ICAP Question Bank P Audit and Assurance Fourth edition published by Emile Woolf Limited Bracknell Enterprise & Innovation Hub Ocean House, 12th Floor, The Ring Bracknell, Berkshire, RG12 1AX United Kingdom Email: info@ewiglobal.com www.emilewoolf.com © Emile Woolf International, September 2017 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, without the prior permission in writing of Emile Woolf Publishing Limited, or as expressly permitted by law, or under the terms agreed with the appropriate reprographics rights organisation. You must not circulate this book in any other binding or cover and you must impose the same condition on any acquirer. Notice Emile Woolf International has made every effort to ensure that at the time of writing the contents of this study text are accurate, but neither Emile Woolf International nor its directors or employees shall be under any liability whatsoever for any inaccurate or misleading information this work could contain. © Emile Woolf International ii The Institute of Chartered Accountants of Pakistan Certificate in Accounting and Finance Audit and Assurance C Contents Page Question and Answers Index v Questions Section A Multiple choice questions 1 Section B Objective test and long-form questions 15 Section C Multiple choice answers 69 Section D Objective test and long-form answers 75 Answers © Emile Woolf International iii The Institute of Chartered Accountants of Pakistan Audit and Assurance © Emile Woolf International iv The Institute of Chartered Accountants of Pakistan Certificate in Accounting and Finance Audit and Assurance I Index to Objective test and long-form questions and answers Question page Answer page Audit framework, regulation and ethics 1 ICAP Code of Ethics 15 75 2 Levels of assurance 15 76 3 Shamsuddin 16 77 4 Core concepts 16 77 5 Threats 16 78 6 Burewala and Kamal 16 79 7 Zaman and Bilal 17 80 8 Audit process 17 80 9 Regulatory and professional requirements 17 81 10 Fundamental principles 18 83 11 Confidential Information 18 83 12 Independence of external auditors 18 84 13 Tahira and Parvez 18 84 14 ABC Limited 18 85 15 Masoom, Chalak and Hoshiyar Limited 18 85 16 Prime Super Markets Limited 19 86 Planning and risk assessment 17 Durable Cement Limited (DCL) 19 87 18 Saad Co 19 87 © Emile Woolf International v The Institute of Chartered Accountants of Pakistan Audit and Assurance Question page Answer page 19 Alpha 20 88 20 Engagement letter and documentation 20 88 21 Shahid Corporation 20 89 22 Assertions 21 89 23 Companies Act, 2017 21 91 24 ASPL 21 91 25 Information Limited 22 92 26 Distributor 22 93 27 Fraudulent Financial Statements 23 94 28 Kashif and Company 23 94 29 Delicious Biscuits Limited (DBL) 23 95 30 Daud and Company 23 95 31 ABC (Private) Limited 23 95 32 Materiality 24 96 33 Auditor’s Expert 24 96 34 Mineral Limited 24 96 35 AMF 24 97 36 Acceptance and planning 25 97 37 SPL 25 98 38 Fruit and nuts 25 98 39 Discussions and judgment 25 99 40 Dynamic 26 100 41 Changing Terms 26 100 42 EL 26 101 43 Calm Co 26 101 44 Azam 27 102 45 Hurricane 27 103 46 Zakir Co 28 105 47 Educational University (EU) 29 106 48 Hajira 29 106 49 Tahir Co 29 108 50 Elegant Limited 30 110 30 111 Internal control 51 © Emile Woolf International Training Manager vi The Institute of Chartered Accountants of Pakistan Index to questions and answers Question page Answer page 52 Vision Limited 31 111 53 Types of Controls 31 112 54 Deehan Super Stores 31 113 55 IT Department 31 113 56 Controls 32 114 57 Bhurbhan Limited 32 115 58 Audit trail 32 116 59 Supermarkets 32 116 60 Controls 32 117 61 Shahzad Limited 32 117 62 Waheed Engineering 33 118 63 Danish 34 119 64 Roses Anytime 34 120 65 Trade Receivables 35 122 66 Granger 35 124 Audit evidence 67 Verification of Evidences 36 126 68 Rehan Limited 37 126 69 Sehat Pharmaceutical Limited 37 127 70 Nobel 38 127 71 Masoom Limited 38 128 72 Sky Blue 38 128 73 Direct confirmations 1 38 128 74 Chill 39 129 75 Sales sampling 39 129 76 PQR 39 130 77 Hard Stone Limited 40 131 78 Related parties 40 131 79 Kamil Limited 40 132 80 Direct confirmations 2 40 132 81 Working papers 40 133 82 Al-Shams 40 133 83 Auditor’s expert 41 134 84 ADL 41 134 © Emile Woolf International vii The Institute of Chartered Accountants of Pakistan Audit and Assurance Question page Answer page 85 Guava & Co 41 135 86 RP Planning 42 136 87 Manufacturing inventories 42 136 88 Framework 42 138 89 MWL 42 139 90 BPR 42 139 91 Taskeen Co 42 140 92 Wings 43 142 93 Glasses2Go 43 143 94 ISA 620 44 145 95 Cuddly World 44 145 96 Auditors 45 147 97 Analytical procedures and materiality 45 148 98 Tahira Transporters 46 149 99 Willow 46 150 100 Sparkle Forever 47 152 101 Bubbles 48 154 102 ISA 500 48 155 103 Javeria Co 48 156 104 Porridge 49 157 105 Trembridge Engineering 49 159 106 ISA 620: Using the Work of an Auditor’s Expert 50 160 107 Heidi Co 50 161 Scenarios 108 Zeedin Co 51 163 109 Sahito Co 52 165 110 Bashir Co 53 167 111 Multiple Situations 54 170 Completion 112 Final audit file 55 171 113 Energy Limited 55 171 114 XYZ & Company 55 172 115 XYZ Limited 56 172 © Emile Woolf International viii The Institute of Chartered Accountants of Pakistan Index to questions and answers Question page Answer page 116 Noncurrent assets 56 172 117 Customized Machinery Limited (CML) 56 173 118 Nadeem Limited 56 173 119 System logs 57 174 120 Overtime payments 57 174 121 Khanewal Limited (KL) 57 174 122 ABD Limited 57 175 123 Cell Phones (Private) Limited 57 175 124 Substantive procedures 58 176 125 Pioneer Textile Limited (PTL) 58 177 126 Multiple Questions 58 177 127 Analytical Procedures 58 178 128 Auditor Responsibility 59 179 129 Al-Badr 59 180 130 Shahrukh and Company 60 180 131 The engagement partner 60 181 132 Different audit clients 61 181 133 Situations have arisen on different clients 61 182 134 Hafiz Limited 62 183 135 An ‘emphasis of matter’ paragraph and an ‘other matter’ paragraph 62 183 136 MM Electronics (Private) Limited 62 184 137 Ranjha Limited 63 185 138 Pervasive effects 63 185 139 Audit report at the end of the audit 64 186 140 Iqra Industries Limited 64 187 141 Blue Sky Limited 64 187 142 Form 35A in the Companies 65 187 143 Written Representations 65 188 144 Kazmi-Wassan 65 188 145 RK Resourcing 66 189 146 Rake Enterprises 67 191 67 193 Review engagements 147 © Emile Woolf International ISRE 2400 ix The Institute of Chartered Accountants of Pakistan Audit and Assurance © Emile Woolf International x The Institute of Chartered Accountants of Pakistan SECTION Certificate in Accounting and Finance Audit and Assurance A Multiple choice questions CHAPTER 1 – CONCEPT AND NEED FOR ASSURANCE 1 2 3 4 The fundamental objective of the audit of a company is to A Protect the interests of the minority shareholders B Detect and prevent errors and fraud C Assess the effectiveness of the company’s performance D Attest to the credibility of the company’s accounts The concept of stewardship means that a company’s directors A Are responsible for ensuring that the company complies with the law B Are responsible for ensuring that the company pays its tax by the due date C Safeguard the company’s assets and manage them on behalf of the shareholders D Report suspected fraud and money laundering to the authorities Why do auditors concentrate their efforts on material items in accounts? A Because they are easier to audit B Because it reduces the audit time C Because the risk to the accounts of their being incorrectly stated is greater D Because the directors have asked for it Which of the following is NOT the responsibility of a company’s directors? A Reporting to the shareholders on the accuracy of the accounts B Establishment of internal controls C Keeping proper accounting records D Supplying information and explanations to the auditor © Emile Woolf International 1 The Institute of Chartered Accountants of Pakistan Audit and Assurance 5 International auditing standards are issued by the: A International Accounting Standards Board B Financial Accounting Standards Board C International Audit and Assurance Standards Board D Auditing Practices Board CHAPTER 2 – OBTAINING AN ENGAGEMENT 6 7 8 9 10 When an auditor is proposed for removal from office, which one of the following is he NOT permitted to do? A Circulate representations to members B Apply to the court to have the proposal removed C Speak at the AGM/EGM where the removal is proposed D Receive notification of the AGM/EGM where the removal is proposed Which one of the following is NOT a duty of the auditor? A Duty to report to the company’s bankers B Duty to report to the members C Duty to sign the audit report D Duty to report on any violation of law Assuming that it is not the first appointment of the auditor, who is responsible for the appointment of the auditor? A The shareholders in a general meeting B The managing director C The board of directors in a board meeting D The audit committee The independent auditor's primary responsibility is to: A the directors B the company's creditors (payables) C the company's bank D the shareholders How long is the auditor’s term of office? A Until the audit is complete B Until the financial statements are complete C Until the next AGM D Until the directors remove them © Emile Woolf International 2 The Institute of Chartered Accountants of Pakistan Question bank: Multiple choice questions CHAPTER 3 – PLANNING AND RISK ASSESSMENT 11 12 13 14 15 Which of the following is correct in relation to materiality? A A matter is material only if it changes the audit report B A matter is material if the auditor and the directors both decide that further work needs to be done in the area under question C A matter is material only if it affects directors’ emoluments D A matter is material if its omission or misstatement would reasonably influence the decisions of an addressee of the auditors’ report Which one of the following is NOT considered to be part of planning? A Background i.e. industry B Previous year’s audit i.e. any qualifications in the report C Considering the work to be done by the client staff e.g. internal audit D Considering whether the financial statements show a true and fair view Audit risk is composed of 3 factors. Which of the following is NOT one of those factors? A Compliance risk B Detection risk C Control risk D Inherent risk Which of the following should NOT be considered at the planning stage? A The timing of the audit B Analytical review C Last year’s written representation letter D Obtaining written representations At the planning stage you would NOT consider: A the timing of the audit B whether corrections from the inventory count have been implemented C last year's audit D the potential use of internal audit CHAPTER 4 – EVIDENCE AND SAMPLING 16 Which of the following describes sampling risk? A The risk of the auditor carrying out a test the wrong way round B The risk of reliance on unsuitable audit evidence C The risk that the sample does not reflect the population D The risk of the auditor reaching the wrong conclusions from testing © Emile Woolf International 3 The Institute of Chartered Accountants of Pakistan Audit and Assurance 17 18 19 20 Which of the following is NOT an accepted method of selection in sampling? A Systematic selection B Pervasive selection C Random selection D Haphazard selection Which of the following are you unlikely to see in the current file of auditors’ working papers? A Memorandum & articles of association B Audit planning memorandum C Summary of unadjusted errors D Details of the work done on the inventory count According to ISA 500, the strength of audit evidence is determined by which two qualities? A Appropriateness & competence B Sufficiency & appropriateness C Reliability & extensiveness D Objectivity & independence Which of the following is normally the most reliable source of audit evidence? A Internal audit B Suppliers’ statements C Board minutes D Analytical review CHAPTER 5 – INTERNAL CONTROL 21 22 23 The degree of effectiveness of an internal control system depends on: A The design of the internal control system and the implementation of the controls B The design of the internal controls and the implementation of the control system C The implementation of the controls and the correctness of the accounting records D The design of the internal control system and the correctness of the accounting records According to ISA 315, which of the following is NOT an element of the control environment? A Participation of management B Information processing C Commitment to competence D Human resource policies and practices According to ISA 315, which of the following is NOT a control activity? A Performance reviews B Physical controls C Organisational structure D Segregation of duties © Emile Woolf International 4 The Institute of Chartered Accountants of Pakistan Question bank: Multiple choice questions 24 25 Which of the following is NOT an internal control? A Authorising purchase orders B Ensuring cash is locked away C Performing external confirmation of receivables D The opening of the post should not be the same person who banks the cheques A walk-through test is designed to do what? A To check that materiality levels are acceptable B As a checklist to see if all substantive tests have been performed C To provide assurance within a letter of representation D To confirm that the auditor’s understanding of the internal control system is correct CHAPTER 6 – FLOWCHARTS AND IT CONCEPTS 26 27 28 29 Which of the following descriptions is correct? A An internal control evaluation questionnaire is circulated to staff within the internal control function of an organisation to ask for feedback about their job satisfaction and targets for the coming year. B Narrative notes are a list of questions about controls in a particular aspect of operations or accounting. They are designed to establish whether appropriate controls exist that meet specific control objectives. C An internal control questionnaire is sent from the internal auditors to the external auditors during the audit to request ideas for improving the internal control system. D A systems flowchart provides a logical representation of an accounting system (or part of a system) in the form of a diagram representing documents generated, processes applied and the flow of documents between departments. Which of the following are levels within a systems flowchart? A Top, middle, lower B Mini, micro, macro C Executive, managerial, operational D Strategic, tactical, factory Which of the following descriptions for flowchart symbols is correct? A A circle is used to indicate the starting and ending points of the process. B An oval represents an individual activity or step in the process C Triangles are used to show decision points. Each path emerging from the triangle must be labelled with one of the potential answers. D A pentagon is used to link a particular step of the process to another page or part of the flowchart. Letters are placed in the pentagon to clarify continuation. Which of the following is not a type of physical access control? A Taking a weekly backup of data B Surveillance video C Fingerprint readers for system log-in D Fences, doors and door-locks © Emile Woolf International 5 The Institute of Chartered Accountants of Pakistan Audit and Assurance 30 Which of the following descriptions of ciphers is correct? A Asymmetric key ciphers – these use related (often identical) keys to both encrypt and decrypt information. This is sometimes called ‘shared secret’ between two or more parties B Block ciphers – data is encrypted one ’data unit’ (typically 1 byte) at a time in the same order it was received. The simplest method is to use translation tables which offset the input blocks across an array of the table. Enhanced encryption can be achieved by combining two or more tables C Symmetric key ciphers – these use related (often identical) keys to both encrypt and decrypt information. This is sometimes called ‘shared secret’ between two or more parties D Stream ciphers – this is where fixed length blocks are encrypted and streamed across the network with a high speed connection CHAPTER 7 – TESTS OF CONTROLS 31 32 33 34 35 Which one of the following is NOT an internal control you would expect to see in a sales system? A All goods received notes are authorised by the customer B All orders are checked against credit limits C All invoices are recorded on pre-numbered sequential documents D All cash is banked on the same day as it was received Which one of the following is NOT an internal control you would expect to see in a purchases system? A Preferred suppliers are used B All invoices are grid-stamped to create the company’s own invoice system C Employees are only paid for work done D There is a list of authorised cheque signatories Which of the following is NOT a main element of a sales system? A Receiving orders from customers B Marketing C Despatching the goods and invoicing customers D Recording sales and debtors in the accounts Which of the following is NOT a test of control? A Checking that all purchase invoice are authorised by the proper people B Test checking from purchase invoices to goods received notes C Where a list of approved suppliers exists, checking that orders are placed only with suppliers on such a list D Checking for sequential numbering by the client of purchase invoices received Which of the following is NOT a main element of a purchases system? A Placing orders B Receiving purchase invoices C Goods received D Decisions at board level on whether to incur capital expenditure © Emile Woolf International 6 The Institute of Chartered Accountants of Pakistan Question bank: Multiple choice questions CHAPTER 8 – INTRODUCTION TO SUBSTANTIVE PROCEDURES 36 37 38 39 40 Which of the following is NOT a financial statement assertion? A Completeness B Occurrence C Cash flow D Existence Which of the following is NOT an accepted means of obtaining audit evidence? A Inspection B Enquiry C Analytical procedures D Estimates Which one of the following types of evidence is the most reliable? A The client's sales invoices B Report obtained from a client’s bank confirming balances C The written representation letter D Confirmation during a telephone call with the Managing Director that there are no loans outstanding At what stage of the audit do ISAs 315 and 520 require the auditor to use analytical procedures? A When tendering for the audit of a new client B During the planning stage and the review stage C At the report writing stage D When deciding whether to rely on the evidence of an expert Which of the following is not an accounting estimate? A Depreciation B Provision for claims under a law suit C Price paid for a new non-current asset D Accrued revenue CHAPTER 9 – SUBSTANTIVE PROCEDURES: NON-CURRENT ASSETS 41 Which tangible non-current assets are normally not depreciated? A Land and buildings B Land only C Buildings only D All tangible non-current assets are depreciated © Emile Woolf International 7 The Institute of Chartered Accountants of Pakistan Audit and Assurance 42 43 Which of the following should not be shown as an intangible non-current asset? A Purchased goodwill B Non-purchased goodwill C Development costs meeting the criteria in IAS 38 D Other intangible assets having a readily ascertainable market value A non-current asset register holds details of non-current assets. These details will include: 44 45 A Cost, depreciation, service details, location, disposal proceeds B Service details, serial number, capital allowances, net book value C Capital allowances, disposal proceeds, supplier, location D Cost, depreciation, asset number, serial number, location Which of the following is NOT a substantive test for the audit of non-current assets? A Reconcile the non-current assets register to the receivables ledger control account B Consider the reasonableness of any revaluations C Physically check a sample of non-current asset additions D Vouch disposal proceeds to the bank statement Which term would you NOT associate with non-current assets? A Net realisable value B Goodwill C Investments D Net book value CHAPTER 10 – SUBSTANTIVE PROCEDURES: CURRENT ASSETS 46 47 The principal audit procedure at the inventory count is? A Analytical review B Computation C Observation D Delegation Which of the following is NOT a substantive test for the audit of inventories? A Test the updating of all inventory count differences to inventory records B Test the accuracy of net realisable value through the review of post year-end sales C Have satisfactory explanations been explained for all material inventory count differences D Check that all administrative overheads have been correctly accrued for in the valuation of inventories © Emile Woolf International 8 The Institute of Chartered Accountants of Pakistan Question bank: Multiple choice questions 48 49 50 Which of the following are acceptable valuation methods under IAS 2? A LIFO and weighted average B FIFO and base C LIFO and base D FIFO and weighted average Which of the following is NOT a substantive test for the audit of receivables? A Test cash received after the end of the reporting period B Check adequate provision for doubtful debts C Check reasons for debit balances (and ensure they are disclosed under payables) D Check brought forward balance What is NOT true about bank reconciliations? A Reconciling items must be followed through to the bank statement B An error, if below materiality, is acceptable C If the client has performed the reconciliation, the auditor must cast the whole reconciliation D It is the primary substantive test for cash CHAPTER 11 – SUBSTANTIVE PROCEDURES: OTHER AREAS 51 52 53 54 A good way to authenticate sales is to view the authorisation of? A Goods received notes B Sales orders C Goods despatch notes D Supplier statements Which of the following audit procedures is primarily intended to provide audit evidence as to existence? A Matching sales invoices to goods despatch notes B Casting the sales ledger C Confirming receivables balances with customers D Checking the dating of outstanding cheques Which of the following is NOT normally a non-current liability? A Corporation tax payable B Debentures C Bank loans D Finance lease obligations Which of the following does not appear in IAS 37? A Deferred income B Contingent assets C Provisions D Contingent liabilities © Emile Woolf International 9 The Institute of Chartered Accountants of Pakistan Audit and Assurance 55 Suppliers’ statements are reconciled in order to: A verify the completeness of payables B ensure cut-off is correct C vouch the authorisation of purchase orders D verify the existence of payables CHAPTER 12 – RELATED PARTY TRANSACTIONS 56 57 58 An example of an external business risk is: A The existence of related parties B Having a small customer database C A customer's insolvency D Process of dealing with customer relations Which of the following statements about the audit of related parties is correct? A The materiality of related parties is judged by reference to the company being audited, not the individual related party. B The main audit concern in relation to related parties is the adequacy of the disclosures of the related parties that have been identified. C It is usually considered unnecessary to obtain written representations from management about related parties. D A company should disclose both the nature of related party relationships and the amount of related party transactions. Which of the following statements are correct? 1 With related party transactions, there is some risk of collusion and fraud. 2 A focus of audit attention with regard to related party transactions should be on significant nonroutine transactions. A Statement 1 only is correct. B Statement 2 only is correct. C Both statements are correct. D Neither statement is correct. CHAPTER 13 – RELIANCE ON OTHERS 59 The auditor may work with a specialist. What effect does this have on the auditor’s responsibilities? A The client must take full responsibility for the specialist B The auditor’s responsibilities are not diminished in any way C The auditor and client have joint responsibility for the specialist D All 3 are equally responsible © Emile Woolf International 10 The Institute of Chartered Accountants of Pakistan Question bank: Multiple choice questions CHAPTER 14 – PROFESSIONAL ETHICS AND CODES OF CONDUCT 60 61 62 63 64 You have been proposed as auditor of a company. What is the first step that you should take? A Obtain the client’s permission to communicate with the existing auditor B Obtain the existing auditor’s working papers C Obtain a copy of the company’s most recent board minutes D Obtain a copy of the existing auditor’s letter of engagement Which one of the following may auditors NOT perform for their client? A Taking management decisions B Preparation of accounting records C Preparing tax computations D Advising on weaknesses in the internal control systems Which of the following are fundamental ethical principles for professional accountants? 1 Competence 2 Compliance 3 Integrity 4 Objectivity A 1, 2 and 3 only B 1, 3 and 4 only C 2, 3 and 4 only D 1, 2 and 4 only An auditor should not accept a loan on favourable commercial terms from an audit client because of the threat to his or her independence. The threat would be a: A Self-interest threat B Self-review threat C Advocacy threat D Familiarity threat Which of the following statements is INCORRECT? A An auditor may serve on the board of directors of an audit client. B An auditor who is an immediate family member of the director of an audit client must not be assigned to the audit team. C Purchasing goods from an audit client on normal commercial terms does not create a threat to the auditor’s independence. D An auditor who was recently a director of an audit client must not be assigned to the audit team for that client. © Emile Woolf International 11 The Institute of Chartered Accountants of Pakistan Audit and Assurance CHAPTER 15 – AUDIT FINALISATION AND REPORTING 65 66 67 68 69 Which of the following is true about written representations? A They are the best source of audit evidence B They should be used only when there is a lack of other substantive audit evidence C They should be used only when there is other substantive audit evidence to complement it D Shareholders receive a copy of all material written representations Which of the following would you not use as a benchmark for comparison when undertaking analytical procedures? A Other audit clients B Previous years C Other companies in the same industry D Budget What is meant by the expression ‘expectation gap’? A The gap between how the directors of a company perform their duties and how the shareholders expect them to perform B The gap between how the directors of a company perform their duties and how the general public expects them to perform C The gap between the public perception of the role of company auditors and their statutory role and responsibilities D The gap between the auditors’ own perception of their duties and how they are set out in the Companies Act Which of the following does NOT belong in the auditors’ report? A Introductory paragraph specifying the pages to which the report relates and the accounting convention adopted B Basis of the opinion C Involvement of any specialist D Statement of responsibilities of directors and auditors Which one of the following is part of the auditor’s function? A Conducting the inventory count B Obtaining and evaluating audit evidence on the financial statements C Calculating the year-end accruals figure for inclusion in the accounts D Providing representations to management CHAPTER 16 – INTERNATIONAL STANDARDS ON REVIEW ENGAGEMENTS 70 What sort of assurance is provided in a review engagement? A Positive assurance B Negative assurance C High level of assurance D No assurance © Emile Woolf International 12 The Institute of Chartered Accountants of Pakistan Question bank: Multiple choice questions 71 72 For companies required to produce interim financial statements (IFI): A one audit firm should audit the IFI and a different firm should audit the financial statements for the year as a whole. B one accountancy firm should review the IFI and a different firm should audit the financial statements for the year as a whole. C the same firm should audit the IFI and the financial statements for the year as a whole. D the same firm should review the IFI and the financial statements for the year as a whole. What is meant by negative assurance? A The auditor cannot give an opinion due to lack of evidence. B The client's financial statements were found to be materially misstated. C The auditor could not conduct any tests due to lack of controls. D The auditor did not find anything to indicate that a material misstatement exists. © Emile Woolf International 13 The Institute of Chartered Accountants of Pakistan Audit and Assurance © Emile Woolf International 14 The Institute of Chartered Accountants of Pakistan SECTION Certificate in Accounting and Finance Audit and Assurance B Objective test and long-form questions AUDIT FRAMEWORK, REGULATION AND ETHICS 1 ICAP Code of Ethics (a) ICAP’s code of ethics has specified five principles of professional ethics for chartered accountants. The circumstances in which a chartered accountant operates may give rise to specific threats to compliance with these principles. Required: (b) (i) Briefly describe each of the fundamental principles of professional ethics. (ii) Briefly describe different categories of the threats to compliance with the fundamental principles. Mustansar is the audit manager of a team engaged on the audit of a listed company. During his initial discussion with the chief executive officer (CEO) of the company, he was informed that depressed economic conditions have badly affected the company and its liquidity. Due to uncertainty about the future of the company, certain key employees have left including several staff members of accounting and finance department. Consequently, the accounting records are in a bad shape and the management is making efforts to complete the draft accounts quickly. He therefore requested Mustansir to carry out necessary accounting work and to help prepare the annual financial statements at a fee to be agreed mutually. Required: Briefly describe the guidelines contained in the ICAP’s Code of Ethics and the extent of support that can be offered by the auditors, in the above situation. 