation. You can
get up to 2 marks for
this presentation!
15 May 2009
Dear Sirs
Management letter
This is to inform you about certain weaknesses in the internal controls relating to the shift-workers’ wages
recording and payment systems that we have observed. We have also recommended ways to improve the
controls.
Do not forget to explain why this is a weakness!
Weakness in the system
Effect of the weakness
Wages system – There is no check on the “log in” by the workers
It is assumed that the workers will This means that absent workers
log in before they start their shift. will get paid.
However, some workers could
carry the cards of their co-workers,
who are not present, and effectively
log in for them.
Wages system – There is no satisfactory check on overtime
The shift foreman does not monitor The
employees
may
take
overtime.
advantage of this and delay logging
off, to ensure that they are paid
overtime.
Payment of wages – Code word
The code word used to authorise
the calculation of net wages is easy
to guess, as it is the name of the
department head’s wife.
Employees may access and
authorise wages which are not
payable.
Payment of wages –Authorisation by a clerk
A clerk authorises and makes the A junior member of the staff should
wage payments to the employees.
not be authorising this, as
erroneous payments might be
made.
Termination of employees –Follow up by personnel department
When an employee leaves the This could result in an incorrect
company,
the
personnel authorisation of wage payment to
department notifies the payroll an employee who is no longer
department by email, but doesn’t working for the company.
ensure that the email has actually
been received.
Recommendation to reduce the
weakness
To avoid this, the shift foreman
should obtain a list of all workers
logged in for the shift, and then
compare that to the actual workers
present.
To avoid this, overtime needs to be
authorised.
If
the
manager
estimates that overtime is required,
they can authorise it in advance.
However, if this is not possible,
they can verify the overtime at the
end of the shift, by confirming the
hours recorded by the electronic
system.
To avoid this, the code word should
be something that cannot be
guessed easily. Ideally it should be
a random set of numbers and
letters. It should also be changed
regularly, to further ensure security.
To avoid this, a senior member of
the staff should be authorising the
payments.
To avoid this, the email should be
tagged, so that a receipt is sent
back, when it is opened by the
recipient.
Or,
the
payroll
department can be requested to
reply and confirm as and when an
email is received.
3 marks for each valid point
We are sure that our recommendations will help to minimise the weaknesses which exist in the internal controls
relating to the shift-workers’ wages recording and payment systems. In case of any queries, please feel free to
contact us.
Yours Faithfully,
Anderson Audit Co.
2 marks for presentation
Maximum marks 14
152: Internal Control
(c) Substantive analytical procedures
© GTG
The verb in the question is list so
detailed explanations are not needed!
¾ Obtain a list of total salary paid out every month: the total salaries paid in each month should be
constant. The amount of salaries will only vary towards the middle of the year, when increments were
announced, and towards the end of the year, when bonus was paid.
¾ Obtain the total salary paid during the earlier year, and agree it with the total salary paid this year:
after making adjustments for salaries of new employees who may have joined, or employees who may have
resigned, and making adjustments for the effect of inflation and increments given during the year, the total
salary paid each year should be the same.
¾ Acquire a list of the number of managers working with the company: then calculate the total salary by
multiplying this number and the average salary of the shift managers. Tally this figure with the figure
disclosed in the financial statements.
2 marks for each valid point
Maximum marks 6
“Compare manager’s salary to the industry average to determine accuracy of amount paid”.
Although the point appears to be an analytical procedure it is invalid because comparison to industry average
does not necessarily help ensure that the amount paid is accurate as different companies pay different rates.
(d) Audit procedures
¾ Reperformance: this involves re-doing the procedure performed in the internal control system. The auditor
can benefit from this exercise, as they will come to know any practical problems in the system, when they
actually perform it again. For example, the auditor could note the logging in and logging out time of the
workers, and then agree the figures with the computerised records.
¾ Recalculation: this involves checking the arithmetical accuracy (or correctness) of the calculations. The
auditor can recalculate the number of hours clocked in by the workers (as the difference between the
clocking in and out times in the time recording system), and tally the figure with the computerised wage
records. This will assure the auditor of the accuracy of the time recording system.
¾ Observation: here, the auditor is required to observe whether the workers use the time recording system
while entering the premises and after completion of the shift. The benefits of this procedure will be limited,
as it will confirm only that the workers are using the system correctly at the particular times that the auditor
observes.
¾ Inquiry: the auditor has to make inquiries to clients’ staff, and if possible, to persons outside the
organisation, and obtain information. The auditor could enquire with the staff from departments outside the
production department (like marketing or security) whether they are any flaws in the internal control systems
such as presence of dummy workers, excess payment of overtime, etc. The use of this procedure will be
limited, as it does not provide a direct evidence of the irregularity in the system.
2 marks for each valid point
Maximum marks 8
Common errors and reasons why those errors will not obtain marks are as follows:
(i) “Re-calculation; the benefit of this procedure is that the auditor obtains evidence that client systems are
working correctly, e.g. hours worked are correctly calculated.”
The above point is incomplete as it does not explain the meaning of recalculation.
(ii) Recalculation -“Ensure that net wages are correctly calculated by the wages programme to show the auditor
that the wages programme is working correctly”.
The point is not relevant as it does not relate to the accuracy of the time recording system.
(iii) Other points:
¾ Explaining the audit procedure inspection although this is specifically excluded by the question requirement.
¾ Using a list of assertions instead of audit procedures
© GTG
Solution Bank: 153
42. Letter of weakness for sales system and audit committee – Rhapsody Co
Part (a) requires you to produce a letter of weakness which identifies four weaknesses in the sales system
provided in the scenario. Furthermore, you need to explain each weakness, the effect of that weakness, and
provide a recommendation to overcome that weakness.
An ideal format would be columnar (three columns each for weakness, effect, and recommendation) with a
heading for each weakness, and explanation for the weakness, its effect, and recommendation in three short
paragraphs within the columns. Do not write the answer in three separate long paragraphs as it will be
cumbersome to read.
Part (b) of the question requires you to explain the advantages of an audit committee. Although you need to
relate your answer to the scenario, there are many general points which apply to all entities. Therefore it will be
quite easy to come up with six valid points.
(a)
Report to audit committee
Inventory control and
Sales System Seed division
12 June 2007
The review of the internal controls in the area of the inventory and sales system by the internal audit has
identified the below mentioned weaknesses. This report suggests the following recommendations to
overcome the weaknesses:
Weakness
Recording of sales: orders which
are placed on the internet site are
manually
transferred
to
the
inventory and sales system. This
process of transferring data would
increase the chances of not just
incomplete data but also incorrect
data (for example the wrong product
code recorded) being transferred.
Potential effect of weakness
Due to incorrect or incomplete
transfer of data, the chances of
incorrect goods being supplied
to customers exist. This would
increase
the
number
of
customer complaints.
Control over orders and packing
lists: for every order / packing list a
random alphabetical code is given.
Using this type of code makes it
hard to check the completeness of
orders at any stage in the despatch
and invoicing process.
The lack of control over
packing lists can result in
either
of
the
following
situations:
Obtaining payment: the credit card
of the customer is charged only after
the goods are despatched. This
means the payments are authorised
only after the despatch of goods.
¾ the goods not being
despatched
to
the
customer i.e. the list is
lost prior to goods being
despatched; or
¾ the customer's credit card
not being charged i.e. the
packing list is lost after
goods are despatched but
prior to the list being
received in the accounts
department).
Rhapsody Co is providing
goods
on
credit
basis
therefore the possibility of
incurring bad debts exits if the
credit company rejects the
payment request. This is
further aggregated by the fact
that customers are unlikely to
return seeds.
Recommendation
Amendments in the
computer
program
need to be made so
that order details are
transferred
directly
between the two
computer
systems.
This
will
avoid
manual transfer of
data.
Orders and packing
lists need to be
sequentially
numbered.
Furthermore,
each
day, if there are gaps
in the sequence of
packing lists, they
need
to
be
investigated.
Marks
3
3
It should be ensured
that Rhapsody Co is
paid for all goods
despatched. It is
necessary that
authorisation to
charge the
customer's credit
card is obtained prior
to despatch of goods.
3
Continued on the next page
154: Internal Control
Weakness
Completeness of orders: there is
no overall check that all orders
recorded on the inventory and
sales system have actually been
invoiced. This is despite the facts
that the computer system correctly
ensures that order details are
available for all charges to
customer credit cards.
© GTG
Potential effect of
weakness
Some orders may not be
recorded in the inventory
and sales system. This can
consequentially lead to
understatement of sales
and profit.
Recommendation
The computer system
should be programmed
in such a manner that a
periodic review of the
order file is made and
orders
with
no
corresponding invoices
will be flagged for
subsequent investigation.
Marks
3
Summary: we look forward to arranging a meeting to discuss these weaknesses with you in more detail.
2 marks
Maximum marks 14
Marking scheme: one mark for appropriate heading and one mark for the report format.
Common errors and reasons why those errors will not obtain marks are as follows:
¾ Bad presentation: the question clearly states that two marks are available for presentation. Do not present
the answer in three long paragraphs as this will prevent clear linking of the four weaknesses being
explained.
¾ Including weaknesses not mentioned in the scenario: the weaknesses would not be relevant as the
requirement in the question clearly states that the weaknesses have to relate to Rhapsody Ltd. Therefore
including a point like and the lack of firewalls on servers is not valid.
¾ Writing too much: a sentence or two at the most for each weakness, effect, and recommendation is
sufficient.
(b) Advantages to Rhapsody of having an audit committee
(i) The absence of an audit committee means that the internal audit function reports to the directors of the
company. This means that the directors would be in a position to hide unfavourable reports. However, the
existence of an audit committee would ensure an independent reporting mechanism. This is because the
audit committee consists of non-executive directors who are not involved in the day to day functioning of the
company.
(ii) Due to the independence of the members of the audit committee, the internal auditor would be facilitated by
the audit committee in ensuring that the recommendations made by the internal audit function are acted
upon.
(iii) The independent review of internal controls by the audit committee will enhance the shareholder and public
confidence in the financial statements of Rhapsody.
(iv) The audit committee will enable implementation, and maintain a proper system of internal control within
Rhapsody. Therefore it helps the directors to fulfil their obligations under corporate governance.
(v) By arranging proper meetings with the internal auditors and external auditor, the committee will assist in
improving communication amongst management, directors, and external auditors.
(vi) The existence of an audit committee will provide the external auditors a clear reporting structure and an
appointment mechanism which is separate from the board of Rhapsody. This will enhance the
independence of Rhapsody's external auditor.
1 mark for each valid point
Maximum marks 6
© GTG
Solution Bank: 155
Common errors and reasons why those errors will not obtain marks are as follows:
¾ Not explaining the point made.
¾ Stating points that are not necessarily advantages of having an audit committee. For example
explaining the role of non executive directors and audit committees, and explaining that the committee set
the remuneration of directors. This point is invalid as the remuneration committee is generally responsible
for it.
¾ Explaining the disadvantages of an audit committee. This is not relevant to the question.
43. Internal control of petty cash system and independence of internal audit – Matalas Co
The question relates to an entity which sells cars across the country. The scenario contains information relating
to the reporting structure of the internal audit department of the entity. Part (a) of the question requires you to
explain issues that could limit the independence of the internal audit department of the entity. Furthermore, you
also need to recommend ways of mitigating the threats caused to the independence of the internal audit
department.
The scenario also contains information relating to the entity’s petty cash system. In part (b) of the question you
need to explain the weaknesses in the petty cash system and then recommend controls to overcome those
weaknesses.
The requirement verbs for both parts of the question are ‘explain’ and ‘recommend’. Each point must contain an
explanation of the issues limiting independence for which you get one mark. Furthermore for each issue you
need to suggest methods of overcoming it, for which you get a second mark.
Part (a) of the question carries eight marks. Therefore in order to score the maximum marks your answer must
contain four valid points. Part (b) of the question carries twelve marks. Therefore in order to score the maximum
marks your answer must contain six valid points.
(a) Factors limiting independence of internal audit
System of reporting
The chief internal auditor reports to the finance director. The scope of internal audit would include review of
internal controls in the areas which are the responsibility of the finance director. When the internal auditor
reviews such functions there could be occasions of a conflict of interest if weaknesses are noticed in the internal
controls of these functions. At such times, to avoid a conflict of interest, the internal auditor would be tempted to
either soften his opinion or limit his criticism regarding the functioning of the internal controls. To ensure
independence, the chief internal auditor should report to an audit committee.
Scope of work
The finance director decides the scope of work of the internal audit department in consultation with the chief
internal auditor. This means that the chief internal auditor can be influenced by the finance director regarding
the scope of work. Such an involvement of the finance director can possibly direct the attention of the internal
audit department away from contentious areas that the director does not want to be audited.
It is therefore recommended that the chief internal auditor should decide the scope of work of the internal audit
department after consultation with the audit committee. This is a way of ensuring the independence of the
internal audit department.
Audit work
According to the scenario, the chief internal auditor frequently advises on implementation of internal controls
which were earlier recommended by them. Therefore the internal audit department faces a threat of self review.
This reduces the effectiveness of the audit function since the auditor may not find any shortcomings in the
controls which were proposed earlier.
To ensure independence, the control systems in Matalas should not be established by the chief internal auditor.
Furthermore, where controls have already been established such as in the area of petty cash, another member
of the internal audit department should carry out the audit.
156: Internal Control
© GTG
Length of service of internal audit staff
The whole internal audit staff at Matalas have been employed for at least five years. This means that they face a
familiarity threat. This may limit their effectiveness and they may not be adequately objective and identify errors
in the systems. This would lead to a biased opinion.
To ensure independence, the chief internal auditor should independently review the work carried out by the
internal auditors. In addition, the existing staff should be rotated and assigned to different areas of internal audit
work. Furthermore, management should think of transferring staff from the internal audit department to other
departments of the company and staff from other departments should be transferred to the internal audit
department. However, suitable care needs to be taken in deciding the areas which they would audit.
Appointment of the chief internal auditor
The chief executive officer (CEO) of Matalas appoints the chief internal auditor. There is a possibility that
the CEO of the company may be biased and appoint as the chief internal auditor, a person who is known to
him, or a person who will not criticise his work or the company.
To ensure independence, it is necessary that the chief internal auditor be appointed by an audit committee
or at least the appointment agreed by the whole board.
2 marks for each valid point
Maximum marks 8
Common errors and reasons why those errors will not obtain marks include:
(i)
Including points in the answer which are not mentioned in the scenario.
(ii) Explaining ‘the involvement of the chief internal auditor in the appointment of staff for internal audit function’
as a limitation is not a valid point.
This point is relevant to the scenario. However, it is not valid as it is a general practice for chief internal auditors
to be involved in appointing staff because they can identify the skills required to work within the department.
Therefore this is not a fundamental flaw limiting the independence of the internal audit department.
(iii) Including points relating to weaknesses in the petty cash system.
These are relevant to section (b) of the answer.
(iv) Not explaining the reason for the weakness.
(v) Good corporate governance recommends the existence of an audit committee.
This point is not valid as it recommends ways of improving the independence of the internal audit function,
without explaining why that change is necessary. In order for it to be a valid point, you need to link the
recommendation with a weakness identified in the scenario.
(b) Internal control weaknesses – petty cash
Weakness
The petty cash balance is equal to
around three months’ expenditure. This
amount appears excessive. This could
lead to theft of petty cash and also
misstatements in petty cash.
The petty cash box is not kept in a
secure area since it is placed on a
bookcase. Hence, it is kept where it can
be easily stolen by any member of the
staff.
Significant expenditure can take place
without authorisation. This is because
petty cash appears to be used for some
larger items of expenditure (up to $500).
Furthermore, petty cash vouchers are
authorised after the expenditure is
incurred.
Suggested control
It is suggested that a petty cash balance of $2,000,
amounting to one month’s expenditure, should be
maintained.
Marks
2
When the petty cash is not required, the petty cash box
should be placed in the branch safe or in a locked
drawer in the accountant’s desk.
2
Prior authorisation should be compulsory for vouchers
above the value of $50.
2
Continued on the next page
© GTG
Weakness
There appears to be a lack of
authorisation control since the petty
cash vouchers do not appear to be
authorised by persons other than those
incurring the expenditure.
The account clerk alone counts the petty
cash. This involves a self review threat
since the accounts clerk is also
responsible for the petty cash balance.
In short, there is no independent check
for the accuracy of the petty cash
balance.
At the time of signing the imprest
cheque, only the journal entry for petty
cash is reviewed, but not the petty cash
vouchers. Therefore the accountant has
no evidence of the accuracy and
completeness of the journal entry i.e.
whether the journal entry actually relates
to the petty cash expenditure incurred.
As the petty cash vouchers are not prenumbered, it is not possible to check
whether the vouchers are complete.
Solution Bank: 157
Suggested control
All vouchers need to be authorised by an independent
official decided by management.
Marks
2
The petty cash balance needs to be checked by
different accountants to make sure that the clerk is not
stealing the cash. Furthermore, the frequency of the
petty cash counts needs to be increased to at least once
a fortnight.
2
To provide evidence of petty cash expenditure, the
journal entry should be reviewed with the petty cash
vouchers while signing the imprest cheque.
2
Pre-numbering of the petty cash vouchers should be
done. This has to be checked with the petty cash book
to confirm completeness in the recording of petty cash
expenditure.
2
Maximum marks 12
Common errors and reasons why those errors will not obtain marks are:
(i) Identifying a weakness in the system without explaining the reason for weaknesses identified. For
example, mentioning that the account clerk alone counts the petty cash– but not the weakness that it could
cause a self-review threat - is an incomplete point as an explanation for the weakness is not provided.
(ii) Suggesting general weaknesses rather than weaknesses mentioned in the scenario.
44. Internal controls and its weaknesses – Snu
The entire question focuses on the inventory counting procedures and the internal controls related to them. This
is a 30 mark question and to answer it, you should not take more that 50-55 minutes in the examination.
Parts (a) and (b) are knowledge-based and they can be attempted if you have read the study text properly. You
can earn good marks in this part of the question.
Part (c) requires you to have knowledge of ISA 501. You are not expected to reproduce the wordings of the
standard but you should relate that to the given scenario. If you don’t know the contents of ISA 501, then just
think about why you believe it is important for auditors to attend the year end count.
In Part (d) the weaknesses need to be explained with regard to the methodology of the inventory count given in
the question, the timing of the inventory count, the segregation of duties amongst the staff (this information is
clearly given in the question), etc. Remember: assume no detail appears in a question by accident, so be
suspicious of everything you are told. Ask yourself why the examiner has included each detail and try to use it to
make a valid point.
Ensure that your answer clearly states the reasons why the controls are weak as well as the reasons why the
weaknesses are difficult to overcome. Write a clear conclusion such as ‘The employees are working individually
and hence this provides them with an opportunity to commit and conceal fraud easily, by altering the sheets or
the tags without anyone finding out. This will lead to losses in inventory which could lead to misstatements in the
figures in the financial statements’. This will show the examiner that you understand the systems and will help
you to earn marks!
158: Internal Control
© GTG
(a) Importance of inventory counting: it is regarded as an important and high risk area of audit because
¾ It usually has a substantial effect on the profit of the entity, as it appears in both, the SOFP and SOCI
(income statement) and so can be manipulated easily e.g. it can be increased so as to increase profits or
decreased, so as to decrease profits
¾ It is usually subject to an element of estimation, which again means that the figure could be manipulated to
show a higher or lower figure
¾ It can be difficult for the auditor to properly understand as there are so many types of inventory, often very
specialist
¾ It may be complex to measure e.g. a gas, as a small change in temperature could change the volume of
the product substantially
Due to the above, the auditor must work hard to ensure that the inventory figure is materially correct.
2 marks
Physical verification and the valuation of the inventory would ensure various assertions such as:
¾ completeness i.e. all transactions and assets have been recorded and no transactions and assets have
been left out.
¾ accuracy i.e. the quantity of inventory and amounts have been recorded accurately
¾ valuation and allocation i.e. the value of inventory appearing on the asset side of the SOFP is according to
the company policy and also complies with the provisions of IAS 2.
¾ cut off i.e. transactions and events relating to the current accounting period have been recorded in the
current accounting period only.
¾ classification i.e. the inventory is properly classified under the heads raw material, work in progress and
finished goods. Proper classification is necessary because the method of valuation of inventory is different
for raw material, work in progress and finished goods.
¾ existence i.e. all the items in the inventory really exist at the date of the SOFP. Physical verification would
help the auditor to ensure existence.
¾ Ownership i.e. sometimes third party inventory might be at a client’s premises.
1 mark for each valid point
Maximum marks 5
(b) Perpetual inventory system: it involves cyclical counting procedures during the year. If the auditors are
satisfied with the results of their visit and the perpetual inventory system in place, they need not refer to the
year end count.
1 mark
The audit procedures necessary for relying on a
Sometimes it makes sense to rephrase the
perpetual inventory system in large dispersed
question and use it as the start of your answer.
organisations are as follows:
While you are writing your answer, you should
keep looking back to this sentence and ask
The responsibility for valuation and quantification of
yourself, ‘am I answering this question?’
inventory rests with management. Management
satisfies this responsibility by designing and implementing
appropriate policies and procedures which will include quarterly verification of all the items of inventory. I
would gain an understanding of the management policies and procedures and would evaluate whether the
verification programme is designed such that material items are physically verified at least once a year.
(ii) I, as an auditor, would confirm that adequate inventory records such as inventory register, goods issue
notes, goods received notes and material requisition forms are maintained and that they are being updated
at regular intervals. To confirm this, I would verify the sample goods issue notes, goods received notes,
material requisition forms and confirm that they are recorded in the inventory register.
(iii) If any discrepancy is observed as a result of the counting, I would check whether the records are corrected
to that extent.
(iv) I would concentrate on the internal controls of different locations and will visit those where the controls are
weak, as weak controls denote a higher risk. Those locations could be identified by larger then average
stock adjustments being made. Not maintaining the required documents such as inventory register, goods
issue notes, goods received notes, material requisition forms, no segregation of duties, no timely inventory
counting, not updating the discrepancies found during the physical counting in the ledger balances would be
examples of weak internal controls.
(i)
(v) I would observe the inventory counting procedure by attending the actual inventory counting exercise at
sample locations. Choosing the sample is very important. I would go by the concept of materiality to choose
the representative sample location. The location having weak internal controls as discussed earlier would be
the representative sample.
(vi) If more than one location is involved, I would assess the risk attached to each location and visit those
locations where the volume and value of the transactions is material.
© GTG
Solution Bank: 159
(vii) If I feel that I am unable to employ sufficient manpower from my team, I will take help from another
professional firm. While relying on the work of an external firm, it is very important to ensure that it meets
my standards of quality of work.
(viii) My firm may visit the locations on a rotational basis throughout the year, to ensure adequate coverage of all
locations.
(ix) The internal audit department (if there is one) will almost certainly test the perpetual inventory system, and I
would review their working papers.
1 mark for each valid point
Maximum marks 5
(c) Auditor’s attendance at physical counting
According to ISA 501, Audit evidence-additional considerations for specific items; when inventory is
material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding its
existence and condition by attending the physical inventory counting unless impractical.
The physical verification of inventory is the responsibility of the management of the company. However, where
the inventories are material and the auditor is placing reliance upon the physical count by management, the
auditor should attend the inventory counting.
1 mark
Auditor’s attendance at physical counting is essential as he can ensure the following:
¾ The instructions issued by management to inventory counting personnel are appropriate. The instructions
would be considered appropriate if they are in writing and they include controls such as handling of used
and unused stationery, identification of responsibilities of different officials who would be handling the
inventory count along with the locations where each official is responsible for the inventory count. Ideally,
the instructions would be reviewed for adequacy before the physical stock take then the auditor can confirm
the implementation of the instructions by attending the inventory count itself.
¾ The auditor, by attending the inventory physically would perform test-counts to satisfy himself about the
effectiveness of the count procedures. This can be done by including items which have high value. It would
ensure the assertions of existence and completeness. The test counts would include counting certain items
and tracing those to the stock sheets and also picking some items from the stock sheets and tracing back to
the physical stock.
¾ The auditor can confirm the condition of the damaged, slow moving or non-moving inventory by attending
the physical verification.
¾ The auditor can ensure that there is no movement of inventory while physical verification is carried out. This
would ensure the adherence to the cutoff assertion.
¾ The discrepancies noticed between the count and the inventory records will be investigated in the presence
of the auditor on the day of the physical count. This will ensure that the discrepancies noticed have been
investigated and properly accounted for. This would ensure the assertions of accuracy, valuation and
allocation.
¾ The numbers of the last goods received notes and dispatch notes for the year can be noted for subsequent
checks on cut-off.
1 mark for each valid point
Maximum marks 5
(d)
It is advisable to write the answer in a tabular form as it will not just cover all the points but also all the
requirements of the question for each point. It should not be written in a paragraph format.
1
Weakness
Date of
inventory
count
Reason for weakness
The inventory count
has been carried out
on a date which is
one of the only two
holidays that Snu has.
Why difficult to overcome
The shop and warehouse are open every day and hence
it is very difficult to find time to prepare for the inventory
count. It is also important that there are no inventory
movements during the count. The employees have only
two holidays in a year which is very less and hence they
cannot be expected to work overtime, beyond a certain
extent.
Continued on the next page
160: Internal Control
2
3
4
Weakness
No senior level
control /
supervision on
the employees
working for
preparation of
inventory count
Too little
preparation
time for
inventory count
No segregation
of duties for
allocating and
supervising the
work of the
staff
© GTG
Reason for weakness
The employees are working individually
and hence this provides them with an
opportunity to commit and conceal fraud
easily. This will lead to losses in inventory
which could lead to misstatements in the
figures in the financial statements.
The time given is only two hours (15.00 –
17.00 hours) for preparation which may
be too little considering the fact that the
inventory count happens only once a
year.
The preparation work prior to the
inventory count would be to ensure good
housekeeping in the stores, i.e. keeping
all the inventory in the correct locations,
segregating the damaged inventory,
updating of stores records.
Insufficient preparation time will create
difficulties in counting as the inventory
might not be properly arranged for
counting and this will lead to incorrect
counting of inventory.
The inventory records can also be
misstated. This will affect the following
assertions
Completeness: that all inventories are
recorded and all recorded inventories are
physically in existence.
Rights and obligations: that all
inventories counted belong to the entity.
Classification: that all inventories
counted are properly classified under
proper headings.
Mr. Sneg is the inventory controller and
also in charge of the inventory count.
This indicates lack of segregation of
duties because if there are some items
in the inventory which are not physically
available, Mr. Sneg may try to avoid
bringing it to the notice of auditors.
Furthermore in the absence of
segregation of duties there is no
internal check i.e. another person does
not check the work done by Sneg.
Why difficult to overcome
The inventory count is required to be
completed quickly and efficiently.
Hiring outside workers to overcome the
weakness will not be feasible since they
would require time to understand the
items in inventory and their locations
which will affect their efficiency
The shop is going to be open on all the
days of the week and 1 Jan is the only
public holiday when the count can take
place. Therefore this weakness may be
difficult to overcome.
Snu is a family-owned company and
hence it is very difficult to overcome
this
weakness.
Family-owned
companies, (even large ones) often
place a substantial amount of trust in
valued employees. These employees
are usually offended if they are
suggested to ‘check’ their work.
If the company wants to employ an
additional person to double check
Sneg’s work, he may resent this and
leave the company. The company may
not be able to afford to lose such an
experienced person.
4 marks for each valid point
Maximum marks 15
You can avoid losing marks if you avoid certain common mistakes generally made by the students.
In part (b), explaining the perpetual inventory system without giving the audit procedure would be considered as
a bad answer.
While answering part (c), many students reproduce the standard. You need to cover the part related to the
question only. To score good marks, you should relate the standard to the given scenario.
While answering part (d) the verb in the question is ’why’ these weaknesses are difficult to overcome. So do not
waste time answering ‘how’ the weakness can be overcome. Explaining the weaknesses only would be
considered as a bad answer.
© GTG
Solution Bank: 161
45. Control activity, tests of control, assertions and audit opinion – Have a Bite Co
This 20-mark question is based on a chain of fast food restaurants.
Part (a), carrying 6 marks, is a knowledge-based question. You need to identify and explain four assertions
relevant to accounts payable at the year-end date. As accounts payables is a period end balance, the
assertions which apply are: completeness, valuation and allocation, rights and obligations and existence.
Part (b), carrying 4 marks, requires you to state two controls to reduce the risk associated with food purchases
and preparation in addition to two tests of control. In order to come up with relevant control activities, think of
physical control, authorisation, performance review, information and segregation of duties. You also need to
recommend tests of control to be conducted in order to satisfy yourself that control risk in this area is low.This
answer can be written in a tabular format wherein the control activity can be explained in one column and the
tests of control to test the control activity can be mentioned in the second column.
Part (c), carrying 6 marks, requires you to state three items of evidence and explain how they might enable the
auditor to assess the likelihood of the claim succeeding. The items of evidence (available from the scenario)
include: a letter from the lawyer, board minutes, discussions with management and written representation. You
need to remember that the auditor is only interested in whether the claim requires a provision or disclosure in
the financial statements. Therefore, you need to make an assessment of the claim along these lines.
Part (d), worth 4 marks, requires you to describe how the claim should be reported in the financial statements
and its effect on the audit report. This matter is a contingent liability which is material to the financial statements
and hence requires to be disclosed. Furthermore, if the disclosures were not made then an ‘except for’ opinion
would be required. The examiner has reminded future candidates to understand audit reports and the various
probable modifications to them.
(a) As regards accounts payable there are many different assertions that have to be addressed. Some relevant
assertions are set out below:
(i) Rights and obligations - Accounts payable represent amounts actually due by the company, that is, there is
an obligation, taking into account:
¾ the actual performance of services for the company;
¾ or transfer of title in goods transferred to the company;
¾ and cash payments or other genuine debit entry,
1.5 marks
(ii) Valuation and allocation - Accounts payable have been correctly valued taking into account original
transaction amount sand such matters as trade discounts and local sales tax.
1.5 marks
(iii) Existence - The original transaction amounts are valid and the liability exists,
1.5 marks
(iv) Completeness - All accounts payable are recorded in the accounting records.
1.5 marks
¾ Assertions provide objectives for the auditor and enable the search for evidence to be carried out in a
logical fashion.
¾ The auditor identifies the assertions that are made about a particular figure appearing in the financial
statements. This provides a series of objectives about that audit area and then the auditor searches for
evidence to prove that each objective is met and that the assertion is valid or invalid.
¾ ‘Financial statement assertions’ is a key element of the syllabus and a crucial part of the audit process. The
examiner has pointed out that future candidates must ensure that they understand the assertions relevant
to classes of transactions, year-end balances, presentation and disclosure.
Maximum marks 6
162: Internal Control
© GTG
¾ Read the requirement in the question carefully.
¾ Do not list all the assertions. Instead, list only those assertions that apply to trade payables.
¾ Do not provide procedures to test an assertion, instead explain the assertion.
(b) Controls that the company has in place to reduce the risk
associated with purchases of food and its preparation in the
kitchen, together with relevant audit procedures on
controls testing, would include the following:
For a restaurant, it is important that
food quality is good and in particular
that it does not present any danger to
the customer arising from deterioration
or poor practices in its preparation.
Controls
Overall authority for food purchasing should
be in the hands of a designated person to
ensure that the food purchased is of the
desired quality. This is often in the hands of
the head chef.
Audit Procedures
Review the company's organisation chart and
identify the person with overall responsibility for
food purchasing. Discuss with management his
or her background and expertise.
Marks
2
(ii)
There should be a list of approved suppliers
to ensure that the food comes from sources
known for their quality.
Examine the list of approved suppliers of food
and check that there are no purchases of food
from other parties.
2
(iii)
On receipt of food, whether meat, fish, or
vegetables and fruit, it should be carefully
inspected by informed people, including those
responsible for food preparation. This would
be to ensure that it was of the desired quality
(as well as quantity). A goods received note
(GRN) should be signed to provide evidence
of receipt and inspection.
Examine a sample of GRNs to ensure that all
bear an approved signature indicating that food
has been inspected for quality on receipt.
2
(iv)
Food purchased should be kept in a clean
place and refrigerated, if necessary. This
would be to ensure that it has kept its quality.
Examine the food storage areas, including
refrigerators, on a surprise basis to ensure they
are clean and tidy. Ensure that the refrigerators
are maintained at the correct temperature.
Another test in this area might be to examine
reports of local authority and other inspectors to
ensure they were happy that the food was being
properly stored.
2
(v)
Strict adherence to use-by dates to ensure
that no poor quality food is prepared.
Check that there is no food on the premises
which is past its use-by date. Discuss with
management what happens to food which is
past its use-by date, that is, how it is disposed
2
(i)
Maximum marks
4
© GTG
Solution Bank: 163
(c) Evidence collected by the auditor to enable a conclusion to be formed on the likelihood of the claim being
successful (that is, whether a provision would be necessary according to IAS 37 Provisions, Contingent
Liabilities and Contingent Assets) includes:
Evidence
Obtain the written claim by the customer.
Explanation
This would tell you the reason why the claim
was being made and provide other relevant
details, such as whether the customer dined in
the restaurant or purchased carry-out food,
and the date when the alleged food poisoning
took place.
(ii)
Review the controls in force over purchases
and food preparation (mention points from
(b) above).
This would be to ensure that the company
controls appeared to be effective.
(iii)
Obtain written reports concerning any
inspections that had been carried out by
company staff or third parties in the food
store and food preparation areas.
This would provide evidence about any
problems that had arisen affecting food
quality. Discuss with management the actions
that were taken to correct any problems that
had arisen.
(iv)
Discuss the matter with the company's
lawyers to obtain their view on the
likelihood of the claim being successful.
This would provide evidence from a
professional third party as to the likelihood of
the claim succeeding and the reasons why the
lawyers had reached their conclusion.
(v)
Obtain management representations
regarding the likelihood of the claim
succeeding.
This is internal evidence and should be
approached with professional scepticism, but it
would provide the auditor with the views of an
informed group of people.
(i)
Marks
2
2
2
2
2
Maximum marks 6
(d) As you have concluded that the likelihood of the claim being successful is only possible, it would be
appropriate for the company to explain the contingent liability by way of note as required by IAS 37, giving a
description of the nature of the contingent liability, an estimate of its financial effect, an indication of the
uncertainties relating to the amount and timing and the possibility of any reimbursement.
2 marks
If the company includes a note of this nature, there would be no need to
modify your audit opinion, however if the litigation is viewed to be
exceptional then an emphasis of matter paragraph might be appropriate.
However, if the contingency is not disclosed, the auditor would modify the
audit opinion on the grounds of an 'except for' disagreement and include in
the report the required details of the contingent liability. The auditor should
include the disclosure before issuing the modified opinion.
An 'except for' qualification would
be appropriate as the contingent
loss is material, that is, the
uncertainty is not major.
try to persuade management to
2 marks
Maximum marks 4
Do not incorrectly assume that a provision is necessary as the question states that management felt they had
good defences against the claim. This demonstrates a failure to apply knowledge of IAS 37 Provisions,
Contingent Liabilities and Contingent Assets to the scenario.
Do not state the effect on the audit report (on account of not disclosing the contingent liability) as a disclaimer of
opinion or an adverse opinion. A disclaimer of opinion is applicable only when the auditor does not obtain
sufficient audit evidence. Furthermore, an adverse opinion does not apply as the effect of the non-disclosure is
not material as well as pervasive to the financial statements as a whole.
164: Internal Control
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46. Control environment, understanding the entity and substantive procedures – Letham
This question relates to a large engineering company with a capital intensive manufacturing process.
Part (a) carrying 4 marks is a knowledge-based question where you are required to explain the importance of
understanding the entity and its environment (as an auditor). To score the maximum marks, you need to write
four valid points. The examiner has observed that many candidates were able to identify only one or two points
such as assessing risks or assessing whether to rely on the internal controls and hence reduce substantive
procedures.
Part (b), carrying 12 marks, requires you to provide six strengths of the control environment from the scenario
and explain how these may reduce the control risk.
Part (c), worth 4 marks, requires you to explain why the completeness test over non-current assets (given in the
requirement) was not a good test. Furthermore, you need to state an alternative. This is a pretty difficult
question to answer.
If you read the question carefully and understand the assertions, you will be able to provide some good
alternative completeness procedures such as ‘selecting a sample of non-current assets on the shop floor and
tracing it back to the inclusion in the non-current assets register’.
(a) The auditor obtains an understanding of the entity, its control environment and its detailed internal controls:
(i) to identify and assess the risks of material misstatements, whether due to fraud or error, at the financial
statement and assertion levels. Risks would include inherent risk and control risk. An important objective
would be to determine the extent to which the auditor would rely on the internal control system.
(ii) to provide a basis for designing and implementing responses to the assessed risks of material misstatement
in the financial statements. This would involve the design and performance of the audit procedures required
to form an opinion on the truth and fairness of the financial statements. An important objective would be to
determine the extent and nature of audit procedures to reduce detection risk, and therefore audit risk, to an
acceptable level.
(iii) to set the scene for identifying assertions and collecting sufficient appropriate evidence to prove that the
assertions are reasonable.
(iv) to assess the adequacy of the accounting system as a basis for preparing financial statements
(v) to assess whether the auditor is competent to perform the audit
(vi) to understand relevant law and regulations impacting the entity
(vii) to consider the reliability of various evidence sources.
1 mark for each point
Maximum marks 4
(b) The strength of the control environment of Letham Co in respect of non-current assets are set out below,
together with explanations as to their impact on control risk:
Strengths
Approval of the five-year and
annual budgets by the board of
directors.
The budget is updated when the
order for new equipment is
placed
Impact on control risk
Marks
The annual budget is the ‘trigger’ for placing orders for
equipment. Its approval by the board will ensure that only
2
authorised non-current assets are purchased
The company can use the updated budget at any time to
anticipate cash outflows. It will also ensure that there is no
2
duplication of assets purchased.
Continued on the next page
© GTG
Strengths
Pre-numbered goods received notes and
operational certificates are available to the
accounting department for comparison with
the purchase invoice
Solution Bank: 165
Impact on control risk
Marks
Only goods that have been received and are
operating effectively will be paid for.
2
Informed people in the production
department carefully assess the proper
operation of the equipment
This will help to ensure the operational effectiveness
of plant and equipment.
2
The accounting department, independent of
the production facility, updates the nontangible assets register and only the
accounting department has access to it.
The potential for fraudulent entries to cover theft/
unauthorised purchases will be reduced and the
non-current assets register, an important noncurrent assets control document, cannot be
manipulated by the people who hold the assets.
Accounting department personnel,
independent of production, perform rolling
tests to ensure that the non-current assets
register and non-current assets on hand are
in agreement with each other.
The internal audit department tests on a
sample basis that recorded non-current
assets are in existence.
Internal audit test the operation of the entire
non-current assets recording system
The risk of theft and loss of plant and equipment is
reduced and the likelihood that all items in the
register existing increased.
The internal auditing department will be more
independent than the accounting department and
hence will provide further comfort that the noncurrent assets register is not overstated.
Any controls which are not operating effectively are
likely to be identified and rectified before significant
errors can occur.
Maximum marks
2
2
2
2
12
In addition to the above, marks are also available for additional strengths such as:
¾ pre-numbered goods received notes are used to update the budget,
¾ permanent identification numbers are recorded on assets,
¾ purchase invoice automatically updates the non-current assets register.