2 Levels of assurance Distinguish between absolute and reasonable assurance. Identify the type of assurance that is expected in an audit of the financial statements, clearly outlining the reasons to justify your point of view. © Emile Woolf International 15 The Institute of Chartered Accountants of Pakistan Audit and Assurance 3 Shamsuddin Shamsuddin a newly qualified chartered accountant has recently established his practice in the name of Shamsuddin & Co., Chartered Accountants. He is continuously trying to expand his practice and in this process he came across the following situations: (i) One of his friends, who is the owner of an advertising agency, has offered to provide significant discount for publicity of his new practice. (ii) Fashion Limited, a private limited company, which has suffered heavily on account of recent financial turmoil, has informed him that it is willing to appoint him in the forthcoming annual general meeting (AGM) of the company in place of the existing auditors, if he can quote a fee below the existing audit fee. (iii) Design Limited has contacted Shamsuddin and informed him that they are willing to appoint him as their external auditor in the next AGM at a fee of Rs. 200,000 if he completes the audit in a month. However, in case of delay in the audit work the audit fee will be reduced to Rs.150,000. (iv) Shamsuddin receives an offer of appointment as auditors from Style Enterprises, a sole proprietorship, who wants to remove the existing auditors before completion of their term of office. Required: Shamsuddin is inclined to accept the above offers. Discuss the options available with him in each of the above situations. 4 Core concepts (a) Briefly highlight the management’s responsibilities relating to the financial statements? (b) During the audit team planning meeting, a member of the audit team passed a comment that based on past experience with the client, he was confident that the management of the client was honest and there was no issue as regards management integrity or risk of fraud in the Company. The audit manager responded that the auditor should always maintain an attitude of professional scepticism throughout the audit. Required: Briefly describe ‘Audit Scepticism’ and elaborate on the response of the audit manager. 5 Threats A chartered accountant is required to comply with five fundamental principles specified by ICAP’s Code of Ethics. However, compliance with the fundamental principles may potentially be threatened by a broad range of circumstances. Required: Briefly describe the categories of threats that may potentially affect compliance with the fundamental principles. Give two examples for each category. 6 Burewala and Kamal Discuss the categories of threats that may be involved in each of the following independent situations and advise the partners of the concerned firm with regard to the possible course of action that may be followed, in each case. (a) Burewala Bank Limited (BBL) is a listed audit client of Umer and Company, Chartered Accountants (UCC). BBL has granted a house loan of Rs. 5 million to a partner in UCC. (b) Kamal was the audit manager during the last year’s annual audit of Faisalabad Textile Mills Limited (FTML). He has joined FTML as their Manager Finance, prior to the commencement of the current year’s audit. © Emile Woolf International 16 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 7 Zaman and Bilal Comment on each of the following independent situations with reference to the applicable rules and regulations. (a) Zaman is a partner in a firm of Chartered Accountants and holds 5,000 shares in Mardan Limited (ML). His firm has received an offer for appointment as auditors of Khanewal Limited (KL). ML and KL are subsidiaries of Dera Khan Limited (DKL). (b) Bilal and Company has received an offer for appointment as auditors of IJK Limited. The total paid up capital of the company is Rs. 990 million whereas its ordinary share capital is Rs. 130 million. Faryal, the wife of a partner in Bilal and Company, is a director in LMN Limited which holds 50 million non-voting preference shares and 2 million ordinary shares in IJK Limited. Faryal also holds 10,000 shares in LMN Limited. The par value of both types of shares is Rs. 10 each. 8 Audit process The purpose of an external audit and its role are not well understood. You have been asked to write some material for inclusion in your firm’s training materials dealing with these issues in the audit of large companies. Required: (a) Draft an explanation dealing with the purpose of an external audit and its role in the audit of large companies, for the inclusion in your firm’s training materials. (b) The external audit process for the audit of large entities generally involves two or more recognisable stages. One stage involves understanding the business and risk assessment, determining the response to assessed risk, testing of controls and a limited amount of substantive procedures. This stage is sometimes known as the interim audit. Another stage involves further tests of controls and substantive procedures and audit finalisation procedures. This stage is sometimes known as the final audit. Describe and explain the main audit procedures and processes that take place during the interim and final audit of a large entity. 9 Regulatory and professional requirements The profession has been criticised recently by politicians for its role in monitoring potential corporate failure. Radical reforms have been called for in the way the audit is regulated. For example, politicians have stated that there should be a change of legislation in the following ways: Auditing standards Auditing standards should be set and enforced independently from the accounting profession. Fraud Auditing firms should have a duty to detect and report fraud. Non audit services Non auditing services supplied to an audit client should be stopped. The duration of the appointment of auditors The appointment of auditors should be for a maximum period of seven years. Required: (a) Describe the current regulatory and professional requirements relating to each of the headings listed above. (b) Discuss the reasons why you feel the audit profession has been criticised over the current regulations in the above areas. © Emile Woolf International 17 The Institute of Chartered Accountants of Pakistan Audit and Assurance 10 Fundamental principles Explain each of the FIVE fundamental principles of ICAP’s Code of Ethics 11 Confidential information Explain the situations where an auditor may disclose confidential information about a client. 12 Independence of external auditors The responsibilities of external auditors are not always well understood. When external auditors provide non-audit services to their audit clients, it is essential that the auditors make a clear distinction between their audit and non-audit responsibilities. Required: Explain why it is essential for external auditors to be independent of their clients 13 Tahira and Parvez Your firm is the external auditor to two companies. One is a hotel, Tahira, the other is a food wholesaler, Parvez, which supplies the hotel. Both companies have the same year-end. Just before the year end, a large number of guests became ill at a wedding reception at the hotel, possibly as a result of food poisoning. The guests have taken legal action against the hotel and the hotel has taken action against the food wholesaler. Neither the hotel nor the food wholesaler has admitted liability. The hotel is negotiating outof-court settlements with the ill guests, the food wholesaler is negotiating an out-of-court settlement with the hotel. At the year end, the public health authorities have not completed their investigations. Lawyers for both the hotel and the food wholesaler say informally that negotiations are ‘going well’ but refuse to confirm this in writing. The amounts involved are material to the financial statements of both companies. Required: Assuming that your firm continues with the audit of both companies, for each company, describe the difficulties you foresee in obtaining sufficient audit evidence for potential provisions, contingent liabilities and contingent assets. 14 ABC Limited Comment on each of the following situations with reference to the appointment of external auditors in accordance with the requirements of the Companies Act, 2017. (a) ABC Limited and DEF Limited are associated companies on account of common directorship. Salman and Company, Chartered Accountants (SCC) have received an offer for appointment as the auditor in ABC. Salman, a partner in SCC is the spouse of Naveen, who is an employee in DEF. (b) All the partners of Kashif Associates are Cost and Management Accountants. The firm has received an offer for appointment as the auditor of Nihal (Private) Limited (NPL). NPL has a paid-up capital of Rs. 500,000 and 30% of its shares are held by Siyal Limited which is a public company. 15 Masoom, Chalak and Hoshiyar Limited Discuss the categories of threats that may be involved in each of the following independent situations and advise the partners of the concerned firm with regard to the possible course of action that may be followed in each situation: (a) Ahmed has recently joined a firm of Chartered Accountants. The firm intends to depute him on the audit of Masoom (Private) Limited (MPL). Prior to joining the firm, Ahmed had been providing accounting and taxation services to MPL for many years, in the capacity of a consultant. (b) It has been discovered that father of one of the trainees posted on the audit of Chalak Limited (CL), has a financial interest in CL. © Emile Woolf International 18 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions (c) Hoshiyar Limited (HL), an audit client of your firm has recently advertised certain vacancies in its accounts department. The said positions have been applied for by number of individuals including two staff members who are posted on the audit of HL. 16 Prime Super Markets Limited Discuss the categories of threats and related safeguards in each of the following situations: (a) Your firm is the auditor of Prime Super Markets Limited, a chain of super markets. During a promotional campaign, the management has distributed discount vouchers which have also been given to the audit team members. (b) You are the manager on the audit of Abid Textile Mills Limited. The client has requested you to send two staff members on secondment for three months to assist the chief financial officer as its two senior accounting team members have resigned recently. (c) Fine Petroleum Limited (FPL) is the audit client of your firm for five years. During the year, the engagement partner has been changed due to mandatory rotation as per Code of Corporate Governance. However, the firm has decided to retain Atif, the audit manager, who has been involved in the audit of FPL for the past five years. PLANNING AND RISK ASSESSMENT 17 Durable Cement Limited (DCL) You are the Audit Manager on the audit of Durable Cement Limited (DCL). The information contained in the planning document includes the following: (i) DCL is presently operating in poor general economic conditions and is also faced with tough competition, due to the availability of low priced imported cement. (ii) In addition to the wholesalers, DCL supplies cement directly to various government departments and real estate developers. The sale is authorized by the credit control department; however, payments from government departments are often delayed. (iii) During the year, DCL has made investment in securities of unlisted public companies. (iv) A long-term loan was obtained in 2007 to finance the existing plant. The amount is repayable in 10 annual instalments. (v) DCL operates a non-funded gratuity scheme for its employees. Required: Assess the inherent risks (high, low or moderate) along with appropriate justification, related to the following assertions: 18 Valuation of factory plant Valuation of trade receivables Ownership right of finished goods inventory Valuation of unlisted securities Accuracy of long-term finance Valuation of provision for gratuity Saad Co You are a manager in the audit firm of Ajmal & Co; and this is your first time you have worked on one of the firm’s established clients, Saad Co. The main activity of Saad Co is providing investment advice to individuals regarding saving for retirement, purchase of shares and securities and investing in tax efficient savings schemes. Saad is regulated by the relevant financial services authority. © Emile Woolf International 19 The Institute of Chartered Accountants of Pakistan Audit and Assurance You have been asked to start the audit planning for Saad Co, by Mr Sher, a partner in Ajmal & Co. Mr Sher has been the engagement partner for Saad Co, for the previous nine years and so has excellent knowledge of the client. Mr Sher has informed you that he would like his daughter Zhura to be part of the audit team this year; Zhura is currently studying for her first set of exams for her ICAP qualification. Mr Sher also informs you that Mr Faisal, the audit senior, received investment advice from Saad Co during the year and intends to do the same next year. Required: 19 (a) Explain the ethical threats which may affect the auditor of Saad Co. (b) For each ethical threat, discuss how the effect of the threat can be mitigated. Alpha The following three entities have approached Alpha & Company, Chartered Accountants (the firm) for appointment as their statutory auditors. In each case there are following issues which need to be considered before the firm decides to accept the assignments. (i) Client: Safe Bank Limited Issue: the firm has acquired office equipment from the bank under finance lease arrangements. In addition, some partners of the firm are also using the bank’s credit card facility. (ii) Client: Pride Communication Limited (PCL): Issue: One of the firm’s partners had remained the director of PCL for many years, as a nominee of Federal Government. (iii) Client: Gama Limited Issue: A partner of the firm holds shares in Beta Limited which is an associated company of Gama Limited. Required: In each case specify the minimum conditions specified by Companies Act, 2017, which should be fulfilled in order to accept the audit engagement. 20 Engagement letter and documentation (a) List down the principal contents of an audit engagement letter. (b) Audit documentation facilitates understanding of the nature, timing and extent of audit procedures; the results of audit procedures and significant matters arising during the audit. Discuss briefly: 21 (i) What are the “significant matters” which are required to be documented? (ii) In how many days after the date of auditor’s report, the auditor is required to complete the assembly of his final audit file? Shahid Corporation Azeem and Company have been the auditors of Shahid Corporation Limited, a listed company, for the past many years. You have been appointed as the audit engagement manager. Briefly explain the matters which you would consider while assessing the following: (a) acceptance and continuance of client relationship. (b) need to send a new engagement letter. © Emile Woolf International 20 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 22 Assertions (a) (b) “The auditor shall perform risk assessment procedures to provide a basis for the identification and assessment of risks of material misstatement at the financial statement and assertion levels.” (i) Briefly explain what you understand by the risk of material misstatement at financial statement level. (ii) List down the risk assessment procedures as referred above. “The auditor’s assessment of materiality and audit risk may be different at the time of initially planning the engagement from at the time of evaluating the results of audit procedures.” Briefly describe the reasons which may lead to such a change in the auditor’s assessment. (c) 23 Briefly describe the assertions used by the auditors in respect of the following: (i) account balances (ii) classes of transactions; and (iii) presentation and disclosures Companies Act, 2017 Comment on each of the following situations with reference to the appointment of external auditors in accordance with the requirements of the Companies Act, 2017: 24 (a) Farrukh & Co., Chartered Accountants, has received an offer to be appointed as the external auditor of Ebrahim Gas Company. The firm is indebted to the company as it has not paid the last two months’ bills amounting to Rs. 4,860. (b) After seventy days of incorporation, the directors of Rahman Limited (RL) decided to appoint Mr Shahid as the company’s statutory auditor. Mr Shahid was employed by RL before he started his own practice. (c) The directors of Fazal Limited (FL) have decided to appoint Syed & Company, Chartered Accountants, as external auditor of the company. One of the partner’s spouse holds 1,000 shares in the subsidiary of FL. (d) The directors of Najam (Pvt.) Limited having paid-up capital of Rs. 4.5 million have appointed Mr Dawood to act as the external auditor of the company. Mr Dawood has been awarded a diploma in International Financial Reporting Standards by the Institute of Chartered Accountants of Pakistan and has completed the mandatory period of training from a leading firm of chartered accountants. (e) All directors of Hussain Associates (Pvt.) Limited are chartered accountants. The company has recently received an offer for appointment as the external auditor of Masood (Pvt.) Limited which has a paid-up share capital of Rs. 1,000,000. ASPL You are the Audit Manager on the audit of Al-Salam Pakistan Limited (ASPL) for the year ended June 30, 20X3. ASPL is engaged in the manufacture of a wide range of plastic products. While reviewing the initial work performed by the audit team, the following matters have come to your notice: (i) The quantity of material scrapped during the year is materially different from the quantity of scrap sold. The company’s records show nil balance both at the beginning and at the close of the year. No reconciliation for the difference has been provided by the company. (ii) Sales for the year have increased by 7% over the previous year. However, it has been noted that sales in the last two weeks of June 2010 have been exceptionally high and represent 15% of the annual sales. The audit working papers carry the following observations in respect of the above: © Emile Woolf International 21 The Institute of Chartered Accountants of Pakistan Audit and Assurance (iii) 70% of the sales in the last two weeks of June were made to two new customers whose credit assessment has not been formally documented; a significant portion of the goods sold to the above referred customers were returned in the first week of July 2010; and management bonuses are linked to the operating performance of the company. During the year, ASPL purchased a machine for Rs. 25 million. The payment voucher is duly supported by the invoice from the supplier. However, the fixed assets schedule provided by the client shows the amount capitalized as Rs. 2.5 million. Depreciation has been charged on this amount. The difference of Rs. 22.5 million is appearing in the Bank Reconciliation Statement. Required: 25 (a) Analyse each of the above situations and assess whether it represents a fraud or an error. (b) What action would you take to deal with the above matters? Information Limited (a) Discuss the external auditor’s responsibility relating to fraud in an audit of financial statements. (b) Sometime the management’s attitude towards the audit/auditors is indicative of the possibility of material misstatement in the financial statements due to fraud. Give four examples of such attitude/circumstances. (c) You are the auditor of Information Limited (IL), which is engaged in the development of customized software. During the last three years IL has become the leading software developer in the industry due to completion of large number of projects. During the initial meeting the client has informed that: i. IL has achieved a growth of 60% as compared to the growth target of 30% set for the financial year ended 30 June 2016 and the board of directors are considering to distribute 25% of the profit to the management staff as performance bonus. ii. one of the competitors has shown its willingness to acquire IL. Required: Identify the fraud risk factors in the above situations. 26 Distributor While reviewing the audit files of four different clients you confronted the following situations: i. Due to tough competition in the market, the company has been unable to increase the prices of its products since last 5 years. ii. Addition to intangible assets, amounting to Rs. 500 million include research cost of Rs. 10 million which is duly supported by invoices from suppliers. iii. During the last three years, the Chief Executive and higher management has been earning handsome bonuses, based on the profitability of the company. iv. Physical stock take on 31 December 2014 included goods sold but not despatched amounting to Rs. 52 million. The delivering of goods was stopped on the request of a distributor. Upto 20 January 2015, the distributor has taken delivery of goods amounting to Rs. 2 million. Required: (a) In each of the above situations, identify with justification whether it represents risk of fraud. (b) Describe what actions are to be taken by an auditor on identifying a fraud risk factor. © Emile Woolf International 22 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 27 Fraudulent Financial Statements (a) Because of its ability to exert influence, management is in a position to perpetrate fraud and prepare fraudulent financial statements. Identify six different ways in which fraud may be committed by management through overriding of controls. (b) 28 Briefly state the audit procedures which may be performed to identify the risks of material misstatement due to fraud. Kashif and Company Justify giving reasons whether the appointment of auditors in the following cases is incompliance with the requirements of Companies Act, 2017. 29 (a) Kashif and Company, Chartered Accountants (KC) has received an offer for appointment as the auditor of National Electricity Limited (NEL). On the request of one of the partners of KC, NEL has allowed him to pay his last month’s electricity bill amounting to Rs. 150,000 in monthly instalments of Rs. 15,000 each. (b) Zubair and Company, Chartered Accountants (ZC) has received an offer for appointment as auditor of Haroon Limited (HL). Saima, who is the wife of a partner of ZC, is the chief executive of Jameel Limited (JL). JL is an associated company of HL. Saima also holds 100,000 shares in JL. Delicious Biscuits Limited (DBL) Identify the threats that may be involved and applicable safeguards, if any, in each of the following scenarios: 30 (a) Your firm is the auditor of Delicious Biscuits Limited (DBL) for the past three years. On previous year’s audit, Affan was the audit manager. He has recently joined DBL as GM finance. (b) ABC leasing company has a lease portfolio of Rs. 500 million. Atif, the Audit Manager on ABC, has obtained a lease finance amounting to Rs. 800,000 from ABC. Daud and Company Daud and Company, Chartered Accountants (DC), has received an offer for appointment as auditor of Jamal Limited (JL). Wife of Daud is a Shareholder and Director in Royal Limited (RL). Required: In accordance with the requirements of the Companies Act, 2017 state whether and under what circumstances DC could accept the audit, under each of the following situations: 31 (a) JL holds 51% shareholding in RL. (b) JL is an associated company of RL. (c) One of the directors in JL also holds 10% shareholding in RL. ABC (Private) Limited Identify the threats which may be involved and suggest appropriate safeguards, if any, in each of the following scenarios: (a) The planning phase of the annual audit of ABC (Private) Limited for the year ended 30 June 2016 is in progress. The engagement partner intends to include Kamran as a member of audit team who joined the firm last month. Before joining the firm Kamran was employed in the finance department of ABC. (b) Nasir is the audit manager on the audit of Diamond Limited (DL) for the year ended 30 June 2016. Nasir has informed that his father owns 10,000 shares in DL. (04) © Emile Woolf International 23 The Institute of Chartered Accountants of Pakistan Audit and Assurance 32 Materiality Determination of materiality level requires professional judgment on the part of the auditor. (a) (b) 33 Briefly describe the importance of materiality in the following stages of audit: i. Planning stage ii. Reporting stage What aspects of materiality should be documented by an auditor in the working papers? Auditor’s Expert You are the audit manager in a firm of Chartered Accountants. Your firm is often required to engage an auditor’s expert for reporting on matters relating to the audits. 34 (a) List four key terms of engagement which should be agreed with the expert. (b) Specify the factors which should be considered in evaluating the adequacy of the work performed by the expert. Mineral Limited Mineral Limited (ML) has incorporated a liability for gratuity payable to its employees on the basis of actuarial valuation carried out by Professionals Limited (PL). As the audit partner of ML you are not satisfied with the valuation report prepared by PL, and have decided to appoint Experts Limited (EL) to carry out the valuation exercise again. Required: (a) (b) 35 State the matters that you would consider regarding: i. The competence, capabilities and objectivity of EL. ii. Evaluation of the adequacy of EL’s work. Briefly discuss the course of action in case you are not satisfied with the work performed by EL. (03) AMF Al-Madad Foundation (AMF) is a charitable organization. It receives donations which are utilized to help the destitute persons in accordance with the rules and regulations prescribed by the AMF’s Trust Deed. The donations are received from the following sources: (i) Cash collected from the general public through charity boxes placed at key points in hospitals, airports, superstores etc., (ii) cash and cheques received from individuals and institutions at AMF’s office; and (iii) cash from generous individuals who prefer to remain anonymous. Donations received in case of (ii) and (iii) above, often contain specific instructions for utilisation of the donated amount for specific purposes e.g. for education of orphan children. Required: (a) Identify the inherent risks in the operations of AMF. (b) Briefly discuss the effect of each of these risks on the audit of AMF. © Emile Woolf International 24 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 36 37 Acceptance and planning (a) What is the difference between audit strategy and audit plan? (b) You have been appointed as the auditor of a company which was previously audited by another auditor. Being a new client, what additional considerations would you take into account while performing the preliminary engagement activities prior to commencement of the audit? SPL Strawberry Pakistan Limited (SPL) was incorporated on March 1, 20X3. The directors of SPL are in the process of appointing the first statutory auditor of the company. They have requested your firm to submit a proposal for the statutory audit assignment. A partner of your firm has asked you to draft the proposal after assessing whether the preconditions for the audit exist. Required: 38 (a) Briefly discuss the term ‘preconditions for an audit’. (b) What are the steps that you would perform in order to ensure that preconditions for the audit exist? (c) Discuss whether your firm may or may not accept the assignment if one of the preconditions for the audit is not present. Fruit and nuts Comment on each of the following independent situations in respect of appointment of auditors, with reference to the applicable rules and regulations: 39 (a) Guava and Company, Chartered Accountants, have received a request for appointment as auditor of Orange Bank Limited (OBL). Most of the partners of Guava and Company maintain their accounts with OBL and are enjoying credit card facilities from them. The maximum outstanding balance on the credit card facility, due from any partner is Rs.399,000. (b) Apricot and Company, Chartered Accountants, have received an offer for appointment as auditor of Banana Limited. Mr Pumpkin who is a nominee director of the Government on the Board of Directors of Banana Limited holds 25% shares in Water Melon Limited. The spouse of a partner also holds shares in Water Melon Limited. (c) Mr Zaheer, a legal practitioner, has received an offer for appointment as external auditor of Lychee (Private) Limited (LPL). The paid up capital of LPL is Rs. 1,500,000 of which 40% is owned by Blue Black Limited, a listed company. (d) Walnut and Company, Chartered Accountants, have received an offer for appointment as external auditors of Wasim (Private) Limited (WPL), in place of the previous auditors, who were removed before the completion of their term. You may assume that WPL has completed all the legal formalities before removing the previous auditors. (e) Mr Sadiq has recently joined your firm as a partner. He has served on the Board of Directors of Strawberry Limited (SL) until 30 June 20X0, as a Government nominee. In the Annual General Meeting of SL held on 31 August 20X2, a shareholder has proposed the name of your firm for appointment as the external auditors for the year ending 30 June 20X3. Discussions and judgment (a) List the benefits associated with holding timely discussion among the team members in respect of matters susceptible to material misstatements. (b) Quite often, the risk of material misstatement is greater in case of non-routine transactions and judgmental matters. Required: (i) What do you understand by non-routine transactions and judgmental matters? © Emile Woolf International 25 The Institute of Chartered Accountants of Pakistan Audit and Assurance (ii) 40 State the reasons on account of which risk of material misstatement is increased in case of: Non-routine transactions Judgmental matters Dynamic In the planning phase of the audit of Dynamic Limited for the year ending 30 June 20X3, you have calculated the following ratios from the management accounts of the company for the eight months ended 29 February 20X3: Eight months period ended 29 February 20X3 Year ended 30 June 20X2 Year ended 30 June 20X1 Gross profit percentage 35% 40% 40% Inventory turnover days 120 105 78 Current ratio 1.5 2.3 2.6 Quick asset ratio 0.78 1.6 1.7 Times interest earned 0.91 1.67 2.1 Debtors turnover days 132 86 68 Required: Identify the prospective audit risks which the auditor should consider while planning the audit. 41 Changing terms An auditor may agree to a change in the terms of engagement provided there is a reasonable justification for doing so. Required: 42 (a) List the circumstances in which the management may request the auditor to change the terms of an audit engagement. (b) What factors should be considered by the auditor before accepting a change in the terms of the engagement? (c) List the steps that the auditor should consider, if he is unable to agree to a change in the terms of engagement. EL List the important matters that are required to be included in an audit engagement letter. 43 Calm Co ISA 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment deals with the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements, through understanding the entity and its environment, including the entity’s internal control. Required: (i) Explain the purpose of risk assessment procedures. (ii) Outline the sources of audit evidence the auditor can use as part of risk assessment procedures. © Emile Woolf International 26 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 44 Azam Azam 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 Azam 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 Accountant. Required: (a) Describe the risks associated with the audit of Azam under the headings inherent and control risks and detection risk and explain the implications of these risks for overall audit risk. (b) List and explain the audit tests to be performed on income and expenditure from fund raising events. 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. 45 Hurricane You are the audit manager in charge of the audit of Hurricane, a limited liability company. The company’s year-end is 31 December, and Hurricane has been a client for seven years. The company purchases and resells fittings for ships including anchors, compasses, rudders, sails etc. Clients vary in size from small businesses making yachts to large companies maintaining large luxury cruise ships. No manufacturing takes place in Hurricane. It is now early in 20X4. Information on the company’s financial performance is available as follows: Revenue Cost of sales Gross profit Administration costs Distribution costs Net profit Non-current assets (at net book value) Current assets Inventory Receivables Cash and bank Total assets Capital and reserves Share capital Accumulated profits Total shareholders’ funds Non-current liabilities Current liabilities © Emile Woolf International 27 20X4 Forecast Rs m 45,928 (37,998) ――― 7,930 (4,994) (2,500) ――― 436 ――― 20X3 Actual Rs m 40,825 (31,874) ――― 8,951 (4,758) (2,500) ――― 1,693 ――― 3,600 4,500 200 6,000 500 ――― 10,300 ――― 1,278 4,052 1,590 ――― 11,420 ――― 1,000 5,300 ――― 6,300 1,000 3,000 ――― 10,300 ――― 1,000 5,764 ――― 6,764 2,058 2,598 ――― 11,420 ――― The Institute of Chartered Accountants of Pakistan Audit and Assurance Other information The industry that Hurricane trades in has seen moderate growth of 7% over the last year. Non-current assets mainly relate to company premises for storing inventory. Ten delivery vehicles are owned with a net book value of Rs 30m One of the directors purchased a yacht during the year. Inventory is stored in ten different locations across the country, with your firm again having offices close to seven of those locations. A computerised inventory control system was introduced in August Year Inventory balances are now obtainable directly from the computer system. The client does not intend to count inventory at the year end but rely instead on the computerised inventory control system. Required: (a) ISA 300 Planning an Audit of Financial Statements, states that an auditor must plan the audit. Explain why it is important to plan an audit. (b) 46 Using the information provided above, prepare the audit strategy for Hurricane for the year ending 31 December 20X4. Zakir Co (a) With reference to ISA 520 Analytical Procedures explain (i) what is meant by the term ‘analytical procedures’; (ii) the different types of analytical procedures available to the auditor; and (iii) the situations in the audit when analytical procedures can be used. Zakir 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. The income statements for the last two financial years are shown below: Income statement Revenue Cost of sales Gross profit Operating expenses Administration Selling and distribution Interest payable Investment income Profit/(loss) before tax Financial statement extract Cash and bank © Emile Woolf International 28 31 March 20X4 Rs m 7,482 (3,520) –––––– 3,962 31 March 20X3 Rs m 6,364 (4,253) –––––– 2,111 (1,235) (981) (101) 145 –––––– 1,790 ‗‗‗‗‗‗ (1,320) (689) (105) – –––––– (3) ‗‗‗‗‗‗ –––––– –––––– 253 ‗‗‗‗‗‗ (950) ‗‗‗‗‗‗ The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions Required: 47 (b) As part of your risk assessment procedures for Zakir Co, identify and provide a possible explanation for unusual changes in the income statement. (c) Confirmation of the end of year bank balances is an important audit procedure. Explain the procedures necessary to obtain a bank confirmation letter from Zakir Co.’s bank. Educational University (EU) You are the audit manager of the Educational University (EU) for the year ended 31 December 2015. EU has a student base of 2,500 students. It follows a policy of receiving 50% of the fees at the start of the semester and 50% in the middle of the semester. However, 10% discount is allowed to those students who pay the entire amount in advance. The cost of course material is included in the fees. The semester starts in December and June each year. You have noticed that 30% of the students who were registered in December 2015 had not claimed the course material till 31 December 2015. Required: Discuss the audit risks in the above scenario and how you would deal with them. 48 Hajira (a) Explain the term ‘audit risk’ and the three elements of risk that contribute to total audit risk. The Hajira 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. Hajira 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 Hajira 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: 49 (b) Identify areas of inherent risk in the Hajira charity and explain the effect of each of these risks on the audit approach. (c) Explain why the control environment may be weak at the charity Hajira. Tahir Co One of your audit clients is Tahir 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 Tahir Co.’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. © Emile Woolf International 29 The Institute of Chartered Accountants of Pakistan Audit and Assurance This fuel has in the past been valued at its cost price of Rs.150 a barrel. The current value of aviation fuel is Rs.1,200 a barrel. Although the audit work is complete, as noted above, the directors of Tahir 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 Tahir Co currently show a profit of approximately Rs.5m with net assets of Rs.1.7 billion. Required: (a) List the audit procedures and actions that you should now take in respect of the above matter. (b) For the purposes of this section assume from part (a) that the directors have agreed to value inventory at Rs.150/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 Tahir Co.’s contract with the government requires Tahir 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 reappointment at the annual general meeting. The finance director refuses to amend the financial statements to remove this ‘fictitious’ inventory. Required: 50 (i) State the external auditor’s responsibilities regarding the detection of fraud; (ii) Discuss to which groups the auditors of Tahir Co could report the ‘fictitious’ aviation fuel inventory; (iii) Discuss the safeguards that the auditors of Tahir Co can use in an attempt to overcome the intimidation threat from the directors of Tahir Co. Elegant Limited Your firm has been re-appointed as the auditor of Elegant Limited (EL) for the year ended 30 June 2015. The firm has been the auditor of EL for the last five years. Required: (a) How would you assess whether it is necessary to send an audit engagement letter to EL for the year ended 30 June 2015? (b) State how you would proceed if EL requests your firm to change certain terms of the engagement. INTERNAL CONTROL 51 Training Manager You are the training manager in a firm of chartered accountants. Prepare brief presentation for newly inducted trainees, on the following: (a) Control Environment and its elements. (b) Walk through tests and why these are performed. (c) Materiality and Performance Materiality. © Emile Woolf International 30 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 52 Vision Limited Following IT related controls are being employed at Vision Limited: (i) The general ledger system is automatically updated with sub-ledger transactions (e.g. Accounts Receivable) every night through batch processing. (ii) The system automatically maintains second copies of all programs and data files. (iii) Access to programs and data files is restricted using passwords. (iv) Invoices that are entered into the system are physically counted. (v) Firewalls (software and hardware) are installed to restrict unauthorized access. (vi) Screen warnings are displayed as regards incomplete processing. (vii) Vision Limited has service level agreements with reliable software companies, for technical support. (viii) Review of output against expected values. Required: 53 (a) In respect of each control, determine whether it is a preventive, detective or corrective control. (b) Also classify each of the above between general IT controls and application controls. Types of Controls Classify the following controls as preventive, detective, or corrective controls. Give brief reasons to justify your answers. 54 (i) Training on applicable policies, department policy/ procedures (ii) Batch totals (iii) Segregation of duties (iv) Contingency planning (v) System logs (vi) System backup Deehan Super Stores Deehan Super Stores has launched a sales promotion scheme. Accordingly, the customers who purchase a loyalty card gain reward points on every purchase. The points may be redeemed by adjusting the value of the available points in any subsequent purchase. Required: Draw a flow chart showing the payment process including point accumulation and point redemption. 55 IT Department (a) You are working in IT department of a firm of Chartered Accountants. The partners are concerned about the confidentiality of client data which is electronically transmitted by firm’s staff from the clients’ offices. Required: Suggest controls over data transmission to ensure confidentiality of data. (b) Discuss the auditor’s course of action if management refuses to allow auditor to send confirmation request. (Impact on audit report is not required) © Emile Woolf International 31 The Institute of Chartered Accountants of Pakistan Audit and Assurance 56 (c) In the context of control activities explain what is included in ‘Performance reviews’. (d) Explain the term ‘Communication protocols’. (e) Specify any four main categories of general controls that an auditor would expect to find in a computer based information system. Controls Controls over data transmission help to ensure that transmitted data is complete, secure and unaltered. Required: State any five controls over data transmission which help to ensure that the data is secure and unaltered. 57 BHURBHAN LIMITED You have been assigned to plan the test of controls in respect of receiving of goods and invoices from suppliers of Bhurban Limited. In this regard, you are required to identify the following: 58 (a) The related risks (b) Controls that you expect to see to address the above risks (c) Audit procedures that you need to perform to test the controls Audit trail Briefly describe the following concepts: 59 (a) Audit trail in a computerized environment (b) Embedded audit facilities and its significance Supermarkets You are the CFO of a newly incorporated company which has recently established five supermarkets in the city. One of your responsibilities is to implement internal controls. List six key controls: 60 61 (a) over cash sales and cash handling; (b) to reduce possibility of misappropriation of inventory. Controls (a) If the auditor plans to rely on controls that have not changed since they were last tested, the auditor should test the operating effectiveness of such controls at least once in every third audit. Identify the situations in which the auditor may decide to test the controls again, in the very next audit. (b) Briefly describe the components of internal control. Shahzad Limited (a) Briefly explain the components of internal control as referred to in the International Standards on Auditing. (b) Your firm is the auditor of Shahzad Limited (SL), a listed company, which is a wholesaler of consumable products. SL records its sale on delivery of goods and maintains up to date computerised inventory records. © Emile Woolf International 32 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions A full inventory count was conducted at the year end. The senior who attended the physical stocktaking at the central warehouse has observed the following matters: (i) The inventory count took place on January 1, 20X3 under the supervision of the Inventory Controller. No movement of inventory took place on that day. (ii) Four counting teams were formed. Each team comprised of two persons. The floor area was allocated by the teams among themselves. (iii) Each team was instructed by the Inventory Controller to remember which inventory had been counted. (iv) Pre-numbered count sheets were provided to the staff involved in the inventory count. The count sheets showed the inventory ledger balances, to facilitate reconciliation. (v) Old, slow-moving or already sold inventories were highlighted on the count sheets at the time of counting. (vi) Items not located on the pre-numbered inventory sheets were recorded on separate sheets which were numbered by the staff. (vii) At the end of the count, all inventories against which advances from customers had been received were removed from the physical inventory on the instruction of the Inventory Controller. Required: Identify the weaknesses in the system of inventory count. Give appropriate explanations to support your point of view. 62 Waheed Engineering Your firm is the external auditor of Waheed Engineering, a listed company, which has revenue of Rs100 million. The head office site includes the manufacturing unit, the accounting functions and main administration. There are a number of sales offices in different parts of the country. Waheed Engineering does not have an internal audit department. At the interim audit you have been assigned to the audit of the wages system. This will involve obtaining an understanding of the wages system, testing the controls and performing substantive procedures in order to verify wages transactions. The wages records are maintained on a computer and all the wages information is processed at the head office. Some of the employees in the manufacturing unit are paid in cash, and all other employees have their wages paid directly into their bank account. Manufacturing employees are paid their wages a week in arrears. All other employees are paid at the end of each week or month. There is a personnel department which is independent of the wages department. The personnel department maintain records of the employees, including their starting date, grade, current wage rate and leaving date (if appropriate). Previous years' audits have revealed frauds by wages department staff facilitated by weaknesses in controls in the wages system. These frauds have included: paying employees after appointment but before they commenced work; paying employees after they have left; and paying fictitious employees. A check of current controls in the wages system has revealed that the company has failed to instigate controls to prevent these types of fraud recurring. So the audit programme requires extensive substantive procedures to be carried out to ensure that recorded wages transactions have not been misstated by similar frauds taking place in the current year. The existence of employees at the head office site can be verified by physical inspection. From a cost effectiveness point of view, only a small sample of sales offices will be visited. The audit manager has asked you to consider the audit procedures you would carry out to obtain sufficient appropriate evidence of the existence of employees at sales offices not visited by the audit staff. © Emile Woolf International 33 The Institute of Chartered Accountants of Pakistan Audit and Assurance The audit manager has explained that 'unclaimed wages' (in part (c) below) arise when manufacturing employees are not present to collect their wages (when they are paid out in part (b)). The unclaimed wage packets are given to the cashier who records their details in the unclaimed wages book and is responsible for their custody. Any employee who has not received his/her wage packet at the pay-out can obtain it from the cashier. You have ascertained that there is no system of checking the operation of the unclaimed wages system by a person independent of the cashier and the wages department. Required: 63 (a) Describe the normal controls you would expect to see in a wages system and explain their purpose. (b) Describe how you would verify that employees are not paid before they commenced work for the company. (c) Describe the audit procedures you would carry out in connection with attending a pay out of wages in cash to manufacturing employees. (d) Describe the substantive procedures on transactions you would carry out on the unclaimed wages system. (e) Describe the evidence you would obtain to verify the existence of employees whose wages are paid directly into their bank account, including those at sales offices. Danish Your firm has recently been appointed as auditor to Danish, a private company that runs a chain of small supermarkets selling fresh and frozen food, and canned and dry food. Danish 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 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 increased. However, the quality of staff that has been recruited has fallen. Senior management at Danish are now prepared to invest in more up-to-date systems. Required: 64 (a) Describe the problems that you might expect to find at Danish resulting from poor internal controls. (b) Make FOUR recommendations to the senior management of Danish for the improvement of internal controls, and explain the advantages and disadvantages of each recommendation. Roses Anytime (a) ISAs identify a number of key procedures which auditors should perform if they wish to rely on internal controls and reduce the level of substantive testing they perform. These include: (i) documentation of accounting and internal control systems; (ii) walk-through tests; (iii) audit sampling; (iv) testing internal controls; (v) dealing with deviations from the application of control procedures. Required: Briefly explain each of the procedures listed above. © Emile Woolf International 34 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions (b) Roses Anytime sells Roses wholesale. Customers telephone the company and their orders are taken by clerks who take details of the Roses to be delivered, the address to which they are to be delivered, and account details of the customer. The clerks input these details into the company's computer system (whilst the order is being taken) which is integrated with the company's inventory control system. The company's standard credit terms are payment one month from the order (all orders are despatched within 48 hours) and most customers pay by bank transfer, An accounts receivable ledger is maintained and statements are sent to customers once a month. Credit limits are set by the credit controller according to a standard formula and are automatically applied by the computer system, as are the prices of Roses. Required: Describe and explain the purpose of the internal controls you might expect to see in the sales system at Roses Anytime over the: 65 (i) receipt, processing and recording of orders; (ii) collection of cash. Trade Receivables There are many reasons for maintaining internal control systems. These include the need to ensure that: (i) transactions are properly authorised; (ii) transactions are promptly and accurately recorded; (iii) access to assets and records is properly authorised; (iv) 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. Receivables is an area in which most organisations expect internal controls to be operating effectively. Required: 66 (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. (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. (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. (d) Explain why external auditors seek to rely on the proper operation of internal controls wherever possible. Granger Granger 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. © Emile Woolf International 35 The Institute of Chartered Accountants of Pakistan Audit and Assurance 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) (b) (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. (ii) Identify other control procedures you would consider necessary to ensure the completeness of the recorded cash receipts and accounts receivable. 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 boots 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 you did not record. Required: (i) Explain the procedures to be followed in making a cash-count for audit purposes. (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. AUDIT EVIDENCE 67 Verification of Evidences (a) List any four ways in which the debtor balances may be stratified. (b) You are the audit incharge on the audit of Opportunity Limited (OL). OL deals in fast moving consumer goods. For sending of confirmations, an audit team member has stratified the debtors as follows: Category A Balances exceeding Rs. 50 million 12 customers Category B Balances below Rs. 50 million 100 customers Category C Balances below Rs. 10 million 280 customers Category D Balances below Rs. 1 million 600 customers © Emile Woolf International 36 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions During a meeting some of the team members have expressed divergent views, as follows: (i) Verification of balances of category A and B will provide sufficient coverage and evidence; therefore there is no need to cover other categories. (ii) Selection should be done on haphazard basis, as under this method all items of population have equal chance of selection. (iii) Selection of sample should be done systematically, whereby items constituting 10% of the amounts in each category should be selected in descending order. Required: Discuss the appropriateness of options discussed in the meeting and give your suggestion in this regard. 68 Rehan Limited You are the Audit Incharge of Rehan Limited for the year ended 31 December 2015. While reviewing the working papers and discussion with audit team, you have noted the following: (i) The audit team did not send balance confirmation requests for amounts below Rs. 100,000 because according to the client, lot of efforts were required to follow up the customers and the balances were also not material. (ii) One of the conclusions drawn as per the working papers is “there are no unrecorded liabilities, as confirmations have been received from all selected parties and no differences were noted. Hence, no further test is required.” Required: 69 (a) Discuss with reasons whether you agree with the approach dopted/conclusion drawn by the audit team. (b) Provide brief guidance to the audit team in respect of each of the above situations. Sehat Pharmaceutical Limited The audit of Sehat Pharmaceutical Limited (SPL) is in progress. Based on the previous experience with the client and the initial tests of control, the auditor has assessed a low risk of material mis-statement in the area of debtors. The debtors circularization summary depicts the following information: Customer segment No. of custo -mers Balance outstanding Confirmations sent Amount covered Nature of confirmations Confirmations received ----------------------------------Rs---------------------------------------------Distributors 12 75,200 8 70,500 Positive 7 Wholesalers 105 52,500 30 12,500 Positive 28 Hospitals and clinics 250 31,200 75 20,300 Negative 4 Retailers 130 12,500 50 7,000 Negative 12 Analysis of confirmations received is as follows: 3 out of 7 confirmations received from distributors did not agree with the amount outstanding in SPL’s ledger. One of the distributors, Saleem Distributors (Private) Limited (SDPL) has gone into winding up. The balance receivable from SDPL is outstanding since last one year. © Emile Woolf International 37 The Institute of Chartered Accountants of Pakistan Audit and Assurance Replies received from the hospitals did not agree with the balance outstanding in SPL’s records. However, the differences were reconciled by the audit staff. All the 12 confirmations received from the retailers showed disagreement with the records of SPL. However, only 2 could be reconciled. Required: 70 (a) Evaluate the decision regarding sending of negative confirmations. (b) Determine the course of action the auditor should consider in case of balances agreed, balances not agreed and replies not received. (c) State the procedures that need to be performed in case of amount due from SDPL. Nobel You are the manager on the audit of Nobel Limited, a listed company, which manufactures automotive parts and air-conditioners for motor vehicle assemblers. Annual sale of the Company is Rs. 850 million and profit before tax is Rs. 60 million. Your review of the audit working paper file has disclosed the following outstanding issues: (i) The company is facing a potential legal claim from Mehran Motors Limited (MML) in respect of defective air conditioners supplied to them. A claim for Rs. 25 million being the cost of replacement of air conditioners and lost production time has been lodged with the Company by MML. The management is of the view that the claim is not justified, as the air conditioners were properly functioning and had been tested for quality and that the defects have arisen because of the negligence of MML and its technicians. However, a provision of Rs. 2 million has been made in the financial statements in this respect. (ii) Depreciation on certain equipment has been charged at 10% per annum on reducing balance method. This rate is consistent with prior years and the same rate is being used by most other companies, in the automobile industry. However, significant losses have recently been recorded on the disposal of similar equipment. Management has provided written representations in respect of the above matters. Required: What audit evidence will you gather to address the above issues? 71 Masoom Limited As the manger on the audit of Masoom Limited you want the management to appoint experts to assist you on certain matters. Explain the circumstances where auditor may use the work of an expert and the auditor’s responsibilities in this regard. 72 Sky blue Mr Mubarak is the audit senior on the audit of Sky Blue Limited. While comparing the draft financial statements with the previous year, he noted many unusual fluctuations. Briefly explain the procedure he should follow, in the above situation. 73 Direct confirmations 1 Direct confirmations from third parties provide independent audit evidence that certain account balances and items in the financial statements are properly recorded and disclosed. Required: (a) Distinguish between positive and negative confirmations. (b) Briefly describe the risks associated with each of the above type of confirmation and the steps that an auditor usually takes to avert such risks. © Emile Woolf International 38 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions (c) 74 Explain why and under what circumstances an auditor may decide to use negative confirmation requests. Also, identify the circumstances where the auditor may use a combination of positive and negative confirmations. Chill You are the engagement manager on the audit of Chill Limited. During the course of audit, you have been provided an Actuarial Valuation Report on the Company’s Employees Retirement Benefits Scheme. You have noted that the report has been prepared by M/s Saleem and Company which is not well known to you. Required: Briefly describe the matters that you would consider before using the report prepared by Saleem and Company. 75 Sales sampling (a) You are the audit manager on a client where an annual sale is Rs. 640 million. During the course of annual audit the following table was developed by an audit team member, to categorize the annual sales: Rs. Category A 50 sales transactions to different customers 300 million Category B 100 transactions to different customers 200 million Category C 500 transactions to different customers 140 million Total 640 million Sohail, a team member, is of the view that if verification of all the transactions in category A is carried out, there is no need to perform further procedures. However, other team members do not agree and consider that proper sampling should be carried out from the total population and categorization should be ignored. Required: As an audit manager of the job, you are required to: (b) 76 (i) Explain how audit efficiency could be improved by using the above table. (ii) List other ways in which the sales population may be categorized and what precaution should be taken while carrying out such categorization. (iii) Give your opinion on the views expressed by: Sohail Other audit team members. Describe the circumstances in which an auditor may decide to examine entire population of items that make up an account balance. PQR During the audit of PQR Limited you have been assigned the task of evaluating the work performed by the internal audit department of the company on certain specific areas. Required: (a) Describe how you would evaluate the work performed, in order to determine the extent of reliance that may be placed thereon. © Emile Woolf International 39 The Institute of Chartered Accountants of Pakistan Audit and Assurance (b) 77 List the important differences between internal and external audit with respect to the following: Independence Objectives Reporting Hard Stone Limited You are the senior member of the audit engagement team, auditing the financial statements of a manufacturing company, Hard Stone Limited. List down the primary substantive procedures, which you would carry out in the verification of: 78 (a) trade debts (excluding receipts from customers). (b) stores and spares. Related parties Describe the procedures that the auditor may perform, in order to ensure the completeness of the information provided by the management, about related parties. 79 Kamil Limited You are the audit manager on the audit of a listed company, Kamil Limited (KL). Prior to completion of audit, you came across a prospectus issued by Neelum Limited (NL) according to which a director of KL is the chief executive of NL. However, the name of NL was not included in the list of related parties provided by KL. On being confronted the management has advised that the name was omitted inadvertently as the appointment took place just two months prior to the year end. Required: Discuss your course of action in the above situation. 