¾ You can score the maximum marks by providing six strengths. Providing more points than required can lead
to time constraints for other questions and should be avoided.
¾ Read the requirement carefully, and provide weaknesses in the control environment rather than strengths.
¾ Do not provide general answers such as ‘this reduces control risk’; you should explain how this reduces the
risk.
(c)
(i) Great care must be taken in selecting the starting point for audit testing. The test that the internal auditors
performed, namely, selecting a representative sample of purchase invoices for testing to the non-current
assets register and to the updating movements on the annual budget, proves merely that register and
budget are in agreement with the purchase invoices issued. It is therefore not a good test to prove the
completeness of purchase invoices and therefore of the entries in the register and budget. In addition, the
purchase invoices are issued by many different suppliers and there is no common serial number to enable
the company to ensure that all purchases are accounted for.
1 mark
166: Internal Control
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(ii) A more appropriate test would be to make the selection from goods received notes (GRNs), as the issue of
a GRN is normally the point at which liability is accepted and is in any event the document used to update
the non-current assets budget. In other words, it is important to identify your audit objective and then to
decide on what sample will be the most appropriate to aid you in meeting that objective. The GRNs would
be traced to the recorded purchase invoices to ensure that the latter were complete and then to the entries
in the non-current assets register and to the updating entries in the budget to ensure that these too were
complete.
1 mark
An additional appropriate test would be to select a sample of plant and equipment visible on the shop floor and
trace them to the non-current assets register to identify whether they have been:
¾ included in the register
¾ noted against the budget as purchased
¾ paid for by tracing purchase invoice through to payment.
1 mark
The auditor would of course wish to prove that the GRNs are complete and might select a sample of purchase
orders and trace them to the GRNs to ensure GRNs have been prepared in each case or the order rejected for
good reason.
1 mark
Maximum marks 4
¾ You would demonstrate a lack of understanding of the principles of sampling and of the aim of audit
procedures if you criticise the test for using a representative sample.
¾ Do not criticise this test as not being a good test for existence. The requirement of the question is for
completeness and not existence.
¾ You must take the time to read the question requirements carefully. The confusion over existence versus
completeness also demonstrates a lack of understanding of the financial statement assertions, and this is
unsatisfactory.
E
SECTION E
SOLUTION BANK
AUDIT EVIDENCE
47. Analytical procedures – ratio analysis - Hivex
Part (a) of the question requires you to analyse the performance of Hivex. Calculation of a number of relevant
ratios such as gross profit ratio, total expenses as a percentage of revenue etc is an important area. See the
presentation given in the model answer below. The tabular presentation of ratios will help you consider relevant
information given in the question. After calculating ratios, you need to analyse and interpret them.
Part (b) requires you to describe the audit risk. You should identify the risks based on your answer to part (a)
above.
Part (c) is a straightforward knowledge based question. You can answer it easily if you have read the theory
well.
(a) Performance
The performance of the company can be evaluated using the following analysis.
No.
1
2
3
4
5
6
7
8
9
10
11
12
13
Particulars
Revenue
Cost of sales
Gross Profit
Gross profit margin (Gross profit/Revenue x 100)
Operating expenses
Distribution costs
Administrative expenses
Selling expenses
Total operating costs
Total expenses as a percentage of revenue i.e. (cost of
sales + operating costs) / revenue
Operating expenses as a percentage of revenue i.e. total
operating expenses / revenue x100
Profits from operation
Operating profit as a percentage of revenue i.e.
operating profit / revenue x100
Net interest receivable
Profit before tax
Income tax expense
Net profit
Percentage
increase
(a-b)/b x 100
20X9
(a)
20X8
(b)
$’000
15,206
3,009
12,197
80%
$’000
13,524
3,007
10,517
78%
12%
nominal
16%
3%
3,006
994
3,002
7,002
1,996
1,768
274
4,038
51%
(44%)
996%
73%
66%
52%
46%
30%
5,195
6,479
34%
50%
995
6,190
3,104
3,086
395
6,874
1,452
5,422
(20%)
152%
(10%)
114%
(43%)
(i) As can be seen from point 1 in the above table, the company has increased its revenues by 12% during the
year 20X9 as compared to 20X8. This implies that the company is expanding its volume of sales (which is a
good sign) and/or has been able to increase its prices. A 12% increase does not look too demanding, but
would need to be looked at in the context of market conditions.
168: Audit Evidence
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(ii) The gross profit of the company has increased substantially, by 16%; this is on account of the increase in
revenue of 12% and a very nominal increase (less than 1%) in the cost of sales. This implies that the
company’s performance is good but might be the result of an understatement in cost of sales.
(iii) The increase in total operating costs is 73% as against the increase in revenue which is 12%. This increase
in the costs looks out of line and could be caused by misstatements in the financial statements. It would
therefore need to be investigated.
(iv) The large increase in the operating costs has resulted in the decrease in profits from operations by 20% in
20X9 as compared to 20X8 (point 8).
(v) If the revenue and production costs are compared, it appears that the gross profit margin (80% in 20X9 and
78% in 20X8) is very high. This is acceptable because the profit margin is generally high especially in the
software industry. However, this may be the result of errors because the information was compiled
unusually fast.
(vi) The selling expenses drastically increased by 996%. This might be derived from erroneous information.
Conceivably, this could be because Hivex needs to spend more on advertising and sales promotion, due to
tough competition in the market.
(vii) It can be observed from point number 5 in the above table that the distribution costs are increased
substantially from $1,996 to $3,006 i.e. 51%. This denotes the inefficiencies in the method of distribution.
This may be because of the increase in commission, changes in the method of distribution etc.
(viii) From point number 5 in the above table, it can be observed that the administrative expenses are reduced
drastically by 44%. This appears to be good, but the reason for the fall needs to be confirmed. It may be on
account of a reduction in the fixed element of the administration expenses, say the sale of non-current
assets which has led to a fall in the depreciation expenses.
(ix) There is a significant increase in the interest receivable during 20X9 i.e. from $395 to $995. Therefore, the
reduction in operating profits has been partially offset by increased net interest receivable, but still profit
before tax is reduced by 10% (point 11)
(x) The reduction in profit before tax and the increased tax expenses have resulted in a reduction in profit after
tax of 43% (point 13). There is a risk that the tax computation is incorrect as the tax charge has greatly
increased whilst profits have fallen.
(xi) Total dividends have increased from $1,439,000 to $1,469,000 despite lower profits. This is unusual and
will have to be investigated.
(xii) Furthermore, there is significant fall in the earnings per share. It does not appear that this can be accounted
for by the reduction in profits, and other reasons such as increase in the number of shares, the calculation
of the EPS etc. will need to be investigated.
1 mark for each point
Maximum marks 8
(b) Higher risk areas and audit procedures
High Gross margin and increased operating expenses
Part (a) of the answer makes it clear that although the gross margin has substantially increased, the operating
expenses have increased by a much higher proportion thereby leading to a much lower operating profit. Such
ratios indicate that there is a possibility of errors or frauds in the areas of gross margin and operating costs.
Hence the areas of high audit risk are revenue, cost of sales and operating expenses.
I will carry out the following audit procedures:
(i) I would obtain:
¾ a detailed schedule of revenue containing the sales mix, quantities sold, etc. and
¾ cost of sales which include:
9 the opening and closing inventory figures for both software and hardware and
9 various expenses which form part of the cost of sales.
With this information, I would perform a detailed review of changes in the above mentioned statements on a
monthly, quarterly and half yearly basis.
© GTG
Solution Bank: 169
Detailed review of changes would include analytical procedures such as comparing the amounts with previous
year’s amounts, obtaining the reasoning of the changes, comparing the performance with the other companies
in same industry to determine whether the profit and expenses ratios are similar to Hivex or not. If those are
significantly different, I can conclude that there may be errors in the income statement of Hivex.
(ii) I would verify the accounting policies of the company relating to revenue recognition for both software and
hardware and confirm that they were in accordance with the provisions of relevant International Accounting
Standards like IAS 18 Revenue recognition, IAS 38 Intangible assets.
Furthermore, I will choose a sample of the revenue transactions and verify that the accounting policies
applied to the transactions match with the company’s accounting policies.
(iii) According to the provisions of IAS 38, certain development costs are to be capitalised in the statement of
financial position. However, the research costs and costs that do not meet the criteria for capitalisation are
to be expensed. I would confirm this treatment with some transactions taken up on a sample basis.
(iv) I would seek to establish why all three categories of operating expenses i.e. distribution costs,
administrative expenses and selling expenses have changed so dramatically. This can be done by enquiry
with the management, by obtaining a schedule of operating expenses, a breakdown of the cost of sales
figure. For selling expenses, if the increase in the selling expenses is on account of increases in the rates of
sales commission, the authorisation for the increase in rates needs to be verified.
(v) I would perform detailed analytical procedures on operating expenses and cost of sales / gross margins, on
a quarterly and monthly basis. Furthermore, I will choose a sample of transactions under various account
heads for operating expenses and confirm that the expenses have been recorded under the appropriate
account head. This will enable detection of misclassifications.
(vi) If the value of inventory as a percentage of cost of sales is disproportionate as compared to the industry
ratios and the ratios of the company for the earlier years, the auditor will once again have to look at his
working papers relating to verification and valuation of inventory. He should confirm that all the areas where
the client needs to work on such as reconciliation of discrepancies in inventory verification have been
looked into.
(vii) I would increase my sample size during tests of control over the recording, processing and posting of
transactions that are posted to revenue, cost of sales and operating expense accounts because of the
possibility of errors.
(viii) I would perform detailed substantive testing on samples of transactions relating to operating expenses by
verifying the transactions with the source documents such as,:
¾ payroll account with salary computation sheets, attendance sheet, etc.
¾ purchase account with purchase invoices for components purchased, purchase register, etc,
¾ ledger account balances with final schedules supporting the income statement (for completeness), and vice
versa.
Interest receivable
I would obtain explanation for the increase in net interest receivable. Furthermore, analytical procedures such
as comparison with previous year balances, calculation of ratios etc would help me to ensure that the current
year’s interest costs and interest income are according to the current interest rates prevailing in the market. I
would obtain the details of the investment held by the company and would confirm whether the interest income
calculated according to the market rate approximately matches with the interest recorded in the books. I would
look at documentation received from the company’s banks or investment managers to substantiate the amounts
of interest received.
Taxation
The significant increase in the tax figure is again a high risk area because the profit before tax has reduced from
$6,874 in 20X8 to $6,190 in 20X9. I would ask for copies of the tax calculations for detailed review, and to
corroborate explanations provided by management.
170: Audit Evidence
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Dividends and earnings per share
(i) Using the performance analysis in part (a), it can be concluded that the dividend has increased despite
lower profits. I would obtain the reasons for this from the management and review the board minutes.
(ii) For the decrease in earning per share, I would further enquire what the company intends to do about the
competition and whether there is any possibility of a take-over. Take over will result into increase in the
earning per share.
(iii) I would enquire with the management whether there had been any shares issued during the year which
might be having an effect on the decrease in earnings per share. I would further enquire the purpose of the
share issue. The reasons could be future expansion plan, proposed capital expenditure or it could be
problems in the current working capital cycle. A share issue might also help to explain the increase in
interest earned.
1.5 marks for each point
Maximum marks 12
(c)
Sources of
evidence
Analytical
procedures
Confirmation
Audit procedure
Reliability of the evidence
Obtaining detailed schedule
of revenue and cost of sales
and reviewing the changes,
comparing the amounts with
past year’s data etc
An analytical procedure such as ratios, being evidence
created by an auditor, is reliable. However, it cannot be
conclusive evidence, as the correctness of the results of
the analytical procedures depends on the reliability of
source data. Lack of availability of reliable data and
unstable operating environment makes it difficult to
predict the relationships.
Verifying the accounting
policies of the company and
confirming its applications
to the actual transactions.
Observation is reliable evidence, as the auditor directly
confirms that the required procedures are being carried
out.
However, staff might behave differently if they know
they are being observed.
Inquiry
Enquiring the management
about the reasons for the
drastic increase in the
operating expenses
This kind of evidence can be used to test any assertion.
However, it is only corroborative evidence which
supports the conclusions drawn on the basis of other
evidence such as analytical procedures. For example, in
this audit procedure, one of the reasons could be an
increase in the advertisement expenses. The auditor
has to cross-verify it by performing additional audit
procedures such as verifying the sample data with
source documents, authorisation of advertisement
expenses etc.
Recalculation
Recalculating the valuation
of inventory for current year
as well as the previous year
This provides evidence for accuracy and of the
transactions. It is considered as the most effective
method to evaluate the outcome of a process. It can be
conclusive and highly reliable evidence created by the
auditor.
Inspection of records
Verifying
the
operating
expenses with the source
documents
This is also evidence created by the auditor, like
recalculation. There is always a risk that management
may deliberately misinform the auditor. However,
inspection of source documents can give reasonable
evidence regarding the genuineness of the transactions.
2 marks for each point
Maximum marks 10
© GTG
Solution Bank: 171
48. Audit evidence
To answer this question effectively, you need to have an understanding of the methods of gathering evidence
and their advantages and disadvantages. Writing only about advantages could not get you good marks, you
need to focus on the disadvantages too as the question specifically asks for those.
(a) Advantages and disadvantages
(i) Analytical procedures
In the exam, you may write just the advantages and the
disadvantages. For your better understanding, an
introductory paragraph is given for each procedure.
Analytical procedures are studies of the
relationship between financial data or between financial and non-financial data from financial statements. They
are used during audit planning, evidence gathering and also at the time of the final review.
Advantages
Analytical procedures can be used at all stages of the audit. They can help the auditor to prepare a good audit
plan. They enable the auditor to decide the priorities of the audit, the nature, timing and extent of the audit
procedures and any areas of major concern.
¾ They provide a good source of information to gather audit evidence regarding the reasonableness of an
amount.
¾ At the final review stage, they help in deciding the need for further audit procedures.
1.5 marks
Disadvantages
¾ In a dynamic operating environment e.g. continuous change in material prices, wage rates etc., it becomes
difficult to determine plausible relationships between different amounts in the financial statements. Ratios
will keep on changing and it becomes difficult for an auditor to understand / determine how much deviation
is due to the changing environment and how much is due to any misstatement.
¾ Often on element of a ratio depends on a figure taken form the statement of financial position and figures
from this source can rapidly change. For example, a receivables collection period can be radically altered
just by the timing of a major receipt.
¾ The success of the analytical procedures depends on the reliability of the available data.
¾ Analytical procedures are only successful when significant deviations are properly investigated. Often the
auditor accepts a plausible explanation given by the client, without properly investigating it.
1.5 marks
(ii) Audit sampling
In sampling, instead of 100% checking, only a sample is checked and the result of the sample is used to draw a
conclusion about the population by applying the sample result to the population.
Advantages
¾ The auditor’s time is saved as he doesn’t have to check 100% transactions.
¾ It enables the auditor to concentrate on the material items and risky areas where 100% checking may be
required.
1.5 marks
Disadvantages
¾ In this technique, there is always a risk that the sample may not represent the population i.e. sampling risk.
Although the auditor assesses this risk and tries to compensate for it using other procedures, the risk is
always present.
¾ In sampling, judgement is needed to decide the confidence level, to draw conclusions etc. This judgement
may be incorrect.
1.5 marks
172: Audit Evidence
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(iii) Tests of controls
Tests of controls are the tests performed to assess the effectiveness of the internal control system and
accordingly decide the nature, timing and extent of audit procedures.
Advantages
¾ Tests of control help in determining the effectiveness of the internal control system and also in deciding the
nature, timing and extent of the further audit procedures.
¾ If, as a result of tests of controls, the auditor decides that the controls are effective, he may decide to
perform fewer substantive procedures and save time, money and energy which he can then use for other
critical areas.
1.5 marks
Disadvantages
¾ Generally, auditors do not check all the controls for the whole year. Instead, they check controls on a
sample basis, for part of the year. This means that the limitations of sampling also apply to tests of controls.
Moreover, controls that are otherwise effective may be ineffective in a busy period when the number of
transactions in a day increases substantially e.g. in festive seasons such as Christmas.
¾ Tests of controls are generally performed on routine transactions e.g. sales and purchases. However, for
transactions / events / areas which are more risky for the financial statements, tests of controls are not
performed e.g. estimates and areas of judgement of management.
1.5 marks
(iv) Detailed testing of transactions and balances
This is substantive testing where the auditor checks transactions / balances in detail. Where tests of controls
are not adequate or effective, detailed testing is performed.
Advantages
¾ Since detailed checking is involved, generally it can give sufficient appropriate audit evidence e.g. third
party confirmation.
¾ In these procedures, the auditor checks the figures directly and confirms the assertions in the financial
statements; therefore the procedure is usually a reliable source of audit evidence.
1.5 marks
Disadvantages
¾ Detailed checking is time-consuming and it is not practical to perform it for all the transactions.
¾ Since detailed checking is not usually performed for all transactions but is instead carried out on sample
basis, it is also subject to the limitations of sampling.
1.5 marks
(v) Computer assisted audit techniques (CAATs)
CAATs are the tools used for performing an audit in a computerised environment. They can be broadly
classified as test data and audit software.
Advantages
¾ If there is a large volume of transactions, it is not possible for an auditor to perform audit procedures
manually. CAATs enable an auditor to test a large volume of data more accurately and quickly. For example
every item of inventory could be examined using a CAAT technique to identify slow moving stock.
¾ In the case of transactions for which there is no audit trail and no hard copies of the transactions, CAATs
are the most suitable audit procedures.
¾ Some controls rely on computer procedures. For example, the automatic rejection of a new order if that
would send a customer over a credit limit. The use of test data (CAAT) might be the only way to verify that
the control is operating.
¾ Certain procedures are too complex to be performed by the auditor manually such as statistical analysis,
standard deviation of a large set of data, etc.
1.5 marks
Disadvantages
¾ Initial cost of setting up CAATs is huge.
¾ When an auditor is using audit software, writing audit software takes a lot of time. Even after writing the
software, the auditor may not be sure that it will run correctly. A lot of time may be wasted in differentiating
between the errors due to mistakes in the audit software and the errors in the financial statements.
© GTG
Solution Bank: 173
¾ If CAATs are used on files in a live situation there is a possibility that they may disturb and corrupt the
system in which they operate.
¾ Updating and modifying CAATs also involves huge cost. In addition, CAATs of the prior period may not be
useful for the next year.
1.5 marks
Maximum marks 15
(b) Relationship between the methods of evidence gathering
Analytical procedures are used to identify the areas which need more attention. They are also used to decide
the nature, timing and extent of audit procedures. Using the results of analytical procedures, the auditor may
decide on the areas and extent to which he needs to perform tests of controls. These results can also be used
to decide the materiality level and the levels of tolerable error to be used in sampling.
On the basis of the results of sampling and tests of controls, the auditor decides the extent to which
substantive procedures can be performed. Tests of controls, analytical procedures and sampling identify
the areas which may need more checking and hence decide the need for detailed checking of the
transactions and balances.
If tests of control suggest that the internal control system is effective, the auditor can place more reliance
on the tests of control and needs to carry out less extensive substantive procedures, and vice versa.
It is known that sampling is used in both tests of controls as well as in detailed checking of transactions.
CAATs can be used as tests of controls (using test data) and for detailed checking (using audit programs).
They can also be used for analysing data and for selecting transactions for the auditor to investigate
further. When CAATs are used, sampling may or may not be used as CAATs can allow 100% of
transactions to be examined efficiently.
Analytical procedures are helpful at all stages of the audit. On the other hand, tests of controls and detailed
checking of transactions and balances are generally used after analytical procedures and sampling.
1 mark for each valid point
Maximum marks 5
49. Assertions and payroll audit – Boulder
Part (a) is a straightforward question which you should answer systematically. As instructed, the answer should
contain six assertions only. If you write about more than six assertions, you will not gain any additional marks.
In the answer given below, all the assertions including completeness are explained for your reference. This
question is for six marks or 1.8 minutes per assertion therefore write one or two sentences maximum about
each assertion. To increase your chance of describing an assertion completely, you might find it useful to give
an example – provided you don’t run over time.
(a) Financial statement assertions
(i) Completeness: all transactions and events are included in the
financial statements. For example, all liabilities should be included.
Listing as well as a brief
description is required. Merely
listing will not give you full marks.
(ii) Occurrence: all the transactions actually took place and are related to the entity. For example, revenue
should include only sales that took place in the period.
(iii) Measurement (valuation and allocation): items in the financial statement are recorded at correct values.
For example, inventory should be valued at the lower of cost and net realizable value.
(iv) Presentation and disclosure (understandability): disclosures are clearly expressed so as to make them
understandable to the users. For example, non-current assets should be correctly described
(v) Accuracy: amounts and other data have been recorded accurately. For example, the calculation of
depreciation should be accurate.
(vi) Rights and obligations: the entity has a right to the assets and is obliged to pay the liability. For example,
id property owned outright or leased.
(vii)Existence: assets, liabilities and equity interest (capital and reserves) really exist. For example, year-end
inventory should be checked for existence.
174: Audit Evidence
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(viii) Cut-off: transactions and events have been recorded in the correct accounting period. For example, if
goods are in inventory then they should be in purchases.
(ix) Classification: transactions and events have been recorded in the proper ledger accounts. For example,
the repairs and maintenance account does not include items which should be capitalised.
1mark for each valid point
Maximum marks 6
(b) Substantive audit procedures
It has to be ensured that proper disclosures are made in
the financial statements in accordance with the accounting
standards and the statutory framework.
Gathering audit evidence for a particular
transaction cycle or balance includes confirming
related assertions. Therefore when writing an
answer for the audit of any transaction cycle or
balance, start with assertions.
1 mark
(i) Payroll balance in the SOFP
To gather audit evidence for the balance in the SOFP, the auditor uses the assertions: completeness, valuation,
existence, rights and obligations.
¾
¾
¾
¾
Completeness: all the unpaid salaries, wages, bonuses etc are recorded in the SOFP.
Valuation: the amount appearing in the SOFP is calculated correctly.
Existence: the liability to pay unpaid wages and salaries does exist.
Rights and obligation: it is obligatory to pay the unpaid wages.
3 marks
In the case of Boulder, the payroll balance could consist of the following components:
¾ Unpaid amount to the agency (i.e. temporary staff)
Often, salaries / wages are paid in the following week / month therefore an amount may remain unpaid and
appear in the SOFP. To obtain assurance of the correctness of the amount a confirmation from the agency may
provide sufficient appropriate audit evidence. Therefore I will ask the agency to confirm the amount payable.
Confirmation from the agency will help in validating the existence of unpaid salary to the temporary staff. It will
also confirm the valuation, completeness and obligation assertions.
If the unpaid amount is not confirmed, i.e. the amount appearing in the SOFP of Boulder is different from the
amount recorded by the agency, I will find out the reason for the difference. To do this, I will check the rates,
deduction etc., agreed by both, the agency and Boulder. This will give evidence for valuation. I will also check
the invoices that have been received from the agency.
I will also obtain corroborative evidence by checking calculations of the amount payable and examining
supporting documents such as the production sheet authorised by the supervisor. On a sample basis I will
select production sheets and calculate wages for the number of units produced by applying the wage rate and
compare it with the calculations made by Boulder to find out differences, if any. This will provide audit evidence
for valuation.
2 marks
¾ Unpaid salaries, wages to the permanent factory staff, administration and sales staff, directors etc.
I will check the amount payable to the permanent factory staff with reference to the authorised clock cards. For
administration and sales staff, I will check the deduction policy, if any. For example, in the case of deductions for
leave or sick days taken during the period, I will check from the attendance register the number of days taken off
during the period and verify the unpaid amount. This procedure will confirm that the amount payable is correctly
recorded (valuation).
1.5 marks
¾ Unpaid bonus to the sales staff and directors
For bonuses due to the sales staff, I will check the calculations by taking the sales made in the period to which
the bonus is related, as a starting point, and follow the calculations through. I will also check the calculations for
bonus to directors taking profit as a base. This will confirm the amount payable on account of unpaid bonus.
1.5 marks
¾ Unpaid amounts on account of tax and social insurance
There is a possibility that an amount may remain unpaid relating to the last one or two months. I will check any
unpaid tax or social insurance with the payroll calculations and deductions. This will confirm the valuation.
For an amount unpaid on account of any dispute, e.g. underpayment of tax by Boulder, I will check the
correspondence from the tax authorities. This will confirm the existence of the unpaid amount.
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Solution Bank: 175
In all cases, I will reconcile payments made after the end of the reporting period with these unpaid amounts. To
do this, I will check the bank account, cash book and other supporting documents. This will provide confirmation
of the completeness, valuation, existence and obligation.
Analytical procedures will also help me to identify any material misstatement. I will perform analytical
procedures such as comparing the salaries and bonuses of the current year with reference to number of
employees, sales level (since bonus to sales staff is paid on the basis of sales), profit (since bonus to directors
is paid on the basis of profit earned) etc. with the salaries and bonuses of prior periods.
2 marks
Maximum marks 10
(ii) Payroll transactions in the income statement, Boulder
While gathering the audit evidence for amount in the income statement, an auditor uses assertions, occurrence,
completeness, accuracy, cut-off and classification.
¾
¾
¾
¾
¾
Occurrence: all the payroll transactions have actually occurred and are related to the entity.
Completeness: all payroll transactions have been recorded without omission.
Accuracy: payroll amount as stated in the income statement is accurate.
Cut-off: amount of payroll appearing in the income statement is related to the particular year.
Classification: only payroll transactions are recorded and all the transactions are recorded.
1.5 marks
Test checking of the calculations of the payroll amount with reference to supporting documents such as
production sheets authorised by supervisor, clock cards etc. will confirm the assertions, occurrence and
accuracy.
1 mark
To confirm that there is no overstatement, I will select a sample of transactions and confirm their existence and
amount with the ledgers and payment slips, and also verify the source documents such as clock cards. This
procedure will confirm occurrence.
1 mark
To confirm that there is no understatement I will start with the source documents such as clock cards and trace
them through ledgers and verify the amount in the income statement. This will confirm completeness, accuracy
and classification.
1 mark
To check that the transactions relate to the particular year, I will verify the date on the pay-sheet and the period
for which the source documents such as production sheets, clock cards are prepared.
1 mark
In addition, I will perform analytical procedures; I will compare the payroll amount for each category with the
prior period and with respect to the number of employees. This will confirm completeness, accuracy, existence
etc.
1 mark
Apart from this, presentation in the financial statements of the proper balances is also important. Therefore for
balance in the SOFP and amount in the income statement, I will check whether appropriate disclosures have
been made in the financial statements in accordance with accounting standards and the statutory framework.
1 mark
Maximum marks 4
50. Audit procedures – BearsWorld
You need to emphasise on the audit procedure i.e. its usage and limitations. Part (a) of the question focuses on
various audit procedures and their uses in gathering the audit evidence. Part (b) deals with practical application
of the audit procedures.
(a) Audit procedures
(i) Analytical procedures
Merely defining each procedure will not give you
full marks therefore also write about its usage.
Analytical procedures consist of studies of the relationships either between the figures of financial statements or
between financial and non-financial information. Analytical procedures test assertions such as completeness,
accuracy, valuation and classification.
176: Audit Evidence
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(ii) Inquiry
Inquiry means asking for information, both financial and non-financial, from knowledgeable persons within the
entity or outside the entity. This procedure can be used to confirm any assertion but usually it is used to obtain
corroborative audit evidence only.
(iii) Inspection
Inspection is physical verification. It can be of records, documents or tangible assets. This procedure tests the
assertions of ownership, cut-off, operation of controls and existence.
(iv) Observation
Watching the process or procedure being performed by others is observation. This gives evidence of the
effectiveness of controls and confirms the assertions of completeness and accuracy.
(v) Re-calculation
Recalculation involves checking the mathematical accuracy of a document or record. This provides assurance
regarding the assertion of accuracy.
1 mark for each point
Maximum marks 5
The critical areas of BearsWorld and the audit
procedures to be applied are as follows:
(i) Analytical procedures
Identify the weaknesses in the process and the
critical areas of BearsWorld for audit, and think
of the appropriate procedure for each such area
Analytical procedures may be performed on the sales. The sales of the current year will be compared with the
sales of the prior period. A significant variance may indicate overstatement or understatement of sales.
Sale orders are received by mail, therefore there is a possibility that the person responsible may process the
order, may not record it and misappropriate the money received. This will result in understatement of sales.
Analytical procedures will help the auditor to identify any such misappropriation and confirm assertions such as
completeness, accuracy, valuation and classification.
1 mark
(ii) Inquiry
You need to give only one example in
all of these. We might give more for
illustrative purposes only.
Payables is also a critical area since there is no control over
purchases. A statement from suppliers may be asked for to check the
completeness of liabilities. I will check whether each purchase transaction as shown in the statement is
recorded in BearsWorld and each payment by BearsWorld is reflected in the Suppliers statement. A balance
confirmation from suppliers will confirm the assertions such as existence, obligation, completeness etc.
In addition, I will make an inquiry to the responsible person (the first assistant) to understand the procedure of
processing of the sales orders i.e. how he records orders to ensure that all orders are properly processed,
whether goods are dispatched only after confirming the receipt of cash and what procedure he adopts to ensure
that all cash received by post is deposited in the bank. This will confirm the assertion of completeness.
1 mark
(iii) Inspection
There is no control over inventory. I will inspect the inventory i.e. carry out a physical count of inventory and
verify it with the records maintained. I will also check the physical condition of the inventory.
I will inspect whether all the large orders or wages are authorised by Mr. Kyto by checking whether the date and
initials of Mr. Kyto are present.
1 mark
(iv) Observation
I will observe the procedure of processing sales orders to find out whether it is performed in exactly the same
way as described by the person responsible. By observing this I will gather evidence about the completeness of
the sales recorded.
I will observe the procedure of opening of orders (when cash is received through post) and recording of cash.
1 mark
(v) Re-calculation
I will calculate whether the cash received during the period matches the corresponding sales. Since there are no
receivables it is expected that the addition in cash should be reflected by sales.
1 mark
Maximum marks 5
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Solution Bank: 177
(b) Suitability
(i) Analytical procedures
Analytical procedures help in identifying any unusual changes in the income or expenditure and thereby the
need for further testing. Therefore analytical procedures are suitable for the audit of BearsWorld. In addition,
there is the possibility of misappropriation of money by the assistant and analytical procedures may help in
identifying any understatement and misappropriation by the assistant.
On the other hand, if the assistant is misappropriating money every year, analytical procedures may not reveal
the misappropriation. This is because the base taken for comparison itself is not reliable. The limitations of
analytical procedures are that they do not work when the source data is not reliable and when the same kind of
fraud or error is committed over several years.
2.5 marks
(ii) Inquiry
Since inquiry provides important information and it is suitable to any entity. Inquiry made to a third party
provides particularly reliable evidence. In BearsWorld, inquiry can be very useful in obtaining confirmation from
suppliers and thereby in obtaining confirmation of the completeness of payables and purchases.
Inquiry is not useful when made internally, since it does not constitute sufficient appropriate audit evidence but
only corroborative evidence (since the auditor has to check the reliability of the information provided by the
employee or manager of the entity). In addition, external inquiry is also not so useful when used for confirming
receivables as customers might not respond to the inquiry.
2.5 marks
(iii) Inspection
Inspection involves checking of documents, records and assets. It is widely used and suitable for the entities
where the internal control system is not effective, as in BearsWorld. There is no proper segregation of duties in
BearsWorld. Therefore I should inspect various documents such as purchase invoices, wages, expense
vouchers etc. and check whether they have been dated and signed by the authorised person. I should also
inspect the inventory.
This procedure is time-consuming. In addition, the procedure itself does not provide sufficient appropriate audit
evidence e.g. the fact that a purchase invoice is authorised does not confirm that it is recorded in the books or
possession of an asset does not confirm the ownership of the asset.
2.5 marks
(iv) Observation
Observation provides audit evidence about the effectiveness of the internal control system. In BearsWorld,
processing of orders, collecting cash etc are the procedures where a person should take care while performing.
Observation of such procedures will provide evidence on the control over operations.
Although observation takes place when the procedure is performed, there is a possibility that the person
performing the procedure may act differently in the presence of the auditor.
2.5 marks
(v) Re-calculation
Re-calculation is performed to check the accuracy of the documents and records. It is useful in checking
calculations on invoices, wages calculations, bank reconciliation etc.
A limitation of this procedure is that it is performed on the figures already recorded. If an incorrect figure has
been recorded or a figure has been omitted, this may not work. For example, in the case of a sales invoice, if
the number of units sold is recorded as 10 instead of 100 and calculations are accurately made for 10 units,
recalculation will not reveal the mistake.
2.5 marks
Maximum marks 10
51. Audit of inventory – IAS 2
The question is divided into three parts. The answers for parts (a) and (b) are straightforward. This question
judges your knowledge about the bases for valuation of inventory. Note that in part (b) marks are allotted for
both cost and NRV. You need to define both in order to score good marks.
Part (c) of the question is scenario-based involving the audit of a manufacturer of household furniture. Again,
the important point to be noted here is that you should take into consideration the net realisable value in addition
to cost.
You have been warned not to describe the audit procedures carried out to confirm the quantity of inventory.
178: Audit Evidence
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(a) Importance of inventory
(i)
Generally, in trading companies, inventory is one of the most significant assets appearing on the SOFP. It
therefore has an important impact on the financial position of the entity. As it is material to the financial
statements and has a direct effect on the profitability, it is a critical area for audit.
(ii) The inventory figure appears on the SOCI as well as on the SOFP Any misstatement in the inventory figure
will affect both the profitability of the entity and the strength of assets. E.g. a company seeking a bank loan
may overstate closing inventory so that greater profit and a stronger assets position can be shown.
(iii) When inventory is of high value or portable or both, the risk is high. There is a risk that inventory can be
misappropriated without this misappropriation being noticed and therefore closing inventory can appear at a
higher value than its actual value. In this case, the auditor has to confirm that the inventory stated in the
financial statements does actually exist.
(iv) Inventory is subject to an element of estimation. Valuation of inventory involves estimation of slow-moving
items, obsolete items, etc. Therefore, the chances of manipulation by management are greater.
(v) The inventory figure affects not only the current year but also the following year. If closing inventory is
overstated it will show more profit in the current year but less profit in the next year. This can be used for tax
planning purposes.
(vi) Inventory management also has an impact on other operations of the entity. Excess inventory locks up
capital whereas shortage may result in stopping production.
Considering its importance, the auditor has to gather audit evidence to confirm that the inventory figure stated in
the financial statements is neither overstated nor understated.
1 mark for each point
Maximum marks 5
(b) Cost and net realisable value
(i) IAS 2, inventories, requires that inventories should be measured at the lower of cost and net realisable
value. As an auditor, you should be aware of the definitions of cost and net realisable value. This will enable
you to compare and confirm the basis of inventory valuation and to ensure that valuation of inventory meets
the requirements of the IAS.
(ii) According to IAS 2, the cost of inventories shall comprise of purchase costs, conversion costs, and other
costs which are incurred for bringing the inventories to their present location and condition.
(iii) Costs of purchase includes all costs incurred for bringing inventories to their present location and condition
i.e. purchase price, all irrecoverable taxes and duties, transportation and handling costs etc. Any trade
discount, rebate etc. should also be deducted.
(iv) Costs of conversion are the costs incurred to convert raw material into finished goods. These include labour
cost and allocated production overheads (both variable and fixed). Fixed overheads are allocated on the
basis of normal level of production and variable overheads are allocated on the basis of actual level of
production. Fixed overheads are indirect costs and variable overheads are costs directly related to the
volume of production.
(v) Storage costs are not included in inventory cost unless these are necessary for the production process.
(vi) IAS 2 defines net realisable value (NRV) as the estimated selling price in the ordinary course of business
less the estimated costs of completion and the estimated costs necessary to make the sale. E.g. in the case
of damaged goods, adverts may be placed to convey to buyers that the goods are available at lower prices.
In this case, the net realisable value will be sales value less cost of advertisement. Similarly, when the seller
agrees to bear the transportation cost, the NRV is sales price less the transportation cost incurred by the
seller.
(vii) Generally, slow-moving or obsolete items are often valued at the realisable value because then NRV often
becomes less than the cost. This practice of valuation is consistent with the conservative (or prudence)
principle that an asset should not be recorded at a price which is greater than the amount which could be
realised from its sale.
(viii) An auditor needs to gather evidence for the appropriateness of the bases used for determining the NRV
and also to ensure that the inventory is neither understated nor overstated.
1 mark for each point
Maximum marks 6
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Solution Bank: 179
(c) Audit evidence
(i) Audit evidence for cost
The cost of purchase includes purchase prices, all irrecoverable taxes and duties, transportation and handling
costs. The cost of conversion includes labour cost and allocated production overheads (both variable and fixed).
1 mark
So, for a company that manufactures household furniture, the relevant cost will be the cost of purchase of
inventory such as timber, metals, fabrics and adhesives, etc. and the cost of conversion such as labour cost and
other production overheads, such as running machinery (a variable production overhead) and a share of the
rent of the factory (a fixed production overhead).
On a sample basis, I will examine purchase invoices for raw materials and check the following:
¾ date of the invoice (whether it falls in the period under audit),
¾ authorisation (whether invoice is dated and signed by the
appropriate person)
¾ the name of the purchaser (whether purchases are made by
the company under audit),
¾ description of the goods (so that the proper inventory
items are valued)
¾ price (whether appropriate details are recorded in the books).
To score marks, just mentioning that you
will check the purchase invoice is not
sufficient. You need to write what you
will check in the invoice. The examiner
has complained about excessive use of
the word ‘check’ where students do not
say exactly what they are checking.
This checking will confirm assertions such as completeness, accuracy, occurrence, cut-off and classification.
1.5 marks
To obtain evidence of labour cost I will re-calculate payments of wages on a sample basis using source
documents, clock cards, timesheets, production records etc. if any. On the source documents I will verify the
signature of the authorised person. I will also check the entries in the cash book or in the bank statement. This
will provide evidence for accuracy, occurrence, cut-off, classification etc. and ensure that the labour cost is not
misstated.
I will also need to examine data that the company has compiled on the times taken to produce each type of item
of inventory. The labour content of each item can them be calculated as labour time x cost per hour.
1.5 marks
For other variable production overheads such as the cost of small tools, I will check them in the same way that I
checked the purchase of raw material i.e. by checking the purchase invoices. For the cost of power consumed
by the machines used in manufacturing furniture (an allocated cost), I will check any recording made of the
number of units consumed by the machines or, according to the consumption capacity of the machinery, I will
check whether the cost allocated is reasonable.
1.5 marks
Fixed production overheads will include depreciation on machinery, heating and lighting charges etc. For these
expenses, I will check the records maintained by the company i.e. assets register, power consumption record if
any. To check that depreciation is not misstated I will check the rate applied for depreciation and its
reasonableness. I will also check the depreciation calculations on a sample basis. This will confirm the
completeness assertion.
1.5 marks
For both variable and fixed production overheads I will again need to make use of the time information I have
already examined and verified as the overhead content of each item will depend on the time taken to produce
the item.
1 mark
To check the cut-off I will check the date on the source documents such as goods received notes, purchase
invoices, dispatch notes, sales invoices, pay-sheets, bank statements, vouchers etc.