80 Direct confirmations 2 Direct confirmations of balances due from customers are obtained to satisfy the objective of ensuring that the customer exists and owes the specified amount to the company at a certain date. Required: 81 (a) State the circumstances in which an auditor may decide not to circulate the requests for direct confirmation. (b) What are the factors that an auditor considers while designing the requests for direct confirmation? (c) Describe the alternative audit procedures which may be conducted if the customer does not reply to a request for confirmation. Working papers The preparation of working papers is an integral part of the auditor’s responsibilities. Identify the factors that the auditor should consider while determining the form, content and extent of audit working papers. 82 Al-Shams Al-Shams Limited is an unquoted public company. A large part of its business is carried out with persons / organisations related to the management or the shareholders. © Emile Woolf International 40 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions Required: 83 (a) State any eight procedures which an auditor may perform for determining the existence of related parties or related party transactions. (b) Give four examples of situations that may be indicative of dominant influence exerted by a related party. Auditor’s expert When expertise in a field other than accounting or auditing is necessary to obtain sufficient appropriate audit evidence, the auditor has to determine whether to use the work of an auditor’s expert. Required: List down the sources from where the auditor may get the information regarding the expert’s competence, capabilities and objectivity. 84 ADL (a) (b) Differentiate between the following: (i) Statistical and non-statistical sampling (ii) Sampling and non-sampling risk You are the audit manager on Apple Distribution Limited (ADL). While reviewing the audit planning documentation, you found that the audit team has selected 100 out of a total of 2,550 debtors for balance confirmation. The details are as follows: 50 largest debtors constitute approximately 40% of total debtors. Out of these, 10 have been selected. 90 other debtors were selected through haphazard sampling. All debtors below Rs. 5,000 were ignored as immaterial. Balances due from government and some of the related parties were ignored as prior years working papers showed that they never responded to requests for confirmation. Required: 85 (i) Comment on the sampling approach adopted by the audit team. (ii) Suggest alternative means of selecting the sample in which the material balances have a greater probability of selection. Guava & Co You are the training manager at Guava & Co., Chartered Accountants. Some trainees in the firm have requested you to clarify the following issues: (a) Can the auditor discard any audit document, forming part of his opinion, after the issuance of the auditor’s report? (b) The changes that can be incorporated during the final file assembly process citing three such examples. (c) The circumstances under which it becomes necessary to modify the existing audit documents or add new audit documents after the issuance of the auditor’s report and the matters that should be documented in such a situation. Required: Offer appropriate explanations for each of the above issues. © Emile Woolf International 41 The Institute of Chartered Accountants of Pakistan Audit and Assurance 86 RP planning As the auditor of a listed company with a number of related parties, what steps would you consider as part of your audit planning to ensure that all related party relationships and transactions are identified and disclosed in the financial statements. 87 Manufacturing inventories List the substantive procedures that may be performed by the auditor to verify the amount of inventories as appearing in the financial statements of a manufacturing concern. 88 89 Framework (i) Fair presentation framework and compliance framework (ii) Tolerable misstatement and performance materiality MWL You are currently in the planning phase of the audit of Mineral Water Limited (MWL) for the year ended 30 June 2012. The following information is available to you: No. of Customers Customer Segment Super markets Wholesalers Retailers Five star hotels Balance outstanding 12 65 553 7 20,014 14,910 4,743 7,694 ――― 47,361 ――― 10 10-20 21-30 days days days Rs. in thousand… 8,125 5,053 6,396 5,078 6,019 3,150 1,756 1,798 724 2,805 2,793 1,784 ――― ――― ――― 17,764 15,663 12,054 ――― ――― ――― 31-90 days > 90 days 311 454 278 201 ――― 1,244 ――― 129 209 187 111 ―― 636 ―― 50% provision for doubtful debts has been made by MWL against balances outstanding for more than 30 days whereas the balances outstanding for more than 90 days have been fully provided. Required: 90 (a) Indicate what would be the basis for selecting debtors for circularising positive and negative requests for confirmations. (b) Briefly explain as to how you would deal with a situation where a debtor confirms a balance which is different from the amount appearing in the confirmation request. BPR List the substantive procedures that may be performed by an auditor to verify the following: 91 (a) Bank reconciliation statements (b) Payroll (c) Raw material purchases Taskeen Co (a) (i) In the context of ISA 530 Audit sampling, explain and provide examples of the terms ‘sampling risk’ and ‘non-sampling’ risk. (ii) Briefly explain how sampling and non-sampling risk can be controlled by the audit firm. © Emile Woolf International 42 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions (b) Taskeen Co is owned and managed by two brothers with equal shareholdings. The company specialises in the sale of expensive motor vehicles. Annual revenue is in the region of Rs70,000,000 and the company requires an audit under local legislation. About 500 cars are sold each year, with an average value of Rs140,000, although the range of values is from Rs130,000 to Rs160,000. Invoices are completed manually with one director signing all invoices to confirm the sales value is correct. All accounting and financial statement preparation is carried out by the directors. A recent expansion of the company’s showroom was financed by a bank loan, repayable over the next five years. The audit manager is starting to plan the audit of Taskeen Co. The audit senior and audit junior assigned to the audit are helping the manager as a training exercise. Comments are being made about how to select a sample of sales invoices for testing. Audit procedures are needed to ensure that the managing director has signed them and then to trace details into the sales day book and sales ledger. ‘We should check all invoices’ suggests the audit manager. ‘How about selecting a sample using statistical sampling techniques,’ adds the audit senior. ‘Why waste time obtaining a sample?’ asks the audit junior. He adds ‘taking a random sample of invoices by reviewing the invoice file and manually choosing a few important invoices will be much quicker.’ Required: Briefly explain each of the sample selection methods suggested by the audit manager, audit senior and audit junior, and discuss whether or not they are appropriate for obtaining a representative sample of sales invoices. (c) 92 Define ‘materiality’ and explain why the auditors of Taskeen Co must form an opinion on whether the financial statements are free from material misstatement. Wings Wings is an airline. The company owns some of its fleet of aircraft. Other aircraft are leased from third parties. Wings has an internal audit function that has recently expanded. Your firm is the external auditor to Wings. Your firm has been asked to investigate the extent of which it may be able to rely on the work of internal audit in the following areas: Sales and ticketing; Fleet acquisition and maintenance; Trade payables and long-term debt financing (borrowings). The company outsources its in-flight catering and payroll functions to different service organisations. Required: 93 (a) Explain why the work of internal auditors, in the three areas noted above, is likely to be useful to you as the external auditor. (b) Explain how the quality of the internal audit function is likely to influence the extent of your reliance on internal audit work. (c) Describe the audit evidence you will seek relating to internal controls over the out-sourced functions (in-flight catering and payroll). Glasses2Go ISA 230 Audit Documentation 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. © Emile Woolf International 43 The Institute of Chartered Accountants of Pakistan Audit and Assurance (b) You have recently been promoted to audit manager in the audit firm of Sadia & Co. As part of your new responsibilities, you have been placed in charge of the audit of Glasses2Go, a long established audit client of Sadia & Co. Glasses2Go 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 Glasses2Go. Describe the information you should expect to obtain from each document. (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: Glasses2Go Year end: 30 April 20X3 Working paper: Payables transaction testing 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. 94 ISA 620 ISA 620 Using the work of an auditor’s expert contains guidance where the auditor uses the work of an expert to provide knowledge relevant to the audit, which the audit firm itself does not possess. Before the firm can rely on the work of the expert, ISA 620 requires the firm to assess that work. Required: 95 (i) Set out FOUR examples of financial statement areas where the audit firm might be likely to rely upon the work of an expert employed by the audit firm. (ii) Set out the main procedures an audit firm should apply before relying on the work of such an expert. Cuddly World You are the auditor of Cuddly World, a company which manufactures and sells small cuddly toys by mail order. The company is managed by Mr Kabir and two assistants. Mr Kabir 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 despatches cuddly toys. Due to other business commitments Mr Kabir only visits the office once a week. © Emile Woolf International 44 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 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. Revenue is over Rs 5.2 million. You are planning the audit of Cuddly World and are considering using some of the procedures for gathering audit evidence recommended by ISA 500 as follows: (1) analytical procedures; (2) inquiry; (3) inspection; (4) observation; (5) recalculation. Required: (a) (b) 96 97 For each of the above procedures: (i) explain its use in gathering audit evidence; (ii) describe one example for the audit of Cuddly World. Discuss the suitability of each procedure for Cuddly World, explaining the limitations of each. Auditors (a) State five key substantive audit procedures for verification of Provisions. (b) Briefly describe how an auditor evaluates the sufficiency of audit evidence. (c) Briefly explain how an external auditor would evaluate the adequacy of the work performed by the internal audit function. (d) List six physical access controls over an IT system. (e) Briefly discuss the concept of ‘Professional skepticism’. Analytical procedures and materiality (a) Analytical procedures are an important and powerful tool for auditors in explaining the performance of a business. ISAs 315 and 320 require the auditor to apply analytical procedures at the planning and overall review stages of the audit. Required: Explain the possible reasons for the following changes in accounting ratios found at the planning stage of the audit: (i) an increase in the current ratio; (ii) a decrease in the gross profit margin; and (iii) an increase in the inventory holding period; Note: No marks will be awarded for showing the calculation of the ratio, all parts carry equal marks. (b) The concept of materiality is fundamental to the work of auditors and is covered by ISA 320 Materiality in planning and performing an audit. Matters that are immaterial are not reported in financial statements. Required: Explain the concept of materiality and describe how materiality affects the audit work performed by auditors. © Emile Woolf International 45 The Institute of Chartered Accountants of Pakistan Audit and Assurance 98 Tahira Transporters You are the external auditor of Tahira Transporters, a public limited company (TT). The company's year-end is 11 March. You have been the auditor since the company was formed 24 years ago to take advantage of the increase in goods being transported by road. Many companies needed to transport their products but did not always have sufficient vehicles to move them. TT therefore purchased ten vehicles and hired these to haulage companies for amounts of time ranging from three days to six months. The business has grown in size and profitability and now has over 550 vehicles on hire to many different companies. At any one time, between five and 20 vehicles are located at the company premises where they are being repaired; the rest could be anywhere on the extensive road network of the country it operates in. Full details of all vehicles are maintained in a non-current asset register. Bookings for hire of vehicles are received either over the telephone or via e-mail in TT's offices. A booking clerk checks the customer's credit status on the receivables ledger and then the availability of vehicles using the Vehicle Management System (VMS) software on TT's computer network. E-mails are filed electronically by customer name in the e-mail program used by TT. If the customer's credit rating is acceptable and a vehicle is available, the booking is entered into the VMS and confirmed to the customer using the telephone or e-mail. Booking information is then transferred within the network from the VMS to the receivables ledger programme, where a sales invoice is raised. Standard rental amounts are allocated to each booking depending on the amount of time the vehicle is being hired for. Hard copy invoices are sent in the post for telephone orders or via e-mail for e-mail orders. The main class of asset on TT's statement of financial position is the vehicles. The net book value of the vehicles is Rs6 million out of total shareholders' funds of Rs15 million as at 31 March 20X3. Required: 99 (a) List and explain the reason for the audit tests you should perform to check the completeness and accuracy of the sales figure in TT's financial statements. (b) List and describe the audit work you should perform on the statement of financial position figure for vehicles in TT's financial statements for the year ended 31 March 20X3. Willow As a staff member of R and A Chartered Certified Accountants you are assigned to the audit of tangible non-current assets of Willow for the year ended 31 March 20X3. R and A have been the auditors of Willow for many years. You obtain the following schedule of movements on property, plant and equipment and analysis of additions from the company’s accountant. Property Plant and machinery Total Rs m Rs m Rs m 1 April 20X2 340 275 615 Additions – 123 123 Disposals – (72) (72) 120 –––– 460 –––– – –––– 326 –––– 120 –––– 786 –––– 1 April 20X2 24 213 237 Provision 5 30 35 Written back on disposal – (65) (65) Adjustment on revaluation (24) –––– 5 –––– – –––– 178 –––– (24) –––– 183 –––– Cost or valuation Revaluations 31 March 20X3 Accumulated depreciation 31 March 20X3 © Emile Woolf International 46 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions Property Plant and machinery Total Rs m Rs m Rs m 455 –––– 316 –––– 148 –––– 62 –––– 603 –––– 378 –––– Carrying amount 31 March 20X3 31 March 20X2 Schedule of additions (plant and machinery) Supplier Description Cost Rs m New Models Milling machine Model 38 55 Drill Suppliers Power drill Type 45C 34 Hoist Co Electric hoist no 722 18 Sundry below Rs 1m 16 ––––––– 123 ––––––– The company’s accountant also advises you that the property was revalued following a valuation by the company’s property manager who is a professionally qualified valuer. During your verification of depreciation you discover that most plant and machinery is fully depreciated. Moreover you discover that, due to oversight, depreciation has continued to be provided on fully depreciated items. As at the beginning of the year the amount of overstatement was Rs 43m. The accountant suggests the correction be made by reducing the current year’s charge for depreciation. Required: (a) State, with reasons, the initial audit procedures you would perform on the schedules provided by the company’s accountant. (b) Outline the substantive audit procedures you would apply in verifying additions to plant and machinery. Your answer should identify procedures applicable to each of the financial statement assertions. (c) Describe the audit procedures applicable to verifying the revaluation of property. (d) With respect to the correction to accumulated depreciation, and assuming the amount to be material, discuss the accountant’s proposed treatment. If you disagree with the accountant’s proposal, state, with reasons, the correct accounting treatment. 100 Sparkle Forever You are the audit manager in the firm of Dandy & Co, an audit firm with ten national offices. One of your clients, Sparkle Forever, purchases diamond jewellery from three manufacturers. The jewellery is then sold from Sparkle Forever’s four shops. This is the only client your firm has in the diamond industry. You are planning to attend the physical inventory count for Sparkle Forever. Inventory is the largest account on the statement of financial position with each of the four shops holding material amounts. Due to the high value of the inventory, all shops will be visited and test counts performed. With the permission of the directors of Sparkle Forever, you have employed JJ, a firm of specialist diamond valuers who will also be in attendance. JJ will verify that the jewellery is, in fact, made from diamonds and that the jewellery is saleable with respect to current trends in fashion. JJ will also suggest, on a sample basis, the value of specific items of jewellery. Counting will be carried out by shop staff in teams of two using pre-numbered count sheets. © Emile Woolf International 47 The Institute of Chartered Accountants of Pakistan Audit and Assurance Required: (a) List and explain the reason for the audit procedures used in obtaining evidence in relation to the inventory count of inventory held in the shops. (b) Explain the factors you should consider when placing reliance on the work of UJ. (c) Describe the audit procedures you should perform to ensure that jewellery inventory is valued correctly. 101 Bubbles Bubbles manufactures and distributes soft drinks. Its inventories are controlled using a real-time system which provides accurate records of quantities and costs of inventories held at any point in time. This system is known within the company as the 'Stockpop' system and it is integrated with the purchases and sales system. Bubbles has an internal audit department whose activities encompass inventories. No year-end inventory count takes place Inventories are held in several large warehouses where nonstop production takes place. Your firm is the external auditor to Bubbles and you have been asked to perform the audit of inventories, Inventories include finished goods and raw materials (water, sugar, sweeteners, carbonating materials, flavourings, cans, bottles, bottle tops, fastenings and packaging materials). Your firm, which has several offices, wishes to rely on the 'Stockpop' system to provide the basis of the figure to be included in the financial statements 'for inventories. Your firm does not wish to ask the company to conduct a year-end inventory count. Required: (a) Describe the audit tests that you would perform on the `Stockpop' system during the year in order to determine whether to rely on it as a basis for the raw materials and finished goods figures to be included in the financial statements. Note: You are not required to deal with work in progress. (b) Describe the audit tests you would perform on the records held by Bubbles at the year end to ensure that raw materials and finished goods are fairly stated in the financial statements. 102 ISA 500 ISA 500 Audit evidence identifies seven main testing procedures. One of these is external confirmation. Required: (a) List FOUR examples of external confirmations. (b) For EACH of the examples in (a) above explain: ONE audit assertion that the external confirmation supports, and ONE audit assertion that the external confirmation does NOT support. 103 Javeria Co Javeria Co has a significant number of cash transactions and recent non-current asset purchases have been financed by a bank loan. This loan is repayable in equal annual instalments for the next five years. Required: (a) Explain the procedures to obtain a bank report for audit purposes from Javeria Co.’s bank and the substantive procedures that should be carried out on that report. (b) List the further substantive procedures that should be carried out on the bank balances in Javeria Co.’s financial statements. © Emile Woolf International 48 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 104 Porridge Porridge is a small manufacturing company of which your firm of Chartered Certified Accountants is the external auditor. You have been assigned to the audit of trade payables. The audit file indicates that control risk for purchases and payments transactions is assessed as slightly less than high because of limitations in the extent of segregation of duties due to the small number of accounts personnel. There are no other identified control problems or prior year audit problems. Narrative notes on the accounting system contain the following descriptions. Purchases are requisitioned by the user department and ordered, using prenumbered order forms, by the purchasing manager. Raw materials and manufacturing supplies are delivered to the receiving department of the factory where the receiver issues prenumbered goods inward notes (GINs). Purchases of other goods and services are delivered directly to the requisitioning department and no GINs are issued. The accounts department checks suppliers' invoices with purchase orders, and for production department purchases, with GINs for other purchases, sends the invoices to the requisitioning department manager who initials the invoice to indicate that it is appropriate to pay. Invoices are then processed to the accounting records using proprietary software. All suppliers are paid at the end of the month following the month of receipt of the invoice. Payables at 31 October 20X3 therefore represent goods and services invoiced in October. In addition, invoices received between 1 and 15 November were divided into those relating to goods received or services provided before and after 31 October, the former being recorded in the accounting records before the October trial balance was produced. On 15 November, any unmatched GINs relating to deliveries before 31 October were posted to the accounts as at 31 October at the estimated amounts of the invoices. Suppliers' invoices are filed alphabetically with supporting documentation, all of which is cancelled with the date of payment when the cheque is issued. Suppliers' monthly statements are also filed with the invoices. These are scrutinised by the accounts department for unusual items, such as overdue invoices, but are not regularly reconciled with the company's own records. Required: (a) In your audit of trade payables in the 31 October 20X3 financial statements explain which of the financial statement assertions you would regard as presenting the greatest inherent risk. (b) Discuss the reasons for undertaking or not undertaking a payables’ circularisation. (c) Outline substantive procedures you would apply in your audit of trade payables relating to production department purchases. (d) Explain additional procedures you would perform in verifying the completeness of non-production department payables. 105 Trembridge Engineering Your firm is the auditor of Trembridge Engineering, and you have been asked to suggest the audit work you will carry out in verifying accounts payable and purchase accruals at the company's year end of 30 September 20X3. You attended the inventory count at the year end. The company operates from a single site and all raw materials for production are received by the goods inwards department. When the materials are received they are checked for quantity and quality to the delivery note and purchase order, and a multi-part goods received note is made out and signed by the storekeeper. If there are any problems with the raw materials, a discrepancy note is raised which gives details of the problems (e.g. incorrect quantities or faulty materials). © Emile Woolf International 49 The Institute of Chartered Accountants of Pakistan Audit and Assurance The purchase accounting department receive the purchase invoices, check them to the purchase order and goods received note and post them to the purchase ledger. At the end of each month, payments are made to suppliers. The purchase ledger is maintained on a PC. The main sundry payables and accruals at the year end include: (i) wages accruals and associated taxes payable; (ii) sales taxes payable; (iii) time dependent accruals, such as interest on loans and overdrafts, telephone, heat and light, and other expenses paid in arrears. Most employees' wages are paid weekly in arrears. Required: Describe in detail the audit work you will carry out to: (a) check suppliers' statements to the balances on the purchase ledger; (b) verify that purchases cut-off has been correctly carried out at the year end; (c) ensure that sundry payables and accruals are correctly stated. 106 ISA 620: Using the Work of an Auditor’s Expert (a) ISA 620 Using the Work of an auditor’s Expert explains how an auditor may use an expert to obtain audit evidence. Required: Explain THREE factors that the external auditor should consider when assessing the competence and objectivity of the expert. (b) Auditors have various duties to perform in their role as auditors, for example, to assess the truth and fairness of the financial statements. Required: Explain THREE rights that enable auditors to carry out their duties. (c) List FOUR assertions relevant to the audit of tangible non-current assets and state one audit procedure which provides appropriate evidence for each assertion. 107 Heidi Co Following a competitive tender, your audit firm Cal & Co has just gained a new audit client Heidi Co. You are the manager in charge of planning the audit work. Heidi Co.’s year end is 30 June 20X3 with a scheduled date to complete the audit of 15 August 20X3. The date now is 3 June 20X3. Heidi 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 Heidi Co by a reputable software house. Data from each location is amalgamated on a monthly basis at Heidi Co.’s head office to produce management and financial accounts. You are currently planning your audit approach for Heidi Co. One option being considered is to re-write Cal & Co.’s audit software to interrogate the computerised inventory systems in each location of Heidi 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 Heidi Co; (ii) Explain the problems that may be encountered in the audit of Heidi Co and for each problem, explain how that problem could be overcome. © Emile Woolf International 50 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions (b) Following a discussion with the management at Heidi 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 Heidi 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. SCENARIOS 108 Zeedin Co Zeedin 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 re-order 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. Staff 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 Zeedin, 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 Zeedin. (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 Zeedin 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 Zeedin Co, explaining the reason for each procedure. (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. (c) (i) State the aim of a test of control and the aim of a substantive procedure. (ii) In respect of your attendance at Zeedin Co.’s inventory count, state one test of control and one substantive procedure that you should perform. (d) On the day of the inventory count, you attended depot nine at Zeedin. You observed the following activities: Pre-numbered 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. © Emile Woolf International 51 The Institute of Chartered Accountants of Pakistan Audit and Assurance All count staff were drawn from the inventory warehouse and were counting in teams of two. 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. Staff were warned that they had to remember which inventory had been counted. Information was recorded on the count sheets in pencil so amendments could be made easily as required. 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. 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. 109 Sahito Co Introduction – audit firm You are an audit senior in Bachani & 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 Sahito 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, Sahito’s system of internal control has not changed in the last year. Client background – sales system Sahito 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 Sahito are always owners of small retail shops, where electrical goods are sold to members of the public. Sahito only sells to authorised customers; following appropriate credit checks, each customer is given a Sahito 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: Customers visit Sahito’s warehouse and load the goods they require into their vans after showing their Sahito identification card to the despatch staff. A pre-numbered goods despatch note (GDN) is produced and signed by the customer and a member of Sahito’s despatch staff confirming goods taken. One copy of the GDN is sent to the accounts department, the second copy is retained in the despatch department. Accounts staff enter goods despatch information onto the computerised sales system. The GDN is signed. 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. 