1 mark
(ii) Audit evidence for net realisable value
As we have seen earlier, IAS 2 inventories requires that inventories should be measured at the lower of cost
and net realisable value. In order to confirm that this principle is followed, the auditor will have to gather audit
evidence of the net realisable value of each line of inventory. In addition, when inventory is valued at the net
realisable value, because it is less than the cost of inventory, the auditor has to gather sufficient appropriate
audit evidence of the net realisable value to confirm that inventory is neither overstated nor understated.
1.5 marks
The net realisable value is management’s estimate of the price the product will fetch in the market. This is the
area where management can manipulate the figures. Therefore the auditor should examine the bases used for
determining net realisable value and its reasonableness in the given circumstances.
1 mark
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Generally, slow-moving items and obsolete items are valued at the net realisable value. In the case of furniture,
changes in fashion also result in lowering the value of the furniture. Post year-end sales are a good source of
evidence in the case of net realisable value. I will check whether any apparently obsolete item has been sold
after the year end. If yes, the selling price of that item will provide evidence of the net realisable value. If an
obsolete item has not been sold, the company’s past experience of selling furniture below value may be
considered.
1.5 marks
Current market conditions and sales made by competitors also provide evidence of the net realisable value of
slow moving and obsolete items.
0.5 marks
Management representations will be important and letters of representation usually contain a declaration by
management that no item of inventory is stated in excess of net realisable value.
1 mark
Maximum marks 9
52. Audit evidence – Company A
The question consists of several parts, each with separate mark allocations. Use these to determine the amount
of detail required in your answers. Remember most ACCA marking schemes in auditing award one mark per
valid point. Part (b) is very specific about the provisions needed and your answer must address that.
(a) A 10-year bank loan with a variable interest rate and an overdraft (a
bank account with a debit balance on the bank statement), both from
the same bank.
(i) Audit of liabilities
Your answer should cover the
audit procedures for both: a
10-year bank loan as well as
an overdraft.
A liability which is still due for payment after 12 months from the end of the
reporting period is a non-current liability. In the case of the audit of non-current liabilities, the auditor will have to
confirm following assertions:
¾
¾
¾
¾
¾
Completeness: all relevant liabilities are recorded.
Rights and obligations: all non-current liabilities relate to the entity.
Valuation and allocation: valuation is proper.
You don’t need to explain these
assertions in the exam. These are for
Existence: liabilities do exist.
your understanding. You can just list
Classification: information is recorded and classified
them to score good marks.
under appropriate headings.
¾ Understandability: the disclosures are understandable.
To confirm these liabilities I will perform the following audit procedures.
¾ Check the authorisation for the loan as well as the bank overdraft by reading the minutes of relevant
meetings. This will provide evidence of the right and obligation.
¾ Read the loan agreement carefully and identify different terms and conditions and then check whether the
terms of the contract are complied with. This is because non-compliance with any clause may result in an
increase in liability. E.g. there is likely to be a clause stating that interest should be paid each month. If any
default is made, penal interest will be charged. Also, if payments are not made when due, the loan might
become repayable immediately – converting a long-term liability into a current liability. In addition, reading
the loan agreement enables an auditor to understand the proper nature of the transaction. E.g. payment of
loan processing fees or inspection or other fees may be wrongly recorded as repayment of a loan although
it is not actual repayment. This procedure will allow the auditor to confirm the classification assertion.
¾ Obtain loan and overdraft statements to confirm the outstanding balances. This will provide evidence for
valuation.
¾ Re-calculate the interest to confirm the accuracy of the interest calculation.
¾ Request a confirmation letter from the bank to confirm various assertions such as completeness, accuracy,
obligation, existence etc.
¾ I will also enquire from the bank about any security that might be held relating to the loans. This can affect
disclosures that need to be made about other assets of the company, for example, that there is a fixed
charge on the company’s property.
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Solution Bank: 181
¾ Apply analytical procedures to the income in the income statement and to the instalments paid during the
period and compare them with the prior period.
¾ In the case of the 10-year loan, I will confirm that the amount payable within 12 months of the end of the
reporting period is classified as a current liability and the rest as a non-current liability. To do this, I will
check the repayment schedule or calculate the installments falling due during that period. This will confirm
the classification assertion. I will also verify the disclosure by going through the financial statements.
¾ For understandability, I will read the financial statements and confirm that proper disclosure of both liabilities
is made e.g. details of securities, interest rates etc. for both the 10-year loan and the overdraft.
1 mark per point
Maximum marks 5
(ii) Expense accruals
In the case of accruals, the following assertions should be tested:
¾
¾
¾
¾
¾
¾
¾
Completeness: all payables are recorded.
Rights and obligations: all payables relate to the entity. The entity has an obligation to pay money.
Valuation and allocation: valuation is proper; discounts available are recorded.
Existence: payables do exist.
Cut-off: payables are recorded in the correct period.
Classification: information is recorded and classified under appropriate headings.
Understandability: the disclosures are understandable.
In the case of accruals, checking the payments made after the year-end is a good source of audit evidence. I
will check these payments by checking the entries in the cash book / bank statements and by checking the
source documents i.e. cash receipts received on payment. This will confirm the assertions such as rights and
obligations, existence and valuation.
Even if payment is not actually made after the year end before the audit report is signed, the accruals can be
checked from the bills pending for payment e.g. telephone bills, electricity bills etc. This will provide evidence of
valuation, existence and completeness.
I will also scrutinise invoices received soon after year end as these might relate to the previous years expenses.
This will provide evidence of valuation, existence and completeness.
The nature of certain expenditure, such as monthly salaries, is such that they are paid in the following month
and therefore they are shown as accruals in the financial statements for every period. In such a case, analytical
procedures may also be a good source of evidence. I will compare the accrued expenses of the current year
with the prior periods to identify significant variances, if any. This will provide evidence for the completeness and
accuracy of the accruals.
When accruals are payable for more than one year, the amount recorded in the financial statements of the prior
period may be checked. This will also confirm the completeness and accuracy of accruals.
The letter of representation will also normally include a paragraph that the directors believe that all liabilities
have been included in the financial statements.
1 mark per point
Maximum marks 4
(iii) Trade payables and purchase accruals
Assertions made are the same as those for
expense accruals.
First of all, I will determine the effectiveness of the internal
control system over purchases. This will help me to decide the nature, timing and extent of audit procedures. If
the internal control system is effective, I will perform less extensive substantive procedures and if the internal
control system is ineffective I will perform more extensive substantive procedures.
While performing audit procedures on purchases, information / evidence gathered can be useful for the audit of
accruals e.g. a supplier’s statement obtained and checked to confirm the completeness of the payables can also
be used as evidence to confirm the completeness of the trade payables.
I will obtain a schedule of the payables and accruals from the entity and check the balances in the individual
accounts and verify that the total of the individual accounts equals the amount recorded in the financial
statements. This will provide evidence of completeness, valuation and accuracy. I will also check the accounts
showing a zero balance on a test basis.
I will also scrutinise the ledger by taking a sample. I will include a ledger with a zero balance because even if the
balance is zero, since there are transactions during the year, there is the possibility of misstatement i.e. a false
amount may be recorded in the financial statements.
A direct confirmation from the supplier of the balance payable will be a good source of information for the
assertions of completeness, existence, accuracy, cut-off, rights and obligation.
182: Audit Evidence
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If direct confirmation is not available or there is a dispute between the supplier and the entity, I will check the
correspondence between them, if any. I will also consult the management / legal advisor of the entity to gather
more information and explanation about the amount recorded in the financial statements.
I will check the discount rates and rebate received, if any, and performs recalculations to arrive at the
outstanding amount. I will also check the reasonableness of the discount rates and rebates. This will confirm the
accuracy of the amount outstanding.
I will also check for payments made after the year-end and check such payments in the bank statements. I will
also ask for the supplier’s statement for the first one or two months of the next period to confirm the payments
made after the year-end. This will confirm assertions such as existence, cut-off, rights and obligation.
The cut-off of the accruals can be checked by checking the date on some purchase invoices recorded in the last
few days of the current year and in the first few days of the next period to verify whether they fall in the year in
which they are recorded. I will also check inventory records to check the dates on which the goods are recorded
in the inward register so as to determine the cut-off.
I will perform analytical procedures on the trade payables and purchase accruals (for example, by calculating
the days of credit taken). This will help to identify any misstatement in the trade payables and purchase
accruals.
I will check the payments made in the current year for the last few invoices. If payment is made, it should not
appear in the payables and if it is outstanding it should be recorded as payable.
If reconciliation of the supplier’s statements is made, I will check the reconciliation statement by performing
recalculations and confirming the outstanding amount.
I will check the accuracy of cut-off in respect of purchases received just before and just after the year end.
1 mark per point
Maximum marks 6
(b) Audit evidence required for provisions.
Assertions used for audit of provisions
Provisions for manufacturing warranty claims are estimates made according to the judgement of management.
Since provisions are not supported by source documents, there is a high risk of manipulation. Therefore greater
care needs to be taken while auditing provisions.
I will first obtain an understanding of the process used by management for making estimates of provisions and
review it. To do this, I will check the reliability of the data used as a base for the estimate e.g. if past experience
is used as a base, I will check whether there has been any change in circumstances, technology etc. If there has
been a change, I will find out whether management has considered this change while using past experience i.e.
due to the use of advanced technology, defects in the goods has been reduced to 5%.
I will also gather information from external sources, e.g. competitors, about the reasonableness of the base
used.
Analytical procedures are a good source of information for the audit estimates. I will compare the provision of the
current year with the prior period and look into any significant variances. For example, if the provision made in
the last 2 years is 10% of the goods sold and in the current year only 5% of sales are provided for, I will ask for
the reason for this difference and check the reasonableness of such a change in estimate.
I will also compare the estimates made in the prior period and the actual outflow on account of the provision. If,
during the previous year, a provision for 10% of the sales is made but actually 15% of the sales were defective,
in the current year, assuming no change in the circumstances and technology, a provision of 10% will not be
sufficient.
I will review warranty payments on a month-by month basis in case there is either an increasing or decreasing
trend in the amount of the claims.
The legal department should be requested to give details of disputes with customers, if any, in relation to claims
and also perform a review of correspondence with customers.
1 mark per point
Maximum marks 5
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Solution Bank: 183
53. Small entities – ISA
While answering the question, you are required to focus on the characteristics and its effects on the audit of
small entities. You need to read the question carefully. The question asks you to describe the effect of the five
characteristics on the client–auditor relationship. One can safely assume that there would be 4 marks per
characteristic.
Meaning of a small entity: A small entity is an entity in which:
This paragraph gives the meaning
¾ there is concentration of ownership and management in
of a small entity, which need not
a small number of individuals (often a single individual);
be reproduced in your answer in
and
the examination. This is given for
¾ one or more of the following are also found:
your understanding and easy
9 few sources of income
reference only.
9 unsophisticated record-keeping; and
9 limited internal controls together with the potential for management override of controls
Small entities will ordinarily display characteristic a) and one or more of the characteristics included under b).
IFAC Glossary of Terms
(a) Common ownership and management
(i) In smaller entities, ownership and management is concentrated in a few individuals or even a single
individual.
(ii) When ownership and management is concentrated there is a possibility that detailed procedures of internal
control are not needed as the owner will look after the company carefully on a day-to-day basis. On the
contrary, it is also possible that, as the owner and the manager are one and the same, the internal controls
are very efficient and strictly adhered to.
(iii) The auditor undertakes audit risk assessment on the basis of knowledge of the client’s business, industry,
management and control environment. Moreover, risk assessment in smaller entities depends on the
knowledge of the owner-manager’s integrity and competencies.
(iv) To conduct an effective audit, it is essential that the owner-manager co-operates with the auditor. However,
in smaller entities there is the possibility that the owner-manager will not understand the importance of audit
and hence will not co-operate with the auditor. In addition, the owner-manager engages an auditor to obtain
a package of professional services such as taxation, accounting, legal compliances etc. Due to this, the
independence of the auditor may be hampered.
1 mark fpr each valid point
Maximum marks 4
These characteristics have an effect on the control framework that is different to the control framework for larger
entities
This paragraph gives the meaning and importance of internal
The way in which internal control is
control. You don’t need to reproduce this paragraph in your
designed and implemented varies with an
answer in the examination. It is given for your understanding
entity’s size and complexity. The larger the
and easy reference only.
size and the greater the complexity of the
entity, the more elaborate and formal the internal control systems which will be in place. The role of governance
may be undertaken directly by the owner-manager where there are no other owners. The active involvement of
the owner-manager may mitigate certain risks that arise from a lack of segregation of duties. When the role of
governance is undertaken directly by the owner-manager, it may increase the risk of override of controls.
Smaller entities do not have formal internal controls and there is an absence of segregation of duties among the
staff members.
However, when ownership and management are common, the internal controls may be more efficient. In this
case, auditors have to assess the internal control environment even though a formal internal control system
does not exist.
In smaller entities, the day-to-day records of every transaction may not be maintained in formal documentation
but this does not imply that the control doesn’t exist at all. Hence, control in the other form may exist and so it is
the duty of the auditor to test those transactions.
An internal control is an efficient tool which an auditor can use to check the operations of the company. If a
formal internal control does not exist, an auditor may apply substantive procedures.
1 mark for each valid point
Maximum marks 4
184: Audit Evidence
(b) According to the Glossary of terms published by the International
Auditing and Assurance Standards Board,”Substantive
procedures are the audit procedures performed to detect
material misstatements at the assertion level”. They include:
¾ tests of details of classes of transactions, account balances and
disclosures
¾ substantive analytical procedures.
The use of standardised computer packages
© GTG
This paragraph gives the
meaning of substantive
procedures and need not be
reproduced in the answer in the
examination. This is given for
your understanding and easy
reference only.
(i) Smaller entities will make use of computer packages which are easily adaptable to their particular needs.
These smaller entities use these packages as they are cost effective and easy to follow.
(ii) Some of these computer packages do not provide an adequate audit trail which, in turn, creates a problem
for an auditor in checking the relevant transactions.
(iii) A specific purpose ready-made package may be helpful to the auditor because of its reliability and
user-friendly features.
(iv) Use of standardised computer packages helps in the auditor’s risk assessment. There are fewer possibilities
of human error and it is usually impossible for client staff to alter the functioning of the package. However, if
these packages are not used appropriately there is the risk of committing major errors.
(v) When these standardised packages are implemented for the first time, minor problems may arise which
may affect the auditor’s risk assessment.
1 mark for each valid point
Maximum marks 4
(c) Reliance on the auditor for accounting expertise
(i) Whether smaller entities use standardised computer packages or still maintain manual system of
accounting, they need to rely more on the work of the auditor for the preparation of financial statements.
(ii) The auditor is not permitted (by ACCA Rules of Professional Conduct) to prepare the accounting records
which are usually prepared by the management. This is because an auditor reports on the work of
management and not on his own work as then there would be a self-review threat.
(iii) Clients would like auditors to prepare financial records for them and also help them to solve any accounting
problems. In this case, it is the responsibility of the auditor to explain the scope of the auditor’s
responsibilities to management, through appropriate engagement letters.
(iv) It is essential that an auditor works with independence and objectivity when a package of professional
services is expected from the auditor.
(v) Nevertheless, there is a possibility that the audit firm might be engaged in the preparation of the financial
statements in one way or another. In this case, different members of the audit firm should review the work
carried out.
1 mark for each valid point
Maximum marks 4
A lack of sufficient appropriate audit evidence to support financial statement assertions relating to income from
cash transactions.
Many small organisations are less formal than larger ones and less documentation tends to be maintained. In
such a situation, the auditor has to perform more substantive audit procedures and less control testing as fewer
controls exist. For a matter that is material to the financial statements, if sufficient appropriate audit evidence is
not available, the auditor may obtain management representation and evaluate its reliability. Evidence
supporting the assertion of completeness is usually in the form of a system of internal controls that ensures that
all the transactions are recorded. The owner-manager of a smaller entity is in a dominant position and may
ensure that some transactions are not recorded. Similarly, the entity may not have internal control procedures
that provide documentary evidence that all transactions are recorded. Therefore it is difficult to obtain evidence
in support of completeness.
(i) While conducting the audit, if the auditor does not obtain sufficient appropriate audit evidence on any
material item, then he must provide a qualified report. An audit report is qualified on the basis of the
limitation in the scope of audit.
(ii) When there is inappropriate evidence, the overall view given in the financial statements is affected. In this
case, the auditor has to limit his opinion i.e. the auditor cannot give an opinion regarding the truth and
fairness of the information presented in the financial statements.
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Solution Bank: 185
(iii) If the auditor gives a qualified report or disclaims his opinion, it becomes difficult for the client to present
such an audit report to the financial institutions that provide finance to the company. Moreover, when such
an audit report is presented with the financial statements to the tax authorities, it may lead to tax
investigation. To avoid all these types of problems, the client may request the auditor to provide an audit
report which is free from qualifications.
(iv) The client will always prefer an auditor who can give an unqualified report even if there is insufficient audit
evidence. In this case, the auditor should consider whether he should accept the audit of the client who
does not provide sufficient audit evidence.
(v) In smaller entities, when ownership and management is concentrated, the owner-manager should provide
the auditor, either verbally or by written management representations, with the information that all the cash
transactions are completed, In this case, written evidence is also necessary; management representations
are no substitute for evidence.
1 mark for each valid point
Maximum marks 4
54. Not-for-profit organisation – Ajio
This is a straightforward question testing your knowledge on the increasingly important not for profit sector. The
examiner is looking to make sure you understand how these entities differ from profit making entities. Look at
the requirement again and ensure you have answered it in the following manner:
2
1
(a) Describe the risks associated with the audit of Ajio under the headings inherent risk, control risk and
detection risk and explain the implications of these risks for overall audit risk.
4
3
This means that in order to obtain the highest marks, you need to ensure that you answer all these parts. Also
remember there will be specific marks allotted to each of these parts, so there is no point in writing 10 marks
worth of inherent risks as there are probably only 3 marks going for this part. So you need to ensure you
answer each part of the question. Also make sure you explain WHY a particular point constitutes a risk. It may
seem like a waste of time having to do this, but remember for every complete point you explain, you will get 1
mark. And 1 mark usually means 1.8 minutes of writing! So get writing!
(b) List and explain the audit tests to be performed on income and expenditure from fund raising events.
In this part of the question you must give the audit test you would carry out and explain what you are testing for
– always go back to the financial statement assertions of completeness, rights and obligations, existence etc.
Remember to explain the test such that an audit junior could pick up your answer sheet and conduct the test
without having to ask you for any further instructions
(a) Risks associated with Ajio
(i) Inherent risk
Inherent risks are the risks that organisations face because of the business they are in and the nature of their
industry. Inherent risk is the risk of an amount being materially misstated due to error without considering
internal controls. The term inherent is used here because these types of risks will always be present for the
organisation and are an inevitable part of its business environment.
Being a small charity, the audit of Ajio involves a high inherent risk. This is because:
¾ It is managed by non-professionals i.e. a part-time book keeper. This means that there is a greater chance
of errors or frauds going unnoticed as the people involved do not have the requisite experience to spot
mistakes. This could potentially mean that any figures in the financial statements are misstated.
¾ Funds are raised from the public by conducting various, scattered fund raising events or through donations.
Whenever large amounts of cash are collected on an ad hoc basis, there is an inherent risk that some of the
cash could be misappropriated before it arrives at the charity. For example if a collector is collecting cash
donations from people on the street and collects $35, he could potentially only give $25 to the charity and
keep $10 for himself. This leads to incompleteness of cash and donations.
¾ The accounts have been prepared by a volunteer who, although qualified, may have a reduced sense of
responsibility. This overall will mean that misstatements may appear in the financial statements and controls
may not operate effectively as no one is checking them on a regular basis.
1 mark for each point discussed
186: Audit Evidence
© GTG
(ii) Control risk
Control risk is the risk that an organisation’s internal control systems do not adequately protect the organisation,
by preventing or detecting errors, either because they have not been adequately designed and/or implemented.
Being a small charity, the control risk is high since:
¾ It cannot afford to employ many people and as a result segregation of duties will be poor. For example, the
book-keeper is likely to receive cash, send out receipts for the cash received, bank the cash and pay
expenses. There is great opportunity for fraud as the book-keeper may not record all the cash received and
keep some for himself. Also there is more room for errors as no one is checking the work of the bookkeeper. Incorrect postings could be made which could lead to misstatements in the financial statements.
¾ Generally, in small entities, there is less formal documentation. For example, trustees may be checking
cash in hand and cross-checking it with the cash book but may not care to put date and initial on the cash
book. This is lack of formal documentation. It is less satisfactory for the auditor to rely on the verbal
representations given by trustees that the cash is checked by the trustees at regular intervals than to see
written evidence of the checks. The auditor has to perform substantive procedures to ensure the
completeness of the cash.
¾ It is difficult to have controls on the funds raised by the volunteers and therefore the risk of misappropriation
is increased. This is because volunteers may collect the cash from donors without giving them a cash
receipt and misappropriate it. In this case, it is difficult to ensure that all the money collected is recorded.
¾ Being the first year of the audit, the opening balances are not certified. Hence risk is more that they may not
be correct. Generally, auditors rely on the report of the previous auditor for opening balances. However, this
being the first year of audit, the opening balances are not audited and may be misstated.
1 mark for each point discussed
(iii) Detection risk
Detection risk covers the risk that an auditor’s checking and sampling procedures will not uncover any existing
irregularities or misrepresentations.
¾ Detection risk involves sampling and non-sampling risks. Generally, sampling risk can be made lower by
carrying out more extensive substantive testing.
¾ Non-sampling risk is the risk that the auditor may express an incorrect opinion. This risk will be higher since
this is the first year of the audit and our firm is not familiar with Ajio and its environment.
1 mark for each point discussed
(iv) Overall audit risk
Inherent risk, control risk and detection risk are the components of audit risk and their relationship can be
expressed as:
Audit risk = Inherent risk x Control risk x Detection Risk
In the case of Ajio, considering all the risks enumerated above, it can be concluded that because both inherent
risk and control risk are high, to achieve a low audit risk, the auditors will have to ensure they achieve low
detection risk. Therefore our firm may plan to perform extensive substantive procedures.
1 mark
Since Ajio is a small not-for-profit entity, there are likely to be relatively few transactions involved and therefore
the detection risk can be reduced by opting to check almost all of the transactions.
1 mark
Maximum marks 10
(b) Audit tests
Since funds are raised by volunteers, there is a risk that some of the cash may be misappropriated. First of all,
we will obtain an understanding of, and assess the effectiveness of, the internal controls, if any, on the fund
raising events. However, we should assume that they will be limited because of the non-profit status, so we are
more likely to go for a substantive approach.
1 mark
(i) Income
¾ Inquiry and observation
We will enquire from the person concerned to find out about the procedure employed in collecting, counting,
banking and recording cash from fund raising events and if possible observe this procedure. This will enable us
to understand the procedure and internal controls involved in it, if any.
1 mark
© GTG
Solution Bank: 187
Observation of the procedure will also provide us with audit evidence about the implementation of the procedure
and thereby of the internal controls. If there are good controls, then we will limit the amount of substantive
testing we will need to do.
1 mark
For example, if the rule is that donation boxes are always to be opened and accounted for in the presence of
two volunteers, observation will help us to see if that control is implemented.
1 mark
We will ensure that donations boxes are numerically controlled when issued and then subsequently collected
and opened.
1 mark
¾ Inspection
For a sample of events during the year, we will cross-check the cash receipts with the total money collected and
recorded. If tickets have been issued, we will check whether all monies were received for all the tickets sold
(the tickets should have been sequentially numbered so it should be relatively straight forward to count the
number of tickets issued and match this to the amount of cash collected).
1 mark
We will also check the counterfoils for cash deposited in the bank and ensure the amounts on the counterfoil
match the amounts shown on the bank statements. Finally, we will check whether up-to-date bank reconciliation
has been prepared. These procedures will assure the completeness of the receipts.
1 mark
¾ Calculation
At the end of the event day i.e. when fund raising events are organised, we will count cash collected
(after opening cash box) and cross-check the cash counted with the deposit slip to check whether all the money
collected has been deposited in the bank or not. This procedure will ensure that all the income i.e. the cash
collected has been recorded and no cash has been misappropriated.
1 mark
We will carry out analytical procedures by comparing income to budget and to similar events in previous years.
1 mark
(ii) Expenditure
To check the expenditure from the fund raising events, the following procedure will be performed:
We will check all the vouchers / bills for the expenditures whether they have been authorised by the responsible
person by putting his signature and date on the bill / invoice. We will check corresponding receipts and the bank
statement / cash book for payment of the bills / invoices.
To confirm occurrence we will check the name of the entity on the bills. In order to record bills in the name of
Ajio, the bills should be raised on the name of Ajio.
To check cut-off we will check date on the invoices and bills and the match the date on which they are recorded.
We will check amount in the bills and cross-verify the amount recorded in the books. This will provide us
assurance about the completeness and accuracy of the amount of expenditure recorded.
Apart from this, we will check whether a budget has been prepared for the events. If yes, we will perform
analytical procedures to discover any deviation from the budget.
We will also check the authorisation of the expenditure more than the budgeted for.
Since in small not-for-profit organisations, less formal documentation is maintained, representation from
management is important. In addition, we will ask for a representation from the trustees that there are not any
unrecorded liabilities, contingent liabilities from the fund raising event.
1 mark for each valid point
Maximum marks 10
55. Statistical techniques in auditing
This is a straightforward question, and should be answered in brief. While answering, you need to remember
that each part of the answer should be completed in 3.5 minutes approximately.
The parts are independent, so if you are not sure what ‘tolerable error’ is, move on to the next part.
188: Audit Evidence
© GTG
(i) Judgment sampling and statistical sampling
Judgement sampling uses the auditor’s judgement to select items for testing, deciding how many items to test,
and to interpret the results.
Statistical sampling (according to ISA 530), means any approach to sampling that has the following
characteristics:
¾ random selection of a sample from the population; and
¾ use of probability theory to evaluate sample results, including measurement of sampling risk.
A sampling approach that does not have the characteristics of (a) and (b), above, is considered to be
non-statistical sampling.
There is always an element of judgement in statistical sampling. For example, judgement is used to decide on
the level of risk which the auditor is willing to accept, but the process of selecting items for testing can still be
statistically based.
2 marks
(ii) A representative sample
A representative sample refers to the sampling plan that can be expected to adequately reflect the properties of
the population. For example, if 4% of time sheets sampled as part of the audit of wages had not been properly
authorised, this sample would be representative if 4% of all the time sheets had not been authorised.
2 marks
(iii) Tolerable error
According to ISA 530, tolerable error is the maximum error in a population that the auditor is willing to accept.
Tolerable error is considered during the planning stage and, for substantive procedures, is related to the
auditor’s judgement about materiality. The smaller the tolerable error, the greater the sample size will need to
be.
2 marks
(iv) The two different methods of selecting a representative sample
A sample should be selected keeping in mind the objectives of the audit procedure and the characteristics of the
population. Statistical sampling requires that each sampling unit should have an equal chance of selection. In
non-statistical sampling, an auditor uses professional judgement to select items.
A statistical sample is selected in one of the following ways:
¾ Systematic sampling
A random number is generated to determine which item in the population is the first in the sample. Using a
sampling interval, usually based on a tolerable error, subsequent items are determined on a regular basis. For
example, every 50th item would then be chosen
¾ Random sampling
Items in the population must be sequentially pre-numbered and random number tables are used to select the
items to make a sample.
¾ Haphazard sampling
The auditor chooses items as randomly as possible.
(but there is always the danger that the auditor
introduces bias into the sample obtained)
You need to write only two methods of sample
selection in your exam. Three methods are
given here for better understanding.
2 marks
(v) The extrapolation of errors
Extrapolation is the process of constructing new data points outside a discrete set of known data points.
Accordingly, extrapolation of errors refers to the fact that, if the auditor encounters a few material errors in the
process of sample testing, he may apply the extrapolation technique in order to assess the presence of similar
errors in the data beyond the sample selected ie to assess the error in the population.
2 marks
Maximum marks 10
© GTG
Solution Bank: 189
56. CAAT – Royal Selection
This question tests your knowledge about CAATs and their practical application. Read the given case carefully
and try to identify where it could go wrong. This will give you an idea about what to check and why.
(a) Use of test data
Test data is data generated by the auditor in order to test processing logic, calculations and controls
actually programmed in computer applications. Therefore test data is used for checking the effectiveness of the
controls in the computer environment. This will help in deciding the nature, timing and extent of audit
procedures.
Audit tests
With the permission of the client, I will try to:
(i) Process an order manually (instead of over the internet) and check whether or not the processing software
accepts the order and processes it. If it doesn’t, this provides me with evidence that the processing software
only processes orders received over the internet. This facilitates the matching of sales orders and sales
invoices.
(ii) Modify the entries made without using the special code. I should not be able to modify them. I will also try to
modify the entries already made using the special code. These should be recorded in the exception report.
These procedures will assure me of the effectiveness of the control over the processing software.
(iii) Process orders for negative numbers and also for 5 to 10 items. For negative numbers, the order should not
be accepted by the software by assuming the number to be positive and for large numbers the software
should generate an exception report. This will provide assurance of the effectiveness of the software.
(iv) Enter no credit card details or enter the wrong details. The system should not accept and process the order
since the money is not received. This will provide me with evidence that the orders get processed only when
payment for them is received.
(v) Enter an item code in the computer for manual processing and try to change the rate that has appeared
automatically along with the item code. If I cannot change the rate, this provides me with evidence of the
completeness and accuracy of the sales since only the appropriate rates can be applied to the items.
(vi) Enter an incorrect code number for the item. The system should not accept any number close to the correct
code number; it should simply show that the item code is wrong. This will ensure that only the correct item is
delivered.
(vii) Process an order for an item which is out of stock. The software should not accept this order since the item
is not available in stock.
1 mark for each valid point
Maximum marks 7
(b) Why to use CAAT
Here, you need to discuss about the special features of CAATs
CAATs are used:
and problems in auditing Royal Selection manually. This will give
you an idea why CAATs are useful in audit of Royal Selection.
(i) In large entities, the volume of
transactions is large and it is therefore difficult or even impossible to perform manual audit procedures. In
this case, CAATs can be used.
(ii) CAATs enable audit work to be carried out quickly and therefore saves time and money.
(iii) CAATs can be used to identify any unusual transactions.
(iv) When the transactions are complex, CAATs can be used.
(v) Last but not the least, if there is no audit trail or documentary evidence available, CAATs can be used.
0.5 marks for each point
In the case of Royal selection, processing software is used to perform many important functions. However, an
audit trail for this processing is not available. Therefore, CAATs are the best method of testing the effectiveness
and efficiency of the controls over the audit software. In computerised environments, the use of CAATs as
opposed to manual procedures is advisable.
1 mark
Maximum marks 3
190: Audit Evidence
© GTG
57. Audit software – Delphic Co
This is a scenario based question relating to Delphic Co, a wholesaler of furniture. The auditor has
decided to use audit software to assist with the audit of the receivables balance for the first time.
For part (a) you are required to:
¾ explain audit procedures using audit software that could be used on receivables balances; and
¾ explain the reason for each procedure.
The requirement verb is ‘explain’. Therefore you need to state the audit procedures clearly and also explain why
the procedures are being used. As the auditor has decided to use audit software you are expected to select
procedures that could be carried out using the software. You need to identify audit procedures such as a
receivables circularisation, show how audit software could be used to select specific balances for circularisation
and potentially produce letters to be sent to those receivables, and then explain the reason for that procedure in
terms of audit assertions. However, to score maximum marks, don’t forget to link the procedure to audit
assertions.
For part (b) you are required to explain the problems of using audit software at a specific client and also explain
how to overcome each problem. The requirement verb for this section is again ‘explain’. The problems have to
be identified from the scenario. However, the solutions have to be relevant to each problem, and have to be
realistic too.
For part (c) you are required to explain the concept of auditing “around the computer”. You can obtain 3 easy
marks by explaining the term in the question and then giving examples of the risks of auditing around the
computer.
(a) Audit procedures using audit software
Procedure
Cast the receivables ledger and ensure that it
agrees with the total on the receivables control
account.
Reason for procedure
To ensure that the items in the receivables
ledger and control accounts are complete
and accurate.
The sanctioned credit limit of each accounts
receivable has to be compared with the balance
in the receivable account to ensure that the
customers were not given credit limits in excess
of the sanctioned credit limits.
To confirm that the control systems were
not violated.
Balances in each receivables ledger, (which
arise from sales during the current year) have to
be compared with the total sales for the year with
that customer. Confirm that none of the accounts
receivable balances exceed the total sales during
the year.
To confirm that there are no unreasonable
items in the ledger.
Calculate receivables days for each month and
confirm that the accounts receivables balances
are monitored.
To obtaining relevant statistical information.
Marks
2
2
2
2
From the list of receivables balances identify all
material items and use them as samples for
testing.
Items are selected for audit testing.
2
Make aged receivables analysis and identify the
irrecoverable / doubtful receivables.
To get assurance relating to valuation of the
receivables.
2
Maximum marks 9
© GTG
Solution Bank: 191
Common errors and reasons why those errors will not obtain marks include:
(i) Explaining procedures such as entering test data into the receivables system in order to check whether
appropriate credit limits have been set in the system.
This is not relevant as the question refers to the use of audit software, not test data.
(ii) Explaining that audit software could check the accuracy of the casting of sales invoices.
This is not relevant as it relates to the audit of sales rather than receivables.
(iii) Explaining how the computer systems at the client should have passwords to control access.
This is not relevant as the question refers to the use of audit software, not testing the program
controls over the client’s systems.
(b) Potential problems of using audit software
Cost and lack of software documentation
Although the auditor has decided to use the audit software, he needs to assess the cost benefit analysis of
using it. This is especially important because Delphic’s computer system has not been tested by the previous
auditors. Furthermore, there is no documentation to support the reliability of the systems. In such circumstances
substantial set up costs will have to be incurred before the audit software can be used.
Therefore this problem can be overcome only if the auditor is ok with the huge set up cost and carries out a
systems audit of the computer system. For this, he may also require to take support of ‘experts’ who are familiar
with auditing computer systems. Only if the results of the system audit are satisfactory, the auditors will be able
to use the audit software for auditing the receivables.
Need for costly amendments to audit software
The client’s computer system will undergo a change next year, which could result in some modifications in the
audit software used by the auditors. Furthermore, this might also require expensive amendments to the audit
software.
In view of the short term benefits which can be received from the use of the audit software, it may be advisable
to use the audit software from the next year.
Outputs required
The auditor should not forget that his aim in testing the audit software is to have a clear idea about the audit
assertions he wants to test along with the outputs that are expected from it. Hence, using the audit software to
gain knowledge of the client’s software system without taking into account the expected output would
unnecessarily increase the workload and add to the client’s costs. Furthermore, if errors exist in the design of
the audit software, then results of the use of the software for testing will amount to spending time and money
investigating this irregularity rather than detecting the genuine irregularities in the data tested.
This problem can be overcome by ensuring that the design of the auditing software used by the auditor has
sufficient controls which have been tested by the auditor.
Use of copy files
The auditors have been provided with the copy files only. This means that there can be a possibility of using
wrong files for carrying out audit tests, so the probability of misstatements in the receivables accounts will exist.
If the auditor wants assurance that the files used for testing are the same files used in Delphic, he will need to
either supervise while they are being copied, or use the live files.
Increased burden due to proposed change in the systems in the next year
Although the auditor is planning to test Delphic’s computer software system, it won’t generate much benefit as
the client plans to change the system during the next year. The use of audit software involves huge costs, the
benefit from which may not be recovered to its full extent.
The disproportionate cost versus benefit may not encourage the auditor to use the software for auditing the
receivables during the current year. Hence it may be advisable to defer the use of the audit software till next
year.
192: Audit Evidence
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Non compatibility of the computer system with the audit software
The audit software is not compatible with the client’s computer system. If the software is used without making it
compatible, it will lead to errors in the results of the audit testing which will make it appear that the accounts
receivables have misstatements.
This problem can be overcome only if the system is made compatible with the software.
IT knowledge, expertise and experience
Auditing with the audit software requires:
(i) Auditors who have knowledge and experience in the use of the software. If Delphic is not geared up with
auditors having sufficient knowledge and skill, the accounts receivables can have material misstatements.
In order to overcome this problem, Delphic’s audit team should have sufficient number of members who
have IT knowledge, to plan and execute the audit using the audit software. Furthermore, they may require
co-operation from the client for the audit.
(ii) Auditors working on the IT systems, to have full knowledge of the client’s computer system. The scenario
indicates that the clients’ computer staff could not assure the completeness of the system documentation,
which could be on account of lack of knowledge. It also raises doubt on the quality of work carried out by the
staff. Therefore there can be misstatements in the accounts receivables balances.
In order to overcome this problem, the auditors would probably have to carry out extensive substantive testing.
2 marks for each point
Maximum marks 8
(c) Auditing around the computer
Do not confuse with CAATs!
'Auditing around the computer' means inspecting and verifying documents which are used to record the data in
the computer and the data which is generated from the software. Here, computer processing is not verified; only
the results of that processing are verified.
Sometimes the application software is neither documented nor audited by a systems auditor. At such
times the auditor audits the system by comparing the inputs to the software with the expected outputs
from the computer. This is known as auditing around the computer.
1 mark
This method of auditing around the computer increases audit risk because:
¾ the actual computer programs are not tested; hence the auditor has no direct evidence that the
programs are working as required.
¾ if the errors are found while reconciliation of inputs to outputs then it may be difficult or even
impossible to determine why those errors occurred. This is because the errors could be due to errors in
the computer systems or in the data file itself. However, lack of information of system documentation
may make it impossible to make constructive amendments to clients' systems and moreover, there is
an increased likelihood of audit qualifications.
2 marks
Maximum marks 3
Common errors and reasons why those errors will not obtain marks are:
(i) Explaining the audit risk model.
The question requirement was to explain why audit risk increased, not to explain the risk model itself. These
comments are therefore not relevant to the question being asked.
(ii) Explaining how CAATs could be used to audit computer systems
This focuses on explaining how a computer system is audited, but not the lack of auditing of that system. The
points made are therefore not relevant to the question.
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Solution Bank: 193
58. Substantive audit procedures and audit evidence – Metcalf Co
Part (a) requires you to list and explain the factors which affect an auditor’s decision regarding the sufficiency of
audit evidence. To score maximum marks your answer must include at least four points.
Part (b) of the question is quite straightforward. It relates to the substantive audit procedures on three specific
credit balances. The verbs in the requirement are ‘list’ and ‘explain’, i.e. one mark per point. Do not get confused
between the terms ‘creditors / payables’ and ‘purchases’.
(a) Factors affecting sufficiency
¾ Assessment of inherent risk: more audit evidence is required to reduce the detection risk caused by an
increase in inherent risk. For example in a departmental store the inherent risk would relate to cash
balances. Therefore the auditor needs to carry out more substantive procedures on cash balances so that
the risk of material misstatement in cash balances is reduced.
¾ Materiality of the item: more audit evidence will be required to ensure that no material error has occurred
due to decrease in materiality.
¾ Nature of the accounting and control systems: more audit evidence is needed when the accounting and
control systems have poor controls as less reliance can be placed on these systems. For example if the
tests of control indicate that the purchase systems are poorly designed, then the auditor would carry out
more extensive substantive testing in the area of purchases.