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. Paper copies of the receivables ledger control account and list of aged receivables are also available. Error reports are produced showing breaks in the GDN sequence. © Emile Woolf International 52 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 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 Range of debt Total debt Current Rs Rs 15 Less than Rs 0 197 153 1 to 2 months old Rs More than 2 months old Rs (87,253) (87,253) Rs 0 to Rs 20,000 2,167,762 548,894 643,523 975,345 Rs 20,001 to 50,000 5,508,077 2,044,253 2,735,073 728,751 23 Rs 50,001 or more 1,495,498 750,235 672,750 72,513 –––– –––––––––– ––––––––– ––––––––– –––––––––– 388 9,084,084 3,256,129 4,051,346 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. (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 Sahito Co and explain the reason for each test. (c) State and explain the meaning of FOUR assertions that relate to the direct confirmation of receivables. (d) (i) Describe the procedures up to despatch of letters to individual receivables in relation to a direct confirmation of receivables. (ii) Discuss which particular categories of receivables might be chosen for the sample. 110 Bashir Co Introduction Bashir 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 Bashir 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. 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 shiftworkers 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. © Emile Woolf International 53 The Institute of Chartered Accountants of Pakistan Audit and Assurance 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 Bashir’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 Bashir’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 Bashir. 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. (b) As the external auditors of Bashir Co, write a management letter to the directors in respect of the shift-workers’ 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. (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. (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 Bashir Co, explain FOUR procedures used in collecting audit evidence and discuss whether the auditor will benefit from using each procedure. 111 Multiple Situations (a) Explain the term ‘Expectation Gap’ in the context of an audit and give three examples of expectation gap. (b) International Standards on Auditing require an auditor to evaluate the control environment and assess its effectiveness. State the factors that the auditor should consider in evaluating the control environment. (c) A schedule of related party transactions provided by the client includes two significant transactions which are outside the normal course of business. State the substantive procedures that an auditor should undertake, in respect of these transactions. © Emile Woolf International 54 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions (d) State key features of a review engagement which distinguish it from a statutory audit and identify two types of review engagements. (e) Identify the factors that are considered in determining the independence of internal auditors. (f) State four substantive procedures for verification of share premium account appearing in the statement of financial position. (g) Briefly explain with examples, the different levels of assurance that can be provided to an assurance client. (h) State the conditions under which an auditor may send negative confirmations. COMPLETION 112 Final audit file (a) State the auditor’s responsibility in respect of ‘Assembly of final audit file’. (b) The audit report of Salim Limited was signed on 30 April 2016. After issuance of the audit report, the auditor was informed that a major debtor has become bankrupt. Required: Specify the matters that the auditor would be required to document in the above situation. 113 Energy Limited (a) Specify the procedures that an auditor should perform to ensure completeness of the list of related parties provided by the directors. (b) As part of audit procedure you have requested the management of Energy Limited to provide specific representation relating to completeness of related parties and related party transactions. The management is of the view that since the auditor has carried out a detailed review in which no undisclosed transactions were identified, a written representation is not necessary. Required: Evaluate the above situation, comment on the management’s stance and suggest the appropriate course of action available to the auditor. 114 XYZ & Company You are the audit partner of XYZ & Company, Chartered Accountants. The following matters are under your consideration: (a) Asif Limited has made certain investments and has classified them as long term investments. The management has also provided written representation in this regard. However, before the finalization of financial statements the company disposed of some of the said investments. (b) Mansoor Limited has entered into significant related party transactions during the year which are approved by the Board of Directors and appropriately disclosed. The management has also agreed to provide a written representation but you have not received it yet. Required: Analyse the above situations and explain how you would proceed in the above matters. © Emile Woolf International 55 The Institute of Chartered Accountants of Pakistan Audit and Assurance 115 XYZ Limited While reviewing the final audit file of XYZ Limited for the year ended 30 June 2014, you have identified that certain amendments were made in the final audit file after the date of the auditor’s report. Required: Comment on the above situation in the light of International Standards on Auditing. 116 Noncurrent assets Briefly state test of details for verifying the valuation assertion of tangible noncurrent assets where the company follows revaluation policy for valuation of such assets. 117 Customized Machinery Limited (CML) Your firm is the auditor of Customized Machinery Limited (CML), a listed company, for the year ended 30 June 2015. CML has an asset base of Rs. 3.5 billion and profit before tax of Rs. 350 million. On 10 August 2015, after the issuance of audit report but prior to the issuance of financial statements, you have been informed as under: (i) CML had been awarded a contract of Rs. 500 million in April 2015 for supply of specialized machinery parts in August 2015 to a foreign customer. CML was expecting a profit of 20% on the contract. However, the government of the foreign country has placed certain restrictions on import because of which the customer has cancelled the purchase order under force majeure clause. (ii) The inventory against the above order is lying in the warehouse and requires an expense of Rs. 105 million in order to become usable for other customers. (iii) According to the management, the cancellation of this order will not affect the operations of the company in any significant manner. Required: Discuss how you would deal with the above situation. 118 Nadeem Limited As the engagement partner, you have reviewed the working papers of Nadeem Limited (NL) in which the audit team has highlighted the following matters: (a) NL provides six months warranty to its customers and has hired an expert to compute the warranty provision. The management is not willing to provide written representation for the warranty provision because the provision is in accordance with the expert’s advice. (b) Certain contingent assets have been disclosed in the draft financial statements in which inflow of economic benefits is possible but not probable. The management is of the view that International Financial Reporting Standards does not prohibit making additional disclosures which enhance the users understanding of the financial statements. (c) According to the accounting policy for revenue recognition, revenue from sale of goods is recognized on dispatch of goods to customers. However, during the year, NL has entered into various agreements in which the goods are required to be delivered at the premises of the customers. Required: Discuss the possible impact on the audit report. © Emile Woolf International 56 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 119 System logs (a) Differentiate between Symmetric key ciphers and Asymmetric key ciphers in relation to data encryption techniques. (b) Identify any four types of information that can be extracted from system logs. 120 Overtime payments You have been assigned to plan the test of controls in respect of salaries and wages. In this regard you are required to identify the following: (a) Possible control weaknesses in overtime payments (b) Principal controls over payment of overtime 121 Khanewal Limited (KL) Khanewal Limited (KL) has requested your firm to submit engagement letter for KL’s statutory audit. The engagement partner has asked you to establish whether preconditions for the audit of KL are present. Required: What matters would you consider in order to ensure that preconditions for the audit exist? 122 ABD Limited Your firm is the auditor of ABD Limited (ABDL). After the acquisition of majority shareholding in HG Motors (Private) Limited (HGM), ABDL has decided to replace the existing auditors of HGM in the next annual general meeting and has approached you for appointment as HGM’s auditors for the next year. Required: (a) In the light of the Companies Act, 2017 explain the procedures to be followed and formalities to be complied with for appointment of your firm as the auditor of HGM. Also explain the rights of the existing auditors in this situation. (b) Explain the responsibilities of your firm and the existing auditors in the above situation under the Code of Ethics for Chartered Accountants. 123 Cell Phones (Private) Limited Your firm is the auditor of Cell Phones (Private) Limited (CPPL), which operates a chain of mobile phone retail outlets. About 25% of shareholding in CPPL is owned by Anwar and his wife. Anwar is the Chief Executive of CPPL and also looks after the finance and operations of the company. There are five other directors and each of them holds 15% shares in CPPL. The Internal Audit Function comprises of three senior officers who are graduates. Their duties include checking of accounting records, physical stock taking, preparation of bank reconciliations, reviewing payments and verification of fixed and current assets. During the planning phase, Anwar stressed the need for early completion of audit, in order to be able to submit the audited financial statements for seeking a long term finance. He was of the view that internal audit working papers would be of enormous help in performing and early completion of the audit. Required: (a) Identify and briefly describe the fraud risk factors in the above scenario. (b) State whether it would be advisable to use the internal audit working papers in the above situation and give three distinct reasons to support your decision. © Emile Woolf International 57 The Institute of Chartered Accountants of Pakistan Audit and Assurance 124 Substantive procedures List any five substantive procedures for the verification of each of the following: (i) Accrued expenses (ii) Contingencies 125 Pioneer Textile Limited (PTL) The management of Pioneer Textile Limited (PTL) has provided you with management representation that they have disclosed to you all known instances of non-compliances with laws and regulations that are relevant to the preparation of the financial statements. However, during the field work your team identified a payment of penalty of Rs. 2 million to an environmental agency. PTL’s management claims that the disclosure of the related non-compliance was inadvertently omitted. Required: Discuss the appropriateness of management representation and how would you deal with the above situation. 126 Multiple Questions (a) Briefly describe the term ‘Integrity’ in accordance with the Code of Ethics for Chartered Accountants. (b) Briefly describe ‘advocacy threat’ and give an example thereof. (c) Briefly state the difference between ‘actual independence’ and ‘perceived independence’. (d) The principle of confidentiality imposes an obligation on chartered accountants to refrain from disclosing confidential information. State three key exceptions to the above rule. (e) Briefly describe the term ‘systematic sampling’. (f) State the conditions under which it may be appropriate to send negative confirmations. (g) State any three procedures which are generally adopted by the auditor to obtain evidence in review engagement. (h) State the auditor’s responsibility with respect to events between the end of the reporting period and the date of the auditor’s report. (i) Give any three audit procedures to ensure completeness of list of related parties provided by the management. (j) State any two factors which the auditor should consider to ensure reliability of audit evidence. 127 Analytical procedures (a) Analytical procedures are an important part of the audit process and a tool which the auditor uses during the various phases of an audit. Required: (b) (i) Describe the nature and purpose of analytical procedures used during an audit. (ii) Describe the factors that the auditor needs to consider while designing and performing analytical procedures as substantive procedures. (iii) Describe the objectives which an auditor expects to achieve while applying analytical procedures at the overall review stage of an audit. Representations by management are considered as audit evidence. Describe the basic elements of a management representation letter. © Emile Woolf International 58 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 128 Auditor responsibility The auditor is required to issue an audit report at the end of the audit, which sets out his opinion on the financial statements. An important element of the audit report is the statement of auditor’s responsibility. Required: Narrate the matters that should be contained in the statement of auditor’s responsibility as included in an audit report issued under ISA-700 ‘The Independent Auditor’s Report on a Complete Set of General Purpose Financial Statements’. 129 Al-Badr Al-Badr & Company, Chartered Accountants, have conducted the statutory audit of the financial statements of Al-Qasim Limited, a listed company, for the year ended June 30, 20X3 under the requirements of the Companies Act, 2017. The job in charge has drafted the following audit report: Auditors’ Report to the Directors We have audited the annexed balance sheet of Al-Qasim Limited as at June 30, 20X3 and the related profit and loss account and statement of changes in equity together with the notes forming part thereof, for the year then ended and we state that we have obtained all the information and explanations which, to the best of our knowledge and belief, were necessary for the purposes of our audit. We conducted our audit in accordance with the auditing standards. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the above said statements are free of any material misstatement. An audit includes examining evidence supporting the amounts and disclosures in the above said statements. An audit also includes assessing the accounting policies and all estimates made by management, as well as, evaluating the overall presentation of the above said statements. We believe that our audit provides a reasonable basis for our opinion and, after due verification, we report that: (a) in our opinion: (i) the balance sheet and profit and loss account together with the notes thereon have been drawn up in conformity with the Companies Ordinance, 1984, and are in agreement with the books of account and further in agreement with accounting policies consistently applied; (ii) the expenditure incurred during the year was for the purpose of the company’s business; and (iii) the business conducted, investments made and the expenditure incurred during the year were in accordance with the objects of the company; (b) in our opinion and to the best of our information and according to the explanations given to us, the balance sheet, profit and loss account and statement of changes in equity together with the notes forming part thereof conform with International Financial Reporting Standards, and give the information required by the Companies Ordinance, 1984, in the manner so required and respectively give a true and fair view of the state of the company’s affairs as at June 30, 20X3 and of the profit and changes in equity for the year then ended; and (c) in our opinion, no zakat was deductible at source under the Zakat and Ushr Ordinance, 1980 (XVIII of 1980). Al-Badr & Company Chartered Accountants Karachi Dated: September xx, 20X3 Required: Identify and explain (where necessary) the errors in the above audit report. (Note: You are not required to redraft the report.) © Emile Woolf International 59 The Institute of Chartered Accountants of Pakistan Audit and Assurance 130 Shahrukh and Company Shahrukh and Company, Chartered Accountants, have conducted the statutory audit of the financial statements of Karim Limited, a listed company, for the year ended 30 June 20X2 under the Companies Act, 2017. The job incharge has drafted the following audit report: Auditors’ Report to the Members We have audited the annexed balance sheet of Karim Limited (the Company) as at 30 June 20X2, and the related Income and Expenditure Account, Statement of Comprehensive Income, Cash Flow Statement and Statement of Changes in Equity together with the notes forming part thereof, for the year then ended and we state that we have obtained all the information and explanations which were necessary for the purposes of our audit. It is the responsibility of the company’s management to establish and maintain a system of internal control and prepare and present the above said statements in conformity with the approved auditing standards and the requirements of the fourth schedule to the Companies Ordinance, 1984. Our responsibility is to audit these statements. We conducted our audit in accordance with the auditing standards as applicable in Pakistan. These standards require that we plan and perform the audit to obtain reasonable and limited assurance about whether the above statements are free of any misstatement. An audit includes examining evidence supporting the amounts and disclosures in the above said statements. An audit also includes assessing the accounting policies and significant estimates made by management, as well as, evaluating the overall presentation of the above said statements. We believe that our audit provides a reasonable basis for our opinion and, after due verification, we report that: (a) in our opinion, proper books of accounts have been kept by the company. (b) in our opinion: (i) the balance sheet and profit and loss account together with the notes thereon have been drawn up in conformity with the Companies Ordinance 1984, and are in agreement with the books of account and are further in accordance with accounting policies consistently applied; (ii) the expenditure incurred during the year was in accordance with the objects of the Company; and (iii) the business conducted, investments made and the expenditure incurred during the year were for the purpose of the Company’s business; (c) in our opinion and to the best of our information and according to the explanations given to us, the balance sheet, profit and loss account, statement of comprehensive income, cash flow statement and statement of changes in equity together with the notes forming part thereof, on form with the approved accounting standards as applicable in Pakistan and give the information required by the Companies Ordinance, 1984, in the manner so required and respectively give a true and fair view of the state of the Company’s affairs as at 30 June 20X2; and (d) in our opinion, no zakat was deductible at source under the Zakat and Ushr Ordinance, 1980. Chartered Accountants Date: 01 September 20X2 Required: Identify the errors in the above report vis-à-vis a standard statutory audit report (Note: You are not required to redraft the report.) 131 The engagement partner As the engagement partner, you have reviewed the audit working papers of Samarkand Limited (SL). The audit team has highlighted the following matters in the working papers. (a) Twenty percent of the company’s recorded turnover (revenue) comprises of cash sales. Proper records of cash sales have not been maintained. Consequently, the audit team was unable to design audit procedures to verify the cash sales. © Emile Woolf International 60 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions (b) During the current year, the company changed the method of charging depreciation on its fixed assets from the straight line to the diminishing balance method. However, all the required disclosures have been included in the notes to the financial statements. (c) The previous year’s financial statements were audited by another firm of chartered accountants which has issued an un-modified opinion on those financial statements. Required: Discuss the impact of each of the above matters on your audit report. 132 Different audit clients The following situations have arisen at different audit clients of your firm: (a) Zafar Technology Limited (ZTL), a listed company, is engaged in the manufacture of compressors used in electrical appliances. During the conduct of the audit for the year ended 31 March 2012, a team member has discovered a letter dated 18 March 2012 from Sartaj Electronics Limited (SEL) which states that SEL will not pay the current outstanding invoices as according to it the compressors supplied by ZTL are of an incorrect specification. ZTL’s Technical Director believes that the problem arose due to changes in the design of appliances produced by SEL and not because of faulty production by ZTL. However, both the companies have agreed to refer the matter to arbitration. Sales to SEL account for approximately 25% of the revenue of ZTL and the balance due from SEL as at 31 March 2012 amounted to Rs. 3.12 million. The profit after taxation of ZTL is Rs.25 million with an asset base of Rs.150 million. (b) The directors’ report of XCP Limited states without any further explanation that the 20% increase in profit as compared to the previous year is due to increase in sales and austerity measures introduced by the management. The income statement for the year shows an increase in profits and sales amounting to Rs. 20 million and Rs. 8 million respectively whereas the costs have reduced by Rs. 12 million. A review of your working papers however indicates that costs have reduced mainly on account of reduction in import duty on certain raw materials. (c) IPL is a manufacturer of diversified products and has factories in seven major cities of the country. The demand for some of its products has been falling and the company wants to concentrate on its core products only. Consequently, it has decided to close three of its factories and has made a provision of Rs. 30 million in respect of redundancies and restructuring. The directors’ report for the year ended 31 May 2012 comprehensively discusses the restructuring plan and states that the factories in Lahore and Multan would be closed in the months of July and September 2012 respectively. The third factory will be closed before December 2012 however, the location of that factory will be decided in November 2012. The profit after taxation of IPL according to its draft financial statements for the year ended 31 May 2012 is Rs. 80 million. Required: Discuss the matters which the auditor should consider for each of the above situations and the possible impact thereof on the respective audit reports. 133 Situations have arisen on different clients The following situations have arisen on different clients being audited by your firm. The year end in each instance is 31 December 2011. (a) The management of Dir Limited intends to present certain unaudited supplementary information, with the audited financial statements, in order to comply with the requirements of the parent company. Before signing the audit report, it has been determined that some of the information is inconsistent with the information in the draft financial statements. (b) Malakand Industries Limited (MIL) is engaged in the supply of customised machinery to textile manufacturers. On 18 February 2012 one of its customers, who owed Rs. 9.6 million, went into voluntary liquidation. In addition to the above amount, a job was in progress on behalf of that customer and on which MIL had already spent Rs. 13.9 million. © Emile Woolf International 61 The Institute of Chartered Accountants of Pakistan Audit and Assurance The directors have refused to make a provision against the debt on the grounds that the liquidator was appointed after the balance sheet date. They have also refused to make any provision in respect of the work in process as they are planning to sell the machinery being manufactured to another customer for Rs. 15.7 million. The profit after tax of MIL is Rs. 85 million. The materiality level is 10% of profit after tax. (c) Swat Limited has invested Rs. 150 million in a business which is not mentioned in the object clause of its Memorandum of Association. However, the object clause was amended a week before the signing of the audit report. Required: In the light of the relevant requirements, discuss how should the auditor deal with the above situations and describe the impact thereof on the audit report. 134 Hafiz Limited You are the manager responsible for the audit of Hafiz Limited (HL), a listed company, whose fieldwork in respect of the statutory audit is in progress. You are reviewing the following issues which were brought to your attention by the audit team: (i) HL’s parent company is registered in a foreign country and has asked your firm to also provide an audit report on a separate set of financial statements which have been prepared under the accounting framework prevalent in that country. (ii) HL has paid a substantial amount of consultancy fee to a firm in another foreign country. The management of HL is unable to provide a convincing explanation for such a payment. An employee of HL has unofficially informed the audit senior that the amount was paid to avoid paying a fine. However, the management has denied this allegation. Required: Discuss how would you deal with each of the above issues and what may be the implications thereof on your audit report. 135 An ‘emphasis of matter’ paragraph and an ‘other matter’ paragraph (a) Differentiate between an ‘emphasis of matter’ paragraph and an ‘other matter’ paragraph. (b) Give three examples each of circumstances which may necessitate the inclusion of the following in the auditor’s report: (i) An ‘emphasis of matter’ paragraph; and (ii) An ‘other matter’ paragraph. 136 MM Electronics (Private) Limited You are the audit manager of MM Electronics (Private) Limited. The company markets its products through retail outlets in nine major cities. The draft financial statements for the year ended 30 June 2011 show a profit after tax of Rs. 20 million and net assets of Rs. 150 million. The audit team has noted the following matters for your consideration: (a) During the year the company has changed its policy of valuation of property, plant and equipment from historical cost to revalued amount. For this purpose, the services of Professional Valuers (Private) Limited were hired. They have issued valuation reports of three outlets indicating a revaluation surplus of Rs. 10 million, which has been recognised in the financial statements. The management has informed you that the valuation reports of the remaining properties are expected to be issued in December 2011. (b) The company was sued for breach of contract by a customer claiming damages of Rs. 10 million. The legal advisor has confirmed the management’s assertion that no liability existed at the balance sheet date. However, while reviewing the customers’ files, you found an email from the © Emile Woolf International 62 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions Manager (Legal Department) addressed to the Chief Executive in which he has opined that the company will have to pay atleast 50% of the damages claimed. (c) With effect from 01 July 2010, the company has introduced a policy of providing one year warranty on its television sets. No warranty is provided on the other products. Sales of television sets aggregated Rs. 20 million, whereas the total sales for the year amounted to Rs. 80 million. The company has a customer support department which provides after sales services on all products. For defects not covered under the warranty, the company bills the customers at 25% above cost. The management has included a note in the draft financial statements stating that no provision has been made in respect of the warranty, as the amount cannot be measured reliably. (d) The directors have decided not to disclose earnings per share as the same had reduced significantly on account of issuance of 100% bonus shares. The disclosure was however made in all previous financial statements. Required: Express your views on each of the above situations and discuss the impact thereof on the audit report. 137 Ranjha Limited Ranjha Limited (RL), a listed company, is engaged in the manufacture of fast moving consumer goods. The draft financial statements for the year ended March 31, 2011 show a profit before taxation of Rs. 12 million and total assets of Rs. 300 million. As the audit manager, you are reviewing the following issues which were brought to your notice by the audit team: (i) On June 1, 2010 RL acquired a plant at a cost of Rs. 50 million. The plant has a useful life of 10 years with no residual value. RL follows the policy to depreciate the plant on the straight line method. On January 1, 2011 the plant suffered physical damage due to a fire in the factory. The technician from the manufacturer has inspected the plant and reported that the damage has affected its production capacity which has now been reduced by 30%. (ii) During the year a petition has been filed against RL by one of its customers for recovery of Rs. 20 million, along with mark-up, damages and compensation, on the ground that materials supplied by RL were defective. RL has filed a written statement in the Court denying the allegations. RL’s legal advisor is of the view that the final liability of the company may range from 0% to 50%. However, at this point of time, it is not possible to determine the amount with reasonable degree of accuracy. No provision in this regard has been made in the draft financial statements. (iii) In April 2007, RL acquired a high-tech production management software for Rs. 10 million. The useful life of the software is 10 years. During the year it was discovered that in the past the software was erroneously amortised assuming a useful life of 20 years. The management has decided to adjust the amount short provided, over the remaining useful life of the software. Required: Discuss the matters that may be of significance to you as an auditor in respect of each of the above issues. Also explain their implication on the audit report. 138 Pervasive effects (a) Briefly explain the term ‘pervasive effects on the financial statements’. (b) As the engagement partner, you have reviewed the audit working papers of Apricot Engineering Limited (AEL). The audit team has highlighted the following matters in the working papers. (i) The company has issued a bank guarantee to one of its related parties after the balance sheet date. No disclosure in this regard has been made in the draft financial statements. © Emile Woolf International 63 The Institute of Chartered Accountants of Pakistan Audit and Assurance (ii) AEL has paid a dividend after many years. Zakat has been appropriately deducted and deposited in the Central Zakat Fund. (iii) Subsequent to the year end, a major debtor has declared bankruptcy. The company expects to recover only 20% of the outstanding amount. The management has refused to make a provision but is ready to disclose the fact by way of a note. (iv) With effect from January 1, 2010, AEL has: changed the method of charging depreciation on its fixed assets from the ‘straight line’ to the ‘diminishing balance’; and revised its estimate of useful lives of vehicles from 6 years to 4 years. Required: Discuss the impact of each of the above matters on your audit report. 139 Audit report at the end of the audit (a) The auditor is required to issue an audit report at the end of the audit, which sets out his opinion on the financial statements. An important element of the audit report is the statement of auditor’s responsibility. Required: Narrate the matters that should be contained in the statement of auditor’s responsibility as included in an audit report issued under ISA-700 ‘The Independent Auditor’s Report on a Complete Set of General Purpose Financial Statements’. (b) Identify the situations in which an auditor may modify his report without affecting his opinion. Also explain how such a modification should be presented in the audit report. 140 Iqra Industries Limited You are the senior responsible for the audit of Iqra Industries Limited (IIL). During the course of the audit you became aware that a legal action has been instituted against IIL by some of its customers, on account of disputes related to performance of its products. In response to your request for an opinion the company’s lawyer has simply stated that “We are totally unable to give any estimate”. No provision was made in the financial statements for the possible loss as a result of the claims (which are considered to be material) or for the related legal expenses although details of those legal claims were fully disclosed in the notes. Required: Comment on the implication of the above matter on the auditors’ report and the financial statements of IIL. 141 Blue Sky Limited You are the auditor of Blue Sky Limited (BSL). The draft consolidated financial statements of BSL and its subsidiary Sea Green Limited (SGL) for the year ended September 30, 2009 show a profit before taxation of Rs. 10.5 million (2008 : Rs. 9.4 million) and net assets of Rs. 55.2 million (2008 : Rs. 50.7 million). You have performed the audit procedures you considered necessary for the year ended September 30, 2009 and are satisfied with the results of those procedures. However, your firm is also the auditor of Sea Green Limited (SGL). You were appointed as SGL’s auditors for the year ended September 30, 2009 after BSL acquired 90% shares of SGL on June 30, 2008. SGL’s draft financial statements for the year ended September 30, 2009 show profit before taxation of Rs. 0.7 million (2008: Rs. 1.7 million) and net assets of Rs. 16.1 million (2008: Rs. 16.6 million). Both the companies are exempt from tax. © Emile Woolf International 64 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions The previous auditors’ report on SGL’s financial statements, for the year ended September 30, 2008 was unmodified. However, during the audit of SGL it was discovered that due to an error, the inventory as appearing in the audited financial statements for the year ended September 30, 2007 was overvalued by Rs. 5.7 million. This amount is now being adjusted by SGL over a period of three years i.e. over the years ended September 2008 to 2010. You have approached the management advising them to adjust the full amount in the current year. However, the management is not willing to accept your point of view. Required: Draft the modification paragraph of the report which you would issue on the consolidated financial statements, in the above situation. (A full report is not required) 142 Form 35A in the Companies The auditor’s report as specified in form 35A in the Companies (General Provisions and Forms) Rules, 1985 includes the auditor’s opinion on certain matters which have not been specified in the format of auditor’s report given in the International Standards on Auditing. Required: List the additional reporting responsibilities of the auditor, as discussed in the preceding paragraph. 143 Written representations One of the objectives of obtaining a written representation from management is to ensure that the management knows and acknowledges its responsibility for the preparation of the financial statements and for the completeness of the information provided to the auditor. Required: Specify the situations which may create doubts as to the reliability of written representations. What course of action would the auditor take in such a situation? 144 Kazmi-Wassan You are the manager in charge of the audit of Kazmi-Wassan, a listed company which manufactures specialist cars and other motor vehicles for use in films. Audited revenue is Rs 140 million with profit before tax of Rs 7.5 million. All audit work up to, but not including, the obtaining of written representations has been completed. A review of the audit file disclosed the following outstanding points: Tiger’s Purr The company is facing a potential legal claim from the Tiger’s Purr company in respect of a defective vehicle that was supplied for one of their films. Tiger’s Purr maintains that the vehicle was not built strongly enough while the directors of Kazmi-Wassan argue that the specification was not sufficiently detailed. Dropping a vehicle 50 metres into the river and expecting it to continue to remain in working condition would be unusual, but this is what Tiger’s Purr expected. Solicitors are unable to determine liability at the present time. A claim for Rs 4 million being the cost of a replacement vehicle and lost production time has been received by Kazmi-Wassan from Tiger’s Purr. The directors’ 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% pa based on reducing balance. However, the treatment is consistent with prior accounting periods (which received an unmodified auditors’ report) and the 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. © Emile Woolf International 65 The Institute of Chartered Accountants of Pakistan Audit and Assurance Required: (a) Explain the purpose of a written representation letter. (b) For each of the above matters: (c) (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. A suggested format for the letter of representation has been sent by the auditors to the directors of Kazmi-Wassan. 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. 145 RK Resourcing You are the auditor of RK Resourcing, a limited liability company which extracts, refines and sells oil and petroleum related products. The audit of RK Resourcing for the year ended 30 June 20X3 had the following events: Date (20X3) Event 15 August Bankruptcy of major customer representing 11% of the trade receivables on the statement of financial position. 21 September Financial statements approved by directors. 22 September Audit work completed and auditor’s report signed. 1 November Accidental release of toxic chemicals into the sea from the company’s oil refinery resulting in severe damage to the environment. Management had amended and made adequate disclosure of the event in the financial statements. 23 November Financial statements issued to members of RK Resourcing. 30 November A fire at one of the company’s oil wells completely destroys the well. Drilling a new well will take ten months with a consequent loss in oil production during this time. Required: (a) International Standard on Auditing 560 Subsequent Events explains the audit work required in connection with subsequent events. List the audit procedures that can be used prior to the auditor’s report being signed to identify events that may require adjustment or disclosure in the financial statements. (b) For each of the following three dates: 15 August 20X3 1 November 20X3, and 30 November 20X3: (i) State whether the events occurring on those dates are adjusting or non-adjusting according to IAS 10 Events After the Reporting Period, giving reasons for your decision. (ii) Explain the auditor’s responsibility and the audit procedures that should be carried out. Note: Marks are allocated evenly across the three dates. © Emile Woolf International 66 The Institute of Chartered Accountants of Pakistan Question bank: Objective test and long-form questions 146 Rake Enterprises You are the audit manager of Rake Enterprises, a limited liability company. The company’s annual revenue is over Rs 100 million. Required: (a) Compare the responsibilities of the directors and auditors regarding the published financial statements of Rake Enterprises. (b) An extract from the draft audit report produced by an audit junior is given below: Auditor’s responsibility '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. '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. REVIEW ENGAGEMENTS 147 ISRE 2400 (a) Explain the meaning of “assurance” and give two examples of types of assurance which can be provided, distinguishing between the two in terms of the level of assurance offered by each of them. (b) ISRE 2400 Engagements to review financial information sets out the objective, general principles and procedures to be applied to a review engagement. Required: Set out the main types of procedures which an accountant should perform when carrying out a review engagement. © Emile Woolf International 67 The Institute of Chartered Accountants of Pakistan Audit and Assurance © Emile Woolf International 68 The Institute of Chartered Accountants of Pakistan SECTION Certificate in Accounting and Finance Audit and Assurance C Multiple choice answers © Emile Woolf International 69 The Institute of Chartered Accountants of Pakistan Audit and Assurance CHAPTER 1 – CONCEPT AND NEED FOR ASSURANCE 1 D 2 C 3 C 4 A 5 C CHAPTER 2 – OBTAINING AN ENGAGEMENT 6 B 7 A 8 A 9 D 10 C CHAPTER 3 – PLANNING AND RISK ASSESSMENT 11 D 12 D 13 A 14 D 15 B CHAPTER 4 – EVIDENCE AND SAMPLING 16 C 17 B 18 A 19 B 20 B © Emile Woolf International 70 The Institute of Chartered Accountants of Pakistan Answer bank: Multiple choice answers CHAPTER 5 – INTERNAL CONTROL 21 A 22 B 23 C 24 C 25 D CHAPTER 6 – FLOWCHARTS AND IT CONCEPTS 26 D 27 B 28 D 29 A 30 C CHAPTER 7 – TESTS OF CONTROLS 31 A 32 C 33 B 34 B 35 D CHAPTER 8 – INTRODUCTION TO SUBSTANTIVE PROCEDURES 36 C 37 D 38 B 39 B 40 C © Emile Woolf International 71 The Institute of Chartered Accountants of Pakistan Audit and Assurance CHAPTER 9 – SUBSTANTIVE PROCEDURES: NON-CURRENT ASSETS 41 B 42 B 43 D 44 A 45 A CHAPTER 10 – SUBSTANTIVE PROCEDURES: CURRENT ASSETS 46 C 47 D 48 D 49 C 50 B CHAPTER 11 – SUBSTANTIVE PROCEDURES: OTHER AREAS 51 C 52 A 53 A 54 A 55 A CHAPTER 12 – RELATED PARTY TRANSACTIONS 56 C 57 D 58 C © Emile Woolf International 72 The Institute of Chartered Accountants of Pakistan Answer bank: Multiple choice answers CHAPTER 13 – RELIANCE ON OTHERS 59 B CHAPTER 14 – PROFESSIONAL ETHICS AND CODES OF CONDUCT 60 A 61 A 62 B 63 A 64 A CHAPTER 15 – AUDIT FINALISATION AND REPORTING 65 B 66 A 67 C 68 C 69 B CHAPTER 16 – INTERNATIONAL STANDARDS ON REVIEW ENGAGEMENTS 70 B 71 D 72 D © Emile Woolf International 73 The Institute of Chartered Accountants of Pakistan Audit and Assurance © Emile Woolf International 74 The Institute of Chartered Accountants of Pakistan SECTION Certificate in Accounting and Finance Audit and Assurance D Objective test and long-form answers AUDIT FRAMEWORK, REGULATION AND ETHICS 1 ICAP Code of Ethics (a) (i) The fundamental principles of professional ethics for chartered accountants are as follows: Integrity: A chartered accountant should be straightforward and honest in all professional and business relationships. Objectivity: A chartered accountant should not allow bias, conflict of interest or undue influence of others to override professional or business judgments. Professional competence and due care: A chartered accountant has a continuing duty to maintain the required professional knowledge and skill to ensure that a client or employer receives competent professional service based on current developments in practice, legislation and techniques. A chartered Accountant should act diligently and in accordance with applicable technical and professional standards when providing professional services. Confidentiality: Confidential information acquired as a result of professional and business relationships should not be disclosed to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose. Confidential information acquired as a result of professional and business relationships should not be used for personal advantage of the chartered accountant or third parties. Professional Behaviour: A chartered accountant should comply with relevant laws and regulations and should avoid any action that discredits the profession. (ii) The threats to compliance with the fundamental principles may be categorized as follows: Self-interest threats: These may occur as a result of the financial or other interests of a chartered accountant or of an immediate or close family member. © Emile Woolf International 75 The Institute of Chartered Accountants of Pakistan Audit and Assurance Self-review threats: These may occur when a current assignment requires re-evaluation of the opinion previously expressed by the same chartered accountant. Advocacy threats: These may occur when a chartered accountant promotes a position or opinion to the point that subsequent objectivity may be compromised. Familiarity threats: These may occur when, because of a close relationship, a chartered accountant becomes too sympathetic to the interests of others. Intimidation threats: These may occur when a chartered accountant may be deterred from acting objectively by threats, actual or perceived. (b) Assisting financial statement audit client in matters such as preparing accounting records or financial statements may create a self-review threat when the financial statements are subsequently audited by the firm. It is the client’s management responsibility to ensure that accounting records are kept and financial statements are prepared. In the above case, the firm can provide assistance provided it does not involve taking management decisions. Such management decisions include: 2 Determining or changing journal entries, or the classifications for accounts or transaction or other accounting records without obtaining the approval of the audit client; Authorizing or approving transactions; and Preparing source documents or originating data (including decisions on valuation assumptions), or making changes to such documents or data. Levels of assurance Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole. Whereas absolute assurance provides a guarantee that the financial statements are free from material misstatements. An audit carried out in accordance with ISAs is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether due to fraud or error. In an audit-engagement, the auditor provides a higher, but not absolute, level of assurance that the information subject to audit is free of material misstatements. An auditor cannot obtain absolute assurance because there are inherent limitations in an audit that affect the auditor’s ability to detect material misstatements. These limitations result from factors such as: (i) The use of testing; (ii) The inherent limitations of any accounting and internal controls system (for example, the possibility of collusion); (iii) The fact that most audit evidence is persuasive rather than conclusive. © Emile Woolf International 76 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Also, the work undertaken by the auditor to form an opinion is permeated by judgment, in particular regarding: (i) the gathering of audit evidence, for example, in deciding the nature, timing and extent of audit procedures; and (ii) the drawing of conclusions based on the audit evidence gathered, for example, assessing the reasonableness of the estimates made by management in preparing the financial statements. Further, other limitations may affect the persuasiveness of evidence available to draw conclusions on particular financial statement assertions (for example, transactions between related parties) 3 Shamsuddin (i) As per the “Code of Ethics” for Chartered Accountants issued by ICAP, the practicing chartered accountants are not allowed to publicize their services in a manner as is done by other normal businesses. Appropriate newspaper/magazine may be used to inform the public of the establishment of a new practice. But such announcements should be limited to a bare statement of facts giving due consideration to the appropriateness of the area of distribution of the newspaper/magazine and number of insertions. What practicing members write or say should not be promotional of themselves or their firm. Thus, Mr Shamsuddin can accept a discount offer provided he ensures compliance to the above. (ii) The Code of Ethics for Chartered Accountants issued by ICAP states that: “Chartered Accountants in practice should be careful not to quote fee lower than that charged by the chartered accountants in practice previously carrying out the audit unless scope and quantum of work materially differs from the scope and quantum of work carried out by the previous auditor.” Keeping in view of the above, it is not advisable for Shamsuddin to accept the audit unless the reduction in fee is on account of the reason discussed above. (iii) As per the Code of Ethics for Chartered Accountants, issued by ICAP, the professional fees should not be contingent upon the findings or results of such services. Condition imposed by Design Limited impairs the objectivity of the auditor on account of selfinterest threat. Therefore, Shamsuddin should not accept such a proposal. (iv) 4 Being a sole proprietorship the existing and proposed auditors should immediately communicate the fact to ICAP and the proposed auditor should not accept the offer without clearance from ICAP and the existing auditor. Core concepts (a) The management’s responsibilities in relation to the financial statements include the following: The overall responsibility for the preparation and presentation of the financial statements. Identifying the financial reporting framework to be used in the preparation and presentation of the financial statements. Designing, implementing and maintaining internal controls relevant to the preparation and presentation of financial statements that are free from material misstatement whether due to fraud or error. Selecting and applying appropriate accounting policies. Making accounting estimates that are reasonable in the circumstances. © Emile Woolf International 77 The Institute of Chartered Accountants of Pakistan Audit and Assurance (b) Audit Scepticism Audit scepticism is an attitude of professional scepticism which means that the auditor should recognize the fact that circumstances may exist that may cause the financial statements to be materially misstated. Consequently, he should make a critical assessment with a questioning mind of the validity of audit evidence obtained. He should remain alert to audit evidence that contradicts or brings into question the reliability of documents and responses to inquiries and the reliability of other information obtained from management and those charged with governance. Elaboration on the response of the audit manager that auditor should always maintain an attitude of professional scepticism throughout the audit: Although the auditor cannot be expected to disregard past experience of the honesty and integrity of the entity’s management and those charged with governance, the auditor’s attitude of professional scepticism is particularly important in considering the risks of material misstatement on account of changes in circumstances. 5 Threats Following are the categories of threats that may potentially affect the fundamental principles: (i) Self-interest threats This may occur as a result of the financial or other interests of a chartered accountant or of an immediate or close family member. (ii) A financial interest in a client or jointly holding a financial interest with a client. Undue dependence on total fees from a client. Having a close business relationship with a client. Concern about the possibility of losing a client. Potential employment with a client. Contingent fees relating to an assurance engagement. A loan to or from an assurance client or any of its directors or officers. Self-review threat This may occur when a previous judgment needs to be re-evaluated by the chartered accountant responsible for that judgment. The discovery of a significant error during a re-evaluation of the work of the chartered accountant in practice. Reporting on the operation of financial systems after being involved in their design or implementation. Having prepared the original data used to generate records that are the subject matter of the engagement. A member of the assurance team being, or having recently been, a director or officer of that client. A member of the assurance team being, or having recently been, employed by the client in a position to exert direct and significant influence over the subject matter of the engagement. Performing a service for a client that directly affects the subject matter of the assurance engagement. © Emile Woolf International 78 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (iii) Advocacy threats This may occur when a chartered accountant promotes a position or opinion to the point that subsequent objectivity may be compromised. (iv) Promoting shares in a listed entity when that entity is a financial statement audit client. Acting as an advocate on behalf of an assurance client in litigation or disputes with third parties. Familiarity threats This may occur when, because of a close relationship, a chartered accountant becomes too sympathetic to the interests of others. (v) A member of the engagement team having a close or immediate family relationship with a director or officer of the client A member of the engagement team having a close or immediate family relationship with an employee of the client who is in a position to exert direct and significant influence over the subject matter of the engagement. A former partner of the firm being a director or officer of the client or an employee in a position to exert direct and significant influence over the subject matter of the engagement. Accepting gifts or preferential treatment from a client, unless the value is clearly insignificant. Long association of senior personnel with the assurance client. Intimidation threats This may occur when a chartered accountant may be deterred from action objectively by threats, actual or perceived. 6 Being threatened with dismissal or replacement in relation to a client engagement. Being threatened with litigation. Being pressured to reduce inappropriately the extent of work performed in order to reduce fees. Burewala and Kamal (a) Burewala Bank Limited: Threats (i) A threat to independence may be created if the loan is made under abnormal lending procedures, terms and requirements and the loan is material to both the firm and the BBL. (ii) A self-interest threat may be created if the loan amount is material to the firm/ partner. Safeguards: As the Companies Act, 2017, restricts a person who is indebted to the company from being auditor of the said company, therefore the course of action available to the partners of UCC is to withdraw from the engagement or repayment of the loan by the partner concerned. (b) Faisalabad Textile Mills Limited: Threats: It has created self-interest, familiarity and intimidation threats. © Emile Woolf International 79 The Institute of Chartered Accountants of Pakistan Audit and Assurance The assurance team’s independence is threatened, on account of the fact that Kamal is in a position to exert direct and significant influence over the assurance engagement as Kamal was a member of the assurance team during the previous year audit. Safeguards: The safeguards might include: 7 (i) Consider the appropriateness or necessity of modifying the assurance plan for the assurance engagement; (ii) Assigning an assurance team that is of sufficient experience in relation to the individual who has joined the assurance client; (iii) Involve an additional chartered accountant who was not a member of the assurance team to review the work or advise as necessary; or (iv) Quality control review of the assurance engagement. (v) Ensuring that the individual concerned is not entitled to any benefits or payments from the firm unless these are made in accordance with fixed pre-determined arrangements. In addition, any amount owed to the individual should not be of such significance to threaten the firm’s independence. (vi) Ensuring that the individual does not continue to participate or appear to participate in the firm’s business or professional activities. Zaman and Bilal (a) As per the Companies Act, 2017 a person shall not be appointed as auditor of a company, if he is disqualified for appointment of any other company, which is that company’s subsidiary or a holding company or a subsidiary of that holding company. Therefore, the firm cannot be appointed as an auditor of KL as Mr Zaman holds 5,000 shares in ML which together with KL is a subsidiary of DKL. For appointment as the auditor of the company, Mr .Zaman is required to dispose of the shares in ML. (b) Bilal and Company, Chartered Accountants are eligible to act as the auditor of IJK Limited. IJK Limited is not an associated company of LMN Limited as LMN Limited holds 15.4% shares of IJK Limited. Therefore the wife of the partner is not required to dispose of the shares in LMN Limited. Holding of non-voting shares is not relevant in determining the status of the company. 8 Audit process (a) Training materials: purpose of external audit and its role (i) The external audit has a long history that derives largely from the separation of the ownership and management of assets. Those who own assets wish to ensure that those to whom they have entrusted control are using those assets wisely. This is known as the 'stewardship' function. (ii) The requirement for an independent audit helps to ensure that financial statements are free of bias and manipulation for the benefit of users of financial information. (iii) Companies are owned by shareholders but they are managed by directors (in very small companies, owners and managers are the same, but many such companies are not subject to statutory audit requirements). © Emile Woolf International 80 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (b) (iv) The requirement for a statutory audit is a public interest issue: the public is invited to invest in enterprises, it is in the interests of the capital markets (and society as a whole) that those investing do so in the knowledge that they will be provided with 'true and fair' information about the enterprise, This should result in the efficient allocation of capital as investors are able to make rational decisions on the basis of transparent financial information. (v) The requirement for an audit can help prevent investors from being defrauded, although there is no guarantee of this because the external audit has inherent limitations. Reducing the possibility of false information being provided by managers to owners is achieved by the requirement for external auditors to be independent of the managers upon whose financial statements they are reporting. (vi) The purpose of the external audit under International Standards on Auditing is for the auditor to obtain sufficient appropriate audit evidence on which to base the audit opinion. This opinion is to the effect that the financial statements give a 'true and fair view' (or 'present fairly in all material respects') of the position, performance (and cash flows) of the entity. This opinion is prepared for the benefit of shareholders. Main audit procedures and processes: interim and final audit Interim (i) The interim audit generally involves risk assessment, the testing of internal controls, and certain analytical and other substantive procedures. Many of these procedures are often performed concurrently. (ii) Risk assessment involves gathering information about the business, inquiries, analytical procedures and determining the response to assessed risk. In practice it also involves the determination of materiality and tolerable error. (iii) Risk assessment also involves evaluating the design of internal controls and determining whether they have been implemented. Final 9 (iv) Final audit procedures involve further tests of controls, substantive procedures and audit finalisation procedures. (v) Further tests of controls are designed to test transactions occurring between the date of the interim audit and the period-end. This is to ascertain whether the conclusions from controls testing during interim work remain valid for the full period. (vi) Substantive procedures may involve a blend of substantive analytical procedures plus tests of detail. The tests of detail typically involve selecting a sample from a source, for example a collection of purchase transactions, and tracing the transactions through to originating evidence, for example purchase invoices. Tests of detail are also carried out in the opposite direction by selecting from the external source (e.g. supplier invoices) then tracing entries through to the books and records (vii) Audit finalisation procedures involve a review of the financial statements as a whole to ensure that they are internally consistent and presented in accordance with the relevant financial reporting framework (and the auditor's knowledge of the business). This phase includes the Partner’s review of significant matters raised by the audit team during the audit. Regulatory and professional requirements (a) Current regulatory and professional requirements (i) Auditing standards Both national and international bodies produce Auditing Standards. International Standards on Auditing (ISAs) are produced by the International Audit and Assurance Standards Board (IAASB), a committee of the International Federation of Accountants (IFAC). IFAC is an international organisation of professional accountancy bodies, including ICAP. © Emile Woolf International 81 The Institute of Chartered Accountants of Pakistan Audit and Assurance National standard-setters are expected to aim for compatibility with ISAs