¾ Control risk: when the internal controls are poor there is an increase in control risk as less reliance can be
placed on these systems. Therefore it is necessary to determine the extent to which the system of internal
control has been implemented by directors.
¾ Experience from previous audits: The auditor can rely on the clients’ systems if they have a favourable
experience from the previous audits. This will decrease the amount of evidence required.
¾ Result of audit procedures: If the results of different audit procedures are in conflict then more audit
evidence would be required. On the other hand, where the result of different audit procedures agree with
each other then less evidence is required overall.
¾ Quality of information available: As some sources of audit evidence are more reliable than others less
evidence is needed when relying on those sources; for example, documentary evidence and external
evidence are more reliable than oral evidence and internal evidence.
1 mark for each point
Maximum marks 4
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Listing the types of evidence obtained, such as computation and observation.
These are not valid as they are not relevant to this question.
(ii) Stating that one type of evidence is better than another (e.g. written compared to oral).
(b) While auditing the current liabilities of Metcalf, the following audit procedures should be followed.
1. Trade Payables:
(i) Audit procedure: while auditing trade liabilities, the arithmetical accuracy of the total of all the trade
payables should be checked with the total payables and their corresponding contra account in the general
ledger.
Reason for the procedure: this audit procedure is carried out to check the audit assertion of completeness and
accuracy of the current liabilities stated in the general ledger. One of the objectives of carrying out this
procedure is to determine the need to investigate any unusual or reconciling items.
(ii) Audit procedure: on a sample basis match some of the items on the individual accounts payables list with
the individual ledger accounts balance. Confirm that the balances match. Reverse this procedure to check
individual ledger account balances to individual accounts payable list also.
Reason for the audit procedure: this procedure is carried out to confirm the existence and accuracy of the
trade payables ledgers by comparing them with the list of individual account payables.
194: Audit Evidence
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(iii) Audit procedure: compare the current year’s trade payables to the prior year’s balances. This should be
done for the individual accounts payables as well as for the total accounts payables.
Reason for the audit procedure: this procedure is carried out to ascertain the range of differences in the
balances of different years. Reasons for any unusual differences should be investigated. This investigation
might bring up points, such as cash flow problems, because of which there is an unusually high balance of
accounts payable. Another reason for the differences could be the incompleteness of the list i.e. some accounts
payables might have got omitted from the list of accounts payable.
(iv) Audit procedure: individual ledger accounts should be checked on a random basis. Emphasis should be
given on material balances, zero balances and other items on the ledger accounts. These accounts must be
verified with the source document viz. purchase invoice, goods received note, purchase order, etc. The
values recorded must be verified with the source documents mentioned.
Reason for the audit procedure: this procedure is carried out to ensure the existence and accuracy of material
balances. Large accounts payables are tested for existence and value. Testing of zero balances is done to
ensure the completeness of recording of the invoices i.e. by checking that no invoice from any supplier is
omitted.
(v) Audit procedure: purchase invoices received after the year end should be checked with respect to the
goods received note. The auditor should ensure that purchase invoices are recorded in the books if the
goods have genuinely been received before the year end.
Reason for the audit procedure: this procedure is carried out to ensure the correctness of cut off procedures
i.e. assertion of cut-off, completeness and valuation in the statement of comprehensive income and statement of
financial position. The value of goods which are received before the year end is checked for ensuring the
completeness of purchase accruals.
(vi) Audit procedure: obtaining a supplier’s statement from each supplier (preferably directly from the vendors)
and comparing the balance in the supplier’s statement to the individual ledger account balances. When
required, the reasons for the differences should be investigated.
Reason for the audit procedure: this audit procedure is carried out to obtain independent third party evidence,
relating to the individual accounts payables’ accuracy, completeness, valuation and existence.
(vii)Audit procedure: a sample of the year end invoices from the purchase day book should be checked with
the goods received note, to ensure that the goods are received prior to the year end.
Reason for the audit procedure: this procedure is carried out to ensure the correctness of the cut off
procedures i.e. assertion of completeness and valuation in the statement of comprehensive income and
statement of financial position.
(viii) Audit procedure: a random sample of goods received notes, just prior to the year end, should be traced to
either the purchase invoices (recorded in the purchase day book) or the ‘goods received but not invoiced’
note to the financial statements.
Reason for the audit procedure: this procedure is carried out to ensure the completeness and accuracy of
payables on the SOFP.
(ix) Audit procedure: a random sample of goods received note raised after the year end, should be traced to
the purchase invoices and to the purchase day book. This is done to ensure that the corresponding
purchase invoice is recorded in the next year.
Reason for the audit procedure: this process is carried out to ensure the valuation of purchases. The purpose
of this procedure is to ensure that purchases are not overstated.
(x) Audit procedure: all the debit balances in the accounts payable register should be analysed and
investigated. Proper explanations should be obtained from the client for the existence of such balances.
Reason for the audit procedure: this process is carried out to understand the reason for the balance and also
consider reclassifying the amount under different account heads e.g. accounts receivables. Furthermore,
existence of debit balances suggests control weaknesses. The existence of such balances means further audit
testing is required. This audit procedure will provide an assurance of classification of the accounts payable in
the financial statements.
1 mark for each point
Maximum marks 9
© GTG
Solution Bank: 195
2. Audit of accruals
(i) Audit procedure: cast the list of accruals and trace the individual amounts in the list to the general ledger
accounts.
Reason for the audit procedure: this procedure will ensure that the accruals list is complete and the balances
are accurately stated in the general ledger. Furthermore, this provides assurance that there is no need for
additional investigation or reconciliation of any item in the list.
(ii) Audit procedure: obtain last year’s list of accruals and compare the individual items on the list with the
current year’s amount.
Reason for the audit procedure: this audit procedure is carried out to ensure the completeness and accuracy
of the accruals. Unusual differences between the two amounts, and omissions of any item in the current year’s
list should be investigated.
(iii) Audit procedure: trace the payment of accruals paid immediately after the year end to the accruals list. An
example of such accruals is the payment of national insurance contributions, collected from the staff, paid in
the following year.
Reason for the audit procedure: this is carried out to ensure the audit assertion of accuracy and existence of
accruals.
(iv) Audit procedure: review the following year’s payments, for ascertaining the existence of any item of
payment, for which accrual adjustment is necessary at the year end.
Reason for the audit procedure: this procedure is carried out to ensure the completeness assertion of the
accrual list.
(v) Audit procedure: trace the items on the list of accruals to the source document. For example tax
deducted at source, which appears in the list of accruals is traced to the payroll slips.
Reason for the audit procedure: this procedure is carried out to ensure the valuation and completeness
assertions. This is done to check the understatement or overstatement of accruals.
1 mark for each point
Maximum marks 3
3. Audit of provision for legal action:
(i) Audit procedure: discuss the adequacy and materiality of the provision made for legal action with the
directors.
Reason for the audit procedure: this procedure is carried out to ensure the existence of liability for legal action
and the possibility of it’s out of court settlement. The expected value of such liability is ascertained during this
discussion.
(ii) Audit procedure: a letter from Metcalf’s lawyers relating to this liability should be obtained.
Reason for the audit procedure: this is carried out to ensure the existence and valuation of liability. A letter
from the lawyer is third party evidence.
(iii) Audit procedure: review all correspondence that took place between the customer and Metcalf. From the
correspondence verify whether the customer is in favour of an out of court settlement.
Reason for the audit procedure: this procedure is carried out to ascertain the liability amount and the
possibility of any out of court settlement.
(iv) Audit procedure: obtain the letter of representation from management, stating all the facts and possibilities
relating to this liability.
Reason for the audit procedure: this is carried out to confirm the intentions of the directors to opt for an out of
court settlement.
(v) Audit procedure: review the payments made at the end of the year to settle the liability. If possible, obtain
a receipt from the customer stating the acceptance of the amount as full and final settlement.
Reason for the audit procedure: this procedure is carried out to verify the accuracy i.e. valuation of the
liability.
1 mark for each point
Maximum marks 4
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Common errors in part (b) (i) and reasons why those errors will not obtain marks are as follows:
¾ Focusing answers on the audit of purchases rather than creditors / payables. For example, providing
detailed explanation on the purchase ordering system, and then the audit of creditors/payables.
¾ Omitting certain common procedures relating to creditors / payables e.g. cut-off testing or casting.
¾ Not explaining the purpose of the procedures. For example, simply stating obtaining the letter of
representation from the management, containing all the facts and possibilities relating to this liability. This is
an incomplete point as the reason for the procedure is not included.
¾ ‘Check the supplier statement’
This is not an audit procedure because it is unclear what the statement is being checked for. Instead, the actual
procedure must be stated, as ‘obtain supplier statements and reconcile them with the purchase ledger account’
in order to ‘identify invoices omitted from the ledger’.
In parts (b) (ii) and (iii), some common errors include:
¾ re-stating creditors / payables testing from part (b) (i).
¾ repeating going concern testing in part (b) (iii).
59. Audit software and audit documentation – Cal & Co
Part (a) of the question has two requirements.
Part (i), carrying four marks, requires you to explain the benefits of using audit software. In order to score the
maximum marks, you are required to explain four benefits.
Your answer can include:
¾ an explanation of “standard” benefits relating to time, cost, use of actual data from the computer etc.
¾ an explanation as to how data in the scenario could be merged in order to avoid visits to the 25 branches of
the company.
For part (ii), which carries 10 marks, you are required to explain the problems relating to a specific audit where
using audit software was one of the problems encountered. Furthermore, you are required to explain how each
problem can be overcome.
Your answer must contain five problems and you can score two marks for each problem. The allotment of marks
is as follows:
¾ 0.5 marks for identifying the problem;
¾ 0.5 marks for explaining it; and
¾ 1 mark for showing how it can be overcome.
In part (b), which carries 6 marks, you are required to explain how the documentation produced by the internal
audit department can be evaluated prior to placing reliance on it.
In order to score the maximum marks you are required to provide six valid points. Your answer must include the
following:
¾ considering the work of internal audit in areas such as experience of computer systems, quality of
documentation provided etc.; and
¾ testing the documentation by comparing it with the actual system. This would require the use of walk-through
or similar testing methods, or obtaining advice from external specialists.
© GTG
Solution Bank: 197
(a)
(i) Benefits of using audit software
Standard systems at client
The same computerised systems and programs as used in all 25 branches of Tirrol Co. This means that the
same audit software can be used in each location providing significant time savings compared to the situation
where client systems are different in each location.
1 mark
Use actual computer files not copies or printouts
Use of audit software means that the TirrolCo's actual inventory files can be tested rather than having to rely on
printouts or screen images. The latter could be incorrect, by accident or by deliberate mistake. The audit firm will
have more confidence that the 'real' files have been tested.
1 mark
Test more items
Use of software will mean that more inventory records can be tested - it is possible that all product lines could
be tested for obsolescence rather than a sample using manual techniques. The auditor will therefore gain more
evidence and have greater confidence that inventory is valued correctly.
1 mark
Cost
The relative cost of using audit software decreases the more years that software is used. Any cost overruns this
year could be offset against the audit fees in future years when the actual expense will be less.
1 mark
Maximum marks 4
(ii) Problems on the audit of Tirrol
Timescale - six week reporting deadline - audit planning
The audit report is due to be signed six weeks after the year end. This means that there will be considerable
pressure on the auditor to complete audit work without compromising standards by rushing procedures.
This problem can be overcome by careful planning of the audit, use of experienced staff and ensuring other staff
such as second partner reviews are booked well in advance.
2 marks
Timescale - six week reporting deadline - software issues
The audit report is due to be signed about six weeks after the year end. This means that there is little time to
write and test audit software, let alone use the software and evaluate the results of testing.
This problem can be alleviated by careful planning. Access to TirrolCo's software and data files must be
obtained as soon as possible and work commenced on tailoring Cal &Co's software following this. Specialist
computer audit staff should be booked as soon as possible to perform this work.
2 marks
First year audit costs
The relative costs of an audit in the first year at a client tend to be greater due to the additional work of
ascertaining client systems. This means that Cal & Co may have a limited budget to document systems
including computer systems.
This problem can be alleviated to some extent again by good audit planning. The manager must also monitor
the audit process carefully, ensuring that any additional work caused by the client not providing access to
systems information including computer systems is identified and added to the total billing cost of the audit.
2 marks
Staff holidays
Most of the audit work will be carried out in July, which is also the month when many of Cal & Co staff take their
annual holiday. This means that there will be a shortage of audit staff, particularly as audit work for Tirrol Co is
being booked with little notice.
The problem can be alleviated by booking staff as soon as possible and then identifying any shortages. Where
necessary, staff may be borrowed from other offices or even different countries on a secondment basis where
shortages are acute.
2 marks
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Non-standard systems
TirrolCo's computer software is non-standard, having been written specifically for the organisation. This means
that more time will be necessary to understand the system than if standard systems were used.
This problem can be alleviated either by obtaining documentation from the client or by approaching the software
house (with TirrolCo's permission) to see if they can assist with provision of information on data structures for
the inventory systems. Provision of this information will decrease the time taken to tailor audit software for use in
Tirrol Co.
2 marks
Issues of live testing
Cal & Co has been informed that inventory systems must be tested on a live basis. This increases the risk of
accidental amendment or deletion of client data systems compared to testing copy files.
To limit the possibility of damage to client systems, Cal & Co can consider performing inventory testing on days
when Tirrol Co is not operating e.g. weekends. At the worst, backups of data files taken from the previous day
can be re-installed when Cal &Co's testing is complete.
2 marks
Computer systems
The client has 25 locations, with each location maintaining its own computer system. It is possible that computer
systems are not common across the client due to amendments made at the branch level. This problem can be
overcome to some extent by asking staff at each branch whether systems have been amended and focusing
audit work on material branches.
2 marks
Usefulness of audit software
The use of audit software at Tirrol Co does appear to have significant problems this year. This means that even
if the audit software is ready, there may still be some risk of incorrect conclusions being derived due to lack of
testing, etc.
This problem can be alleviated by seriously considering the possibility of using a manual audit this year. The
manager may need to investigate whether a manual audit is feasible and if so whether it could be completed
within the necessary timescale with minimal audit risk.
2 marks
Maximum marks10
Here are some common errors which must be avoided:
¾ Stating that “inventory must be valued at the lower of cost and net realisable value. To overcome this
problem the auditor must attend counting at all 25 inventory locations.”
This point is invalid as although the inventory valuation method mentioned above is correct, the scenario does
not mention it as a problem. Furthermore, the auditor’s attendance at inventory counts will confirm only the
existence rather than overcoming problems relating to inventory valuation. Therefore, the recommendation
provided is incorrect.
¾ Suggesting that inventory valuation would be difficult as experts on vehicle spares were difficult to find, or
that the auditor had to attend counting at all 25 locations simultaneously to prevent double counting of the
inventory in more than one location.
This point is irrelevant as this is not mentioned in the question.
(b) Reliance on internal audit documentation
There are two issues to consider; the ability of internal audit to produce the documentation and the actual
accuracy of the documentation itself.
The ability of the internal audit department to produce the documentation can be determined by:
¾ Ensuring that the department has staff that have appropriate qualifications. Provision of a relevant
qualification e.g. membership of a computer related institute would be appropriate.
¾ Ensuring that this and similar documentation is produced using a recognised plan and that the
documentation is tested prior to use. The use of different staff in the internal audit department to produce
and test documentation will increase confidence in its accuracy.
¾ Ensuring that the documentation is actually used during internal audit work and those problems with
documentation are noted and investigated as part of that work. Being given access to internal audit reports
on the inventory software will provide appropriate evidence.
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Solution Bank: 199
Regarding the actual documentation:
¾ Reviewing the documentation to ensure that it appears logical and that terms and symbols are used
consistently throughout. This will provide evidence that the flowcharts, etc should be accurate.
¾ Comparing the documentation against the 'live' inventory system to ensure it correctly reflects the inventory
system. This comparison will include tracing individual transactions through the inventory systems.
¾ Using part of the documentation to amend Cal &Co's audit software, and then ensuring that the software
processes inventory system data accurately. However, this stage may be limited due to the need to use live
files at Tirrol Co.
1 mark per point
Maximum marks 6
In order to score the maximum marks, avoid spending too much time explaining the general nature of work of
internal audit.
60. Substantive procedures, audit planning and inherent risks – Redburn Co
This question relates to a publisher who produces poetry books. The areas examined include inventory, royalty
charges and sales statistics. Furthermore, there was also a stand-alone sub-requirement in relation to audit
planning.
Part (a) of the question is knowledge-based and is worth 6 marks. You need to explain the importance of audit
planning and state two matters to be included in an audit plan.
Part (b) of the question is worth 4 marks. You need to provide two procedures which will ensure that sales
statistics used by the company may be relied upon. This is a tricky question; you must remember that sales
statistics relate to records of sales made by month and by type of customer and colleges. Therefore, you must
discuss the analytical procedures which will be needed to test their reliability first.
Part (c) of the question carries 6 marks. You need to provide three substantive tests in relation to the
completeness and accuracy of royalty charges. Furthermore, you also need to state the objective of each test.
Part (d) of the question carries 4 marks. You need to provide two inherent risks in relation to inventory and
appropriate controls to mitigate each risk. Inherent risks relate to damaged goods, theft and slow moving books.
Part (e) of the question carries 10 marks and has two sub-parts.
In part (i), you need to define net realisable value (NRV) and in part (ii) you need to write four procedures to
ensure that the NRV of inventory is above cost.
In part (ii), you need to apply your accounting knowledge relating to IAS 2 Inventories gained in F3 Financial
Accounting and apply it to the audit question.
(a) Audit planning is addressed by ISA 300 (Redrafted) Planning an Audit of Financial Statements. The
standard notes that an audit plan will be developed after the overall audit strategy has been established and
then states that adequate planning benefits the audit of financial statements in several ways, including the
following:
¾ Helping the auditor to devote appropriate attention to important areas of the audit.
¾ Helping the auditor identify and resolve potential problems on a timely basis.
¾ Helping the auditor properly organise and manage the audit engagement so that it is performed in an
effective and efficient manner.
¾ Assisting in the selection of engagement team members with appropriate levels of capabilities and
competence to respond to anticipated risks and the proper assignment of work to them.
¾ Facilitating the direction and supervision of engagement team members and the review of their work.
¾ Assisting, where applicable, in coordination of work done by experts.
The following are examples of matters that would be included in the audit plan:
(i) A description of the nature, timing and extent of planned risk assessment procedures sufficient to assess the
risks of material misstatement.
(ii) This would include assessment of inherent risk and control risk at both the entity and assertion level. An
important element of the plan would be the understanding and assessment of the control environment of the
organisation.
(iii) A description of the nature, timing and extent of planned further procedures at the assertion level for each material
class of transactions, account balance, and disclosure.
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(iv) This would include an explanation of the decision:
¾ whether to test the operating effectiveness of controls (an important decision is whether reliance is to be placed
on controls).
¾ on the nature, timing and extent of planned substantive procedures (this would depend on the decision as to the
level of control risk).
(v) Audit procedures required to be carried out for the engagement in order to comply with ISAs, for example, the
use of external confirmations to obtain sufficient appropriate evidence at the assertion level.
Marks would also be available for additional points such as:
¾ Materiality
¾ Timetable of detailed audit work
¾ Allocation of work to team members
The question has two requirements. In order to score well you must use clear headings and subheadings for
your answers as it will help your answer to be focused. This will also enable you to avoid repetition of points.
(b) Appropriate procedures would include:
Other audit procedures
¾ Reconcile the sales statistics to the recorded sales in the accounting
should already have
records.
proven the validity of
¾ Compare trends this year to those of prior years to ensure they are
the recorded sales
reasonable.
¾ In this connection consider any changes in client circumstances and
exercise professional scepticism as these statistics are produced internally.
¾ Discuss with management the analyses they have made and the actions they have taken as a result of the
statistical information available to them. They would probably use them, for example, in deciding whether
reprints of books are necessary.
¾ On a test basis check that the customer codes on the customer master file are properly entered to ensure
that the type of customer is properly identified.
¾ Review reports from sales staff to ensure that information on college take-up of books is accurate.
As a general rule, statistics that are kept on a day-to-day basis for the company’s own purposes will be much
more reliable than those prepared especially for the auditor. However, the auditor should carry out procedures
to ensure that they are accurate enough for audit purposes.
¾ Do not confuse sales statistics with the royalties that the company gave to its poets.
¾ Avoid general sales procedures like ‘vouching a sample of sales from goods despatch note to invoice to the
sales ledger’. This is inappropriate as it does not relate to the sales statistics.
¾ You need to provide two procedures for four marks. Therefore, it is not sufficient to write a brief explanation
of each audit procedure.
(c) Appropriate substantive tests to satisfy the auditor that the royalties charge is accurate and complete include:
(i)
(ii)
Test
Compare the royalties charge with stated sales
income and obtain explanations from
management if the figures do not appear
reasonable.
Objective
To satisfy the auditor that the royalties charge in the
income statement is reasonable in relation to stated
sales income.
Compare budgeted royalties figure with actual
figures. If variations are significant, obtain
explanations from management.
To satisfy the auditor that the actual figures had been
anticipated by management, thus providing evidence
as to their reliability.
Continued on the next page
© GTG
(iii)
(iv)
(v)
(vi)
(vii)
Solution Bank: 201
Review the sales statistics (proven in (b) above)
to ascertain those despatches that attract
royalties.
Take a sample of recorded sales entries and
check:
¾ whether royalties are due in respect of the
customer.
¾ if they are, that the entry in the computerised
royalties file has been calculated at 10%
according to the contracts agreed with the
published poets.
Take a sample of royalty payments and agree to
supporting despatch and sales documentation,
checking in particular that all despatches are to
individuals
and
organisations
attracting
royalties.
Select sales for 15 days before the year end
and 15 days afterwards and compare with the
dates of despatch notes.
Calculate the expected level of royalty
payments based on monthly trend information
for type of customer. Obtain sales figures and
multiply by 10%. Compare expectation to actual
royalties and obtain explanations from
management for any significant variations.
This would be evidence that the royalties charge
was soundly based.
These are detailed tests to prove that royalties were
due on despatches and that the calculation of the
royalty was accurate.
This is a test to prove that recorded royalty
payments have resulted from despatches and sales
attracting royalties
This is to check that cut-off is accurate. The
royalties charge should only include royalties on
sales up to the cut-off date.
This test should provide the auditor with evidence
as to the completeness and accuracy of royalties
paid.
In order to score the maximum marks, you must:
¾ avoid providing procedures which test sales income rather than royalty charges. This is because the
question relates to royalty charges
¾ avoid providing tests of control as you need to come up with substantive procedures
¾ answer both parts of the question
¾ link each procedure to the financial statement assertions of completeness and accuracy
(d) There are many inherent risks that may affect the inventory of books and some of these are set out below,
together with controls that would mitigate each risk.
Inherent risks
Risk of deterioration.
Some books may not be saleable
because of lack of demand.
Books may be defective and
therefore not saleable.
Books may be attractive and
easily transportable, making
attempted theft likely.
Poor counting of inventory at the
period end.
Poor cut-off as there may be
movements of goods during the
inventory count.
Goods on sale or return are held
by customers but should be
included within inventory until the
return period is passed.
Mitigating controls
Books should be stored in a location with air conditioning to keep them in
saleable state.
Maintenance of movement records to identify
slow-moving items.
¾ Inspection of books returned from customers to identify those that are
not in good condition.
¾ Identification of defective items at interim or period-end inventory
counts.
Books to be kept in a secure location with restriction of entry to authorised
personnel.
¾ The use of independent and experienced inventory counters.
¾ The use of teams to cover specific areas of the locations where
inventory is held.
¾ The use of pre-numbered inventory count sheets and other inventory
count procedures.
¾ Movement of books stopped during the count or only allowed by
permission of authorised official in charge of the count.
¾ Book returns received during count held in separate area.
¾ Identification of last movements in and out.
Detailed records should be maintained of goods on sale or return and this
should be reviewed at the year end to ensure that any goods within the
return period have been included in inventory.
202: Audit Evidence
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In order to score the maximum marks you must:
¾ avoid stating the risk as: ‘inventory may be overstated’, without explaining how it might be overstated
¾ not get confused between controls to mitigate risk and substantive procedures
¾ avoid defining inherent risk, as this is not the requirement of the question
(e)
(i) Net realisable value is defined in IAS 2 Inventories as: ‘the estimated selling price in the ordinary course of
business lessthe estimated costs of completion and the estimated costs necessary to make the sale.’
(ii) Appropriate procedures to determine that net realisable value of book inventory is above cost would include:
¾ Assessment of estimated proceeds from the sale of items of inventory. Sales price in the period following
the year-end is one important element of net realisable value. Procedures to determine sales prices include:
9 obtain actual sales prices by reference to invoices issued after the year-end and determine that the
sales were genuine by vouching sales invoices to orders, despatch notes and subsequent receipt of
cash.
9 if actual sales prices are not available, the auditor should obtain estimated sales prices from
management. It would be necessary to assess how reasonable these estimated prices were. The
auditor might be aided in this respect by reviewing the reports from sales staff backed up by discussions
with management.
Slow- moving books might be identified by
9 particular attention should be paid to
obtaining lists of sales made in the preceding
sales prices of books identified as slow(say) six months and
moving.
reviewing reports from sales staff. The sales
statistics would also be useful in this respect.
9 For damaged books disposal price may be nil or very
low and the auditor should examine
records of disposal of such books in the
past.
Damaged books should have been
identified during the inventory count
¾ Determine estimated costs to completion. These costs represent another important element of net realisable
value. Relevant procedures include:
9 Some books may still be in production and
It is not uncommon for publishers to print
will initially be included in inventory at cost
books but leave them unbound until sales in
to date; for example, they may have been
the immediate future are expected
printed but not bound. The auditor should
examine production budgets and actual costs
(for binding, for example) to determine actual costs to completion.
9 Books returned may incur extra costs before they can be made ready for resale and the auditor should
examine cost records to obtain a reasonable estimate of such costs.
¾ Determine costs to be incurred in marketing, selling and distributing directly related to the items in question.
9 In general terms the auditor may determine the percentage relationship between sales and selling and
distribution expenses. However, the distribution costs of heavy books are likely to be higher than for
(say) light paperback books and the auditor should assess whether the cost weighting is reasonable.
¾ All of the above matters should be discussed with management bearing in mind that, although they
represent an internal source of evidence, they are the most informed people regarding the saleability of
books on hand and regarding determination of the various elements of net realisable value.
¾ Discuss with management the need for an inventory provision for slow moving and/or obsolete books.
SECTION F
SOLUTION BANK
REVIEW
F
61. Written representations – Crighton-Ward
Part (a) is straightforward and easy to answer. It should earn you 5 easy marks! You should clearly state the
meaning of letters of representation, followed by the reasons why these are required to be obtained. Explain
each reason in a separate paragraph to make things clear. In addition, to show true understanding, give a small
example if you can.
For part(b) (i), explain your reasons regarding whether a paragraph is required, but ensure your answer clearly
states the conclusion whether to include a paragraph in the representation letter or not. This will show the
examiner you are not sitting on the fence and unsure!
Part (c) of the question asks about the rights of the auditor when management refuses to give a written
representation. You should list the possible actions that the auditor will take to persuade management to sign
the letter and also state the actions he will take if management still refuses to sign.
(a) Written representations are letters given by the management to the auditor. ISA 580 requires an auditor to
obtain written representation as they form a part of the audit evidence. These are written by the company's
directors and are sent to the auditor at the completion of audit work and before the audit report is signed.
They are normally dated the same as the audit report.
1 mark
The purpose of a written representation is as follows:
(i) Preparation of financial statements is the responsibility of the management and management should
acknowledge its responsibility through the written representation. This helps an auditor to obtain audit
evidence that the financial statements have been approved by management.
(ii) An auditor can use the written representation as audit evidence where there is no sufficient and appropriate
evidence regarding a material matter. This is because in such a situation, the auditor has to believe in the
judgement and opinion of the management. Examples are where knowledge of the facts is confined to
management (such as management’s intentions) and where the matter is primarily of judgement and
opinion (such as the recoverability of a debt).
(iii) The written representation acknowledges the representations previously discussed verbally between an
auditor and management. This acknowledgement in writing confirms the verbal discussion. E.g. In the case
of related party transactions, the auditor obtains a certificate from
management that it has disclosed all the related party
Give examples of situations where
transactions. This is not conclusive evidence for the auditor, but
representations are required. This
at least gives reassurance that management has acknowledged
will display your understanding.
its responsibility for disclosing related party transactions.
1 mark for each valid point discussed
Any representations given by management should be:
¾ compared to other evidence for corroboration of the representation
¾ assessed for reasonableness
¾ judged with reference to the knowledge and skill of those giving the representation.
Written representations cannot be a substitute for other audit evidence that the auditor could be expected to be
available.
2 marks
Maximum marks 5
204: Review
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(b) A review of the audit file has disclosed the following outstanding points.
Lion's Roar
The amount of claim is $4 million which is 53.33% ($4/$7.5) of the profit before taxation, $7.5 million. This is
more than 50% of the profits and therefore highly material. The only pieces of evidence available in support of
the amount of claim are the claim from Lion’s Roar, the legal advice from Crighton Ward’s solicitors and the
directors’ opinion. However the amount of claim cannot be ascertained accurately since the litigation is still not
settled.
2 marks
The claim certainly needs to be disclosed in the accounts, probably by way of note, so that the readers are
aware how the management has dealt with the claim. In which case there would be an emphasis of matter
paragraph in the audit report.
2 marks
In order to obtain sufficient evidence to show how the treatment of the potential claim was decided for the
financial statements, the auditor must obtain this opinion in writing from management to corroborate other audit
evidence. Reference must therefore be made to the claim in the representation letter.
2 marks
Paragraph for inclusion in representation letter
'There is a legal claim against Crighton-Ward by Lion's Roar which is estimated at $4 million by Lion's Roar. The
directors are of the opinion that the claim is not justified since the product specification was not detailed enough
in the order. This expense has not been provided for in the financial statements. Disclosure of the fact is
adequate. No similar claims have been received or are expected to be received.'
2 marks
Depreciation
The lack of profit or loss on sale indicates that the depreciation charge is appropriate - large profits would
indicate over-depreciation and large losses, under-depreciation. The amount of depreciation also meets industry
standards ensuring that Crighton-Ward's accounting policy is acceptable. Including the point in the
representation letter is inappropriate since the matter is not crucial and does not appear to be based on
judgement or opinion. The opinion of the auditor is not justified enough to require a representation.
2 marks
In this case the auditor has obtained sufficient appropriate audit evidence as it seems from the information
available to him.
1 mark
Maximum marks 10
(c) Lack of representation letter
The auditor may take the following actions:
Try and resolve the issues that are raised by the directors by discussing the situation with the directors. This will
help the auditor know the reason why management declines to sign the representation letter. Finding out the
exact reasons why the directors will not sign the letter might allow the auditor to consider amendments that can
be made in the letter to incorporate the directors' concerns.
1.5 marks
The auditor will need to explain the need for the representation letter again (and note that the signing of the
letter was mentioned in the engagement letter). The fact that the engagement letter required signing the
representation letter will give the auditor the authority to demand a signed representation according to the terms
of agreement.
1.5 marks
If the auditor cannot obtain appropriate and sufficient audit evidence in any other way, management should be
made aware that the audit report will have to be modified.
1.5 marks
The auditor will modify his report by giving a qualification i.e. an ‘except for’ opinion or he may also give a
disclaimer if in his opinion a provision for the legal claim is necessary and the management has not made this
provision.
1.5 marks
Representation letter supports the audit evidence obtained by the management and is not audit evidence in
itself. Therefore the auditor still needs to evaluate the reliability of the evidence gathered by him before he
frames an opinion on the financial statements. Even if the letter is signed there could still be insufficient
appropriate audit evidence and then the auditor will have to consider modifying the audit report.
1.5 marks
Maximum marks 5
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Solution Bank: 205
62. Audit finalisation, review and subsequent events – Calva
Part (a) of the question carries 10 marks so you should take 18 minutes to answer it. In addition to writing the
objectives, remember to write how these review procedures will help the auditor express an opinion on the
financial statements. This will show the examiner that you are aware of the purpose of the review and help you
to earn marks!
Part (b) also carries 10 marks. You should write the reasons for the review of subsequent events along with the
listed procedures to be followed by the auditor. This will display your understanding of the review procedures
and help you to score maximum marks!
(a)
(i) Objectives of the overall review of financial statements
The overall review of financial statements is conducted to provide the auditor with sufficient appropriate audit
evidence together with the conclusions drawn from other audit procedures carried out by him. This evidence
enables the auditor to form an opinion on the financial statements, in particular whether the financial statements
are properly presented in accordance with the applicable accounting standards, legislation and other regulatory
requirements. Calva is a listed company and therefore is required to comply with stock exchange disclosure
requirements by the completion of a disclosure checklist. The auditor should verify whether Calva has made all
the disclosures according to the checklist since this will ensure proper compliance by Calva.
2 marks
Auditors should review the appropriateness of accounting policies in particular and whether they have been
consistently applied, particularly where changes have been made. It is essential to confirm this fact to ensure
that the financial statements are not misstated or misleading. Any change in the accounting policy requires a
disclosure of the effects of the change in the policy on the amounts in the financial statements (IAS 1). There is
no indication that any such changes have been made in this case as no additional information is available.
2 marks
The auditor should also apply his knowledge of the business in forming an opinion on the financial statements.
He can do so by applying analytical skills to the review of the financial statements. He should carefully consider
the effect of any uncorrected misstatements on the amounts reflected. These procedures should be carried out
by the senior managers since they are much more experienced and can gauge the effects of any misstatements
more accurately. This is important since the auditor is a professional and is expected to exercise his judgement
on the financial statements based on his knowledge and experience. It will also lend greater credibility to his
work and the senior managers and audit engagement partners will get a chance to appraise the work performed
by their staff.
2 marks
Maximum marks 4
(ii) Objectives of the review of working papers
In the given case, the audit firm has a staff of 250 people and hence it is very likely that the regular audit
procedures will be carried out by the audit juniors. The audit manager and the senior audit engagement partner
will draw conclusions based on the work performed by the audit juniors. In such a case, it is very important to
review the working papers before expressing an opinion on the financial statements. This gives the auditor
assurance that the audit juniors have carried out their work properly.
2 marks
The following are the main objectives of the review of working papers
To ensure that all work has been adequately planned, executed and recorded and that all outstanding matters
have been followed up. The auditor should ensure that, if there are any set work procedures to be followed as
designed by the audit firm, then these are followed. This will ensure that all areas of audit are covered.
2 marks
In the case of Calva, it is likely that some work will have already been reviewed. This is because the audit
seniors and audit managers review the work of audit juniors, and partners review the work of managers and
seniors. In addition to that, there is also a final partner review. This will help the auditor have an internal check
on the work done by his team. It also assures the client that thorough procedures have been followed.
2 marks
206: Review
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Where the working papers are prepared manually, staff normally put their initials to show that working papers
have been reviewed. The review comments are generally written in red and referred to the person preparing the
working paper or to the partner where significant matters of judgement are concerned. Where papers are
prepared electronically, electronic 'signatures' can be used. The review of these by the senior partner is
essential to ensure that the juniors have covered all audit areas.
2 marks
The audit working papers in relation to the critical areas which have higher audit risks are required to be
reviewed in detail. In the case of Calva, critical areas are likely to include inventory (despite the fact that it is
well-controlled, it is still a material item), cash and non-current assets. This is essential to know whether any
further audit procedures are required to form an opinion on the financial statements.
2 marks
It is important, that all outstanding areas (i.e. the substantive areas) are completed and reviewed and any issues
arising are followed up during the final stages of the audit of Calva. This is a crucial stage. During this stage, it is
extremely possible that the apparent insignificant matters to go undetected because both the auditors and the
client are under time pressure. The auditor should follow this procedure to look for any undetected or
unresolved areas that could be material and hence make the financial statements misleading. He should
investigate any unadjusted differences and their impact on the figures as shown in the financial statements.
2 marks
Maximum marks 6
(b)
(i) Responsibilities of auditors regarding subsequent events in accordance with ISA 560.
Auditors are required to perform all the procedures to ensure that they obtain sufficient appropriate audit
evidence in relation to all the material subsequent events that occur up to the date when the audit report is
signed. These subsequent events should be material enough to require a disclosure in the financial statements
either by adjustment or by way of note.
1 mark
If any matters are discovered after the audit report is signed but the financial statements are still to be issued or
are already presented, then the auditor should consider whether and how any amendments are required to be
made to the financial statements.
1 mark
He should extend his audit procedures if any subsequent events come to his notice. He should also issue a
fresh audit report, if required, when the financial statements are amended and he has to carry out certain
additional audit procedures for the review of the subsequent events.
1 mark
Whether to make any amendments to the financial statements is entirely the decision of management. The
auditor can only make suggestions if he feels that the subsequent events will affect the financial statements in
such a way so as to make them misleading. If management decides to amend the financial statements then the
auditor should issue a fresh audit report on these. A reference to the previous audit report issued should be
made in the new one.
1 mark
If auditors consider that the financial statements contain material errors or are misleading, they may exercise
their right to speak at general meetings and to make written representations to members. They can make use of
their legal rights to safeguard their position.
1 mark
If a matter is discovered long after the financial statements have been issued, it can be dealt with as a prior
period adjustment in the subsequent financial statements. This is done because there has to be a cut-off for the
procedures for the current year.
1 mark
Maximum marks 6
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Solution Bank: 207
(ii) Subsequent events review procedures to be followed by the auditor are as follows:
The auditor is required to make enquiries of management on the issues as to how they have ensured that
subsequent events have been identified, although it is likely that in this case, the company will rely on the audit
firm to help them with this. This is because the audit firm has been auditing Calva for a long time and the
auditors are familiar with the transactions and events taking place at Calva.
2 marks
The auditor should read the minutes of management meetings, shareholders and other meetings and review
relevant accounting records such as budgets or cash flow forecasts. Calva must have prepared these records
for negotiations with banks and hence the auditor should look at these. These may reveal any major cash flows
(acquisition or disposal of any major asset) that might have an impact on the previous year’s financial
statements. They should review correspondence with lawyers and insurance companies, customers and
suppliers.
2 marks
The auditor should enquire about the possibility of issuing any new shares or loans to fund the expansion that
may require disclosure. They should also enquire about any significant changes in the property market that
might (if the supermarket properties are valued at market price) require either disclosure or adjustment in the
accounts. This will reveal any major liabilities undertaken that might require disclosure in the financial
statements.
2 marks
He should consider the need for disclosure of significant leasing transactions occurring early in the following
year as these transactions might reveal some events that it are important and should be disclosed in the
financial statements.
2 marks
Maximum marks 4
63. Written representations
The question carries 20 marks and hence you can take full 36 minutes to solve it. In answer (a) you should
clearly state the reasons why auditors seek letters of representations and how these help them express an
opinion on the financial statements.
In answer (b) you should display your knowledge of the critical areas where written representations are required
and explain why it is important that these areas should be covered by a written representation.
In answer (c) you should explain the reasons why the discussions are important and how these will help the
auditor.
In answer (d) you should specify the possible reasons why management refuses to sign the letter and the
actions that the auditor can take, in separate paragraphs.