as far as possible and some (for example the UK) issue their own version of ISAs. National accountancy bodies will then adopt all of the auditing standards produced by their own standard setting body. Failure by auditors to comply with auditing standards will then lend them open to disciplinary action by their own accountancy body. Local legislation will usually require recognised supervisory bodies to have rules and practices as to the manner in which these standards are to be applied in practice. Each supervisory body will adopt auditing standards in order to meet local legislation and each body will be required to have arrangements in place for the effective monitoring and enforcement of compliance with those standards. Failure to apply relevant auditing standards is a factor which a supervisory body will take into account when deciding whether persons are fit and proper to be eligible for appointment as company auditor. (ii) Fraud Currently the responsibility within a company for the prevention and detection of fraud rests with management. The auditor is not responsible for preventing fraud but audit procedures should be designed to give the auditor a reasonable expectation of detecting any material misstatements, whether intentional or unintentional, in a company’s financial statements. (iii) Non-audit services There is no objection in principle to a practice providing non-audit services but care must be taken not to perform management functions or make management decisions. The key factor is that there is no conflict of interest between audit and the other services provided. Accountancy work, however, should not be performed for a public company except in emergency situations. The scale and nature of such work should be regularly reviewed. In all cases in which a practice is concerned in the preparation of accounting records for an audit client, the following safeguards should be observed: the client should accept responsibility for the records as its own; the practice should not assume the role of management conducting the operations of an enterprise; the practice should make appropriate audit tests even where it has processed or maintained certain records. Other types of non-audit work such as valuation services and internal audit services are prohibited where the management threat or self-review threats are too great. Local legisalation will also usually provide that an auditor may not be an officer or employee of a client company. Thus it is necessary for the auditor to ensure that he does not make executive decisions. (iv) Duration of appointment Local legislation (i.e. Companies Act, 2017) provides that a company shall at each general meeting appoint an auditor to hold office from the conclusion of that meeting until the conclusion of the next general meeting at which accounts are laid. Although the ICAP Code does not specifically deal with the length of audit appointments it recognises that using the same senior personal on an engagement over a long period of time may create a familiarity threat. Safeguards might include rotating senior staff or review by an independent party. For listed companies in Pakistan this period have been prescribed as 5 years by the Code of Corporate Governance 2012. (b) Reasons for criticism in the above areas (i) Auditing standards ISAs are set by the IAASB whose members are mainly drawn from the members of the auditing profession. The local disciplinary procedures applied against an auditor for noncompliance with an auditing standard are enforced by the professional bodies of © Emile Woolf International 82 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers accountants. Thus politicians have criticised this self-regulatory procedure believing it to be open to abuse and lacking independence. The argument put forward is that auditing standards should be set by an independent body. (ii) Fraud It is quite apparent from the press and audit research that the public believe that the auditor should and in fact does search for fraud during the conduct of an audit. In view of the scandals over the years, the public expectation of the extent of an audit has increased. The public finds it difficult to accept that an auditor has no responsibility for the detection and reporting of fraud, especially when one sees the high social cost of recent scandals. (iii) Non-audit services Audit firms do not act exclusively in the capacity of auditors for their clients. Audit work is in some cases, not the main business of audit firms. Auditors provide many other services to their clients including tax advice, brand name valuation and recruitment advice. Audit firms are dependent upon the fees earned from non-audit services, and this dependency can affect the auditors’ attitude to the audit. If an audit firm loses the audit, the financial loss to the auditors can be significantly more than just the audit fee if he provides other services to the client. (iv) Duration of appointment It has been argued that the long-term nature of the company audit engagement can lead to a loss in auditor independence due to an increasing familiarity with the company’s management. In many countries the audit appointment has to be terminated after a fixed number of years. If the audit appointment was for a fixed maximum period, then auditors would not be under the same pressure to maintain their client base if they know that their relationship with the company was for a limited period, and that audit appointments would be rotated. 10 Fundamental principles Fundamental principles Integrity A professional accountant should be honest and straightforward in performing professional services. Objectivity A professional accountant should be fair and not allow personal bias, conflict of interest or influence of others to override objectivity. Professional competence and due care When performing professional services, a professional accountant should show competence and duty of care by keeping up-to-date with developments in practice, legislation and techniques. Confidentiality A professional accountant should respect the confidentiality of information acquired during the course of providing professional services and should not use or disclose such information without obtaining client permission. Professional behavior A professional accountant should act in a manner consistent with the good reputation of the profession and refrain from any conduct which might bring discredit to the profession. 11 Confidential information General rules Information obtained during an audit is normally held to be confidential; that is it will not be disclosed to a third party. © Emile Woolf International 83 The Institute of Chartered Accountants of Pakistan Audit and Assurance However, client information may be disclosed where: consent has been obtained from the client there is a public duty to disclose or there is a legal or professional right or duty to disclose. However, these rules are general principles only; more detailed guidance is also available to accountants, as explained below. ICAP’s Code of Ethics and Conduct – obligatory disclosure As noted above, ICAP’s Code of Ethics and Conduct confirms that when a member agrees to work for a client in a professional capacity, it is an implied term of that agreement that the member will not disclose a client’s affairs to any other person. The recognised exceptions to this rule are where a member knows or suspects that his client has committed treason, or is involved in drug trafficking or terrorist offences. In these situations, information must be disclosed to a competent authority. The actual disclosure will depend on the laws of the jurisdiction where the auditor is located. The auditor may also be obliged to provide information where a court demands disclosure. Refusal to provide information is likely to be considered contempt of court with the auditor being liable for this offence. ICAP Code of Ethics and Conduct – voluntary disclosure A member may also disclose client confidential information voluntarily, that is without client permission, in a limited number of situations. 12 To protect a member’s interests e.g. to allow a member to sue a client for unpaid fees or defend an action for negligence. Where there is a public duty to disclose e.g. the client has committed an action against the public interest such as unauthorised release of toxic chemicals. Independence of external auditors External auditor independence 13 (i) External auditors are unable to fulfil their duties to shareholders if they are not independent of the entity on which they are reporting. (ii) If external auditors have an interest in the financial statements on which they are reporting, they may not be objective. For example, if, in the case of a listed company, they have prepared the financial statements on which they are reporting, their view may not be considered objective. (iii) If they have financial or employment connections with the company on which they are reporting they will not be objective. (iv) If they provide a significant level of additional services to the entity, some argue that they cannot report objectively as auditors to shareholders. Tahira and Parvez Sufficient audit evidence and audit reports (i) The main problem for the auditors will be gaining sufficient evidence to determine whether any amounts should be provided for and/or disclosed in the financial statements of the two companies. (ii) The lawyers refuse to provide anything other than informal evidence and this will almost certainly not be sufficient to form an audit opinion. (iii) Unless audit evidence can be obtained elsewhere – a qualified opinion may be needed for both companies as the amounts involved are material. © Emile Woolf International 84 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 14 (iv) It may be possible for the auditors to suggest to the companies that it would be very helpful for the lawyers to provide some indication as to their view of the likely outcome and the amounts involved, in order to avoid a modified opinion. (v) The auditors should also take note of the progress of any legal proceedings and any proceedings that may be instigated by the public health authorities as such authorities might impose significant fines, and they might even close the businesses down, which has implications for the going concern status of both. (vi) The auditors may also seek written representation under ISA 580 from the management about the likely outcome of the case to be obtained. ABC Limited (a) Salman and Company is eligible to be appointed as the auditor of ABC Limited because, Naveen is in the employment of DEF which is an associated company and such employment has no relevance in the context of appointment of an auditor. (b) Kashif Associates can be appointed as the auditor of NPL as for a private company having paid up capital of less than Rs. 3 million the auditor can be a chartered accountant or cost and management accountant. Holding of 30% shares of NPL by a public company is of no relevance. 15 Masoom, Chalak and Hoshiyar Limited (a) The previous provision of accounting and taxation services to MPL and long association of Ahmed with MPL will create self-review and familiarity threat. Significance of threats needs to be evaluated and if threats are other then clearly insignificant, safeguards need to be applied to reduce the threats to an acceptable level. In case Ahmed is included in the Audit engagement the related safeguards may include: involving an additional chartered accountant to review the work done by Ahmed or otherwise advise as necessary. independent internal quality reviews. If the threats are significant, Ahmed should not be part of the assurance engagement team. (b) In the given situation involvement of such trainees in the audit of CL may result in a self-interest threat. The materiality and significance of the financial interest, needs to be evaluated. If the financial interest is immaterial then the audit trainee may be allowed to work on that client, otherwise only safeguard available is to withdraw the trainee from this assignment. (c) A self interest threat is created when a member of the assurance team participates in the assurance engagement while knowing, or having reason to believe, that he may join the assurance client in future. The threat created can be reduced to an acceptable level by the application of the following safeguards: Ask the individual to notify the firm when entering serious employment negotiations with the assurance client; Remove of the individual from the assurance engagement; Perform an independent review of any significant judgments made by that individual while on engagement. © Emile Woolf International 85 The Institute of Chartered Accountants of Pakistan Audit and Assurance 16 Prime Super Markets Limited (a) Accepting of discount vouchers may create self interest and intimidation threats. However, if the value of discount vouchers is not clearly insignificant, the threat to independence cannot be reduced to an acceptable level by the application of any safeguard. If the value is other than clearly insignificant, the members of the audit team should be instructed not to accept the discount vouchers. (b) The lending of staff by a firm to an audit client will create a self-review threat. However, the threat may be reduced to an acceptable level if the firm's personnel: are not involved in exercising discretionary authority; or do not assume management responsibilities. are not given audit responsibility for any function or activity that they performed or supervised. The audit client should acknowledge its responsibility for directing and supervising the activities of assigned personnel. (c) Familiarity and self-interest threats are created by using the same senior personnel on an audit engagement over a long period of time. This applies to the audit manager also. The significance of the threats shall be evaluated and following safeguards should be applied if necessary to eliminate the threats or reduce them to an acceptable level: Rotating the audit manager as well; Having a professional accountant who was not a member of the audit team review the work of the audit manager; Regular independent internal or external quality reviews of the engagement. © Emile Woolf International 86 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers PLANNING AND RISK ASSESSMENT 17 Durable Cement Limited (DCL) S. No. Assertion (a) Valuation of factory plant Assessment of inherent risk High Justification Due to poor economic conditions, there is a risk that the value of plant may be impaired. Inherent risk is also high due to the complexity and subjectivity involved in calculation of impairment loss. 18 (b) Valuation of trade receivables Low/Moderate The valuation assertion for trade receivable and allowance for doubtful debts is affected by judgments. However as the debts from Government departments are usually secured, the chances of bad debts are low. (c) Rights to ownership of finished goods inventory Low/Moderate Cement bags are usually kept in company’s’ premises (Godowns) and in the absence of any other information the ownership of inventory can be verified. (d) Valuation of unlisted securities High Determination of fair value is complex, and involves subjectivity and judgment in the absence of any market quotations. (e) Accuracy of long term finance Low Third party confirmation i.e., bank confirmation is available therefore inherent risk is low. (f) Valuation of provision for gratuity High Due to complexity and subjectivity involved in the calculation of provision for gratuity. Saad Co (a) Ethical threat (b) Mr Sher, the engagement partner has been involved with the client for the last nine years. Mitigation of threat Mr Sher should be rotated from being engagement partner. He can still contact the client but should not be in the position of signing the audit report. This means he may be too familiar with the client to be able to make objective decisions due to this long association. There is no ethical rule which stops Mr Sher recommending Zhura for the audit, or letting Zhura take part in the audit, providing Zhura has the appropriate skills. If she does not have the appropriate skills then there could be a breach of the need for an audit team to demonstrate professional competence and due care. © Emile Woolf International 87 To show complete independence, Zhura should not be part of the audit team. However, if Mr Sher is no longer the engagement partner then this removes the ethical threat and Zhura could be included in the audit team so long as she possesses the appropriate skills. The Institute of Chartered Accountants of Pakistan Audit and Assurance (a) Ethical threat (b) Mitigation of threat There may also be the impression of lack of independence as Zhura is related to the engagement partner. Zhura could be tempted not to identify errors in case this prejudiced her father’s relationship with the client. As long as Mr Faisal paid a full fee on normal commercial terms to Saad Co for the investment advice, then there is no ethical threat. This would be a normal commercial transaction and Mr Faisal would not gain any benefit. To show independence from the client, Mr Faisal could be asked not to use the services of Saad Co again unless this is first agreed with the engagement partner. However, continued use of client services could imply a lack of independence especially if Mr Faisal is not paying a full fee and therefore receiving a benefit from the client. 19 Alpha (i) The firm is not qualified for appointment as auditor of Safe Bank because it is indebted to the bank. The firm may accept appointment by terminating the lease agreement and ensuring that the credit card balance remains within the limit of Rs 1 million. (ii) The firm is not qualified for appointment as auditor of PCL as one of the firm’s partners had been a director of PCL during the past three years. There is no way for the firm to accept the appointment except that the partner resigns from the firm. (iii) The firm is not qualified for appointment as auditor of Gama Limited, as a partner of the firm holds shares in Beta Limited, the associated company of GL. Firm can accept appointment if the fact of holding shares is disclosed at the time of appointment and the share are disposed within ninety days of appointment. 20 Engagement letter and documentation (a) The form and content of audit engagement letters may vary from client to client, but they would generally include reference to: The objective of the audit of financial statements. Management’s responsibility for the financial statements. The financial reporting framework applicable to financial statements. The scope of the audit, including reference to applicable legislation, regulations, or pronouncements of professional bodies to which the auditor adheres. The form of any reports or other communication. The fact that because of the test nature and other inherent limitations of an audit, together with the inherent limitation of internal control, there is an unavoidable risk that even material misstatements may remain undiscovered. Management’s responsibility to provide unrestricted access to whatever records, documentation and other information that may be required in connection with the audit. Management’s responsibility for establishing and maintaining effective internal controls. © Emile Woolf International 88 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (b) i) Significant Matters to be documented Matters that give rise to significant risk; Results of audit procedures indicating (a) that the financial information could be materially misstated, or (b) a need to revise the auditor’s previous assessment of the risks of material misstatements and the auditor’s responses to those risks; Circumstance that cause the auditor significant difficulty in applying necessary audit procedures; Findings that could result in a modification to the auditor’s report. ii) Completion of assembly of final audit report The auditor is required to complete the assembly of his final audit file within 60 days of the date of the audit report. 21 Shahid Corporation (a) Acceptance and continuance of client relationships and specific audit engagements include considering: The integrity of the principal owners, key management and those charged with governance of the entity; Whether the engagement team is competent to perform the audit engagement and has the necessary time and resources; and Whether the firm and the engagement team can comply with ethical requirements Deciding whether to continue a client relationship includes consideration of significant matters that have arisen during the current or previous audit engagement, and their implications for continuing the relationship. For example, a client may have started to expand its business operation into an area where the firm does not possess the necessary knowledge or expertise. (b) 22 The auditor may decide not to send a new engagement letter for each period. However, under the following situation it may be appropriate to send a new engagement letter: Any indication that the client misunderstands the objective and scope of the audit Any revised or special terms of the engagement A recent change of senior management or those charged with governance. A significant change in nature or size of the client’s business A significant change in ownership Legal or regulatory requirements. Assertions (a) (i) Risks of material misstatement at the financial statement level refer to risks that relate pervasively to the financial statements as a whole and potentially affect a number of assertions. They are not necessarily identifiable with specific assertions at the class of transactions, account balance, or disclosure level. Rather, they represent circumstances that may increase the risks of material misstatement at the assertion level. For example, through management override of internal control. Financial statement level risks mostly relate to situations arising from fraud. © Emile Woolf International 89 The Institute of Chartered Accountants of Pakistan Audit and Assurance (ii) (b) (c) Risks at the financial statement level may derive in particular from a weak control environment. For example, weaknesses such as management’s lack of competence. The risk assessment procedures related to the risk of material misstatement at the financial statement/assertion level are as follows: Inquiries of management and of others within the entity who in the auditor’s judgment may have information that is likely to assist in identifying risks of material misstatement due to fraud or error. Analytical procedures. Observation and inspection. The auditors assessment of materiality and audit risk at the planning stage may change later i.e. at the time of evaluating the results of audit procedures, on account of the following: change in circumstances change in auditors knowledge as a result of performing audit procedures because the auditor may have intentionally set the materiality at a lower level, to reduce the likelihood of undiscovered misstatement and hence provide a margin of safety. Assertions about classes of transactions and events and related disclosures are as follows: Occurrence: Transactions and events that have been recorded or disclosed have occurred and relate to the entity. Completeness: There are no unrecorded transactions, events and disclosures. Accuracy: Amounts and other data relating to recorded transactions and events have been recorded appropriately and related disclosures have been appropriately measured and described. Cut-off: Transactions and events have been recorded in the correct accounting period. Classification: Transactions and events have been recorded in the proper accounts. Presentation: Transactions and events are appropriately aggregated or disaggregated and clearly described and related disclosures are relevant and understandable. Assertions about account balances and related disclosures are as follows: Existence: Assets, liabilities and equity interests exist. Rights and obligations: The entity holds or controls the rights to assets, and liabilities are those of the entity. Completeness: There are no unrecorded assets, liabilities or equity interests and all related disclosures have been included. Accuracy, valuation and allocation: Assets, liabilities and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments areappropriately recorded and related disclosures have been appropriately measured and described. Classification: Assets, liabilities and equity interests are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable © Emile Woolf International 90 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 23 24 Companies Act, 2017 (a) The appointment of Farrukh & Co. will be in order because the firm would not be considered indebted to the company as the period for which the utility dues are unpaid does not exceed 90 days. (b) Mr Shahid cannot be appointed as statutory auditor of Rehman Limited because only 70 days have passed since the company’s incorporation and therefore obviously less than three years have not elapsed since he left the employment of the company. (c) Syed & Co. shall not be appointed as auditor of the company because one of the partners’ spouse holds shares in its subsidiary company. However, the firm can be appointed as auditor of Fazal Limited if the fact of holding shares is disclosed at the time of appointment and the spouse of the partner disinvests the shares within 90 days of appointment. (d) Mr Dawood’s appointment shall be void because only a chartered accountant can be appointed as auditor of a private limited company having share capital of Rs. 3 million or more. (e) Hussain Associates (Pvt.) Ltd. being a body corporate cannot be appointed as external auditor of any company. ASPL (a) (i) In the absence of any valid explanations from the management, it would be considered as misappropriation of assets i.e. fraud as it seems to involve the theft of an entity's assets. (ii) It is a case of fraudulent financial reporting as it seems that management has tried to inflate the sales in order to deceive financial statement users. An apparent intention behind this action is the management bonuses which are linked to the operating performance of the company. (iii) It is an error on the part of accountant. The underlying records such as the invoice etc. have not been altered and even the voucher has been prepared with the correct amount which shows that it is an unintentional misstatement. (b) (i) If we have identified a fraud or has obtained information that indicate that a fraud may exist, we should communicate these matters on a timely basis to the appropriate level of management. This is so even if the matter might be considered immaterial. We should consider whether there are matters related to fraud to be discussed with those charged with governance of the entity. Matters may include: Concerns about the nature, extent and frequency of management's assessments of the controls in place to prevent and detect fraud and of the risk that the financial statements may be misstated. A failure by management to appropriately address identified significant deficiencies in internal control, or to appropriately respond to an identified fraud. Our evaluation of ASPL’s control environment, including questions regarding the competence and integrity of management. Actions by management that may be indicative of fraudulent financial reporting, such as management's effort to manage earnings in order to deceive financial statement users by influencing their perceptions as to the entity's performance and profitability. © Emile Woolf International 91 The Institute of Chartered Accountants of Pakistan Audit and Assurance Concerns about the adequacy and completeness of the authorization of transactions that appear to be outside the normal course of business. Based on the discussion and our overall understanding of the matter, we should: (iii) 25 ask the management to reverse the sales made; revise its risk assessment of the entity’s control environment and modify the further planned audit procedures accordingly. Consider the impact on audit report. Since this seems to be an error, the appropriate level of management should be informed about it and the relevant adjustments in fixed assets and depreciation account should be made. Information Limited (a) The objective of a statutory audit (an external audit) is to express an opinion on the truth and fairness of the views presented by the financial statements. The auditor is not primarily responsible for the prevention or detection of fraud. The auditor will be concerned with fraud only to the extent that it might impact on the view shown by the financial statements. He will therefore be concerned with the risk of material fraud. The auditor should maintain an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence. Further, he must respond appropriately to fraud or suspected fraud identified during the audit. (b) Management’s attitude towards the auditor which may indicate the possibility of a material misstatement includes: Denial of access to records, facilities, certain employees, customers, vendors, or others from whom audit evidence might be sought. Undue time pressures imposed by management to resolve complex or contentious issues. Unusual delays by the entity in providing requested information. An unwillingness to add or revise disclosures in the financial statements to make them more complete and understandable. (c) Rapid growth or unusual profitability. Significant portions of key management personnel’s compensation i.e. bonus being contingent upon achieving aggressive targets for operating results. Pressure on management to show good profitability considering the proposed acquisition. © Emile Woolf International 92 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 26 Distributor (a) i. Inability to increase the prices of its products since last 5 years The Company’s profitability is under threat due to increased competition therefore the management may be inclined to manipulate the accounting records. ii. Research costs wrongly capitalized It is an error and is not indicative of fraud, as research costs is only 2% of the total amount capitalized and the underlying records were duly supported by invoices from the suppliers. iii. Bonuses linked with profitability It is a fraud risk factor as it is evident that management is receiving profit related bonuses, therefore the management may be inclined to manipulate the accounting records. iv. Goods sold but not dispatched It is a fraud risk factor as it seems that management has tried to inflate the sales in order to deceive financial statement users, an apparent intention behind this action can be to overstate the profits of the company. (b) Course of action: In response to assessed risk of material misstatement due to fraud, the auditor shall: emphasize to the Audit team the need to maintain an attitude of professional skepticism. assign more experienced staff or increased supervisor of staff. To the extent not already done, the auditor shall obtain an understanding of the entity’s related controls, relevant to such risks. evaluate whether the selection and application of accounting policies by the entity, particularly those related to subjective measurements and complex transactions, may be indicative of fraudulent financial reporting resulting from management’s effort to manage earnings; and incorporate an element of unpredictability in the selection of the nature, timing and extent of audit procedures. design and perform further audit procedures whose nature, timing and extent of audit procedures are responsive to the assessed risk of material misstatements. © Emile Woolf International 93 The Institute of Chartered Accountants of Pakistan Audit and Assurance 27 Fraudulent Financial Statements (a) (b) (i) Forging or altering accounting records or supporting documentation which form the basis of the financial statements (ii) Misrepresenting or intentionally omitting events or transactions from the financial statements (iii) Intentionally misapplying accounting principles (iv) Concealing or not disclosing, facts that could affect the amounts recorded in the financial statements. (v) Engaging in the complex transactions that are structured to misrepresent the financial position or financial performance of the entity. (vi) Embezzling receipts (for example, diverting them to personal bank accounts) The auditor is required to perform the following procedures to identify the risks of material misstatement due to fraud: 28 Make inquiries of management in respect of: their assessment of the risk of material fraud their process in place for identifying and responding to the risks of fraud any specific risks of fraud identified or likely to exist any communications within the entity in respect of fraud (including to employees regarding management’s views on business practices and ethical behaviour) Make inquiries of management and others within the entity as to whether they have any knowledge of any actual, suspected or alleged frauds and to obtain views about the risks of fraud. Evaluate any unusual or unexpected relationships identified in performing analytical procedures which might indicate a risk of material fraud. Evaluate information obtained from other risk assessment procedures to see if any fraud risk factors exist. Kashif and Company (a) The appointment of KCC is valid, as 90 days have not lapsed in case of outstanding bill. However, the concerned partner should be requested to settle the amount of bill before the expiry of 90 days as it will result in disqualification of KCC as auditors of NEL. (b) Appointment of Zubair and Company is valid. Under the Companies Act, 2017 there is no restriction on the appointment of spouse of chief executive of an associated company as the auditor. The holding of 100,000 shares by Saima is required to be disclosed at the time of appointment. Further, these shares should be disposed off within 90 days of the appointment. © Emile Woolf International 94 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 29 Delicious Biscuits Limited (DBL) (a) Familiarity or intimidation threats may be created if a member of audit team joins the audit client. Following are the safeguards: i. Modifying the audit plan; ii. Assigning individuals to the audit team who have sufficient experience as compared to the individual who has joined the client; (b) A loan from an audit client to an audit team member will not create a threat to independence, if the loan is made under normal lending procedures, terms and conditions. If the loan is not made under normal lending procedures, terms and conditions, a self- interest threat would be created that would be so significant that no safeguard could reduce the threat to an acceptable level. However, as the loan has already been disbursed, the only safeguard available is to remove the manager from the audit team or ask him to settle the lease obligation. 