Answering the questions in this manner will give the examiner an idea of the clarity of your thoughts and assure
him that you understand the purpose and need for representations. Examples are given in many places in the
answer; however you should give these only if time permits.
(a) Written representation
A written representation is required by an auditor when the auditor is not able to obtain sufficient audit evidence
regarding certain matters. These matters generally involve judgement where the auditor is not in a position to
make these judgements and also on matters where knowledge is confined to the directors – such as their
intentions.
An auditor seeks a written representation for the following reasons:
(i) To obtain written audit evidence on matters that are material to the financial statements when other
sufficient appropriate audit evidence cannot reasonably be expected to exist (ISA 580 'Written
representations'). These letters act as definitive audit evidence when other pieces of audit evidence are not
available.
2 marks
(ii) To obtain audit evidence in support of his audit work, when other evidence is not available. For example, if
management wants to hold a particular non-current asset (e.g. a machine) for the long term and the auditor
is not in a position to judge whether the value of the machine will appreciate, then he will have to rely on the
judgement of the management. In this case, he will seek a representation from management for this matter.
However, the auditor cannot use a written representation as a substitute for other audit evidence.
2 marks
208: Review
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(iii) To ensure that directors acknowledge their collective responsibility for the presentation and approval of the
financial statements. The letter is signed by those who have the requisite knowledge of the accounting
matters concerned, on behalf of management. Generally the auditor should insist that the CFO signs it. This
protects the position of the auditor regarding any misstatements due to certain matters included or excluded
in the preparation of the financial statements.
2 marks
(iv) To obtain written confirmations for the verbal assurances given by management and to clear up any
misunderstandings regarding certain matters (e.g. the rate of depreciation used for machinery is 10%
whereas the auditor says that it should be 12% according to international standards. Management,
however, might explain that the local laws have been used during preparation of the financial statements.)
In addition, to obtain reasonable assurance that the internal control systems are sufficient and appropriate.
2 marks
Taking representations on these matters will help the auditor to authenticate his audit procedures and
express an opinion on the financial statements
Maximum marks 5
(b) Some common categories of matters included in the written representation
(i) Confirm the responsibility for, and approval of, the financial statements. This is required so that the auditor
is not made responsible for any inclusions or exclusions of matters in the financial statements.
(ii) Confirm the availability of all accounting records and related documentation (such as the minutes of
management and shareholder meetings) and check that the company transactions have been properly
reflected therein. The auditor cannot verify any documents that were not presented to him. Obtaining this
confirmation will enable the auditor to confirm that all the documents that were relevant to the audit of the
financial statements were presented to him.
(iii) Confirm that the outcome of legal claims is according to the expectations of the company. Pending
litigations can have a great impact on the financial statements, especially when the amounts of claims
involved are large. A representation from management will confirm the potential impact of the case on the
financial statements and hence the auditor will be in a better position to express an opinion.
(iv) Confirmation of company plans in relation to certain tax provisions. Representations are required in this
case when certain events are likely to affect the amount of tax provisions. For example, if the company is
likely to get a tax holiday in relation to an expansion planned in a developing area, this will affect the
provision for taxation and the auditor may ask for a representation on this matter from management.
(v) Confirm the completeness of disclosure regarding related party transactions. A representation might be
required if the disclosures or the accounting treatment of related party transactions are not in accordance
with the applicable standards.
(vi) Confirm that the required revisions in the financial statements have been made for events which occurred
after the reporting period. These events are to be made known to the auditor by management since the
auditor is only responsible for verifying the events up to the reporting date. The auditor therefore needs to
obtain representations relating to the occurrence of these events.
(vii) Confirmation that there is not intention to close or discontinue part of the business
(viii) Confirmation that all liabilities have been included in the financial statements
1 mark for each valid point
Maximum marks 6
(c) Discussion of the content of the letter
Letters of representations are taken in all cases. As pointed out above, they are particularly needed when other
sufficient appropriate evidence is available and also to ensure that the directors are aware that they are
responsible for the financial statements.
Written representations should be discussed with management at an earlier rather than a later stage. This is
because:
(i) The directors may disagree with what the auditors wish them to sign. On certain matters, the auditor and
management may have different opinions e.g. whether to write-off or to defer certain expenses such as
amortisation of advertisement expenses. The auditor might think that these expenses need to be written off
whereas management may believe that the company is still benefiting from the advert and therefore the
expenses need to be deferred until the next year.
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Solution Bank: 209
(ii) If negotiations are required, the letter, and perhaps the financial statements, will have to be redrafted until it
is acceptable to both the auditor and the client. Continuing the above example, management does not agree
with the auditor that the expenses should be written off but agrees that they should be carried forward only
until the next period then the auditor will redraft the letter. This letter will contain management’s reasons as
to why they think the expenses should still be carried forward.
(iii) The written representation can be a critical piece of audit evidence for certain items. If discussions regarding
the matters to be considered in this letter are left to a late stage in the audit, when there is pressure on
auditors and clients alike, negotiations may be difficult.
1 mark for each valid point
Maximum marks 3
(d) Management unwilling to sign and actions if management refuses to sign
(i) The primary responsibility of audit is that of the auditor and not of management. Management is sometimes
unwilling to sign because it feels that the auditors are capable of obtaining independent evidence in relation
to the relevant matters. Giving representations might appear to shift the responsibility regarding the audit to
management.
(ii) At times, management is genuinely uncertain about giving assurance on the matters to be included in the
written representation.
(iii) However, it is possible that management is trying to 'hide' from the auditors the fact that the income
recorded is incomplete or that there is an outstanding undisclosed legal claim against the company, for
example. Management may do this so that the auditor gives an unmodified audit report.
Actions that can be taken if management needs to sign the report
(i) Auditors should try to find out why management is refusing to sign the letter. Auditors should then attempt to
negotiate an agreement with management if they are not ready to sign the letter and it might be possible to
redraft the letter.
(ii) The auditors should point out that signing the written representation was included as a condition in the letter
of engagement.
(iii) If management still refuses to sign, and the auditor feels that the matter is material enough so as to misstate
the financial statements, it may be necessary to qualify the audit report with an 'except for' (or even
disclaimer of) opinion, on the basis of a limitation in the scope of the audit. The type of opinion to be given
will depend on the gravity of the limitation on the scope of audit.
1 mark for each valid point
Maximum marks 6
64. Subsequent events – Chemical Compounds
Part (a) is divided into two sub-parts and carries a total of 15 marks. You therefore have 27 minutes to solve the
question. Answer questions (i) and (ii) for each date separately.
Part (b) is a straightforward question which carries 5 marks therefore it should take you only 9 minutes to write
your answer. Do not give details of the procedures as you are only asked to list the procedures. Give instances
for one or two procedures if you can.
(a)
In answer (i), you should write the reasons for the adjustments in accordance with IAS 10.
In answer (ii), along with the procedures to be followed, make sure that you clearly state the ways in which
these will help the auditor gather evidence that will help him frame an opinion on the financial statements.
(i) 17 August 20X7
The bankruptcy of a major customer who accounts for 15% of the total trade receivables on the SOFP is a
major event that will lead to misstatement of the figure for receivables.
210: Review
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Applying IAS 10, this is an event for which provides evidence of conditions that existed on the reporting date.
Therefore this is an adjusting event and adjustments will have to be made in the financial statements to reflect
this. Considering the bankruptcy and hence the impossibility of any recovery from the customer, the figure of
receivables is overstated in the SOFP and that of the provision for bad debts is understated. Both these figures
need to be adjusted in the financial statements.
2 marks
This event falls in the category of events occurring after the reporting period but before the signing of the audit
report. The auditor has a responsibility to carry out audit procedures as regards any event that happens until he
finalises the audit report. Therefore he will have to audit the receivables once again and ensure that he has
gathered sufficient appropriate audit evidence to express an opinion on the truth and fairness of the financial
statements. To do this, he will carry out the following procedures:
2 marks
¾ Confirm that the dues from the customer are all relating to the period prior to the year-end and try to obtain
a confirmation letter from the customer regarding the amount of dues.
¾ Confirm from the list published by the court whether the customer is paying the dues according to the
priority given and whether the entity appears as a “creditor to be paid” on this list.
¾ Check the adjustments made to the figures of receivables and the provision for bad debts. The receivables
figure needs to be decreased and the bad debts need to be written off from the income statement
depending on the amount that is expected to be recovered from the customer.
¾ Confirm that no amounts have been received from the customer in respect of this receivable.
¾ Include a paragraph in the written representation to confirm that no other amounts are due from the
customer apart from those reflected in the financial statements.
0.5 marks for each valid point discussed
(ii) 4 November 20X7
The accidental release of toxic fumes into the atmosphere from one of Chemical Compound’s plants is an event
occurring after the reporting period. Therefore, according to IAS 10, this is a non-adjusting event and does not
call for any adjustment in the financial statements. However, the event is significant enough to require a
disclosure in the financial statements as it might involve considerable legal claims or other liabilities.
2 marks
The accidental release of the toxic fumes from the entity’s chemical plant is an event that occurred on 4
November 2007, which is after the audit report has been signed and the financial statements have been
approved by management. Once the audit procedures are complete and the audit report is signed, the auditor
does not have any active responsibility to conduct any enquiry regarding the financial statements. After the
report is signed, it is the responsibility of the management of Chemical Compound to make him aware of any
such event.
In this case, when management has made him aware of the event and he knows that it can significantly affect
the financial statements and therefore requires proper disclosure, he should discuss the matter with
management.
2 marks
The specific procedures that need to be followed are as follows:
¾
Obtain exact information regarding the event from management, press releases (since the auditor might
obtain important information from the media) and from the lawyers. The release of toxic fumes is a major
threat to the environment and hence there is a possibility that the entity might face litigation claims from the
ministry of environment / health and safety. If any case is registered against the entity then the claim
amount will affect the financial statements as it is not provided for in the statements. In such a case a
specific disclosure of the possible claims needs to be made in the statements.
¾
Verify the note to the financial statements to ensure that there is adequate disclosure made in the financial
statements for the event and consider an emphasis of matter paragraph in an amended audit report that
might be issued.
¾
Discuss with management the accounting treatment to be given to the event in the disclosures to be made
for this in the financial statements.
¾
Obtain a written representation from management confirming that there are no other events that will require
a disclosure in the financial statements apart from this event. This should be done as it is not the
responsibility of the auditor to look for events that might affect the financial statements but of the
management to tell him about any such subsequent events once the auditor’s report has been signed.
0.5 marks for each valid point discussed
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Solution Bank: 211
(iii) 29 November 20X7
The flood destroying the entire machinery and equipment set up at one of Chemical Compound’s locations
entails production losses and hence a reduction in the profits of the entity. This event has occurred after the end
of the financial period and, indeed, after financial statements have been issued. A disclosure is, however,
required for this event because it involves major losses. The financial statements will be misleading if a
disclosure is not made.
2 marks
The flood took place after the financial statements had been issued. After the financial statements have been
issued, the auditor does not have any responsibility to enquire into any event, according to ISA 560.
However, the auditor has now been informed of this event by the management of Chemical Compounds and
hence he should consider its potential effect on the financial statements to ensure that they are not misleading.
2 marks
The specific procedures that he should follow are:
¾ Checking the minutes of the board meetings in relation to the event, insurance claims etc. to ensure that the
damage caused by the floods is adequately covered. This will help the auditor assess the financial impact of
the flood on the entity‘s future profits.
¾ Ensuring that no other contingent liability exists with regard to the non-current assets that have been
destroyed in the flood and any other environmental damage that needs to be taken care of.
¾ Making enquiries to management as to how they are going to disclose the event to the members.
¾ Ensuring that a proper disclosure is made in the financial statements, if the directors plan to re-issue the
financial statements.
¾ If the directors do not intend to amend the financial statements, but the auditor considers the matter to be
material then he should make sure that he discloses the matter to those charged with governance and the
members. He should make use of his legal rights in doing so, if need be.
¾ Contacting the lawyers, if necessary, when the proper disclosures are not made in the financial statements.
0.5 marks for each valid point discussed
The above procedures are necessary so that the auditor’s position is
safeguarded against any potential losses that might incur to the
readers who take decisions based on these financial statements.
Important to write how these
procedures help the auditor
Maximum marks 15
(b)
Remember to give the reasons, in one sentence each, as to why these procedures are carried out in order to
show how the procedures help in the identification of subsequent events.
International Standard on Auditing 560 Subsequent events lists the procedures to be followed by the auditor for
the review of subsequent events. These are listed below:
(i) Review the procedures followed by management to identify the subsequent events and ensure that these
are sufficient.
(ii) Read the minutes of the meetings of the directors, the audit committee and the shareholders to find out any
unusual events that might affect the financial statements.
(iii) Go through the latest interim financial statements such as budgets, cash
flows, forecasts etc. to look for items that are significantly different from the
year-end financial statements. This will reveal any significant subsequent
events.
Write how this
procedure helps!
(iv) Obtain additional evidence from the lawyers of the company. This will reveal any major litigation, the
outcome of which was uncertain on the reporting date.
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(v) Ask management and, where appropriate, those charged with governance, as to whether any subsequent
events have occurred that might affect the financial statements. Subsequent events include:
¾
¾
¾
¾
¾
significant sale of assets
any natural disaster such as flood, fire etc. destroying the assets
new borrowings or commitments undertaken
any new shares or debentures issued
any unusual accounting adjustments
(vi) Finally, ensure whether any event has occurred that might affect the going concern
status of the entity. This will reveal any major event that needs a disclosure in the
Give an
financial statements so as not to mislead the readers. For example, the discontinuation
illustration!
of a major branch that accounts for 40% of the profits will affect the financial statements
in a significant way and might cast doubt on the going concern status of the entity. This will require a
disclosure and adjustments in the financial statements.
1 mark for each valid point discussed
Maximum marks 5
65. Going concern – Posco
Questions (a) and (b) are straightforward, carrying 5 marks each. Hence you should write the procedures for
both in brief. Do not forget to state how they help in assessment of the going concern status of an entity since
this will display your understanding of the procedures and their usefulness. Give reference to the relevant ISA
and IAS wherever applicable.
In answer (c), include:
¾ the type of report that the auditor will issue (either modified or unmodified)
¾ the reason why the auditor can or cannot issue the audit report
In answer (d), the difficulties that the auditor faces should be related to the auditor’s duty as an independent
auditor. This will show the examiner that you have knowledge of the duties of an auditor as well as the
difficulties he faces and will help you earn marks.
(a) Management is responsible for making a preliminary assessment of the going concern status of the entity
according to IAS 1 and ISA 570 and should make the assessment as follows:
(i) Management should make an assessment of the going concern status of the entity while preparing the
financial statements in accordance with IAS 1. This is essential as the valuation of assets and liabilities
depends on whether or not the entity is a going concern.
1 mark
(ii) IAS 1 requires that when making its assessment, if management becomes aware of material
uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to
continue as a going concern, those uncertainties should be disclosed. These disclosures are essential
since the financial statements will be misleading to the readers if the disclosures are not made.
1 mark
(iii) Management should disclose the following facts to confirm the going concern status
of the entity:
Listing the
disclosures
shows the
examiner your
level of
understanding!
¾ conditions and events giving rise to the substantial doubt about the entity’s ability to
continue as a going concern
¾ the possible effect of such conditions and events
¾ management’s evaluation of the significance of those conditions and events
¾ mitigating factors
1 mark for each sub-point
The above disclosures will leave no room for any doubt and will help the auditor to form an opinion on the
statements as well as help the readers in taking informed decisions based on these financial statements.
1 mark
Maximum marks 5
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(b) The auditor should perform the following procedures for reviewing the going concern status of the entity.
(i) When performing risk assessment procedures as required by ISA 315, Identifying and assessing the risks of
material misstatement through understanding the entity and its environment, the auditor shall consider
whether there are events or conditions that may cast significant doubt on the entity’s ability to continue as a
going concern.
(ii) The auditor should evaluate management’s assessment of the entity’s ability to continue as a going
concern.
(iii) The auditor should remain alert throughout the audit for audit evidence of events or conditions that may cast
significant doubt on the entity’s ability to continue as a going concern.
If events or conditions have been identified that may cast significant doubt on the entity’s ability to continue as a
going concern, the auditor shall obtain sufficient appropriate audit evidence to determine whether or not a
material uncertainty exists through performing additional audit procedures, including consideration of mitigating
factors. These procedures may include the following:
¾ Analysing and discussing cash flow, profit and other relevant forecasts with management.
¾ Analysing and discussing the entity’s latest available interim financial statements.
¾ Reading the terms of debentures and loan agreements and determining whether any have been breached.
¾ Reading minutes of the meetings of shareholders, the board, those charged with governance and relevant
committees for reference to financing difficulties.
¾ Inquiring of the entity’s legal counsel regarding the existence of litigation and claims and the reasonableness
of management’s assessments of their outcome and the estimate of their financial implications.
¾ Confirming the existence, legality and enforceability of arrangements to provide or maintain financial support
with related and third parties and assessing the financial ability of such parties to provide additional funds.
¾ Performing audit procedures regarding subsequent events to identify those that either mitigate or otherwise
affect the entity’s ability to continue as a going concern.
¾ Confirming the existence, terms and adequacy of borrowing facilities.
¾ Obtaining and reviewing reports of regulatory actions.
¾ Determining the adequacy of support for any planned disposals of assets.
Inclusion of a going concern paragraph in the written representation i.e. that the directors see no going concern
problems.
0.5 marks for each valid point discussed
Maximum marks 5
(c) Report issued to Posco
In the case of Posco, there are some indicators of going concern problems. However, the company may still be
a going concern since the fact that the company has been approached by take-over bidders. It could possibly
mean quite the opposite as the bidders might want to take over a company with good future prospects.
2 marks
The audit opinion issued on Posco in the current year is not likely to make reference to the going concern status
of the company in previous years. The situation has not deteriorated significantly in the current year.
2 marks
Severe curtailing of the capital investment programmes and restructuring of finances
has been adequately disclosed in the previous financial statements. The previous
Reasons why the
auditors have not given any modified reports, neither have they expressed doubt on
auditor cannot
the going concern status of the entity. In such a situation, it will be difficult for the
express a qualified
auditors to justify any change in the previous auditors’ opinion, and the company
opinion need to be
has survived sine those opinions and deterioration is no worse this period.
given so that the
They will rely on the previous auditors’ work to this extent since the business is
examiner can test
new to them and they might make an incorrect assessment of the going concern
your knowledge!
status. However, they should carry out their own audit procedures necessary to form
an independent opinion on the financial statements.
2 marks
Maximum marks 4
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(d) Difficulties associated with reporting on going concern
If the auditors of Posco were to report on a going concern problem, the reporting itself could create a going
concern problem. It is unusual for a large power company listed on a stock exchange to be issued a modified
audit report and therefore this could cause a sudden fall in the share prices. This is because the public may
become sceptical about the future prospects of the company and will not expect it to make profits in the
foreseeable future. A fall in share price is not itself damaging to the company’s existing finance, but it will make
raising capital in the future, whether of shares or loans, more difficult.
1.5 marks
However, recent events taking place at Posco such as the restructuring of the finances, the severe losses due
to non-production because of a litigation case and curtailment in the capital investment programme are
indicative of the deteriorating circumstances at the entity. If the auditor and the entity do not report a problem
that can emerge from such conditions the auditors will be failing in their duties to act with integrity and
objectively.
1.5 marks
The auditors need to make reference to the going concern status of the entity since the problems are large
enough to cast a doubt on the going concern status of the company. However, they might face pressure from
management since the company is huge and management might feel that such problems are common to big
businesses and it is inappropriate to issue a modified report.
1.5 marks
The auditor should never substitute his judgement with that of the directors since he is an independent person
expressing an opinion on the financial statements based on his knowledge and expertise. However, where large
companies involved in complex financing arrangements are concerned, auditors may have to fight against
people with powerful, vested interests if they disagree with the directors' judgements and decide to make
reference to the going concern problem in the auditor's report. An auditor making reference to going concern
issues in an audit report in such circumstances may lose the audit (and any other work) and may run a
significant risk of litigation if their opinion is proved to be wrong. They might also face the risk of losing the audit
assignment.
1.5 marks
Maximum marks 6
66. Going concern – EWheels
Answers to both the sub-questions (a) and (b) should be brief since they individually carry only 5 marks each.
You should take only about 16 minutes to answer this question.
List the enquiries and explain, in one sentence for each enquiry, how the enquiry will help the auditor, for
answer (a). This will help you to show your knowledge about the purpose of the going concern review.
Since the part (b) of the question carries only 5 marks, you should briefly state the types of opinions that can be
given and the circumstances under which these can be given. An illustrative paragraph can be given only if time
permits.
(a) Reference to the going concern status
To review the overall financing position of the company in detail, I will examine budgets and cash flow forecasts,
and performance against budgets and cash flow forecasts. This will help assess whether the cash position is
positive, whether the company is in a position to continue its day-to-day activities and whether the company is
capable of repaying the existing loans. If this information is not available for whatever reason, it will probably be
necessary for the directors to produce it.
1 mark
To know whether the company can procure any additional finance if needed, the relationship between the
company and its bankers should be investigated thoroughly. If the relationship is poor and the chances of
getting additional finance are poor then it is an indication that the company‘s position is threatened.
Correspondence with the bank will be examined.
1 mark
EWheels is partly financed by bank loans. In such a case, it must be sending its financial statements regularly to
the banks. The auditor should inspect these. This is likely to reveal the exact repayment pattern of EWheels in
the past. It will also give him an idea of the potential of the company to expand its operations.
1 mark
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Solution Bank: 215
EWheels plans to take over its competitors and acquire additional office space. Enquiries should be made of
directors about the availability of additional equity and other finance which will be necessary for the planned
expansion. All statements in this respect should be substantiated and supported by documentation. The
statements will help the auditor to assess the capability of the company to afford the expansion. This information
should be compared to the budgets and cash flow forecasts of the company.
1 mark
Enquiries should be made of the company's lawyers as to the likely outcome of the dispute with the ex-director.
It will be necessary to make either a provision or a disclosure in the financial statements unless it is improbable
that any amount will be payable to him. The liability and its nature will help the auditor assess whether there is
any threat to the going concern of the entity due to the financial obligation.
1 mark
Maximum marks 5
(b) Audit reports can be modified in the following ways
If there is adequate disclosure in the financial statements regarding the problem then an 'emphasis of matter'
paragraph might be included in the audit report highlighting the problem. This would only be possible however, if
the matter were adequately disclosed in the financial statements.
2 marks
If the matter were not adequately disclosed in the financial statements, it might be necessary to issue an 'except
for' opinion, disagreeing with the lack of disclosure in the financial statements. However, this opinion should be
given only when the non-disclosure is material enough so as to make the financial statements misleading.
2 marks
An 'adverse' opinion stating that the financial statements do not fairly present the position at all because of the
lack of disclosure might be necessary if the auditors considered the matter to be fundamental to the view given
by the financial statements as a whole. This opinion will be given if the auditor feels that the weaknesses in the
internal control systems and the litigation against the entity and other such matters are material enough that the
non-disclosure will cause the financial statements to be misleading.
2 marks
In extreme circumstances, where it is clear that EWheels is not a going concern due to its several outstanding
loans, the litigation case and the weak internal controls yet the financial statements were still prepared on a
going concern basis, it would probably be necessary to issue an 'adverse' opinion.
1 mark
Maximum marks 5
67. Going concern and negative assurance – Smithson Co
This is a scenario based question relating to the going concern concept. Part (a) is knowledge based where you
need to define going concern and discuss auditors’ responsibilities with respect to going concern. The question
carries four marks and the definition carries one mark therefore you need to mention the basic meaning of going
concern. The discussion on the auditor’s responsibilities carries three marks, so you need to have three valid
points.
Part (b) is scenario based. You are required to state the audit procedures that an auditor carries out in order to
determine whether the entity is a going concern. As the requirement verb is ‘state’, you need to state eight valid
procedures in order to score the maximum marks, as each relevant procedure carries a mark. The question is
quite easy because you could include certain general points such as reviewing cash flow forecasts or obtaining
representations from the directors.
In part (c), you are required to explain the audit procedures the auditor may undertake where the auditor has
decided that the entity is unlikely to be a going concern. The question carries four marks. The requirement verb
is ‘explain’. Therefore valid points would include the effect of this development on the audit reports, obtaining a
written representation, etc.
In part (d), you are required to define negative assurance and then explain how this differs from assurance on
an audit report. The question carries 4 marks. The definition carries one mark with additional marks available
for explaining the difference between the two types of assurance.
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(a) Going concern
Going concern indicates that an entity will continue its operation in the foreseeable future (the future period
which is not restricted to but not less than a period of 12 months).
Going concern is the basic assumption on which financial statements of an entity are prepared. It is one of the
fundamental accounting concepts used by auditors and stated in IAS 1 Presentation of Financial Statements.
IAS 10, Events After the Reporting Period, states that an entity should not prepare its financial statements on a
going concern basis if:
¾ it intends to liquidate
¾ it intends to cease trading
¾ the directors find no other option suitable other than to liquidate or close down
1 mark
The auditor's responsibility in respect of going concern is explained in ISA 570 Going Concern. The ISA states
'when planning and performing audit procedures and in evaluating the results thereof, the auditor should
consider the appropriateness of management's use of the going concern assumption in the preparation of the
financial statements'.
1 mark
The auditor's responsibility therefore falls into three areas:
(i) To assess management’s evaluation relating to going concern. For this, it is necessary to carry out
appropriate audit procedures such as analysing and discussing cash flow, profit and other relevant forecasts
with management, and analysing and discussing the entity’s latest available interim financial statements
with management. This analysis is made to understand whether the entity’s going concern status is likely to
be affected in the near future.
1 mark
(ii) While preparing financial statements an auditor has to ensure that the organisation's management have
been realistic in their use of the going concern assumption. For this, the auditor would have to document
audit procedures followed in evaluating management’s assessment of the going concern of the entity.
1 mark
(iii) A report to the members needs to be submitted where the auditors consider that the going concern
assumption has been used inappropriately, for example, when the financial statements indicate that the
organisation is a going concern, but audit procedures indicate this may not be the case.
1 mark
Maximum marks 4
Common errors and reasons why those errors will not obtain marks are as follows:
(i) “Going concern means that the company will be in existence for the unforeseeable future.”
(ii) “The auditor is responsible for ensuring that the company will be a going concern by producing cash flow
forecasts and other documentation to prove this.”
The auditor only needs to evaluate management’s assessment of the going concern status of the entity.
Therefore the auditor is not responsible to ensure that the company will be a going concern.
(b) Audit procedures that are carried out to try to determine whether or not Smithson Co is a going
concern are as follows:
(i) Discuss with the directors their opinion on whether Smithson can continue as a going concern or not. Ask
for their reasons and try to decide whether these are correct.
(ii) Get a copy of the cash flow forecast (for the next twelve months) and discuss the results of this with the
directors.
(iii) Make an enquiry with the directors about whether they have considered any other forms of finance for
Smithson to make up the cash shortfall identified in the cash flow forecast.
(iv) Analyse, and discuss the entity’s latest available interim financial statements with the client. Match the level
of sales / income after the year-end (given in the interim financial statements) with the cash flow forecast.
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Solution Bank: 217
(v) Make an enquiry about the possible lack of capital investment within Smithson as identified by the employee
leaving. Review current levels of non-current assets with similar companies and review the purchase policy
with the directors.
(vi) The auditor should judge the extent to which Smithson relied on the senior employee who recently left the
company, and find out from the human resources department whether the employee will be replaced, and if
so, how soon.
(vii) The auditor needs to identify whether the entity faces any legal claims from customers on account of
providing below standard services to clients. For this the auditor must obtain a solicitor's letter containing
details of all such claims. Furthermore, the auditor must consider the financial impact of the claims on
Smithson and verify whether insurance is available to mitigate any claims.
(viii) Review Smithson's order book and client lists to try and determine the value of future orders
compared to previous years.
(ix) The auditor needs to determine whether bank repayments due in the next one year can be made without
further borrowing. For this the auditor needs to verify the bank letter and the cash forecasts.
(x) The auditor needs to read the minutes of the meetings of shareholders, those charged with governance and
relevant committees for reference to financing difficulties.
(xi) Check other events after the end of the financial year and decide whether these have an impact on
Smithson.
(xii) Obtain a point in the written representation confirming the directors' opinion that Smithson is a going
concern.
1 mark for each valid point
Maximum marks 8
Common errors and reasons why those errors will not obtain marks are as follows:
(i)
“Check whether any more employees have left the company.”
The word “check” is vague. It would have been better to suggest that the auditor should discuss the
replacement of key employees with management, rather than simply “checking”.
(ii) “Key employees leaving the company”
This is actually an indicator of going concern problems, not an audit procedure.
(iii) Listing general audit work on the financial statements (for example, carry out an inventory count)
This is not relevant as it does not relate to the future of the company.
(c) Audit procedures if Smithson is not considered to be a going concern.
(i) Discuss the situation with the directors. Decide whether financial statements should be made on a
'break up' basis or whether additional disclosures are needed in the financial statements.
(ii) If the directors refuse to prepare the financial statements on a 'break up' basis or refuse to put up the
additional disclosures relating to the going concern status not being met then the auditors would have
to issue a modified audit report. Matters relating to the issue of a modified audit report must be
discussed with the directors.
(iii) The audit report would be as follows:
Situation 1
Where the directors provide adequate disclosure relating to the going concern situation of Smithson, an
emphasis of matter paragraph is likely to be appropriate to draw attention to the going concern
disclosures.
Situation 2
Where the directors do not make adequate disclosure of the going concern situation the audit report would
have to be qualified after making reference to the going concern problem. Furthermore the qualification
would be either an 'except for' opinion or an adverse opinion.
(iv) The auditor would have to obtain a written representation wherein the client should mention the fact
that the entity’s going concern status is not met along with reasons for the going concern not being
met. Such a representation will provide evidence of the director’s view on going concern.
1 mark for each valid point
Maximum marks 4
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Obtain a written representation.”
This is an incomplete point as the reason for the procedure is not included. It would be more appropriate to state
that written representation must be obtained in order to confirm the directors’ view on going concern.
Repeating audit procedures from part (b) of the question. This is not required as the auditor had made a
decision regarding the going concern concept.
(d) Negative assurance
Negative assurance relating to cash flows indicates that the cash flow forecast contains no material
errors. Such an assurance is therefore given in the absence of any indication to the contrary.
1 mark
A negative assurance is issued in contrast to an unmodified audit report which indicates that the financial
statements are true and fair and contain no material misstatement. That is why it is said that the audit
report on statutory financial statements provides positive or reasonable assurance.
1 mark
Under a negative assurance, the auditor warns the users that the cash flow forecast may be inaccurate.
Therefore less reliance can be placed on the forecast than the financial statements, where the positive
assurance was given.
1 mark
With the negative assurance, the auditor is also warning that there were limited audit procedures that
could be used; as the cash flow relates to the future therefore the auditor cannot get all the evidence to
guarantee its accuracy. As financial statements are on past basis, the auditor should be able to obtain
information to confirm they are correct; hence the use of positive assurance.
2 marks
Maximum marks 4
Common errors and reasons why those errors will not obtain marks are as follows:
(i) “Negative assurance means that the cash flow does not present a true and fair view.”
Negative assurance should not be linked to true and fair view as it relates to the lack of knowledge of material
error.
(ii) Repeating audit procedures on going concern.
These were relevant to part (b) of this question.
68. Subsequent events – ZeeDiem Co
The scenario contains two events relating to Zee Diem, which occurred after the reporting period. In part (a)(i)
you are required to explain whether the two events are adjusting or non-adjusting and in part(a)(ii) you need to
explain the auditor’s responsibility and actions that should be taken on the two events.
Part (i) carries four marks. Therefore you can get 2 marks for explaining whether each event is adjusting or
non-adjusting. Part (ii) carries twelve marks. Each event carries six marks where you need to explain the actions
and responsibilities. Two marks are also available for stating general responsibilities of the auditor regarding
subsequent events.
For part (b), you are expected to explain the additional work an auditor should carry out in respect of a fine
being levied on their client relating to a non-adjusting event. The question carries four marks. Therefore in order
to score the maximum marks, you need to state 4 relevant procedures.
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Solution Bank: 219
(a) Event 1
(i) The event is adjusting, according to IAS 10 Events After the Reporting Period, as it provides additional
evidence. The problem with the mattresses existed at the end of the reporting period, as the inventories with
the faulty springs were on hand at that time. This inventory should be valued at cost or net realisable value,
whichever is lower, and so will be valued at $225,000. The financial statements should be adjusted to reflect
this decrease in value of the inventory.
2 marks
(ii) The auditor will be responsible for material events affecting the financial statements, up till the time the audit
report is signed. The decrease in the value of inventory was discovered after the reporting date, but before
the audit report was signed.
2 marks
Audit procedures
¾ Make sure the financial statements are amended to reflect the value of inventory as $225,000. Also confirm
that the value of inventory is decreased by $525,000 ($750,000 – $225,000) in the statement of financial
position and the income statement.
¾ Contact the insurers and acquire proper documentation showing the current valuation of inventory. Confirm
that no further claims can be made from the insurer for the loss.
¾ Obtain a confirmation from management that the amount written off from the inventory is accurate.
¾ Make sure the defective springs are not used in any other product of the company. This will require a review
of the inventory list to confirm that the defective springs are not included in the inventory list.
¾ Contact the spring suppliers and verify that no refund is possible from the company for the defective
springs.
¾ Find out about the directors’ decision relating to the valuation of inventory. A qualified opinion may be
necessary if no appropriate adjustments are made by the company to the financial statements.
¾ The written representation received from management must include the amounts of inventory written off and
also confirm that no other items of inventory are affected.
¾ If management refuses to make the required adjustments to the financial statements, the auditor would
need to assess its effect on the audit opinion i.e. assess whether the audit report would need modification.
1 mark for each valid point
Maximum marks 8
Event 2
(i)
The event is non adjusting, as the event occurred after the end of the reporting period, and could not be
foreseen during the period. The event is therefore indicative of conditions existing after the end of the reporting
period. However, investigations by the Environmental Agency could give rise to legal claims, so a disclosure
in the financial statements is necessary.
2 marks
(ii) The dye spill happened before the auditors signed the report. So, the auditors have a responsibility to make
sure the event is disclosed, as it materially affects the financial statements of the company.
2 marks
Audit procedures
¾ To assess the extent of damage, reports from the environmental agency should be obtained. In addition,
documentation such as minutes of the board meetings, copies of the environmental legislation etc. should
be obtained.
¾ Determine, through discussions with the directors, whether they intend to disclose the event in the financial
statements.
¾ If they do intend to disclose, make sure the disclosure is complete and proper.
¾ If they do not intend to disclose, assess the situation and form an opinion, as to whether such a disclosure is
necessary. Make the directors aware of your opinions.
¾ If the directors still do not intend to disclose the event, the audit report may have to be qualified on account
of disagreement with accounting treatment.
¾ Finally, if the auditor is of the opinion that this event may endanger the future of the company, then this has
to be included in the auditor’s opinion paragraph under ‘emphasis of matter’.
1 mark for each valid point
Maximum marks 8
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Common errors and reasons why those errors will not obtain marks are as follows:
(i) No clarity regarding the reason for the events being adjusting or not.
(ii) Stating that “Event 2 is non-adjusting because it takes place after the year end and the amount of the claim
has yet to be determined.”
This is an incomplete point as the point must mention that it is a non-adjusting event as it took place after the
end of the reporting period.
Stating that “Regarding event 1, the auditor needs to amend the financial statements to show the fall in the
value of inventory.”
This common error must be avoided as the auditor is not responsible for amending the financial statements. It is
the responsibility of the management of the company.
(iii) Stating that ‘a lawyer’s letter would be obtained’
This is a general procedure for subsequent events as it does not relate to the scenario. Instead, the point can
be explained as the lawyer’s opinion is needed on the likelihood of being sued for environmental
damage’.
(b) Additional audit work
Audit procedures for the event after the audit report has been signed
¾ Ascertain the course of action that the directors have planned, by discussing it with them.
¾ If the directors decide to amend the disclosure in the financial statements, the amendment needs to be
audited, i.e. the auditor would have to verify the report issued by the environmental agency and get the
matter mentioned therein confirmed by an ‘expert’ on environmental legislature / lawyer. Furthermore, even
the audit report needs to be re-drafted and re-dated.
¾ The directors may decide against amending the disclosure in the financial statements. In this case, the
auditor will need to think of other ways of informing the members, such as disclosing it in the next general
meeting, etc.
¾ Alternatively, the auditor has the option to resign, and call for an extraordinary AGM. But it cannot be held
before the AGM, so this option will not work.
1 mark for each valid point
Maximum marks 4
Common errors and reasons why those errors will not obtain marks are as follows:
Stating that the financial statements need to include a monetary provision for this non-adjusting event. This is an
invalid point as a non-adjusting event does not require adjustments to the financial statements.
G
SECTION G
SOLUTION BANK
REPORTING
69. Report to management – Cliff
The question carries 30 marks and you are expected to complete the answer in 54 minutes.
While answering part (a), you should highlight the relevant points in the scenario to find out what the problem is.
You should write about all the possible legal, financial and operational implications of the existing systems and
their effects on the cash flows, profits and finally on the financial statements.
In part (b), read the requirement of the question carefully. The requirement itself will provide you with the
answer plan. You have to make four recommendations along with their respective advantages and
disadvantages.
(a) The possible problems expected at Cliff
due to the poor internal control are:
Inventory management
Remember, internal control means:
¾ efficiency and effectiveness of operation
¾ reliability of financial reporting
¾ compliance with applicable laws and regulations
(i) Financial implication
Implications of poor inventory management when discussed under
I would expect the company to
sub-heads given below will provide better presentation because
experience some level of overimplications on various areas can be discussed. In addition, this will
ordering. This is because the
help you to avoid getting confused and jumbling up issues.
company
trusts
the
local
managers to purchase inventory and they might take wrong decisions due to lack of experience. This will
lead to reduced profitability as a result of inventory passing its expiry date and going to waste.
Additionally, overstocking increases the need for working capital, and providing capital has a cost.
(ii) Legal and regulatory implication
Over-stocking of inventory might lead to a lot of substandard, old goods being kept in the supermarkets.
This will lead to a breach of health and safety regulations which may result in fines or even closure of the
supermarkets.
(iii) Operational and financial implications
I would expect stock-outs and therefore sales forgone in other supermarkets due to over-stocking of food
items at Cliff. This will affect the overall market scenario leading to scarcity of food items in other
supermarkets. While one supermarket will earn profits, the others will suffer losses leading to a reduction
in profits.
I would expect inefficiencies in ordering of food items since there is no central ordering system. This will lead
to uneven, i.e. excessive or insufficient quantities being ordered at each location. Since each location will
order independently, the company will not be able to receive quantity discounts on bulk purchases. This will
lead to increased inventory costs and hence loss of profits.
There is no regular system of inventory counting and that means any cases of pilferage will go
undetected. Over-stocking coupled with lack of inventory counts is a very dangerous situation since
supermarket inventory is prone to theft either by staff or customers.
(iv) Management of affairs and staff
The problems stated above will increase when the supermarket staff are poor quality. The question states
that the quality of the staff has fallen hence they are likely to be inexperienced and they may be
dishonest. Dishonest staff is / are likely to commit fraud creating financial losses. Inexperienced staff will
lead to bad operational management resulting in errors and misleading financial statements due to
inventory figures being materially misstated.
222: Reporting
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I would expect there to be a lack of understanding of the business as a whole as to the availability of new
products, products with high margins or other areas in which profitability might be improved. This is
because the staff are inexperienced and most of the managers operate locally. This makes their outlook
very narrow for a business that operates across several outlets. This could lead to loss of future
business opportunities and hence loss of profits.
2 marks for each valid point
Maximum marks 10
(b)
While answering this make sure you do what the question asks and point out both advantages and
disadvantages. It can be difficult to point out disadvantages arising from your own recommendations!
Four recommendations and explanation of advantages and disadvantages: improvements to internal
control
Recommendation 1
An integrated computerised system should be introduced across all supermarkets that links sales,
purchases and inventory records.
Advantages
An integrated system will enable the records of inventory to be updated centrally at
all times. The company will be able to obtain an update of the overall position of
inventory at any time. If the records are updated in real-time, it will reduce the
scope for pilferage as any pilferage will be immediately detected by the system.
It is important
to clearly state
the implications
in each case.
When management is able to obtain an overall view of the inventory it will be able to take timely decisions
regarding fresh purchases as well as disposal of obsolete inventory items. This will result both in reduced
stock-outs and reduced inventory obsolescence.
Disadvantages
Installation of a fully integrated system will require considerable capital investment in hardware, software
and training. It will also take control away from local managers which will almost certainly cause
resentment. This might lead to some of them leaving the organisation which could prove to be a serious
problem, especially if those who leave are experienced. The resentment may also make them commit
fraud as they are familiar with the operation of the supermarkets and hence can commit fraud easily.
These frauds may lead to losses as well as misstatements in the financial statements.
4 marks
Recommendation 2
Regular or continuous inventory counting procedures should be introduced together with the prompt updating of
inventory records for discrepancies found and investigation of the reason for the discrepancies.
Advantages
A continuous check on the inventory will reduce the possibility of stock-outs and provide evidence of
over-ordering. A regular update of inventory records will ensure that management is aware of the real time
conditions and any pilferage or theft will be detected at an early stage and investigated. It will also streamline
the purchases. As the system is updated for discrepancies, the inventory records will be up-to-date and errorfree. The financial statements will also be free of any material misstatements.
Disadvantages
A continuous check on the inventory may lead to the staff feeling that they are being spied on or that they
are no longer trusted. The disgruntled employees may commit fraud for personal benefits. There will be
costs in terms of staff time since the inventory will now be checked frequently. Training will also be required
and additional administrative work will need to be undertaken by local managers. This will lead to
resentment amongst the local managers.
4 marks
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Solution Bank: 223
Recommendation 3
There should be regular analysis of the management accounts. Regular analysis includes the preparation
of management accounts on a timely basis i.e. at least on a quarterly basis, but ideally on a monthly basis.
The management accounts should be submitted promptly to head office. After receiving the reports from
the individual supermarkets, head office should analyse the performance and inventory lines of each
individual supermarket.
Advantages
A regular analysis of the accounts will enable the company to determine which supermarkets are performing
better than others. This will make the supermarket managers more responsible and answerable for the
performance of their supermarket. It should lead to improvement in the performance of the supermarkets.
Regular analysis will also lead to timely detection of any major deviations or errors in the accounts and
hence rectification can be done at an early stage. It will lead to preparation of error-free financial statements
at the year end.
It will also enable the company to identify those inventory lines that sell well and those that don’t.
Discussions can also be undertaken with the local managers to explore the possibility of introducing new
products or exchanging certain products (although a product might not sell in one supermarket, it might
sell in another).
This will lead to an increase in business and hence greater profits.
Disadvantages
The production of more regular and detailed information will be time-consuming. This will lead to more time
being spent on preparation and analysis of accounts with less time left to actually implement the plans.
Local managers may feel that they are unable to service the particular needs of their local customers if
decisions are made centrally; customers may feel the same way. This could lead to customer
dissatisfaction which will lead to long-term profit reduction since the supermarkets will lose customers.
4 marks
Recommendation 4
Decisions relating to sales price need to be centralised at the head office.
Advantages
This will enable the company to experiment with the use of 'loss leaders', i.e. those products that are
sold at a loss deliberately so that customers come to the supermarket to buy these and end up buying
other products as well. This is a technique used to attract customers.
At times the local managers might take decisions based on their own local circumstances. This might
lead to wrong prices being set and hence might also lead to competition amongst their own counterpart
nearby supermarkets.
Centralised pricing decisions will impose a degree of consistency across supermarkets to prevent
inappropriate pricing decisions being taken by local managers. It can also permit a more unified approach
to marketing, such as advertising certain price reductions in all supermarkets in the chain.
Disadvantages
Again, loss of control at a local level is likely to result in resentment and the possible loss of good staff.
What sells well in one supermarket may not do so in another. As the head office has less experience of local
conditions than local staff, inappropriate pricing decisions may be made by the head office.
Any wrong decisions relating to pricing could lead to loss of customers. Whereas over-pricing will lead to
customers looking for substitutes, under-pricing might make them feel that the product quality has gone
down. This could adversely affect the profitability.
4 marks
Maximum marks 12
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(c) The auditor’s communication in the internal control system
According to ISA 265, Communicating deficiencies in internal control to those charged with governance and
management:
(i) The auditor shall communicate in writing significant deficiencies in internal control identified during the audit
to those charged with governance on a timely basis.
1 mark
(ii) The auditor shall also communicate in writing, on a timely basis, to management at an appropriate level,
significant deficiencies in internal control that the auditor has communicated or intends to communicate to
those charged with governance, unless it would be inappropriate to communicate directly to management in
the circumstances. Certain identified significant deficiencies in internal control may call into question the
integrity or competence of management. For example, there may be evidence of fraud or intentional
non-compliance with laws and regulations by management or management may exhibit an inability to
oversee the preparation of adequate financial statements that may raise doubts about management’s
competence. Accordingly, it may not be appropriate to communicate such deficiencies directly to
management.
1 mark
(iii) During the audit, the auditor may identify other deficiencies in internal control that are not significant
deficiencies but that may be of sufficient importance to merit management’s attention. The communication
of other deficiencies in internal control that merit management’s attention need not be in writing but may be
oral. Where the auditor has discussed the facts and circumstances of the auditor’s findings with
management, the auditor may consider an oral communication of the other deficiencies to have been made
to management at the time of these discussions. Accordingly, formal communication need not be made
subsequently.
1 mark
(iv) In determining when to issue the written communication, the auditor may consider whether such
communication would be an important factor in enabling those charged with governance to discharge their
responsibilities. For listed entities in certain jurisdictions, those charged with governance may need to
receive the auditor’s written communication before the date of approval of the financial statements in order
to discharge specific responsibilities in relation to internal control for regulatory or other purposes.
1 mark
(v) Regardless of the timing of the written communication of significant deficiencies, the auditor may first
communicate these orally to management and to those charged with governance to assist them in taking
timely remedial action to minimise the risks of material misstatement. Doing so, however, does not relieve
the auditor of the responsibility to communicate the significant deficiencies in writing
1 mark
(vi) The fact that the auditor communicated a significant deficiency to those charged with governance and
management in a previous audit does not eliminate the need for the auditor to repeat the communication if
remedial action has not yet been taken. If a previously communicated significant deficiency remains, the
current year’s communication may repeat the description from the previous communication, or simply
reference the previous communication. The auditor may ask management or, where appropriate, those
charged with governance, why the significant deficiency has not yet been remedied. A failure to act, in the
absence of a rational explanation, may in itself represent a significant deficiency.
1 mark
Contents of letter of weakness
The management letter, which communicates the weaknesses in the internal controls, contains:
(i) Weaknesses in the system: the auditor should give details of the weaknesses noticed by him. He should
also communicate the reasons for the weaknesses, such as inadequacies / redundancies of control, etc.
(ii) The implications of weaknesses: the auditor should also communicate the possible consequences of
such weaknesses like misappropriation of money due to poor authorisation controls. This will give
management an idea of the impact of the weakness on the financial statements.
(iii) Recommendations suggested by the auditor: the auditor should also give recommendations for
corrective actions to be taken to overcome the reported weaknesses in future. For example, for
discrepancies in authorisation policies relating to payment, the auditor should suggest that there should be a
proper authorisation policy. This policy should state which people are responsible for authorisation and the
limit up to which each person is authorised to approve the payment.
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Solution Bank: 225
(iv) Disclaimer by the auditor: it is not the primary duty of the external auditor to evaluate the controls and find
out the weaknesses in the internal control system. Therefore, the auditor should mention in the
management letter that only those weaknesses which the auditor has noticed as a result of his audit are
reported in the letter, and that he has not designed his audit plan to determine the adequacy of the overall
internal control system.
0.5 marks for each valid point
The management letter enables the management to take necessary actions to remove the reported
weaknesses and make the system more effective in future.
Maximum marks 8
Do not waste your time in writing the introduction i.e. definition of internal control etc.
Simply repeating the facts given in the question would amount to a bad answer. For example, in part (a) of the
answer, while writing ‘operational and financial implications’, do not repeat the facts given in the case such as
‘Cliff is a private company that runs a chain of small supermarkets selling fresh and frozen food, and
canned and dry food’ etc. Re-read your answer, and check if you have repeated any facts.
In part (a), differentiate the points with the help of bullets. This will help the examiner to identify different points.
You should cover at least 6-8 points in part (a) to score good marks.
70. Audit reports – Rudra Plc
This is a 30 marks question based on audit reports. You should complete the answer in 54 minutes in the
examination. The answer to this question is not lengthy. However, you are required to write a detailed answer to
every sub-part.
While answering part (a), when you mention the type of report and the circumstances in which the auditor
issues such a report, explain the auditor’s reasons why he thinks such a report is essential and also give an
illustrative paragraph of the report.
In part (b), while discussing the type of audit report to be issued, make sure to give the auditor’s reasons for
issuing such a report. This part carries 12 marks and hence you should make sure to write a detailed
explanation for all the reasons point by point. This will make it clear why the auditor expresses the opinion that
he does!
In part (c), you need to explain the purposes for which auditor’s responsibility is disclosed in the audit report in
detail. This part will help you to score marks easily.
(a) An auditor generally issues an unqualified report when the financial statements show a true and fair view of
the affairs of the entity and no material misstatements exist that cause the statements to be misleading.
However, in certain circumstances, the auditor may still feel that there is an important matter, properly disclosed
in the accounts, which the shareholders should be aware of. In this case, the auditor can refer to the matter in
an extra ‘emphasis of matter’ paragraph. An emphasis of matter paragraph highlights any matter that
requires the attention of the readers and which might be overlooked if not also referred to in the audit report.
This paragraph draws attention to a note given in the financial statements that discusses the matter more
extensively. It is important to note that this is not a qualified opinion; it is merely the auditor pointing out an
important matter.
2 marks
An emphasis of matter paragraph is given under the following circumstances:
(i) There is substantial doubt regarding the going concern status of the entity. Any doubt about the going
concern status of an entity might affect the decisions of the users of the financial statements and hence
needs to be included in the audit report as an emphasis of matter paragraph. The paragraph should draw
the readers’ attention to a note in the financial statements that discusses the going concern doubt in detail.
E.g. the bankruptcy of a major customer and the amounts involved along with the possible losses that can
ensue.
3 marks
226: Reporting
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(ii) Material uncertainty exists, the outcome of which is dependent on future events and which may affect the
financial statements.
Any pending litigation is a perfect example of this kind of uncertainty because the financial effects are based on
the occurrence, or non-occurrence, of a certain event. E.g. in the case of pending litigation for claims against the
entity, the entity will incur a liability if it loses the case. Therefore the incurrence of the liability is dependent on
the outcome of the case. These matters require a separate emphasis of matter paragraph since uncertainties
can reduce the reliability of the financial statements. The readers’
Reasons why these matters require
attention should be drawn to these matters so that they can take
an emphasis of matter paragraph!
informed decisions based on these statements.
3 marks
This clearly shows that the extra paragraph is not a qualified opinion, but because the matter being discussed is
so important, it was necessary to highlight it in the auditor’s report.
Maximum marks 8
(b) The basic responsibility for the preparation and presentation of the financial statements is that of the
management. The auditor is only responsible for checking the accounting records provided to him and
expressing an opinion on them.
An auditor’s report can be divided into two broad categories. It is either an unqualified report or a qualified one.
Modifications in an auditor’s report can be mainly due to any disagreement with the management, inability to
obtain sufficient and appropriate audit evidence or any material fact that needs disclosure. Disclosures of these
modifications need to be made in a uniform way. Uniformity in the form and content of each type of the modified
audit report enhances the users’ understanding of these reports.
2 marks
In the given case, Sia, the auditor, was not provided with the records relating to inventory and trade receivables
for the last six months of the audit period under review. In such a case, the auditor can have the following
remedies:
¾ ask the management to update the records of inventory and receivables and these would then be audited
as far as possible;
¾ try to acquire third party confirmations from, eg from customers, to obtain alternative pieces of evidence
1 mark
Sia would need to follow these procedures in order to be able to express an opinion on the financial statements.
Currently, there is a severe limitation on the scope of Sia’s audit since she cannot confirm amounts which
constitute two major items on the SOFP.
1 mark
Before forming an opinion on the financial statements, Sia will consider the following facts:
¾ inventory and receivables together account for 45% of the assets on the SOFP.
¾ inventory accounts for $250,000 and receivables $150,000, both of which are material amounts.
¾ the lack of confirmation of these figures by the auditor could make the financial statements materially
misstated.
2 marks
In such a case, Sia will have to issue a disclaimer considering the gravity of the inability to obtain sufficient and
appropriate audit evidence on the scope of her audit. The modified report can be given by Sia in the following
manner:
Description of inability to
“We did not observe the counting of the physical inventories as of
obtain sufficient and
December 31, 20X7, since management did not allow us to attend the stock
appropriate audit evidence!
take. The records of the inventory and that of receivables were not updated
for the last six months of the audit report. Owing to the nature of the company’s records, we were unable to
satisfy ourselves as to inventory quantities by other audit procedures.
1 mark
“We were not able to observe all physical inventories and confirm
Reason - material enough
accounts receivable due to limitations placed on the scope of our work by
to issue disclaimer.
the company.
“Due to the significance of the matters discussed in the preceding paragraph, we do not express an opinion on
the financial statements.”
1 mark
Maximum marks 8
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Solution Bank: 227
(c) The auditor’s report should disclose the auditor’s responsibility clearly. This disclosure should state that his
responsibility is to express an opinion on the financial statements based on the audit procedures carried out
by him.
1 mark
The paragraph explaining the ‘Auditor’s responsibility’ is given to convey to the user that:
(i) the audit was carried out in accordance with the ISAs which require the auditor to comply with ethical
requirements.
(ii) reasonable care has been exercised while planning the audit procedures. The audit has been performed in
such a way so as to obtain reasonable assurance that the financial statements are free from material
misstatements.
(iii) an audit involves procedures to obtain audit evidence, on a test basis, regarding the amounts and
disclosures in the financial statements.
(iv) the audit procedures followed by the auditor depend on his judgement. This judgement includes
assessment of the risk of material misstatements. In this assessment, the auditor considers the internal
controls existing in the entity. He includes a statement on the effectiveness of the internal controls only
when there is an explicit requirement.
(v) an audit involves evaluation of whether proper accounting policies have been used, the accounting
estimates made are reasonable and the presentation of the financial statements is appropriate.
(vi) the auditor believes that sufficient audit evidence has been obtained in order to form an opinion on the
financial statements.
0.5 marks for each valid point
Such a disclosure in the auditor’s report assures the readers that proper procedures have been followed by the
auditor. This increases the reliability of the audit report.
Maximum Marks 4
(d) Extract of drafted audit reports
Extract
No.
1.
2.
3.
Meaning of the extract
Purpose of the extract
This paragraph is known as the opening or
introductory paragraph. It confirms basic
information about the name and contents of
the report.
It provides introduction to the user regarding
the name of the entity whose audit is carried
out, the fact that the financial statements have
been audited. It also provides information about
the components of the financial statement, date
and period of the audit, reference to the
summary of the significant accounting policies
and explanatory notes.
The ‘Auditor’s responsibility’ paragraph builds
confidence in the user’s mind. It assures the
readers that the audited financial statements
are trustworthy because those are in
accordance with the ISAs and the ethical
standards of the ACCA.
This is a part of ‘Auditor’s responsibility’ in
the audit report. This disclosure states that
the auditor’s responsibility is to express an
opinion on the financial statements based
on the audit procedures carried out by him.
The extract confirms that the auditor has
carried out the audit work in accordance
with the generally accepted auditing
standards and not those made up by the
audit firm. Furthermore, it confirms that
audit planning was carried out in order to
detect material errors.
It states that the auditor has compared the
normally accepted method for valuation of
the inventory (as given in IAS 2) to that
used by the company and found
discrepancy in the methods used.
It might also limit the auditor’s liability. How
could you expect an auditor to do better then to
follow current international auditing standards?
It informs the readers of the financial
statements that the company is not following
the IAS in this particular matter and so the
financial statements may be incorrect in this
respect.
Continued on the next page
228: Reporting
Extract
No.
4.
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Meaning of the extract
Purpose of the extract
It shows how the IAS would normally be
applied to the inventory and by using the
FIFO method, how the valuation will differ
from the reported amount.
This information enables the readers of the
financial statements to quantify the impact of
the non-compliance of the IAS
i.e. by $75,000.
5.
It shows the overall impact of noncompliance with the IAS – with specific
focus on the overstatement of current
assets of $75,000.
From this information, the reader can make out
that the current assets and profit for the year,
both are overstated by $75,000. It may affect
the ‘value’ of the company, which is based on
the value of the assets and the profitability.
6.
This information means that the auditor
disagrees with the inventory amount
reported by the management. However, this
is the only matter that the auditor disagrees
about and the accounts are qualified in this
limited area only.
The purpose behind this information is to
communicate to the readers that in the opinion
of the auditor, the financial statements do not
show a true and fair view in respect of
inventory, but otherwise the accounts do show
a true and fair view.
2 marks for each valid point (1 mark for meaning and 1 mark for its purpose)
Maximum marks 10
71. Audit reports – Corsco
This question is partly knowledge based and partly scenario based. Parts (a) and (b) require knowledge about
ISA 570 – Going concern. In parts (c) and (d), you have to apply that knowledge to the given scenario.
You should analyse the scenario and form an opinion to answer the question well.
(a) External auditor responsibilities – going concern
ISA 570 Going Concern deals with this issue.
(i) Going concern is an important issue and every auditor needs to consider it while carrying out an audit
because it concerns the continued existence of the company. The auditor, after investigation, should form
and disclose his opinion on any doubts he has about the going concern status of the company. According to
the provisions of ISA 570, listed companies may have to make some additional disclosures in relation to the
going concern issue.
(ii) The auditor has to form an opinion about the going concern status by assessing the adequacy of internal
controls by other means such as internal control processes. For this, the auditor should verify the internal
audit reports and practise segregation of duties, etc. Poor internal controls could lead to poor decision
making and overstatement of assets.
(iii) Furthermore, the auditor has to verify the means by which the management and directors have satisfied
themselves that the going concern status is appropriate. The auditor should cross-verify management
observations based on his past experience and judgment.
Along with this, the auditor needs to check that the disclosures made by the management in the financial
statements are according to the requirements of ISA 570.
(i) The auditor can conduct an initial analysis at the planning stage of the audit as well as assessments at the
later stages. He should check the evidence supporting the company’s going concern status. The evidence
could be future orders for sale, a plan for a substantial capital expenditure in the near future, renewal of
borrowing facilities etc.
(ii) The auditor should make enquiries with the directors and examine the documents such as cash flow
forecasts, production budgets, etc which form a part of the audit evidence and help to confirm the going
concern status of the company.
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Solution Bank: 229
(iii) To form an opinion about the going concern status, the period under consideration is very important. The
auditor should verify that the period the directors have considered is minimum 12 months from the SOFP
date. Auditors should enquire with the directors regarding their knowledge of events or conditions beyond
this period that may cast significant doubt on the entity’s ability to continue as a going concern.
(iv) Assumptions play a very important role in deciding whether the company enjoys a going concern status.
These assumptions include the directors’ plans for any external and internal changes, any obligations which
may arise in future, any guarantees or undertakings with other entities etc. Auditors need to consider the
appropriateness of the assumptions which the directors have made. The auditor has to assess the
sensitivity of these assumptions and the plans of management to deal with any going concern problems.
(v) Documentation of any matter regarding financial, operational or other indicators of going concern problems
is the prime responsibility of the auditor.
(vi) Indicators of going concern issues would include:
¾
¾
¾
¾
¾
¾
¾
¾
trading losses
impairment of assets
net liabilities i.e. total assets are not sufficient to cover total liabilities
defaults on loans
liquidity problems
fundamental changes in the markets or technology having an adverse effect on the company
loss of management, staff, customers or suppliers, or major litigation
Legal changes which might threaten the company’s trade.
(vii) Auditors should obtain a written management representation wherever needed.
1 mark for each valid point
Maximum marks 5
(b) Possible audit reports and circumstances
‘Emphasis of matter’ paragraph
Where the auditor, after considering all the points given in ISA 570 comes to a conclusion that the entity has
certain going concern problems, he has to satisfy himself that:
¾ the reasons considered for coming to this conclusion are correct
¾ adequate disclosures are made by the management
2 marks
After satisfying these conditions, the auditor has to modify his opinion by including an ‘emphasis of matter’
paragraph highlighting the existence of a material uncertainty as to the going concern status of the entity.
Including this paragraph does not mean that the auditor has qualified the report. The auditor just needs to draw
the user’s attention to this fact by means of the separate paragraph.
2 marks
When adequate disclosures are not made by management, the auditor needs to qualify the report.
If the period considered is less than 12 months from the reporting date, the auditor can modify the audit report
by disclosing the fact that the period considered is not representative of the going concern status.
An adverse opinion will be issued if the auditor disagrees with the preparation of the financial statements on the
going concern basis. However, this is a very rare situation because auditors rarely have sufficient evidence to
be sure.
2 marks
Maximum marks 5
(c) Report issued to Corsco
In the case of Corsco, a fall in share price, frequent changes in the management and failure of the take-over
due to negative sentiments in the market are indicative that the company might be facing some going concern
problems.
1 mark
However, the fact that the company has been approached by take-over bidders shows that Corsco may not be
facing a going concern problem. The company may still have a positive sentiment in the market and so the
company may have be a going concern.
2 marks
230: Reporting
Furthermore, as given in the question, the situation has not deteriorated
significantly in the current year and it will be difficult for the auditors to justify any
change in their opinion from the previous years. Therefore, the audit opinion
issued on Corsco in the current year is not likely to make a reference to the going
concern status of the company.
© GTG
Perhaps not what you
expected: an
unmodified audit report.
Fine if you can justify it!
2 marks
Maximum marks 4
(d) Difficulties associated with reporting on going concern
Corsco is a large company listed on a stock exchange. Reporting the going concern issue in the audit report
might cause the share price to fall drastically. It will then, in a real sense, cause the company to have going
concern issues as the value of the business will fall significantly and this might alarm suppliers, lenders and
collaborators.
2 marks
This means that it is very difficult for companies such as Corsco and their auditors to send out any clear signal
to the markets that the company is facing a going concern problem without running the risk of creating panic i.e.
a self-fulfilling prophecy. This will lose the trust the suppliers and buyers have in the company.
2 marks
However, if the auditors do not report on going concern problems of which they are aware the auditors are
failing in their professional duties of integrity and objectivity
1 mark
An auditor making reference to going concern issue in an audit report of a large listed company may lose the
audit (and any other work) of that client and may run a significant risk of litigation.
1 mark
Maximum marks 6
72. Audit reports – Hood Enterprises
The question specifically asks about the responsibilities of directors and auditors regarding the financial
statements. Therefore you should state the responsibilities for both in separate paragraphs. Here the answer
is given in detail for your understanding. You are not expected to write such a detailed answer in the
examination.
(a)
(i) Preparation of financial statements
¾ Directors’ responsibility
It is the responsibility of the directors to prepare and present the financial statements in accordance with the
International Accounting Standards (IASs) and the law of the country in which they operate. This ensures that
the financial statements are consistent with the international standards and hence increases the
understandability of the statements for the readers.
¾ Auditor’s responsibility
The auditor is responsible for verifying whether the financial statements prepared and presented by the
management are in accordance with the legislation of their country and the International Accounting Standards.
The auditor is responsible for expressing an opinion as to whether the accounts show a true and fair view.
This next paragraph is not expected to be given in the answer in the examination. It is given for your
understanding.
“In our opinion, except for the effects of such adjustments, if any, as might have been determined to be
necessary had the international accounting standards been used in the preparation of the financial statements,
the financial statements give a true and fair view of the financial position of company and of its financial
performance and its cash flows for the year ended in accordance with the local laws.”
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Solution Bank: 231
(ii) Fraud and error
¾ Directors’ responsibility
It is the responsibility of the management to design, implement and maintain internal controls relevant to the
preparation and fair presentation of the financial statements so that the financial statements are free from
material misstatements. Hence it is the primary responsibility of the directors to prevent and detect even the
smallest fraud or error in the financial statements.
¾ Auditor’s responsibility
The auditor is responsible for expressing an opinion on the financial statements based on the audit procedures
followed. He has to ensure that the financial statements present a true and fair view of the financial position of
the company i.e. the financial statements are materially correct. This requires him to be aware of any material
fraud that might make the financial statements misleading although he is not responsible for detection of any
fraud or error.
(iii) Disclosure
¾ Directors’ responsibility
The directors must ensure that there is adequate disclosure of all matters required by statute or IASs in the
financial statements. They should ensure that all the disclosure requirements of IAS 1 are fulfilled and
disclosures are made regarding the accounting policies followed. The directors are also required to ensure that
any unusual adjustments made and any matters that are important for the readers of the financial statements
are brought to the notice of the auditor. This is because the directors are responsible for the preparation and
presentation of the financial statements and hence are aware of all the policies followed and adjustments made.
¾ Auditor’s responsibility
The auditor is responsible for verifying whether proper disclosures have been made by management in the
financial statements. Wherever certain disclosures have not been made (e.g. ISA 550 regarding related party
transactions) the auditor has to provide this information in the audit report. This reduces his responsibility as
regards any misstatement in the financial statements because of the failure of the management to make certain
disclosures.
(iv) Going concern
¾ Directors’ responsibility
It is the responsibility of the directors to ensure that the company continues its operational existence for the
foreseeable future. If this is not likely then they are required to report this fact to the members in the published
financial statements. This makes the readers aware of any uncertainties that might affect the existence of the
entity and hence make informed decisions based on these financial statements.
¾ Auditor’s responsibility
The auditor is required to check the accuracy of the directors' workings and assumptions based on which they
have assessed the going concern status of the entity. If these are considered incorrect or inappropriate, then the
audit report may be modified or qualified to bring the situation to the attention of the members of the company.
This will absolve him of any incorrect assumptions made by management in its assessment.
1 mark for each valid point
Maximum marks 6
(b)
The extract of the draft report is given and you are expected to find the errors in this.
The easiest way to do this is to read through the draft line by line and think from the readers’
point of view (i.e. readers of the financial statements). This will give you an idea of where a reader might be
unsure of the information in the report and what information is not provided by the report. You should also try to
remember the standard audit report extracts given in the Study Guide and compare them with the following
extract. This will help you recognise the errors.
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The basis of the opinion paragraph may not meet the requirements of ISA 700 for the following reasons:
The audit report is said to be based on the audit conducted in accordance with auditing standards. However, it
does not mention which auditing standards are used. The audit report should state whether ISA (international
standards on auditing) are followed as this gives the users an idea of the standard of the work completed. The
understandability of the financial statements is also enhanced when the readers are aware of the exact
standards followed.
The directors make estimates and judgements only for significant matters and not for all matters. The audit
report states that the auditor has assessed all the estimates and judgements of the directors which indicates
that the audit was much more detailed than it ought to be. The report should therefore include the word
“significant” to indicate that the audit was mainly limited to material amounts.
An auditor is responsible for expressing an opinion on the financial statements based on the audit procedures
conducted by him. Before expressing an opinion he has to ensure that he obtains sufficient appropriate audit
evidence to support his opinion on the statements. The paragraph here states that the auditor obtained “as
much information as was possible given the time available”. This is wrong as the auditor should obtain all the
required information and explanations necessary before expressing an opinion and not stop the procedures due
to lack of time.
The categorical statement: “We confirm that the financial statements are free from material misstatement”
should not be made. Rather, the auditor should state that he has obtained reasonable assurance that the
financial statements are free from material misstatements. This will limit his liability towards third parties, if any
errors are found later and will clarify that the audit procedures are limited.
The disclaimer regarding errors is useful since it limits the auditor's liability for any fraud or errors committed by
management. However, this should not be included in the basis of opinion paragraph. Mentioning this here
limits the auditor’s basis of opinion to a very large extent.
The directors' responsibilities are clearly outlined in another section of the report. Mentioning that the directors
are responsible for all the errors in the basis of opinion paragraph appears to extend those responsibilities
making the audit report overall less clear. This is because there will now be two paragraphs that state the
responsibilities of the directors. This could also imply that the auditor has done little or no work since the auditor
has expressly denied his responsibility in the report.
The auditor is responsible for checking the financial statements and not the
Important to mention
annual report. Therefore the auditor should not express an opinion on the entire
readers’ point of view!
annual report but restrict it to the observations on the accuracy of the financial
statements. This will make the reader aware that the auditor has limited his audit procedures to the financial
statements and does not cover any other areas that might be a subject matter of the annual report. This makes
the report much clearer.
2 marks for each valid point
Maximum marks 10
(c) A positive assurance report means that the auditor has carried out sufficient work to be able to state that
the financial information is free from material error.
A negative assurance report means that nothing has come to the attention of the auditor, which indicates the
financial information being reported on has errors in it. In the case of negative assurance, the wordings of the
sentence depicts that because the mistakes have not come to auditor’s notice, he is giving an unmodified
report. This also means that there is a possibility of unnoticed errors.
The main difference between the two is that the extent of the audit work carried out in the case of negative
assurance report is less than that of the positive assurance report. Therefore, less reliance can be placed by the
reader on the negative assurance report.
The advantages to the directors for providing negative assurance on their cash flow forecast are as follows:
(i) as the financial information is reviewed by a professional accountant, it adds some credibility to the report.
(ii) when the user of the report reads the negative assurance report, he will not have the same comfort as a
positive assurance report. However, he can have some confidence because though it is a negative
assurance report, it certainly means that the financial information presented by the company is not wrong.
(iii) as the level of assurance provided by an auditor is lower, less work is required and consequently often the
cost too is lower and the report will be prepared more quickly.
1 mark for each valid point
Maximum marks 4
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Solution Bank: 233
73. Audit reports – MSV Co
Part (a) of the question is designed to test your knowledge on audit reports, and requires you to list six basic
elements of an auditor’s report. Therefore you must be familiar with the structure of audit reports and also the
wordings in the International Standards on Auditing relating to the elements. The elements include title,
addressee etc. For each element you also need to explain the reason for the presence of that element in the
audit report.
For part (b) you are provided with a scenario which contains two issues affecting the income statement and the
SOFP respectively, where evidence from normal audit procedures is lacking. This section of the question is
divided into two sub-sections. In part (b) (i) you need to ‘list’ the audit procedures you should conduct to reach a
conclusion on these issues. As the basic audit work is completed, you need to concentrate on the audit
procedures in order to reach a conclusion on the issues. Furthermore, in part (b) (ii) you need to explain the
potential effect of the unresolved issues on the audit report. Here you need to identify the audit opinion and
explain the reasons for the opinion.
(a)
Audit report element
Title of 'independent
auditor'
Reason for that element
This title indicates that the audit has been conducted according
to the relevant ethical requirements that are applicable to an
independent auditor. It also distinguishes the report from any
other audit report that might be given by others.
Addressee (according to
local regulations)
This element is used to identify the persons who may use or rely
on the report. The audit report is generally addressed to those
charged with governance such as the directors, or the
shareholders.
Opening or introduction
paragraph identifies:
The introductory paragraph of the auditor’s report includes the
following matters:
1. financial statements
audited
2. responsibilities of
entity's management
and auditors
(i) the name of the entity whose financial statements have been
audited
(ii) the fact that the statements have been audited
(iii) the title of each of the financial statements that comprise the
entire set of the financial statements audited
(iv) reference to the summary of the significant accounting
policies and explanatory notes
(v) date and period of audit covered
Marks
1
1
Opinion paragraph refers to:
1. financial reporting
framework
2. expressing the auditor’s
opinion
Date of the report
This gives assurance that the financial statements are prepared
by directors and the auditor has audited them following the
1
International Standards on Auditing (ISAs).
It provides the auditor’s opinion on the financial statements
which gives assurance to the reader that the audit has been
carried out in accordance with established principles and
practices. The auditor either expresses a modified or an
unmodified opinion on the statements based on their
assessment of the true and fair presentation of the financial
statements. In an unmodified report, it is expressed that the
accounts are true and fair.
1
The date of the audit report is very important since it informs the
readers that the auditor has considered the effects of all the
events and transactions that happened up to this date. The date
of the audit report should be the date when the auditor has
obtained sufficient appropriate audit evidence based on which
they can give an opinion on the financial statements. This audit
evidence includes evidence that a complete set of financial
statements has been prepared by management and that
management takes responsibility for the preparation.
1
Continued on the next page
234: Reporting
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Audit report element
Auditor’s address
Reason for that element
The report contains the name, location, country or jurisdiction
where the auditor practices.
1
Auditor’s signature
It is the signature of the audit firm and not of the individual
engagement partner. The audit firm assumes responsibility for
the audit. Certain jurisdictions may also require the auditor to
mention the fact that the firm or the auditor is recognised by the
proper licensing authority in the jurisdiction, or the auditor’s
professional accountancy designation.
1
Marks
Maximum marks 6
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Only listing the elements of the report but not explaining those elements. These would be incomplete
points as only half of the question would be attempted.
(ii) Including ‘elements’ (e.g. chairman’s statement) which are not contained in a standard audit report.
(iii) Stating ‘Date of report: the date of the report’
This point is not valid as it does not explain the significance of the date i.e. the auditor has considered the
effects of transactions on the financial statements to that date.
(b) Issue one –
Understatement of sales income
¾ Conduct day-by-day analytical review of sales income and decide the extent of the misappropriation.
¾ The situation needs to be discussed with the other directors; try to find out whether they were aware
of the happenings.
¾ Enquire with the directors about the actions which they propose to take against the directors who
appear to have misappropriated the money.
¾ Provide a recommendation to the directors in the management
letter that they need to maintain a numerical sequence over the
sales invoices. Also suggest that at least two directors always
need to be present on duty, so that misappropriation of income
is prevented.
Remember, a management letter
is written by the auditor and
relates to the findings of the audit
¾ Obtain a written representation from the directors. The letter must confirm the directors' estimate of
the extent of the fraud and also confirm that the directors are unaware of any other instances of fraud.
6 marks
(i). The misappropriation is material, being about 5% of the income for the year. Therefore:
¾ The auditor's report needs to be modified with an 'except for' opinion on account of inability to obtain
sufficient appropriate audit evidence on sales income.
¾ The basis of opinion paragraph (above the opinion paragraph) must explain the reason for the
understatement of income.
3 marks
Issue two - Director's use of the yacht
(i) The director should be questioned about the reason for the yacht being in the director’s house.
Enquire with the directors whether any payments for the yacht were made. If payment is made then verify
the payment with the cash book and company bank statements.
If the yacht is only for private use, then confirm that disclosure of the benefit has been made in the directors'
emoluments note in the financial statements.
Depending on the law of your jurisdiction, inform the director that the use of the asset in kind derived from
the company's asset means that he would be liable to pay tax on the usage.
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Solution Bank: 235
Make sure that the company has provided relevant information to the benefit authority (taxation
authorities) and also confirm that in case of non-disclosure, the financial statements have recognised the
penalty for nondisclosure.
Furthermore, also determine whether or not any other company assets have been used in a similar fashion.
For this, carry out additional audit work such as physical verification of other non-current assets, enquiry
from the client etc.
4 marks
(ii) Assuming that the disclosure of the benefit has not been shown in the financial statements:
¾ The auditor's report needs to be modified using an 'except for' opinion disagreeing with the amount of
information disclosed (i.e. material misstatement which has a material effect on the financial
statements).
¾ As the lack of disclosure relates to directors' emoluments, provide information relating to the benefit
in the audit report itself.
3 marks
Maximum marks 14
Common errors relating to the sales and the yacht included:
¾ Listing audit procedures such as ‘tracing sales invoices into the cash book’, ‘confirming systems
notes’, ‘explaining how to audit non-current / fixed assets’.
These are standard audit procedures relating to sales and cash receipts. Therefore they are irrelevant as they
would normally have been completed, being a part of standard audit work.
¾ Stating ‘ensuring that a separate person reconciled the bank account would not stop a director removing
cash prior to banking’.
The test of control is irrelevant; this test is not required as it would not help to quantify the potential fraud.
¾ Stating that the audit report would be qualified, but not explaining the reason for this type of
qualification.
74. Audit reports – JonArc & Co
You are the audit manager of JonArc, and you are at the end of the audit. For part (a), you are required to
explain how you would attempt to resolve an outstanding issue relating to not providing for depreciation on
buildings in the financial statements of Galartha Co. The question requires you to ‘state’ the additional audit
procedures and actions in respect of the outstanding issue. As the verb in the question is “state”, your answer
must include valid procedures and actions rather than detailed explanations as to why those procedures were
being carried out. In order to score the maximum marks, the answer must include six valid procedures / actions
relevant to the scenario.
For part (b) the scenario includes five different extracts from an audit report. You are required to explain the
meaning and purpose of each extract. Remember, ‘meaning’ relates to explaining the extract while ‘purpose’
relates to stating why the extract is in an audit report. To get the maximum marks, split the answer into two
parts for each extract and explain its meaning and purpose.
Part (c) has two situations. You are required to state the effect of two different situations on the auditors’ report.
In order to score the maximum marks you need to provide two valid points for each situation.
236: Reporting
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(a) Audit procedures for non-depreciation of buildings
(i) The audit file should be reviewed to make sure that sufficient proper audit evidence has been
collected in respect of this matter. The evidence would be in the form of the value of the building, date
of purchase, rate of depreciation which applies to the building (based on the useful life of the building),
the reason for not providing depreciation as informed by the client and also the amount of depreciation
which applies to the building.
(ii) The auditor must make sure that GAAP does apply to the specific buildings owned by Galartha Co and
to show a true and fair view of the financial statements, exit from GAAP is not required.
(iii) The reasons for not depreciating buildings have to be confirmed by the directors through a meeting
with them.
(iv) In the opinion of the auditor, the directors should be warned that the buildings need to be depreciated
and that non provision of depreciation would result in a modified audit report.
(v) The auditor needs to determine the effect of the disagreement in terms of the modified opinion being
material or of pervasive materiality to the financial statements.
(vi) The auditor needs to draft the appropriate sections of the modified audit report.
(vii) The auditor must obtain a written representation from the directors to confirm that depreciation would
not be charged on buildings. This will provide the director’s opinion on record.
1 mark for each valid point
Maximum marks 6
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Explaining in detail how to audit buildings, including procedures such as verifying title and determining
existence by seeing the buildings.
This kind of explanation is not relevant as it relates to the general audit work on buildings rather than the issue
of lack of depreciation.
(ii) Not stating clearly the type of audit report to be provided.
(iii) Considering resignation from the audit assignment before other procedures / actions have been attempted.
The question states that there was only one matter outstanding. Therefore resigning would be inappropriate.
(b)
Extract 1
¾ Meaning
It confirms that the audit work has been carried out in accordance with International standards of
auditing i.e. not arbitrary standards made up by the audit firm. Furthermore, it also conveys that the
audit was planned and performed in such a way that material errors could be detected.
1 mark
¾ Purpose
The readers of the financial statements are provided with the information that the auditor has followed
the ISAs and the ethical standards of the ACCA, and so they can be trusted to carry out the audit.
1 mark
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Solution Bank: 237
Extract 2
¾ Meaning
When the auditor compared the normal accounting treatment for depreciation (as suggested in the IAS)
to that used by the directors it was observed that the directors’ method was different from the standard.
1 mark
¾ Purpose
The readers were informed that the accounting treatment relating to depreciation followed by the
company is not in accordance with IAS 16. Hence the financial statements can be incorrect in this
respect.
1 mark
Extract 3
¾ Meaning
It shows the amount of depreciation that would have to be charged on the building if a standard 5%
depreciation rate was applied.
1 mark
¾ Purpose
The readers are informed about the impact of the IAS non-compliance - in this case $420,000.
1 mark
Extract 4
¾ Meaning
It gives details of the non-compliance with the IAS – i.e. overstatement of non-current assets and
profits amounting to $1,200,000.
1 mark
¾ Purpose
The readers are informed about the impact of the non-provision of depreciation, which is overvaluation
of non-current assets and overstatement of profits amounting to $1,200,000. This will affect the
shareholders’ perception of the value of the company.
1 mark
Extract 5
¾ Meaning
The only matter which the auditor disagrees with, relates to the depreciation figure provided by the
directors i.e. the auditor’s disagreement with the financial statements relates only to non-provision of
depreciation which is materially different from the auditor’s calculation.
1 mark
¾ Purpose
The members are informed that the auditor does not believe that the financial statements show a true
and fair view in relation to depreciation.
1 mark
Maximum marks 10
Common errors and reasons why those errors will not obtain marks are as follows:
(i) Considering each report extract as a separate opinion paragraph and explaining it in terms of different types
of qualification.
This is inappropriate as the question states that these are extracts from an audit report (singular), not separate
reports. Furthermore, by using this approach you would focus on explaining modifications / qualifications, rather
than the actual meaning and purpose of each extract.
(ii) Explaining paragraph 5 as a modified audit report without explaining the type of opinion clearly.
238: Reporting
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(c) Other reporting options
(i) As the auditor still disagrees with the lack of depreciation on non-current assets, he would have to issue a
modified opinion on the grounds of disagreement.
As significant amendments are required in the financial statements (i.e. the disclosed profit is actually a
large loss) the auditor can conclude that the financial statements do not show a true and fair view and issue
an adverse report (rather than an 'except for' report).
(ii) The question mentions that inventory is significant to the financial statements. Therefore it is important that
auditors confirm the existence of inventory. For this, inventory count is the most reliable evidence. However,
in the absence of inventory count, the confirmation of the existence of the inventory is not possible.
This uncertainty regarding the existence can amount to material misstatements in the valuation of inventory.
Under these circumstances, an 'except for' audit report will be issued, noting that adjustments may be
necessary to the inventory value.
1 mark for each valid point
Maximum marks 4
2: Mock Exam
© GTG
1. Electromax Plc is a company listed on the London Stock exchange. The company assembles a range of
televisions and LCD players. Electromax has 200 employees. The current year’s sales revenue is $50
million. Rex has recently been recruited by the company’s internal audit department. He has been asked to
review the internal controls relating to the purchase system for the year 20X8-X9. The following are his
observations relating to the procurement of material:
Requisitioning
The inventory system has fixed re-order levels. Whenever the re-order levels are crossed, the inventory system
automatically raises requisitions. The company has clearly fixed the level of authority regarding who would
authorise requisitions for the capital and non-capital items. The requisitions are raised on preprinted stationery.
However these requisitions are not pre-numbered.
Ordering
The purchase department has two purchase executives and five clerks. The staff in the purchase department
has been clearly assigned the task of handling pre-determined items. Based on the hard copies of the
requisitions, the concerned staff obtains suitable quotations from vendors and identifies the suitable ones. There
is no formal system of documenting this process.
The purchase orders are raised on the inventory systems. The purchase order numbers are automatically
assigned by the system. After raising the purchase order, the purchase requisitions are not retained.
The inventory system has a vendor master file which contains details of all the vendors. Changes to the master
file requires authorisation from the purchase manager. The purchase manager is often not available at his seat
during the core working hours; therefore he has permitted two purchase executives to use his log-in password
to make changes to the vendor master file as and when required.
Receipt of material
The material is received at the security gate. The security guard stamps the vendor’s delivery note (indicating
the date and time of receipt). The material is sent to the stores inward section. The store keeper counts the
material and confirms that there is a valid purchase order for the received goods. The inventory system
prepares a Goods Inward Note (GRN), and then updates the purchase order file.
After preparing the GRN, the material is inspected by the quality department staff. Based on the results of the
quality check the material is accepted / rejected, and the same is updated in the inventory system. The rejected
material is kept in a separate area in the stores. The rejected material is periodically returned to the vendor.
Recording
The accounts clerk manually verifies the purchase invoice, with the purchase order and the GRN. He confirms
the accuracy of the quantity, and the value of the purchase bill. The purchase invoice is then recorded in the
ledger.
Payment
When the payment becomes due, the computer prints out the cheques for each supplier together with a
remittance advice. The assistant accountant test checks the remittance advice with the vendor’s ledger account
and approves the copy of the remittance advice for payment.
Required:
(a) Using the information given above:
Identify and explain the internal control weaknesses, and provide a recommendation to overcome each
weakness.
(15 marks)
(b) The value of the trade payables as at 31 March 20X9 was $12millions.
List the audit procedure you will need to follow to audit the trade payables for the year ending 31 March, 20X9.
Further, explain the audit assertions or audit objectives behind these procedures.
(7 marks)
© GTG
(c)
Mock Exams: 3
In April X9, one of Electromax’s major clients, to whom it sells nearly 90% of its total production, raised
serious doubts about the quality of its products. As a result they have banned Electromax’s products.
State the additional audit procedures which the auditors of Electromax are required to conduct, in order to test
the going concern status of the entity while conducting the audit for the financial year April X8- March X9.
(8 Marks)
(30 marks)
2. (a) Explain the external auditors’ responsibilities in respect of the risk of fraud and error in an audit of
financial statements.
(7 marks)
(b) Outline the sources of audit evidence the auditor can use as part of risk assessment procedures.
(3 marks)
(10 marks)
3.
May Queen is a medium sized limited liability company which manufactures ground support equipment
which is used by the airline industry. Its annual sales for 2009, is $46 million. Most of its sales are on
credit.
The accounts receivable totalled $5,700,000. The ledger contains 4,000 accounts with balances ranging from
$2,500 to $20,000. During the year the company has made a provision for doubtful debts amounting to
$360,000. This provision relates to the following:
Details
General provision (i.e. a specific percentage of overdue receivables)
Specific provision (i.e. against specific accounts receivables)
Total amount
Amount
$120,000
$240,000
$360,000
Batson (the engagement partner) was in the final stages of the audit when he communicated to the audit
committee of May Queen that his brother had purchased 1500 shares of the company when the shares were
quoted at $8.5 on the London Stock Exchange. However his brother recently sold the shares when the share
price was $12.5 followed by a profit warning. Batson had convinced the management that he was aware of his
brother’s shareholding only after his brother sold his shares. Batson’s explanation has convinced the audit
committee of May Queen about Batson’s ignorance on the matter.
Required:
(a)
Describe six audit procedures which the staff members of May Queen’s external audit team would adopt in
verifying the specific provision for bad and doubtful debts.
(8 marks)
(b)
Explain the assertions validated by direct confirmations.
(4 marks)
(c)
Comment on the ethical issues raised on account of the shares held by Batson’s brother and the further
action the auditors should take.
(8 marks)
(20 marks)
4: Mock Exam
4.
(a)
© GTG
Globe Manufacturing, a company that manufactures washing machines appointed Becker and Swing Co
as their auditor for the financial year 20X8 to 20X9. Tony, a new employee, who recently graduated in
Business administration, has been appointed as the audit assistant. McBride is the senior Audit manager.
Although McBride has completed the Audit, one matter is still unresolved. Globe Manufacturing has not
provided for an impairment allowance on receivables, even though the circumstances, as stated in the
international accounting standards, were present at the end of the reporting period. The directors of Globe
Manufacturing were adamant in their policy of not providing for an impairment allowance.
Tony decided to discuss this matter with McBride and asked for her help in deciding the audit approach that
Becker and Swing Co should take.
Required:
State the audit procedures and actions that should be initiated by the auditor in response to the decision taken
by the directors.
(6 Marks)
(b) Globe’s directors have not changed their opinion relating to providing for an impairment allowance .As a
result McBride has to draft an ‘except for’ audit report. Tony being new in this field did not understand the
meaning and purpose of the following Audit extracts. . He is also confused about when to use ‘except for’
and ‘Adverse’ audit report.
Extracts of the audit report are reproduced below for your reference.
¾
‘We have audited the financial statements of Globe Manufacturing in accordance with International
standards on auditing. According to these standards we are required to comply with the ethical
requirements of these standards, plan and perform the audit in order to obtain reasonable assurance that
the financial statements are free of any material misstatements”
¾
The financial statements do not provide for an impairment allowance (Refer note 8 to the financial
statements) which is not in conformity with the International Accounting standards. If these international
accounting standards have been followed, an impairment allowance
for $100,000 would have been
charged in the financial statements. Accordingly the current assets would be reduced by $100,000 and
profit for the year would be decreased by $100,000. The financial statements would have shown $100,000
as a provision for doubtful debt.
¾
In our opinion, the financial statements of Globe Manufacturing give true and fair view except the effects of
the transaction stated in the earlier paragraph on the financial statement.
Required:
Explain to Tony the meaning and purpose of the above stated audit report extracts.
(10 Marks)
(c) Tony has insufficient audit evidence on the income from cash transactions relating to Globe.
Required:
How should the auditor deal with the situation?
(4 Marks)
(20 marks)
© GTG
Mock Exams: 5
5. Autolines Plc produces components for European motor car manufacturers. It has factories located in the
UK and Central and Eastern Europe. The company is not listed but has plans to register with a stock
exchange. It is keen to display its reputation for accurate reporting. Jeremy held a board meeting, where it
was agreed to set up an internal audit department which reports to a newly formed audit committee of nonexecutive directors.
The members of the board unanimously felt that the company would experience difficulty in recruitment and
retention of staff for the internal audit department. The reason for the difficulty in recruitment and retention is the
location of the factories which are situated in small towns over 100 kms from the nearest major city.
The board is therefore looking at two options:
Either appoint:
¾
¾
Accurate LLP, a firm located in Dagenham which specialises in accountancy and internal audit services or
Watson LLP, external auditors of Autolines, who have offices in 25 countries and employ over 30,000 staff.
Required:
(a) Discuss the advantages and disadvantages of appointing Accurate as internal auditors for Autolines.
(8 marks)
(b) Discuss the issues Watson needs to consider before it can accept the appointment as internal auditors for
Autolines.
(7 marks)
(c) Assume that an outsourcing company has been chosen to provide internal audit services.
Describe the control activities that Autolines should apply to ensure that the internal audit service is being
maintained to a high standard.
(5 marks)
(20 marks)
6: Mock Exam
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2: Solution to Mock Exam
© GTG
1.
(a)
Weaknesses
Purchase requisitions not prenumbered.
No formal system of
documenting the process of
choosing vendors before
raising purchase orders.
Details of weaknesses in the
purchase system
This means that there could be
requisitions not given to the purchase
department, or there could be delays
in giving requisitions to purchase
department, thereby causing delays
in procurement.
Recommendation to overcome the
weaknesses
Requisitions must be made on prenumbered stationery. This will
ensure that orders are raised
promptly so that there are no delays
in the receipt of ordered material.
This will ensure completeness of the
purchase orders.
In the absence of any formal
documentation, the purchase staff
will be tempted to choose vendors for
purchase, without asking for alternate
quotations. This could cause excess
payment for purchases.
The procedure of asking for alternate
quotations and preparing pricecomparative statements before
finalising vendors needs to be
ensured.
This will ensure accuracy of
purchase orders.
Copies of the purchase
requisitions are not retained.
Purchase orders could be raised
even though there are no supporting
purchase requisitions. This could
lead to excess purchases.
Every purchase order must be
supported with hard copies of
purchase requisitions.
This will ensure completeness of
purchase orders.
Two purchase executives can
make unathorised changes to
the vendor master file.
Materials entering the
premises are not checked by
the security staff.
Unauthorised changes to the master
file can take place, which could lead
to alteration of any information (like
payment terms) in the master file.
This could lead to unfavourable
payment terms for the company.
The vendor master file must not be
accessed by unauthorised officials.
This means that there are insufficient
internal checks on the quantity of
material received. This could cause
dummy purchases/ shortages in
materials received.
The security staff must count the
material as it enters the premises,
before stamping the receipt of
material in the vendor’s delivery
challan.
This will ensure accuracy of the
purchase orders.
This will ensure accuracy of the
material received.
The rejected material is kept in
the stores department
The rejected material can be used for
routine production when there is a
shortage of raw material.
The rejected material must never be
kept in the stores department. It must
be kept in the custody of the dispatch
section. Furthermore, it must be
returned to the vendors as soon as
possible.
This will ensure occurrence and
accuracy of the purchase receipts.
Manual verification of the
purchase invoice with the
purchase order and the GRN.
There is a possibility of committing
errors of omissions and commissions
while manually verifying the purchase
invoices. This could lead to recording
dummy purchases / incomplete
purchases.
The inventory system must
automatically generate the purchase
vouchers which must be compared
with the vendor’s invoice.
This will ensure accuracy of the
purchase vouchers.
2.5 marks for each point
Maximum marks 15
© GTG
Solution to Mock Exam: 3
(b) While auditing the current liabilities of Electromax, the following audit procedures should be followed.
1.
Trade Payables:
(i) Audit procedure: While auditing trade payables, the arithmetical accuracy of the total of all the trade
payables should be checked with the total payables, and its corresponding contra account in the general
ledger.
Reasons for procedure: This audit procedure is carried out to check the audit assertion of completeness
and accuracy of the current liabilities stated in the financial statements. One of the objectives to carry out
this procedure is to determine the need to investigate any unusual or reconciling items.
1 mark
(ii) Audit procedure: conduct random checks on individual accounts payables list to individual ledger accounts
balance and ensure that the balances tally. Emphasis should be given on material balances, zero balances
and other items on the ledger accounts. Reverse this procedure to check individual ledger account balances
to individual accounts payable list.
Reasons for Audit procedure: This procedure is carried out to confirm the existence and accuracy of
material balances. Large accounts payable balances are tested for their existence and value. Testing of
zero balances is done to ensure the completeness of recording of the invoices i.e. by checking that no
invoice from any supplier is omitted.
1 mark
(iii) Audit procedure: Compare the current year’s trade payables to the prior year’s balances. This should be
done for the individual accounts payables as well as for the total accounts payables.
Reasons for Audit procedure: This procedure has been carried out to ascertain the range of differences in
the different year’s balances. Reasons for any unusual differences
should be investigated. This
investigation might bring up points, such as cash flow problems, because of which there is an unusually
high balance of accounts payable. Another reason for this difference could be the incompleteness of the list
i.e. some accounts payables might have got omitted from the list of accounts payable.
1 mark
(iv) Audit procedure: Purchase invoices received after the year end should be matched with the goods
received note. It should be confirmed that the purchase invoices have valid GRNs (i.e. the materials have
been received during the financial year 20X8-X9). Furthermore, the quantities in the GRNs must match with
the quantities mentioned in the invoices and the rates charged on the purchase invoices must be matched
with the rates mentioned on the purchase orders.
Reasons for Audit procedure: This procedure is carried out to ensure the correctness of cut off
procedures i.e. assertion of cut-off, completeness and its valuation in statement of comprehensive income
and statement of financial position. The value of goods which are received before the year end is checked
for ensuring the completeness of purchase accruals. Furthermore, the value of goods received after the
year end should be deducted from the purchases, and the corresponding liability should be reduced.
1 mark
(v) Audit procedure: Obtaining a supplier’s statement from each supplier and comparing the entries in the
supplier’s statement with the individual ledger account balances. If there are discrepancies, the reasons
should be investigated.
Reasons for Audit procedure: This audit procedure is carried out to obtain independent third party
evidence, relating to the individual accounts payables accuracy, completeness, valuation and existence.
1 mark
(vi) Audit procedure: A walk through test must be performed on a sample of purchase invoices recorded
during the year. This involves:
¾
¾
¾
¾
comparing the purchase invoices with the corresponding goods received notes, to confirm that the
quantities match.
matching the rates mentioned on the purchase invoices with the rates mentioned on the corresponding
purchase order.
verifying the existence of purchase requisitions for the purchase orders.
matching the rates on the purchase orders with the rates mentioned on the price comparative sheets (or any
other decision making process followed by the purchase department before finalising purchase orders).
4: Solution to Mock Exam
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Reasons for Audit procedure: This procedure is carried out to ensure the completeness, existence,
valuation, obligation and allocation, of the payables on the balance sheet.
1 mark
(vii) Audit procedure: Goods received note after the year end should be traced to the purchase invoices. This
is done to ensure the corresponding purchase invoice is recorded in the next year.
Reasons for Audit procedure: This process is carried out to ensure the accuracy of purchases. The
purpose of this procedure is to ensure that purchases are not over stated.
1 mark
(viii) Audit procedure: all the debit balances in the accounts payable register should be analysed and
investigated. Proper explanations should be obtained from the client for the existence of such balances.
Reasons for Audit procedure: This process is carried out to classify the accounts under different heads.
Further existence of debit balances suggests control weaknesses. The existence of such balances means
further audit testing is required. This audit procedure will provide an assurance of classification of the
accounts payable in the financial statements.
1 mark
Maximum marks 7
(c)
ISA 570 includes the ‘loss of a major market’ as an example of an event or a condition that may cast a
significant doubt about the going concern assumption of an entity. Electromax had lost its major customer
whom it sells more than 90% of its products. This has therefore put the going concern status of Electromax
in danger. According to ISA 570, management should make an assessment of the entity’s ability to
continue as a going concern. However, the auditor should evaluate the management’s assessment of the
entity’s ability to continue as a going concern.
1 mark
The above part of the answer c will get maximum 1 mark.
This could be evaluated by applying the following audit procedures:
Review of Management’s assessment of going concern status
Audit procedures relating to the review of management’s assessment regarding its going concern status
involves considering the process that management followed to make its assessment, i.e.
(i)
(ii)
Discussing with the directors about their views on whether the loss of a major customer will affect the going
concern status of Electromax.
1 mark
Ask for the reasons and try to determine whether the reasons are valid.
1 mark
(iii) Obtain a solicitor’s letter and identify any legal claims against Electromax on account of poor quality of
goods sold to its customers.
1 mark
(iv) Review Electromax’s order book to determine the value of future orders compared to the previous years.
1 mark
(v) If the financial statements include any loans, determine whether the repayments due in the next 12 months
can be made without any borrowing.
1 mark
(vi) Appropriate audit evidence relating to the generation of future cash flows and assumptions on which they
are based should be collected.
1 mark
The ‘review of Management’s assessment of going concern status’ will get
maximum 4 marks.
Evaluating managements’ assessment
© GTG
Solution to Mock Exam: 5
The assessment of the feasibility of the assumptions on which the assessment is based i.e. gather evidence
whether the revised plans will ensure that the going concern status of the entity is not affected
1 mark
Reviewing managements’ plan for future action
This involves:
(i)
(ii)
enquiry with the directors about whether alternative customers have been found’;
If alternative sources have been identified, review the interim financial statements of the entity for the year
20X9-Y0 determine the level of sales matches with the managements assessment of the cash flow forecast.
1 mark
Assessment to include all information which the auditor is aware of
The auditor considers whether the assessment has taken into account all relevant information of which the
auditor is aware as a result of the audit procedures
1 mark
Obtaining a management representation
Obtain a letter of representation from the client if the directors are of the opinion that the going concern status of
Electromax is not affected. The written representations must include its plans for future action.
1 mark
Maximum marks 8
2.
(a) An external auditor needs to express an opinion on whether or not the financial statements have been
prepared, in all material respects, in accordance with an applicable financial reporting framework and
whether they provide a true and fair view of the financial position of an entity. It is not the primary
responsibility of the external auditor to prevent or detect fraud or error in the financial statements.
However, in the course of conducting the audit, if he comes across a situation where he has reason to
believe that fraud or error might exist to a material extent, he should modify his audit programme or
perform additional procedures to confirm or dispel his suspicion of fraud or error.
2 marks
In the case of Kingston Cotton Mills Company (1896), it was held that an auditor is not bound to be a detective
or to perform his audit work with the suspicion that there is something wrong.
However, at the same time, this does not mean that it is not the duty of the auditor to detect fraud if situations
give indications of fraud. The auditor should exercise due care and diligence to uncover the fraud.
1 mark
The following summarises the steps that an external auditor needs to take to consider fraud or error in an audit
of financial statements:
(i)
ISA 240 (The Auditor's Responsibility to Consider Fraud in an Audit of Financial Statements)
requires an external auditor to consider the risks of material misstatements in the financial
statements due to fraud. Although, in the absence of any indication of fraud, the auditor does not
need to engage himself to detect fraud, he needs to maintain an attitude of professional
scepticism while conducting an audit.
1 mark
(ii) The auditor should enquire about management's assessment of fraud risk, its process for dealing
with risk, and its communications with those charged with governance as well as employees. He
should enquire into the supervision process with those charged with governance.
1 mark
(iii) The auditor should also enquire of those charged with governance i.e. board of directors about any
suspected or actual instance of fraud.
1 mark
(iv)
The auditor should assess fraud risk and error risk factors (e.g. by trying to identify unusual results of
ratio analysis), and assess the risk of misstatements due to fraud, if any significant risk is identified.
He should evaluate the relevant internal controls, and assess their effectiveness.
1 mark
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(v) The auditor should determine an overall response to the assessed risk of material misstatements due to
fraud or error and develop appropriate audit procedures, including testing certain journal entries,
reviewing estimates for bias, and obtaining an understanding of the business rationale of significant
transactions outside the normal course of business. Appropriate written representations should also be
obtained in this regard.
1 mark
(vi) The auditor is only concerned with risks that might cause material error in the financial statements. He
might therefore pay less attention than internal auditors to small cases of fraud (and errors), although
he must always consider whether evidence of single instances of fraud (or error) are indicative of
more systematic problems.
1 mark
(vii) Where an auditor has reason for suspicion or he encounters actual instances of fraud (or error), he must
consider the effect on the financial statements, which will usually involve further investigations. He
should also consider the need to report to management and those charged with governance.
1 mark
(viii) Where material fraud (or error) is detected, the auditor also needs to consider the effect on the going
concern status of the entity, and the possible need to report externally to the stakeholders, either in the
public interest, or for regulatory reasons. Many entities in the financial services sector are subject to
this type of regulatory reporting and many countries have legislation relating to the reporting of money
laundering activities.
1 mark
(ix) An audit conducted in accordance with ISAs may not always detect a material misstatement in the financial
statements arising from fraud due to the hidden nature of the fraud. In practice, routine errors are much
easier to detect than fraud.
1 mark
Maximum marks 7
(b) Sources of audit evidence:
The auditor can use the following sources of audit evidence as a part of risk assessment procedures:
a. Observation of the entities activities, like in the case of a manufacturing set up, the auditor will observe the
procedures followed for procurement of materials.
b. Inspection of documents like the prior year’s audit reports, valuation reports and internal audit reports.
c.
Inquiries of individuals related to the entity such as valuation experts or external legal counsel.
d. Inquiries of management about the existence of fraud and inefficiencies in the internal control systems.
e. Analytical procedures including ratio analysis to collect high level data relating to the client.
1 mark for each valid point
Maximum 3 marks
3.
(a) Audit procedures for verifying the specific provision for bad and doubtful debts would include
the following:
Obtain the list of bad and doubtful debts. The list must contain the following:
¾
¾
¾
¾
¾
name of the customer,
amount of receivable,
due date for payment,
amount of bad and doubtful debts and
the reason for the provision
(ii) Correspondence related to bad debts should be seen. This would include correspondence from the customer
spelling out the reasons for not making the payment, court decree, etc.
(iii) From the court order, verify the receiver’s expected payment to creditors on liquidation.
© GTG
Solution to Mock Exam: 7
(iv) Review the results of the accounts receivable circularisation. Confirm that the accounts which are included in
the list have not provided direct confirmation.
(v) From the direct confirmations relating to material balances, assess whether any additional provisions (in
addition to the provisions already made) are required.
(vi) For responses which relate to non-material balances which do not have direct confirmations, assess whether
the non-responses were on account of problems like faults in the products. In such a case, assess whether
the amounts require to be provided.
(vii) Review correspondence with customers to identify evidence of problems that might require a provision.
(viii) Verify the aged analysis prepared for making the general provision. Look for particularly unusual items for
which a specific provision would be appropriate, such as individual unpaid invoices where subsequent
invoices had been paid. This could indicate a disputed item.
(ix) Review the subsequent events:
¾
Confirm that cash is not received subsequent to making specific provisions in the books. If cash is
received then the provision made would be inappropriate.
¾
From trade articles, public notices in newspapers, etc. identify the companies which are liquidated and
confirm that if any of the companies relate to May Queen, suitable provisions were made in the books.
¾
Verify minutes of board meetings and correspondence with customers (after the date of the SOFP) to
identify any subsequent event that might require a provision against specific receivables.
(x) Verify the credit notes issued after the date of the SOFP for amounts which were outstanding on the SOFP
date, and assess whether a specific provision is required. For example goods rejected on account of quality
reasons.
(xi) Confirm that the provision has been properly considered and approved by the directors.
The above mentioned audit procedures would provide assurance about assertions relating to completeness,
existence, rights and obligations and existence of bad and doubtful debts.
1 mark for each procedure
Maximum marks 8
(b)
The assertions that are validated by direct confirmations are as follows:
Assertion
Application to direct confirmation of receivables
Existence
The existence of the receivable is confirmed when the customer accepts the amount of
accounts receivables by way of confirmation of the account balance. Furthermore, when
the auditor seeks a negative confirmation request from the customer, if the customer
does not send out a reply it means that the customer’s account balance exists in the
clients’ financial statements.
Rights and
obligations
The assertion of ‘rights and obligations’ means that the entity has a right to the asset. It is
free to use or dispose of the asset as it sees fit. The receivable confirms that the amount
is owed to the entity.
Valuation
and
allocation
Any receivable amount which does not relate to the financial account will be disputed
and the correct amount of receivables will have to be incorporated in the financial
statements. This means that any allocations or valuation adjustments required in the
financial statements (due to discrepancies in the recording of entries) have been made
correctly.
Transactions and events have been recorded in the correct accounting period. In other
words, the transactions that are recorded in the current financial year do not include any
transactions relating to any other year. The circularisation will identify reconciling items such
as sales invoices/cash in transit. The auditor then confirms that the transactions are
recorded accordingly.
Cut-off
1.5 marks for each assertion
Maximum marks 4
8: Solution to Mock Exam
(c)
© GTG
It is important for accountants to act in accordance with the principles set out in the code of ethics.
However, in the course of acting in accordance with the principles, the professional accountant may face
threats to his independence. These threats can be mitigated by applying safeguards.
Batson has faced certain ethical issues on account of his brother’s financial interest. The following table
summarises those ethical issues and their implications:
Ethical issues (threats)
Familiarity threat
Batson, the engagement partner has been
involved with the client for the last five years. This
can cause a familiarity threat as Batson may be
too familiar with the client which will affect his
ability to make objective decisions.
Self interest threat
Shares held by Batson’s brother in May Queen
show that he had a financial interest in the
company. If Batson was aware of his brother’s
financial interest, it would have constituted a self
interest threat. Self interest exists when the
accountant is biased on account of financial,
personal or any other interest in the client. This in
turn would affect his integrity, objectivity and
independence.
Confidentiality threat
Even though the audit committee is convinced
that Batson was not aware of his brother’s
financial interest in the company, there is a
possibility that Batson’s brother has acted on the
information (about May Queen) confided in him by
Batson. This could have compelled his brother to
sell the shares before the profit warning. Thereby
the principle of confidentiality appears to be
breached.
Safeguards
Marks
So as to ensure independence and objectivity,
Batson should be rotated from being the
engagement partner.
2.5
In this case, self interest would occur only if
Batson is aware of the shares held by his brother
in the company. However, in this scenario, the
self interest threat would no longer exist as
Batson’s brother has disposed of the shares.
2.5
It is important for the firm, to investigate the
matter to know the real facts of the case.
4
Situation 1:
If, during investigation it is found that Batson has
given the inside information about the price of the
shares to his brother, then he is liable to a
criminal offence of insider trading and must be
immediately removed from the audit team.
Further, the company would have to notify the
professional authority under which Batson is
registered so that proper action can be taken for
the offence committed by him.
Situation 2:
Batson may be included as an audit team
member if inquiry proves that there was no
breach of confidentiality by him.
General safeguards
The company and the firm should make sure that there are suitable quality control systems and safeguards to
prevent threats. Some of the safeguards which ensure this are:
¾
¾
¾
The audit conducted by Batson should be reviewed by another partner of the firm. This is to provide
assurance on the independence and objectivity of Batson.
The firm must not include audit staff in the team if they pose a threat to its independence.
Finally, the company should obtain a declaration twice a year from all the audit team members in writing,
that they do not have any personal or financial interest in the company.
1.5 marks
Maximum marks 8
© GTG
Solution to Mock Exam: 9
4. (a) Becker and Swing need to verify the reasons behind the management’s decisions. The reasonableness
of the decisions should be judged by Becker and Swing in accordance with the International Accounting
Standards. If Becker and Swing are not satisfied with this, then they could either issue an ‘adverse’ or
‘except for’ report.
1 mark
Becker and Swing should follow the following audit procedures:
(i) Review the audit file to ensure the sufficiency of the audit evidence collected in this matter. This will involve
verification of:
¾
¾
the correspondence with the customers (for whom impairment allowance needs to be made) and
confirmation that the reasons for the impairment were genuine.
a court decree (if applicable).
1 mark
(ii) Ensure the applicability of related International Accounting Standards (IAS 32, IAS39 and IFRS7) to the
impairment under consideration.
1 mark
(iii) Ensure that whether the departure from the international accounting standards is required to present a true
and fair view of the financial statements.
1 mark
(iv) Find out/ confirm the reasons why the directors have not provided for the impairment by having a meeting
with them.
1 mark
(v) Judge the reasonableness of the director’s action in accordance with the international accounting standards
e.g. whether the directors have any collateral security or guarantee against those receivables .In such cases
auditor needs to verify the sufficiency of the collateral to judge the reasonableness of the director’s actions.
1 mark
(vi) If required, warn the directors that their action of not providing for an impairment allowance could result in
an adverse or an except for report.
1 mark
(vii) Determine the impact of the disagreement on the audit report, and evaluate the need to issue a modified
audit report, or whether the disagreement is material to the financial statements as a whole, requiring the
issue of an adverse report.
1 mark
(viii) Draft the audit report based on your judgment.
1 mark
(ix) Take written representation from the directors confirming that they will not provide for an impairment
allowance.
Maximum marks 6
(b) Meaning and purpose of the audit report extracts given in the question:
(i) Meaning
This extract of the Audit report provides the assurance that the audit work has been carried out in accordance
with the international auditing standards. It also implies that they have maintained independence. Furthermore,
it means that the audit planning was carried out to detect material errors, and the audit firm has not applied any
arbitrary standards while conducting the audit.
1 mark
Purpose
It also provides the assurance that the auditor can be trusted, and that he has conducted the audit by applying
all the ethical and international auditing standards recommended by the ACCA.
1 mark
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(ii) Meaning
This extract conveys that the auditor has compared the provisions of the respective standards relating to an
impairment allowance with the director’s method of not providing for an impairment loss. Furthermore, it states
that that the director’s method is different from what is prescribed by the International Accounting Standards.
2 marks
Purpose
The extract is written to let the readers know that the company is not following the International Accounting
Standards, and hence the financial statements are incorrect to that extent. It quantifies the impact of not
following the international accounting standards on the financial statements. In this case it amounts to
overstatement of profits and current –assets amounting to $100,000.
This extract conveys that if the International Accounting Standards were applied, the current assets and the
profit for year would reduce by $100,000 and the SOFP will show a provision of $100,000 for doubtful debt.
2 marks
(iii) Meaning
This extract is meant to convey that the auditor disagrees with the treatment given by the directors to the current
assets. The auditor’s assessment of current assets is materially different than the amounts reported by the
directors. Hence the auditor does not agree with the financial statement figures reported by the directors. It
further conveys that this is the only point where the auditor is in disagreement with the figures stated in the
financial statements.
2 marks
Purpose
The purpose behind this extract is to convey that the financial statements are not depicting the true and fair view
in respect of the profit for the year, and the amount of the current assets.
2 marks
Maximum marks 10
(c) In case, an auditor does not have sufficient appropriate evidence to support the financial statement
assertions relating to income from cash transactions, the following actions will have to be taken:
¾
As a general rule, where appropriate audit evidence relating to any material area of the financial statements
could not be obtained, an auditor needs to modify his audit report. The report can be a qualified opinion if
the matter has a material effect on the financial statements. For example, if the past records, current year’s
budgets, current year financial statements, etc indicate that income from cash transactions is material to the
financial statements, the ‘except for’ report would have to be issued.
1 mark
¾
On the other hand, if the lack of evidence has a material and pervasive effect on the financial statements as
a whole then a disclaimer should be issued. It should state, in the absence of evidence, a judgment on
whether the financial statements give a true and fair view cannot be formed. For example, if the auditor feels
that lack of audit evidence not only affects the income but may also have an impact on cash balance or
other asset balances, then he will issue a disclaimer of opinion.
1 mark
¾
An auditor should not, at any cost, associate himself with fraud. If the management insists on obtaining an
unqualified report instead of a qualified report or a disclaimer, the auditor may leave the assignment.
1 mark
¾
The auditor should obtain a written management representation letter stating that all the cash transactions
are recorded and they are accurate. The management might give such a representation. However, the
auditor should remember that written management representation is not a substitute for audit evidence.
1 mark
Maximum marks 4
© GTG
Solution to Mock Exam: 11
5.
(a) Benefits to Autolines from outsourcing the internal audit function to Accurate
(i)
A higher level of efficiency and, at the same time, a reduction in cost can be achieved. This is
because the outsourcing company needs to be efficient in order to quote a competitive price and take
advantage of economies of scale, as they will tend to specialise in internal audits. For example, a senior
internal auditor specialising in IT can work on several audits in an outsourcing company. However, an
individual company such as Autolines may not find such an IT expert cost effective.
1 mark
(ii)
Access is provided to the outsourcing firm’s broad range of expertise which would otherwise be too
expensive to maintain internally. The audit staff in an outsourcing firm receives versatile exposure to the
audit because of their engagement in the audit of various organisations with varied types of operations. On
the other hand, the internal auditor who is a staff member of a company may only have exposure to
auditing that particular company.
1 mark
(iii) Risk of employee turnover is passed to the outsourcing firm. This is especially in view of the
difficulties relating to appointment and retention of staff for the internal audit department, which Autolines
expects to face,
1 mark
(iv) May improve the independence of the internal audit function since personal relationships of the
employees and reporting relationships would not come in the way of conducting an internal audit.
1 mark
(v)
Access is provided to the latest technologies / software for auditing without incurring associated
costs. Outsourcing firms can afford to buy the audit software that is needed for their different clients.
However, it is cost-prohibitive for a company to procure such software (e.g. audit methodology software)
for its own internal audit department.
1 mark
(vi) Saving management time required for administering an internal audit department.
1 mark
(vii) Employee training costs to educate them about the principles, methods and techniques of an
internal audit can be saved by way of outsourcing.
(viii) Although no information has been has been given about Accurate’s staff, it is expected that the company
will employ independent staff having appropriate qualifications (such as ACCA qualification) to provide a
suitable level of service.
1 mark
The ‘benefits to Autolines from outsourcing the internal audit function to accurate’
will get maximum 4 marks.
Problems with outsourcing from Accurate
(i)
The independence of the internal audit function may be jeopardised if the management unduly
influences the internal audit firm (e.g. if the management threatens not to renew the contract). This will be
reflected in the form of reports from the internal audit department which may not be objective.
1 mark
(ii)
There will always be a risk that the firm’s staff may be ignorant of the organisation’s objectives,
culture or business. Hence, the audit staff would have to acquaint themselves with the accounting
policies and controls at Autolines prior to the commencement of the internal audit. Furthermore, they may
not be aware of the areas in which there are weaknesses in the internal controls, which will be a
disadvantage.
1 mark
(iii) Outsourcing decisions are sometimes taken based on cost considerations ignoring the possibility of
the effectiveness of the function being adversely affected. In order to minimise the risk, regular reviews of
the quality of audit work performed is essential.
1 mark
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(iv) The flexibility and availability of the audit personnel may be adversely affected when the audit
function is outsourced.
1 mark
(v)
Lack of control over the audit staff of the outsourced firm may make it difficult to maintain the
audit standard. This can be overcome by monitoring the internal audit function by having a detailed
discussion with Accurate about the work carried out, the documents reviewed, the irregularities noticed,
etc. Also, Accurate’s system of reviewing the work done by the audit team would have to be reviewed by
Autolines.
1 mark
(vi) The loyalty or trustworthiness of the internal auditor is one of the major considerations while deciding on
whether or not to outsource the department. It is difficult to ascertain whether or not the accounting
firm will be loyal enough to examine the internal control system of the company diligently.
1 mark
The ‘problems with outsourcing from Accurate’ will get maximum 4 marks.
Maximum marks 8
(b) Matters to be considered by Watson
¾ Independence
Watson needs to ensure that its independence is maintained in the following areas:
(i) Independence: sometimes the internal audit function will require offering a recommendation on systems
or maintaining working papers. If the internal auditors are called in for conducting an external audit, they
may have to subsequently check the systems or working papers recommended by the internal auditors.
This will cause a threat of self-review which will affect Watson’s independence. In order to mitigate the risk
of self-review, the staff (including the engagement partner) conducting the internal and external audits must
not overlap.
(ii) Watson would have to follow the ethical guidance of the ACCA. For this it must ensure that there are no
situations of conflict of interests, such as if Watson is already the auditor of Autolines’s, then accepting the
assignment of Autolines will lead to a conflict of interest. In this situation Watson would have to follow the
ethical guidance of the ACCA to mitigate the risk of a conflict of interest. Furthermore, Watson must ensure
that its independence is not affected because of personal interest, financial interest, etc. in Autolines. The
importance of maintaining independence stems from the fact that any threats to independence, real or
perceived, will lower the overall trust that can be placed in the internal report produced by Watson.
4 marks
¾ Training
As a firm of auditors, Watson will train its staff in auditing. This will ensure in-house compliance with association
regulations (e.g. compulsory CPD was introduced from January 20X5). Watson will have to train its staff in
internal auditing. Watson will have to make sure that the staff providing the internal audit function to Autolines is
aware of the relevant guidance for internal auditors.
1 mark
¾ Skills
To undertake internal audit work with Autolines, Watson needs to make sure that it has staff with necessary and
sufficient skills. As a firm of auditors, the staff at Watson must be well-versed in audit procedures.
1 mark
¾ Fee pressure
Watson will face fee pressure to maintain the cost effectiveness of the internal audit department. Furthermore, it
may be under pressure to maintain a high quality of audit work, bearing in mind the fees which are offered.
1 mark
¾ Knowledge
As Autolines’s external auditor, Watson will have knowledge about Autolines. The systems documentation will
already be available. Watson will already be aware of potential weaknesses in the control systems. This will
help in establishing the internal audit department.
1 mark
Maximum marks 7
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Solution to Mock Exam: 13
(c) Controls to maintain the standard of the internal audit department
(i) In case Watson is appointed as the internal auditor, the internal and external audit needs to be managed by
different partners of the firm. In addition, the team members for both the functions must not overlap.
1 mark
(ii) The internal auditors must be asked to report directly to the audit committee, which is made up of
independent non-executive directors. The audit committee must provide the scope of work to the internal
auditors and also monitor the functioning of the internal audit department by reviewing the internal audit
reports and discussing the observations of the internal auditors with the operations staff.
1 mark
(iii) The firm conducting the internal audit must use the appropriate audit methodology. This will include
clear documentation of the audit work carried out, adequate review and drawing of conclusions. The firm
must also set up controls while conducting the audit, like reviewing performance measures e.g. cost, areas
reviewed, etc. Explanations must be obtained for any significant variance from the performance measures.
1 mark
(iv) Ensure adherence to International Standards on Auditing or any in-house standards for auditing by
filling checklists and sending out questionnaires to the operations staff.
1 mark
(v) Furthermore, the outsourced firm must carry out a second partner review of the function. This will
ensure that a high audit quality is maintained.
1 mark
Maximum marks 5
14: Solution to Mock Exam
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Audit and Assurance
(International)
Time allowed
Reading and planning:
Writing:
15 minutes
3 hours
ALL FIVE questions are compulsory and MUST be attempted.
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed from the examination hall.
The Association of Chartered Certified Accountants
Paper F8 (INT)
Fundamentals Pilot Paper – Skills module
2: Pilot Paper
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This is a blank page
The question paper starts on page 3
2
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Pilot Paper: 3
ALL FIVE questions are compulsory and MUST be attempted
1
Westra Co assembles mobile telephones in a large factory. Each telephone contains up to 100 different parts, with each
part being obtained from one of 50 authorised suppliers.
Like many companies, Westra’s accounting systems are partly manual and partly computerised. In overview the
systems include:
(i) Design software
(ii) A computerised database of suppliers (bespoke system written in-house at Westra)
(iii) A manual system for recording goods inwards and transferring information to the accounts department
(iv) A computerised payables ledger maintained in the accounts department (purchased off-the-shelf and used with
no program amendments)
(v) Online payment to suppliers, also in the accounts department
(vi) A computerised general ledger which is updated by the payables ledger
Mobile telephones are assembled in batches of 10,000 to 50,000 telephones. When a batch is scheduled for
production, a list of parts is produced by the design software and sent, electronically, to the ordering department. Staff
in the ordering department use this list to place orders with authorised suppliers. Orders can only be sent to suppliers
on the suppliers’ database. Orders are sent using electronic data interchange (EDI) and confirmed by each supplier
using the same system. The list of parts and orders are retained on the computer in an ‘orders placed’ file, which is
kept in date sequence.
Parts are delivered to the goods inwards department at Westra. All deliveries are checked against the orders placed
file before being accepted. A hand-written pre-numbered goods received note (GRN) is raised in the goods inwards
department showing details of the goods received with a cross-reference to the date of the order. The top copy of the
GRN is sent to the accounts department and the second copy retained in the goods inwards department. The orders
placed file is updated with the GRN number to show that the parts have been received.
Paper invoices are sent by all suppliers following dispatch of goods. Invoices are sent to the accounts department,
where they are stamped with a unique ascending number. Invoice details are matched to the GRN, which is then
attached to the invoice. Invoice details are then entered into the computerised payables ledger. The invoice is signed by
the accounts clerk to confirm entry into the payables ledger. Invoices are then retained in a temporary file in number
order while awaiting payment.
After 30 days, the payables ledger automatically generates a computerised list of payments to be made, which is sent
electronically to the chief accountant. The chief accountant compares this list to the invoices, signs each invoice to
indicate approval for payment, and then forwards the electronic payments list to the accounts assistant. The assistant
uses online banking to pay the suppliers. The electronic payments list is filed in month order on the computer.
Required:
(a) List the substantive audit procedures you should perform to confirm the assertions of completeness, occurrence
and cut-off for purchases in the financial statements of Westra Co. For each procedure, explain the purpose
of that procedure.
(12 Marks)
(b) List the audit procedures you should perform on the trade payables balance in Westra Co’s financial statements.
For each procedure, explain the purpose of that procedure.
(8 Marks)
(c) Describe the control procedures that should be in place over the standing data on the trade payables master
file in Westra Co’s computer system.
(5 Marks)
(d) Discuss the extent to which computer-assisted audit techniques might be used in your audit of purchases and
payables at Westra Co.
(5 Marks)
(30 marks)
3
4: Pilot Paper
2
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(a) ISA 210 Terms of Audit Engagements explains the content and use of engagement letters.
Required:
State SIX items that could be included in an engagement letter.
(3 marks)
(b) ISA 500 Audit Evidence explains types of audit evidence that the auditor can obtain.
Required:
State, and briefly explain, four types of audit evidence that can be obtained by the auditor.
(4 marks)
(c) ISA 700 The Independent Auditor’s Report on a Complete Set of General Purpose Financial Statements explains
the form and content of audit reports.
Required:
State three ways in which an auditor’s report may be modified and briefly explain the use of each
modification.
(3 marks)
(10 marks)
3
You are the audit manager in the audit firm of Dark & Co. One of your audit clients is NorthCee Co, a company
specialising in the manufacture and supply of sporting equipment. NorthCee have been an audit client for five years
and you have been audit manager for the past three years while the audit partner has remained unchanged.
You are now planning the audit for the year ending 31 December 2007. Following an initial meeting with the directors
of NorthCee, you have obtained the following information.
(i) NorthCee is attempting to obtain a listing on a recognised stock exchange. The directors have established an audit
committee, as required by corporate governance regulations, although no further action has been taken in this
respect. Information on the listing is not yet public knowledge.
(ii) You have been asked to continue to prepare the company’s financial statements as in previous years.
(iii) As the company’s auditors, NorthCee would like you and the audit partner to attend an evening reception in a
hotel, where NorthCee will present their listing arrangements to banks and existing major shareholders.
(iv) NorthCee has indicated that the fee for taxation services rendered in the year to 31 December 2005 will be paid
as soon as the taxation authorities have agreed the company’s taxation liability. You have been advising NorthCee
regarding the legality of certain items as ‘allowable’ for taxation purposes and the taxation authority is disputing
these items.
Finally, you have just inherited about 5% of NorthCee’s share capital as an inheritance on the death of a distant
relative.
Required:
(a) Identify, and explain the relevance of, any factors which may threaten the independence of Dark & Co’s audit
of NorthCee Co’s financial statements for the year ending 31 December 2007. Briefly explain how each threat
should be managed.
(10 Marks)
(b) Explain the actions that the board of directors of NorthCee Co must take in order to meet corporate governance
requirements for the listing of NorthCee Co.
(6 Marks)
(c) Explain why your audit firm will need to communicate with NorthCee Co’s audit committee for this and future
audits.
(4 Marks)
(20 Marks)
4
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4
Pilot Paper: 5
SouthLea Co is a construction company (building houses, offices and hotels) employing a large number of workers on
various construction sites. The internal audit department of SouthLea Co is currently reviewing cash wages systems
within the company.
The following information is available concerning the wages systems:
(i)
Hours worked are recorded using a clocking in/out system. On arriving for work and at the end of each days work,
each worker enters their unique employee number on a keypad.
(ii) Workers on each site are controlled by a foreman. The foreman has a record of all employee numbers and can
issue temporary numbers for new employees.
(iii) Any overtime is calculated by the computerised wages system and added to the standard pay.
(iv) The two staff in the wages department make amendments to the computerised wages system in respect of
employee holidays, illness, as well as setting up and maintaining all employee records.
(v) The computerised wages system calculates deductions from gross pay, such as employee taxes, and net pay.
Finally a list of net cash payments for each employee is produced.
(vi) Cash is delivered to the wages office by secure courier.
(vii) The two staff place cash into wages packets for each employee along with a handwritten note of gross pay,
deductions and net pay. The packets are given to the foreman for distribution to the individual employees.
Required:
(a) (i)
Identify and explain weaknesses in SouthLea Co’s system of internal control over the wages system that
could lead to mis-statements in the financial statements.
(ii) For each weakness, suggest an internal control to overcome that weakness.
(b) Compare the responsibilities of the external and internal auditors to detect fraud.
(8 Marks)
(6 Marks)
The computer system in the wages department needs to be replaced. The replacement will be carried out under the
control of a specialist external consultant.
Required:
(c) Explain the factors that should be taken into consideration when appointing an external consultant.
(6 Marks)
(20 Marks)
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6: Pilot Paper
5
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EastVale Co manufactures a range of dairy products (for example, milk, yoghurt and cheese) in one factory. Products
are stored in a nearby warehouse (which is rented by EastVale) before being sold to 350 supermarkets located within
200 kilometres of EastVale’s factory. The products are perishable with an average shelf life of eight days. EastVale’s
financial statements year-end is 31 July.
It is four months since the year-end at your audit client of EastVale and the annual audit of EastVale is almost complete,
but the auditor’s report has not been signed.
The following events have just come to your attention. Both events occurred in late November.
(a) A fire in the warehouse rented by the company has destroyed 60% of the inventory held for resale.
(b) A batch of cheese produced by EastVale was found to contain some chemical impurities. Over 300 consumers
have complained about food poisoning after eating the cheese. 115 supermarkets have stopped purchasing
EastVale’s products and another 85 are considering whether to stop purchasing from EastVale. Lawyers acting on
behalf of the consumers are now presenting a substantial claim for damages against EastVale.
Required:
In respect of EACH of the events at EastVale Co mentioned above:
(i)
Describe the additional audit procedures you will carry out;
(8 Marks)
(ii) State, with reasons, whether or not the financial statements for the year-end require amendment; and
(6 Marks)
(iii) Discuss whether or not the audit report should be modified.
(6 Marks)
Note: The total marks will be split equally between each event.
(20 Marks)
End of question paper
6
Answers
7
2: Solution to Pilot Paper
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Pilot Paper F8 (INT)
Audit and Assurance (International)
Answers
Tutorial note: Some answers are longer than could be expected from candidates sitting this examination. The answers may also include
more points than would be necessary to obtain full marks in the examination. This is to provide examples of valid points that could
be made.
1
(a)
Audit procedures – purchases
Audit procedure
Reason for procedure
Obtain a sample of list of parts documents from the
computer. Trace individual parts to the goods received
note (GRN).
Checks the completeness of recording of liabilities.
For entries in the list of parts where no GRN number has
been entered, enquire with goods inwards staff why there
is no GRN. Document reasons obtained.
Checks that goods have not been received but details not
recorded. Possible cut-off error where goods have been
received but GRN not raised.
Obtain a sample of GRNs. Agree details to the list of
parts document on the computer.
Ensures that the parts received had been ordered by Westra,
giving evidence for the occurrence assertion.
For a sample of GRNs from the goods inwards
department, trace to the invoice held in the accounts
department.
Ensures the completeness of recording of liabilities. GRNs
with no matching invoice indicate a liability has been
incurred. Unmatched GRNs should be included in the
payables accrual.
Note this test will be difficult because there is no cross
reference maintained of the GRN to the invoice.
Review file of unmatched GRNs, investigate reasons for
any old (more than one week) items.
Ensures the completeness of recording of liabilities.
Unmatched items prior to the year end should be included in
the payables accrual.
Obtain a sample of paid invoices. Ensure that the GRN
is attached.
Confirms that the invoice should be included in the payables
ledger, meeting the completeness assertion.
For the sample of invoices, check details into the
computerised payables ledger, ensuring the correct
account has been updated and the invoice amount is
accurate.
Confirms the completeness of recording of payables invoices
in the ledger.
Obtain the unmatched invoices file. Investigate old
items obtaining reason for GRN not being received /
invoice not being processed.
Unmatched items at the year end could indicate unrecorded
liabilities. Ensure included in the payables accrual if the
goods had been received pre-year end.
For a sample of entries from the payables ledger, agree
details back to the purchase invoice.
Ensures that the liability does belong to Westra, meeting the
occurrence assertion.
For the sample of entries on the payables ledger, agree
to the electronic payments list confirming that the
supplier name and amount is correct.
Ensures that the liability has been properly discharged by
Westra and that the payments list is therefore complete.
For a sample of entries on each electronic payments list,
agree details to the purchase invoice.
Ensures that the payment has been made for a liability
incurred by Westra, meeting the occurrence assertion.
For the sample of entries in the electronic payments list,
agree details to the bank statement.
Shows that the payment was actually made to that supplier.
Obtain the bank statements. Trace a sample of payments
to the electronic payments list.
Confirms that the payment made does relate to Westra,
confirming the occurrence assertion.
For a sample of GRNs in the week pre- and post- year-end,
trace to the supporting invoice and entry in the payables
ledger, ensuring recorded in the correct accounting year.
Confirms the accuracy of cut-off in the financial statements.
Tutorial note. This answer follows the structure of the scenario provided in the question. An alternative and valid format would
be to use the assertions as main headings and to make points under each heading.
8
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(b)
(c)
Solution to Pilot Paper: 3
Audit procedures – payables
Audit procedure
Reason for procedure
Obtain a list of payables balances from the computerised
payables ledger as at Westra’s year end.
Cast the list.
To ensure that the list is accurate and that the total is
represented by the individual balances (completeness
assertion).
Agree the total of payables to the general ledger and
financial statements.
To confirm that the total has been accurately recorded and
that the balance in the financial statements is represented by
valid payables (occurrence assertion).
Perform analytical procedures on the list of payables.
Determine reasons for any unusual changes in the total
balance or individual payables in the list.
Provides initial indication of the accuracy and completeness
of the list of payables.
For a sample of payables on the list, agree to supplier
statements at the year-end.
Confirms that the payables balance is due from Westra
meeting the occurrence assertion.
Reconcile supplier statement balances to the payables
ledger.
Ensures that the liabilities exist and belong to Westra at the
year-end.
For invoices on the statements not in the ledger, agree to
invoices entered after the year-end. Check the date of
goods receipt per the GRN attached to the invoice.
Where goods received pre-year end agree invoice to the
payables accrual.
Ensures that all liabilities were recorded at the year end,
meeting the completeness and cut-off assertions.
For payments not included in the supplier statements,
agree to the next month-end statement ensuring that
the payment has been recorded.
Ensures that payments have been made to the correct
supplier.
Review the payables ledger for old unpaid invoices.
Enquire of the chief accountant the reason for
non-payment.
Non-payment may be indicative of goods being returned for
credit indicating that the payables figure may be overstated.
Alternatively, taking additional credit from payables may be a
going concern indicator.
Review credit notes received post-year end ensuring
that where they relate to pre-year end purchases that
the payables accrual has been reduced.
Ensures that payables are not over-stated at the year-end.
Large credit notes may also be an indication of overstating
payables deliberately to reduce profit.
Ensure that payables have been included in the financial
statements under the heading of current liabilities.
Confirm the correct classification of payables in the financial
statements.
Controls over standing data
Controls include:
–
Any amendment (addition, amendment or deletion) to the payables ledger should be authorised by a responsible official,
for example, the chief accountant.
–
Authorisation can be by a manual form being signed or by the chief accountant having restricted access password to
amend the standing data.
–
The computer should reject deletion of a supplier account where there is an outstanding balance (debit or credit).
–
A record of amendments made to the payables ledger should be maintained within the ledger and reviewed on a regular
basis by the chief accountant to ensure that the changes are bona fide.
–
The chief accountant should review the list of suppliers on a regular basis (perhaps every four to six months) and delete
those which are no longer used.
–
A comparison should be made regularly (perhaps every month) between the authorised list of suppliers on the computerised
list of suppliers and the payables ledger. Any new supplier on the list of suppliers should be added to the payables ledger
in preparation for payment.
–
A review of the computer control log regarding access to the payables standing data should be made on a regular basis
and any unauthorised access identified and changes made under that access identified and if necessary reversed.
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4: Solution to Pilot Paper
–
(d)
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A list of suppliers should be printed out occasionally (about every three months) and kept in a secure location in the chief
accountant’s office. The chief accountant should then compare this list with the computerised list in three months time
and account for any unauthorised additions.
Use of CAATs
Audit software may be used to identify old/obsolete balances in some of Westra’s systems eg outstanding deliveries and
payments not being made to suppliers. However, the usefulness of the testing is limited and it is possible that the computer
system already provides similar controls.
Test data input by the auditor would be useful in checking the online payments system, perhaps by setting up some “dummy”
accounts and ensuring that payments are sent to the correct suppliers. Other controls over payments such as access controls
are more likely to be tested manually by the auditor.
Use of Computer-Assisted Audit Techniques (CAATs) may be limited in Westra due to the lack of integration of computer
systems. For example, the suppliers’ database is not connected to the payables ledger, limiting the use of test data to check
transactions all the way through the purchases/payables system.
There is no indication provided in the scenario regarding the extent and effectiveness of computer controls. Controls would have
to be identified and assessed for reliability prior to reliance being placed.
Given that some of Westra’s systems are bespoke, then it may not be cost effective to use CAATs given the time required to write
specific test data or program audit software to use Westra’s data.
Use of CAATs in the suppliers’ database may not be effective given that the database does not input directly into any financial
accounting system. Testing GRNs to purchase invoice to ledgers, etc will provide greater assurance of the completeness and
accuracy of purchases than testing the suppliers’ database.
2
Engagement letter
(a)
Contents of an engagement letter
–
–
–
–
–
–
–
–
–
–
–
(b)
Objective of the audit of the financial statements
Management’s responsibility for the financial statements
The scope of the audit with reference to appropriate legislation
The form of any report or other communication of the results of the engagement
The auditor may not discover all material errors
Provision of access to the auditor of all relevant books and records
Arrangements for planning the audit
Agreement of management to provide a representation letter
Request that the client confirms in writing the terms of engagement
Description of any letters or reports to be issued to the client
Basis of fee calculation and billing arrangements.
Types of audit evidence
–
Inspection – examination of records or documents in whatever form eg manual computerised, external or internal.
–
Observation – looking at the processes or procedures being carried out by others.
–
Inquiry – seeking information from knowledgeable persons, both financial or non-financial, either within or outside the
entity being audited.
–
Confirmation – the process of obtaining a representation of an existing condition from a third party eg a receivables
letter.
–
Recalculation – checking the mathematical accuracy of documents or records.
–
Reperformance – this is the auditor’s independent execution of procedures or controls that were originally performed as
part of the entity’s internal control system.
–
Analytical procedures – evaluation of financial information made by a study of plausible relationships among both financial
and non-financial data.
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(c)
Solution to Pilot Paper: 5
Modification of audit reports
Emphasis of matter paragraph. Used where the auditor wishes to draw attention to an important item in the financial
statements.
Qualification – limitation in scope. Used where the audit cannot obtain sufficient evidence regarding an item in the financial
statements.
Qualification – disagreement. Used where the auditor disagrees concerning the amount or disclosure of an item in the financial
statements.
3
(a)
Threats to independence
Rotation of audit partner
NorthCee Co have had the same audit partner for the last five years. An audit partner’s independence may be impaired where
that position is retained for more than five years for a listed company. The reason being that the partner has become too close
to the directors and staff in the firm and this may impair his judgement on the financial statements. However, NorthCee is
currently not listed so this requirement does not apply.
As NorthCee is now being listed, Dark & Co should rotate the audit partner this year to avoid any familiarity threat. However,
given that NorthCee was not a listed company up to this audit, may imply that the partner could continue this year, but would
be recommended to be rotated before the 2008 audit.
Preparation of financial statements
Apparently Dark have been preparing NorthCee’s financial statements as well as carrying out the audit in previous years.
While this may not have been an independence issue in the past, it is likely to be now as in many jurisdictions auditors may
not provide other services to their audit clients, especially listed client. Preparing financial statements as well as auditing them
would provide Dark with a self-review threat, that is they may not see any errors, or want to report errors in material that they
have previously prepared.
Dark should therefore decline from preparation of NorthCee’s financial statements.
Attendance at social event
Attending the social event with respect to the new listing may be inappropriate as Dark may be seen as supporting NorthCee
in this venture. There is an advocacy threat to independence. Support for a client may imply that the audit firm are “too close”
to that client and may therefore lose their independent view regarding the audit. There is also a familiarity threat.
Dark should therefore politely decline the dinner invitation, clearly stating their reasons.
Unpaid taxation fee
The unpaid fee in respect of taxation services could be construed as a loan to the audit client. Audit firms should not make
loans to or receive loans from audit clients. An outstanding loan will affect independence as closure of the loan may be seen
as more important than providing an appropriate audit opinion.
Dark need to discuss the situation with NorthCee again, suggesting that a payment on account could be made to show that
the whole fee will be paid. Alternatively, audit work on the 2007 financial statements can be delayed until the taxation fee is
paid.
Inheritance
Under ACCA’s Code of Ethics and Conduct, audit partners may not hold beneficial shares in a client company. This provision
includes audit staff where they are involved in the audit. The independence issue is simply that the shareholder (the auditor in
this case) may be more interested in the value of the shares than providing a “correct “opinion on the financial statements.
The shares should be disposed of as soon as possible. However, given the inside knowledge of the listing, disposal now,
or delaying disposal a few days to obtain a better price may be considered “insider dealing”. It may be better that the audit
manager resigns from the audit immediately to limit any real or potential independence problems. Professional advice may be
needed on when to sell the shares.
(b)
Meeting corporate governance requirements
Currently, the only action that the directors appear to have taken is to establish an audit committee. Given that NorthCee is
going to be listed on a recognised stock exchange, then there are other corporate governance requirements to be met. These
requirements include:
–
Ensuring that the chairman and the company chief executive officer (CEO) are different people.
–
Appointing non-executive directors (NEDs) to the board of NorthCee. The number of NEDs should be the same as the
number of executive directors less the chairman.
–
Ensuring that at least one NED has relevant financial experience.
11
6: Solution to Pilot Paper
–
–
–
–
–
(c)
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Appointing the NEDs to the audit committee, remuneration committee and possibly an appointments committee. The
chairman will also have a seat on these committees.
Establishing an internal audit department to review NorthCee’s internal control systems and make reports to the audit
committee.
Ensure that NorthCee has an appropriate system of internal control and that the directors recognise their responsibilities
for establishing and maintaining this system.
Establishing procedures to maintain contact with institutional shareholders and any other major shareholders. The evening
reception for shareholders could become a regular event in this respect.
Checking that the annual financial report contains information on corporate governance required by the stock exchange
(eg a report on how directors monitor the internal control systems).
Communication with the audit committee
Under most systems of corporate governance, the external auditor’s primary point of contact with a company is the audit
committee. There are various reasons for this:
4
(a)
•
Initially, to ensure that there is independence between the board of directors and the audit firm. The audit committee
consists of non-executive directors (NEDs), who by definition are independent of the company and can therefore take an
objective view of the audit report.
•
The audit committee will have more time to review the audit report and other communications to the company from the
auditor (eg management letters) than the board. The auditor should therefore benefit from their reports being reviewed
carefully.
•
The audit committee can ensure that any recommendations from the auditor are implemented. The audit committee has
independent NEDs who can pressurise the board to taking action on auditor recommendations.
•
The audit committee also has more time to review the effectiveness and efficiency of the work of the external auditor than
the board. The committee can therefore make recommendations on the re-appointment of the auditor, or recommend a
different firm if this would be appropriate.
Control weaknesses and recommendations
Control weakness
Internal control recommendation
Employees can be paid for work not done.
There appears to be no check to ensure that hours
recorded in the computer system actually relate to hours
worked.
A record of hours worked by each employee should be printed
from the computerised wages system and signed by the site
foreman to confirm that the hours are accurate.
There is no check to ensure that each employee inputs
his/her employee number. One employee could input
two numbers hiding the fact that one employee is absent.
The computerised wages system should print a list of
employees present per the computer system during the day
and the foreman should then sign this list to confirm it is
accurate.
Fake or dummy employees can be put onto the payroll.
The foreman can set up employee records for workers
who do not exist. As payment is made automatically
from the record of hours worked.
The wages office should check the list of employees against
personnel records of authorised employees. Any new
employees particularly should be verified in this way before
payment is made.
The staff in the wages office could collude by setting up
fake employee records in a similar way to the site foreman.
The list of employees on the payroll should be checked for
accuracy by a person outside of the wages department, for
example the personnel department or the chief accountant.
The list of net payments should be signed by this person to
show it is correct.
Gross pay inflated by wages department staff.
The staff in the wages department could add extra hours
to the records of some employees, and remove the net
pay from the payment received from the courier prior to
making up the pay packets.
The computerised payroll system should be programmed
to produce a list of all amendments made to the payroll.
This list should be reviewed by a responsible official outside
of the wages department prior to wages being paid.
Alternatively, the computerised payroll system should produce
payslips for each employee showing the hours worked, gross
and net pay etc. Employees should then check that the cash
paid agrees to the net payment recorded on the payslip.
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(b)
Solution to Pilot Paper: 7
Fraud and External/Internal audit
Guidance on the auditor’s responsibility with respect to fraud can be found in ISA 240 The Auditor’s Responsibility to Consider
Fraud in an Audit of Financial Statements.
Main reason for audit work
The external auditor is primarily responsible for the audit opinion on the financial statements. The main focus of audit work
is therefore to ensure that the financial statements show a true and fair view. The detection of fraud is therefore not the main
focus of the external auditor’s work.
The main focus of the work of the internal auditor is checking that the internal control systems in a company are working
correctly. Part of that work may be to conduct detailed review of systems to ensure that fraud is not taking place.
Materiality
In reaching the audit opinion and performing audit work, the external auditor takes into account the concept of materiality.
In other words, the external auditor is not responsible for checking all transactions. Audit procedures are planned to have a
reasonable likelihood of identifying material fraud,
However, internal auditors may carry out a detailed review of transactions, effectively using a much lower materiality limit. It is
more likely that internal auditors will detect fraud from their audit testing.
Identification of fraud
In situations where the external auditor does detect fraud, then the auditor will need to consider the implications for the entire
audit. In other words, the external auditor has a responsibility to extend testing into other areas because the risk of providing
an incorrect audit opinion will have increased.
Where internal auditors detect fraud, they may extend testing into other areas. However, audit work is more likely to focus on
determining the extent of fraud and ensuring similar fraud has not occurred in other locations.
(c)
Use of expert
Qualification
The consultant should have a relevant qualification to show ability to undertake the work. In this case being a member of a
relevant computer society or the Institute of Internal Auditors would be appropriate.
Experience
The consultant should be able to show relevant experience from previous projects for example, upgrading or amending wages
systems for other clients.
References
Hopefully the consultant will be able to provide references from previous employers showing capability to undertake the
work.
Project management skills
The consultant should be able to display appropriate project management skills as managing a team will be an important
element of the systems change work.
Access to information
The consultant will need access to important and sensitive information in SouthLea. The chief accountant must ensure that
this information will be made available to third parties. The consultant will have to sign a confidentiality agreement.
Acceptance by other staff
Employing a consultant can be difficult as other internal audit staff may feel threatened or resentful that a consultant has been
employed. The chief internal auditor must ensure that the reasons for employing the consultant are understood by members of
the internal audit department.
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8: Solution to Pilot Paper
5
(a)
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Fire at warehouse
(i)
(ii)
Audit procedures
–
Discuss the matter with the directors checking whether the company has sufficient inventory to continue trading in
the short term.
–
Enquire that the directors are satisfied that the company can continue to trade in the longer term. Ask the directors
to sign an additional letter of representation to this effect.
–
Obtain a schedule showing the inventory destroyed and if possible check this is reasonable given past production
records and inventory valuations.
–
Enquire that the insurers have been informed. Review correspondence from the insurers confirming the amount of
the insurance claim.
–
Consider whether or not EastVale can continue as a going concern, given the loss of inventory and potential damage
to the company’s reputation if customer orders cannot be fulfilled.
Amendment to financial statements
–
Enquire whether the directors have considered whether the event needs disclosure in the financial statements.
Disclosure is unlikely given that the inventory was not in existence at the year-end and on the assumption that
insurance is adequate to cover the loss.
–
Amendment is not required as the fire did not affect any company property and the inventory would not have been
in existence at the year end (inventory turn being very high).
(iii) Modification of audit report
(b)
–
Consider modifying the audit report with an emphasis of matter paragraph to draw attention to the disclosure of the
note on the fire in the financial statements.
–
If the going concern status of EastVale is in doubt, then consider modifying the audit report with an emphasis of
matter paragraph to this effect.
–
If disclosure made by the directors is considered to be inadequate, then modify the audit report with an “except for”
qualification.
Batch of cheese
(i)
(ii)
Audit procedures
–
Discuss the matter with the directors, determining specifically whether there was any fault in the production
process.
–
Obtain a copy of the damages claim and again discuss with the directors the effect on EastVale and the possibility
of success of the claim.
–
Obtain independent legal advice on the claim from EastVale’s lawyers. Attempt to determine the extent of damages
that may have to be paid.
–
Review any press reports about the contaminated cheese. Consider the impact on the reputation of EastVale and
whether the company can continue as a going concern.
–
Discuss the going concern issue with the directors. Obtain an additional letter of representation on the directors’
opinion of the going concern status of EastVale.
Amendment to financial statements
–
The event should be disclosed in the financial statements in accordance with IAS 37 Provisions, Contingent Liabilities
and Contingent Assests as it may have a significant impact on EastVale. Over two-thirds of EastVale’s customers
have either stopped purchasing products from the company or are considering taking this action.
–
No adjustment is required for the event itself as it was not a condition at the balance sheet date.
–
However, the event may become adjusting if company’s reputation has been damaged and the amount of the
legal claim is significant. In this situation the directors may decide that EastVale is no longer a going concern so
the financial statements may have to be re-drafted on a break-up basis. This action complies with International
Accounting Standard 8; the break-up basis is used where the directors have no realistic alternative but to liquidate
the company.
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Solution to Pilot Paper: 9
(iii) Modification of audit report
Modification of the audit report depends on the director’s actions above.
–
If the financial statements are prepared on a breakup basis, and the auditor agrees with that assessment, then a
modified report can be issued with an emphasis of matter paragraph drawing attention to the accounting basis
used.
–
However, if the financial statements are prepared on a going concern basis then the auditor should consider modifying
the audit report with an emphasis of matter paragraph to draw attention to the disclosure of the note on the fire in
the financial statements. This is providing that the auditor agrees that the going concern basis is appropriate.
–
If the going concern status of EastVale is in doubt, then consider modifying the audit report with an emphasis of
matter paragraph to this effect, drawing attention to disclosure made by the directors.
–
If EastVale is not a going concern, and the financial statements have been prepared using this assumption, qualify
the audit report with an adverse qualification stating that the company is not a going concern.
15
10: Solution to Pilot Paper
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Pilot Paper F8 (INT)
Audit and Assurance (International)
1
(a)
Marking scheme
Audit procedures – purchases 12 marks. 1 for procedure and 1 for the reason. Limit to .5 mark in each category where stated
briefly without full detail.
Audit procedure
Parts to GRN
Parts no GRN number
GRN to computer
GRN agree to invoice
Review unmatched GRN file
Paid invoice – GRN attached
Invoice details to payables ledger
Review unmatched invoices file
Payables ledger to purchase invoice
Payables ledger to payments list
Payment list entries to invoice
Payments list to bank statement
Bank statement entry to payments list
GRN cut-off testing
Reason for procedure
Check completeness
System error or cut-off error
Parts received were ordered – occurrence
Completeness of recording
Completeness of recording of liabilities
Confirms invoice in PDB
Completeness and accuracy of recording
Indicate understatement of liability (lack of completeness)
Liability belongs to Westra
Liability properly discharged – payments complete
Payment made for bona fide liability
Confirms payment to supplier
Confirms payment relates to Westra
Accuracy of cut-off
Maximum marks
(b)
12
Audit procedures – payables 8 marks. 1 for procedure and 1 for the reason. Limit to 0.5 mark in each category where stated
briefly without full detail.
Audit procedure
Obtain and cast list of payables
Total of payables to the general ledger and
financial statements
Analytical procedures
Agree payables to supplier statements
Supplier statement reconciliation
Reconcile invoices
Reconcile payments
Review ledger old unpaid invoices
After date credit notes
FS categorisation payables
Reason for procedure
Ensure that the list is accurate
Marks
Confirm that the total has been accurately recorded
Indicates problems with the accuracy and completeness
of payables
Confirm balance due from Westra
Liabilities exist and belong to Westra
Confirms completeness and cut-off assertions
Payment to correct supplier
Credits OS or going concern indicator
Payables not overstated
Classification objective
Maximum marks
(c)
Marks
8
Controls over standing data 5 marks. 1 mark for explaining each control. 0.5 for poor/limited explanation.
Amendments authorised
How authorised (form or access control)
Reject deletion where outstanding balance
Keep record of amendments
Review list of suppliers – unauthorised amendments
Update supplier list on computer regularly
Review computer control log
Review list of suppliers – unauthorised additions
Other relevant points (each)
Maximum marks
5
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(d)
Solution to Pilot Paper: 11
Marks
5
Use of CAATs
Review computer control log
Identify old / obsolete – computer may already do this
Test data – online payments system
Use of CAATs – limited – lack of computer system integration
Need to assess computer controls prior to use of CAATs
Not cost effective – bespoke systems
Limited use of CAATs in suppliers ledger
Other relevant points (each)
Maximum marks
2
5
Engagement letter
(a)
Contents of an engagement letter – 3 marks. 0.5 mark per point.
Objective of the audit of the financial statements
Management’s responsibility for the financial statements
The scope of the audit with reference to appropriate legislation
The form of any report or other communication of the results of the engagement
The auditor may not discover all material errors
Provision of access to the auditor of all relevant books and records
Arrangements for planning the audit
Agreement of management to provide a representation letter
Request that the client confirms in writing the terms of engagement
Description of any letters or reports to be issued to the client
Basis of fee calculation and billing arrangements
Maximum marks
(b)
(c)
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
3
Types of audit evidence – 4 marks: 0.5 only for stating the type and 0.5 for explanation. Maximum 2 marks for simply providing
a list of types of evidence.
Inspection
Observation
Inquiry
Confirmation
Recalculation
Reperformance
Analytical procedures
1
1
1
1
1
1
1
Maximum marks
4
Modification of audit reports. 3 marks. 0.5 for the type of report and 0.5 for explanation.
Emphasis of matter paragraph
Qualification – limitation in scope
Qualification – disagreement
1
1
1
Maximum marks
3
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12: Solution to Pilot Paper
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Marks
3
(a)
Audit risks 10 marks. 0.5 for identifying risk area, 1 for explanation of risk and 1 for stating how to resolve. Maximum 2.5 for
each area.
Rotation of audit partner
Preparation of financial statements
Attendance at social event
Unpaid taxation fee
Inheritance
Other relevant points (each)
Maximum marks
(b)
(c)
4
(a)
10
Meeting corporate governance requirements. 6 marks. 1 mark for each point.
Chief executive officer (CEO)/chairman split
Appoint NED
NED with financial experience
NEDs to sub-committees of board
Internal audit
Internal control system
Contact institutional shareholders
Financial report information
Other relevant points (each)
1
1
1
1
1
1
1
1
1
Maximum marks
6
Communication with audit committee 4 marks. 1 each point.
Independence from board
Time to review audit work
Check auditor recommendations implemented
Review work of internal auditor (efficiency, etc.)
Other relevant points (each)
1
1
1
1
1
Maximum marks
4
Control weaknesses and recommendations. 8 marks. 1 for explanation of weakness and 1 for internal control recommendation.
Maximum 2 per weakness/recommendation.
Recommendation
Control weakness
Employees can be paid for work not done.
No check hours actually worked
Authorise hours worked on computer
Fraudulent input employee number
Reconcile computer to actual employees
Fake or dummy employees can be put onto the payroll.
Foreman setup
Check employees against personnel records
Wages office staff setup
List of employees reviewed for accuracy
Gross pay inflated by wages department staff.
Add extra hours work done
List amendments to payroll produced
Other valid points
Maximum marks
Marks
8
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Solution to Pilot Paper: 13
Mark
(b)
Fraud and External/Internal audit. 6 marks. 1 for internal audit work and 1 for external audit. Maximum 2 per point
Main reason for audit work
Materiality
Identification of fraud
Other relevant points
Maximum marks
(c)
5
(a)
6
Use of expert. 6 marks. 1 mark per valid point.
Qualification
Experience
References
Project management skills
Access to information
Acceptance by other staff
Other relevant points (each)
1
1
1
1
1
1
1
Maximum marks
6
Fire at warehouse
(i)
(ii)
Audit procedures. 5 marks for fire 1 per well-explained point.
Discuss the matter with the directors
Letter of representation point
Schedule of inventory destroyed – reasonable?
Insurance
Going concern status of company
Other relevant points (each)
1
1
1
1
1
1
Maximum marks
4
Amendment to financial statements 2 marks – 1 per well-explained point
Disclosure in FS – unlikely with reason
No amendment to B/S etc
Other relevant points
1
1
1
Maximum marks
3
(iii) Modification of audit report 3 marks – 1 per well-explained point
Modification of report
Going concern status?
Inadequate disclosure by directors
Other relevant points (each)
1
1
1
1
Maximum marks
3
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14: Solution to Pilot Paper
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Marks
(b)
Batch of cheese
(i)
(ii)
Audit procedures 5 marks for fire 1 per well-explained point.
Discuss with directors
Copy of damages claim
Legal advice
Press reports (or other third party) on cheese
Going concern?
Other relevant points (each)
1
1
1
1
1
1
Maximum marks
4
Disclosure of event 2 marks – 1 per well-explained point
Disclosure event – because significant impact
No adjustment
Going concern issue – reputation
May result in amendment to FS
Other relevant points (each)
1
1
1
1
1
Maximum marks
3
(iii) Modification of audit report – 3 marks – 1 per well-explained point
Preparation of FS breakup basis
Prepared going concern basis – emphasis of matter to note this
Prepared going concern – but in doubt – emphasis of matter to note this
Prepared going concern and disagree – qualify report
1
1
1
1
Maximum marks
3
20
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