30 Daud and Company (a) JL holds 51% shareholding in RL: As Daud & Co. (DC) is not qualified for appointment as the auditor of RL due to directorship and shareholding of partner’s wife in RL, DC cannot be appointed as the auditor of any of its holding company i.e. JL. (b) JL is an associated company of RL: DL is ineligible to act as the auditor of JL, as the spouse of the partner holds shares in the associated company. However, since Daud’s wife holds shares prior to the appointment, DC can be appointed as auditor of JL subject to comply with the following requirements: Disclose this fact to JL at the time of appointment as auditor. Divest her investment in RL within 90 days of appointment. The directorship of Daud’s wife in RL is not relevant for the appointment of DC as the auditor of JL. (c) One of the directors in JL also holds 10% shareholding in RL: Daud and Company can be appointed as the auditor of JL as there is no disqualification with respect to common shareholding in another company, which is neither a subsidiary nor an associated company of the prospective audit client. 31 ABC (Private) Limited (a) Self-interest, self-review and familiarity threats will be created, as Kamran has served as an employee in ABC. Safeguards: Conducting a review of the work performed by Kamran as a member of the audit team, Not including the member in the audit team. (b) As the father of Nasir is a close family member, having a direct financial interest in DL, a selfinterest threat is created. © Emile Woolf International 95 The Institute of Chartered Accountants of Pakistan Audit and Assurance Safeguards: Disposing as soon as practicable, of all the shares by Nasir’s father (a close family member) Having a professional accountant review the work of Nasir; Replacement of Nasir from the Audit team. 32 Materiality (a) (b) 33 Planning stage – The concept of materiality is used in determining the nature, timing and extent of further audit procedures; ii. Reporting stage – The materiality concept is used in evaluating the effect of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor's report. The auditor shall document the following aspects of materiality: i. Materiality for the financial statements as a whole; ii. Performance materiality; iii. Basis of computing materiality; and iv. Any revision of (i) to (ii) as the audit progresses. Auditor’s Expert (a) (b) 34 i. (i) the nature, scope and objectives of the expert’s work (ii) the respective responsibilities of the expert and the auditor (iii) the form of the expert’s report (iv) confidentiality requirements The factors that should be considered in evaluating the adequacy of the expert’s work, include: reasonableness of the expert’s conclusions consistency of those conclusions with other audit evidence reasonableness of significant assumptions and methods used relevance, completeness and accuracy of source data. Mineral Limited (a) (i) Matters that should be considered by the auditor in determining the competence, capabilities and objectivity of EL The competence, capabilities and objectivity of an expert may be assessed in one or more of the following ways: Personal experience with previous work of that expert. Discussions with that expert. Discussions with other auditors or others who are familiar with that expert’s work. Knowledge of that expert’s qualifications, membership of a professional body or industry association, license to practice, or other forms of external recognition. Published papers or books written by that expert. © Emile Woolf International 96 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (ii) While evaluating the adequacy of the EL’s work, the following would be considered: Reasonableness of the EL’s conclusions. Consistency of such conclusions with other audit evidence. Reasonableness of significant assumptions and methods used. Relevance, completeness and accuracy of source data. (b) If the auditor decides that the work of the expert is not adequate he is required to: agree additional work with the expert, or perform other appropriate additional audit procedures. hire another expert 35 AMF (a) Areas of Inherent Risk (i) Donations Donations may fall, especially where donors’ own income is limited or declining, or there is a change in the circumstances. No control over the completeness of donations (especially over the cash donations). (ii) Expenses Donations are spent outside the aims and objectives of AMF. Donations are not spent in accordance with donors’ instructions. (b) Effect on the audit approach (i) It is difficult to estimate that income in the future will be sufficient to meet the expenditure of the AMF. Audit of the going concern concept (as in ensuring that the AMF can still operate) will therefore be quite difficult. (ii) Audit tests are unlikely to be effective to meet the assertion of completeness. The audit report may need to be modified and qualified to explain the lack of evidence stating that completeness of income cannot be confirmed. (iii) Careful review of expenditure will be necessary to ensure that expenditure is not ‘ultra vires’ the objectives of the AMF. The auditor will need to review the trust deed and other documents of the AMF carefully in this respect. (iv) The use of donations received for specific purposes would have to be checked to ensure that instruction of donors has been followed. 36 Acceptance and planning (a) The audit strategy sets the scope, timing and direction of the audit. It also provides guidance for the development of audit plan. The audit plan is more detailed than the audit strategy and it includes the nature, timing and extent of audit procedures to be performed by the engagement team members. The planning for these audit procedures takes place over the course of audit as the audit plan for the engagement develops. (b) The auditor should perform the following activities prior to starting an initial audit engagement: (i) Performing procedures regarding the acceptance of the client relationship and the specific audit engagement. © Emile Woolf International 97 The Institute of Chartered Accountants of Pakistan Audit and Assurance (ii) Unless prohibited by law, arrangements to be made with the predecessor auditor, for example, to review the predecessor auditor’s working papers. (iii) Any major issues discussed with management in connection with the initial selection as auditor, the communication of these matters to those charged with governance, and how these matters affect the audit strategy and audit plan. (iv) The audit procedures necessary to obtain sufficient appropriate audit evidence regarding opening balances. (v) 37 SPL (a) (b) (c) 38 Other procedures required by the firm’s system of quality control for initial audit engagements. Preconditions for an audit are as follows: (i) An acceptable financial reporting framework has been used by the management in the preparation of the financial statements; and (ii) the management and, where appropriate, those charged with governance agreed on the premise on which the audit is to be conducted. In order to establish whether the preconditions for an audit are present, we will: (i) determine whether the financial reporting framework to be applied in the preparation of financial statements is acceptable; (ii) obtain the agreement of management that it acknowledges and understands its responsibility: for the preparation of the financial statements in accordance with the applicable financial reporting framework. for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. to provide us with access to all information of which management is aware, that may be relevant to the preparation of the financial statements; additional information that the auditor may request from management for the purpose of the audit; and unrestricted access to persons within the entity from whom the auditor determine it necessary to obtain audit evidence. If a precondition for an audit is not present, the matter would be discussed with the management. Unless required by law or regulation to do so, we will not accept the proposed audit engagement, if the pre-conditions are not met. Fruit and nuts (a) The appointment of Guava and Company, Chartered Accountants, will be in order. The firm would not be deemed indebted to the company as the amount of debt is not exceeding Rs. 1 million. (b) The Appointment of Apricot and Company, Chartered Accountants will be in order. Banana Limited and Water Melon Limited are not associated companies as the common director is a Government nominee. © Emile Woolf International 98 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (c) Mr Zaheer cannot be appointed as the Auditor of Lychee (Private) Limited The auditor of private companies having paid-up capital of less than Rs. 3 million can be a chartered accountant or a cost and management accountant having a valid certificate of practice from their respective institutes or a firm of chartered accountants or cost and management accountants whereof the majority of practicing partners are qualified for appointment by its firm name to be the auditors of the company. The fact that 40% of the shareholding is owned by Blue Black Limited does not disqualify Mr Zaheer as the auditor of LPL. (d) Before accepting the offer Walnut and Company, Chartered Accountants, apart from obtaining professional clearance from the existing auditor is also required to inform the ICAP (Institute) and obtain prior clearance from the Institute. (e) Since the three year period has not been lapsed, Our firm cannot be appointed as the auditor of Strawberry Limited, The fact that Mr Sadiq was serving on the board as a Government nominee does not make any difference, in this case. 39 Discussions and judgment (a) Benefits of discussion among the engagement team about the susceptibility of the entity’s financial statements to material misstatement are as follows: (i) Provides an opportunity for more experienced engagement team members to share their insights based on their knowledge of the entity. (ii) Allows the engagement team members to exchange information about the business risks to which the entity is subject to and about how and where the financial statements might be susceptible to material misstatement, due to fraud or error. (iii) Assists the engagement team members to gain a better understanding of the potential for material misstatement in the areas assigned to them. (iv) Develop an understanding; about the results of the audit procedures that they perform on specific areas may affect other aspects of the audit including the decisions about the nature, timing and extent of further audit procedures. (b) (v) Provides a basis upon which engagement team members communicate and share new information obtained throughout the audit that may affect the assessment of risks of material misstatement or the audit procedures performed to address these risks. (i) Non routine transactions: Non-routine transactions are transactions that are unusual, due to either size or nature, and that therefore occur infrequently. Judgmental matters: Judgmental matters may include the development of accounting estimates for which there is significant measurement uncertainty. (ii) Reasons on account of which risk of material misstatement is increased on account of Non routine transactions: (1) Greater management intervention to specify the accounting treatment. (2) Greater manual intervention for data collection and processing. (3) Complex calculations or accounting principles. (4) The nature of non-routine transactions, which may make it difficult for the entity to implement effective controls over the risks. © Emile Woolf International 99 The Institute of Chartered Accountants of Pakistan Audit and Assurance Reasons on account of which risk of material misstatement is increased on account of Judgmental matters: 40 (1) Accounting principles for accounting estimates or revenue recognition may be subject to differing interpretation. (2) Required judgment may be subjective or complex, or require assumptions about the effects of future events, for example, judgment about fair value. Dynamic The prospective audit risks are as follows: Overstatement of Debtors: Average period for outstanding debtors has reached to four months which is indicative of a risk of inadequate provision against doubtful debts. Overstatement/ Understatement of Inventories: The inventories turnover rate has decreased to 3 times per year from 5 times in 20X1. It is indicative of the following types of risks: (a) Obsolescence of inventories. (b) Improper valuation of inventories. Overstating of income as well as understating of expenses: The income position has weakened and the company has suffered losses as the interest coverage has moved below 1.0. In such a situation there is a risk that the management may like to overstate its revenue, and understate its expenses. Liquidity Problems: The company is experiencing liquidity problems as are evidenced from the decline in current ratio and quick asset ratio. Decline in Gross Profit %: The decline in GP % needs to be justified. The absence of an appropriate explanation may be indicative of: (a) Improper pricing and discounting policies (b) Improper purchasing policies (c) Other irregularities like unauthorized spending, intentional manipulation of profitability etc. Going Concern: Losses/significant decline in profitability and fast deteriorating liquidity position are financial indicators of going concern issues, which should not be overlooked. 41 Changing terms (a) Circumstances in which the management can request the auditor to change the terms of audit engagement: (i) Change in circumstances affecting the need for the service. (ii) A misunderstanding as to the nature of an audit as originally requested. (iii) A restriction on the scope of an audit engagement, whether caused by management or caused by other circumstances. © Emile Woolf International 100 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (b) (c) Factors that are to be considered by the auditor before accepting the change in terms of engagement: (i) Justification provided for changing the terms of engagement. (ii) The information in respect of which the change is requested by the management. (iii) Legal or contractual implications of the change. Steps that the auditor can take, if he is unable to agree to a change in terms of engagement: If the auditor is unable to agree to a change in the terms of the audit engagement and is not permitted by management to continue the original engagement, the auditor shall: 42 (i) Withdraw from the audit engagement where possible under applicable law or regulation; and (ii) Determine whether there is any obligation, either contractual or otherwise, to report the circumstances to other parties, such as those charged with governance, owners or regulators. EL Key Components of Audit engagement letter: 43 The objective and scope of the audit of financial statements; The responsibilities of the auditor; The responsibilities of management; Identification of the applicable financial reporting framework for the preparation of the financial statements; Reference to the expected form and content of any reports to be issued by the auditor and; A statement that there may be circumstances in which a report may differ from its expected form and content. Calm Co Risk assessment procedures (i) Purpose The main purpose of risk assessment procedures is to help the auditor obtain an understanding of the audit client. The procedures will provide audit evidence relating to the auditor’s risk assessment of a material misstatement in the client’s financial statements. The auditor will also obtain initial evidence regarding the classes of transactions at the client and the operating effectiveness of the client’s internal controls. Finally, the auditor may identify risks in other areas such as being associated with a particular client or not being able to follow ethical guidelines of ICAP. (ii) Sources of audit evidence The auditor may obtain evidence from: Enquiries of management and others connected with the entity such as external legal counsel or valuation experts Analytical procedures including ratio analysis to obtain high level data on the client Observation of entity activities and inspection of documents, etc. © Emile Woolf International 101 The Institute of Chartered Accountants of Pakistan Audit and Assurance 44 Azam (a) Risks and implications for audit risk Inherent and control risks (i) Charities such as Azam can be viewed as inherently risky because they are often managed by non-professionals and susceptible to fraud. In Azam’s case inherent risk is likely to be high as there is no full-time accountant and volunteers are used to raise funds. (ii) As Azam is staffed mainly by volunteers the inherent risk also increases that transactions are not properly recorded. Volunteers are often more enthusiastic as to what they typically perceive as the ‘value add’ and ‘making a difference’ activities and hence paperwork can be overlooked. (iii) Azam’s small size also reduces the opportunity for segregation of duties and thus increases control risk and susceptibility to fraud. (iv) Azam may be at risk of being in violation of its constitutions which is important where funds are raised from public or private donors who may well object strongly if funds are not applied in the manner expected. The question states that funds are required for educational projects so this could be a problem if funds have been used for other purposes. (v) Azam is likely to have a high level of control risk because formal internal controls are expensive and unlikely to be in place. This means that donations are susceptible to misappropriation and Azam will have had to rely heavily on the trustworthiness of volunteers. (vi) Inherent risk is also increased due to the fact that Azam has not been audited previously which could lead to a greater risk of misstatement of opening balances. Detection risk (vii) Detection risk comprises sampling risk and non-sampling risk. It is possible with Azam that all transactions will be tested and therefore sampling risk (the risk that samples are unrepresentative of the populations from which they are drawn) eliminated. (viii) Non-sampling risk is the risk that auditors will draw incorrect conclusions because, for example, mistakes are made, or errors of judgement are made in interpreting results, or because the auditors are unfamiliar with the client. As this is Azam’s first audit nonsampling risk is increased. Audit risk (ix) (b) Audit risk is the product of inherent risk, control risk and detection risk that the auditors will issue an inappropriate audit opinion. This risk can be managed by decreasing detection risk by altering the nature, timing and extent of audit procedures applied. As inherent risk is high and controls likely weak (as is likely to be the case with Azam) more audit work will be performed in appropriate areas in order to reduce audit risk to an acceptable level by reducing detection risk. Audit tests – fund raising events (i) Attend fund raising events and observe the procedures employed in collecting, counting, banking and recording the cash. This will help provide audit evidence that funds have not been misappropriated and that all income from such events has been recorded. Sealed boxes or tins that are opened in the presence of two volunteers are often used for these purposes. (ii) Perform cash counts at the events to provide evidence that cash has been counted correctly and that there is no collusion between volunteers to misappropriate funds. (iii) Examine bank paying in slips, bank statements and bank reconciliations and ensure that these agree with records made at events. This also provides evidence as to the completeness of income. © Emile Woolf International 102 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 45 (iv) Examine the records of expenditure for fund raising events (hire of equipment, entertainers, purchase of refreshments etc.) and ensure that these have been properly authorised (where appropriate) and that receipts have been obtained for all expenditure. This provides evidence as to the completeness and accuracy of expenditure. (v) Review the income and expenditure of fund raising events against any budgets that have been prepared and investigate any significant discrepancies. (vi) Ensure that all the necessary licenses (such as public entertainment licences) have been obtained by the trustees for such events in order to ensure that no action is likely to be taken against the charity or volunteers. (vii) Obtain representations from the trustees to the effect that there are no outstanding unrecorded liabilities for such events – again for completeness of expenditure and liabilities. Hurricane (a) Importance of audit planning According to ISA 300, the auditor should plan the audit work so that the engagement will be performed in an effective manner. Specifically, planning is required for the following reasons: (b) To develop a general strategy and detailed approach for the specific nature, timing and extent of the audit work. This will help to ensure that the audit is carried out in an efficient and timely manner. So that attention is devoted to the important areas of the audit. Planning will also help to identify problem areas so they can be addressed in a timely fashion. To determine the amount of work to be carried out and therefore assist in determining the number of staff required to perform the audit work. To provide a document as a reference for an initial discussion of the approach to the audit with the company’s audit committee. The plan will also help ensure that audit work is coordinated with client staff: e.g. for production of specific documentation to assist the auditor. To act as a basis for the production of the audit program. Audit strategy Client: Hurricane Year ended: 31 December 20X4 Prepared by: A Manager Characteristics of entity Hurricane requires a normal statutory audit – there are no audit or filing exemptions available. The financial reporting framework is the International Accounting Standards and there are no industry specific reporting requirements. Hurricane buys and then resells all types of fixtures and fittings for ships from yachts through to large cruise ships. The company has ten warehouses, seven of which are located near to branches of our audit firm. Key dates Key dates in the audit timetable are: Interim audit Final audit Meeting with audit committee Financial statements approved by management Specific dates are to be confirmed. © Emile Woolf International 103 The Institute of Chartered Accountants of Pakistan Audit and Assurance Overview of audit approach The shipping supply industry has grown by 7% during the last year. Hurricane’s sales increase is 12% indicating that the company continues to perform well within the industry. There have been no changes to the accounting policies of Hurricane during the year. This is the first year that International Standards on Auditing (ISAs) are relevant to this company. A detailed check will be required to ensure that no changes are required to the audit plan. The overall audit approach will be to use tests of control where possible. However, the fall in gross profit indicates that sales may be understated or cost of sales (COS) overstated, so additional substantive procedures may be required in this area. Materiality determination Materiality will initially be set at ½ to 1% of revenue as this figure appears to be more accurate than gross profit. Materiality on the statement of financial position will be based on net asset values. Performance materiality will be set for specific areas. Identification of risk areas with a higher risk of misstatement A review of the draft financial statements for the company shows the following risks: Sales have increased by 12% but COS by 19%. There is a risk of COS being overstated. Inventory on the statement of financial position is down significantly on last year indicating that there may be valuation or quantity errors. Trade receivables have increased by about 50%, significantly more than the increase in sales. This indicates that the company may have debt collection problems. Additional testing may be required on after date cash collections to check for bad debts. Non-current assets have fallen by Rs. 900m, which is significant given that most noncurrent assets are land and buildings. The reason for sale must be ascertained. Non-current liabilities have also fallen by Rs1 billion. While not necessarily linked to the fall in non-current assets, there is a possibility that non-current assets have been sold to pay off the liabilities. Audit approach – extent of controls testing Audit testing will focus on the use of tests of controls where possible. However, changes have been made to the inventory system during the year, limiting the extent of testing of controls. Client systems have changed in the year with a new computerised inventory control system. Unfortunately, the change was not identified until audit planning started. Three actions are necessary in respect of this system: Audit initial installation of the system including transfer of balances. One of the reasons for the low inventory value could be omission of inventory balances on transfer. Test count inventory at the year end and agree to the computerised inventory records (and vice versa) to test their accuracy. Note that the client will not be counting inventory at the year end but relying on the computerised system. Test check bookings into and out of inventory from the purchases and sales systems. Other risk areas The client appears to be a going concern, although the fall in gross profit must be investigated. Cash and profit forecasts for the next 12 months must also be obtained to confirm ongoing profitability and that the fall in cash balances will not continue. There is the possibility of related party transactions. One of the directors purchased a yacht during the year. Checks to be made to determine whether company products were purchased, and if so whether these were in the normal course of business. A new engagement letter is required in ISA format. Assistance may be required on the inventory count; three warehouses are located away from our offices. © Emile Woolf International 104 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 46 Zakir Co (a) (i) Explanation of analytical procedures Analytical procedures are used in obtaining an understanding of an entity and its environment and in the overall review at the end of the audit. ‘Analytical procedures’ actually means the evaluation of financial and other information, and the review of plausible relationships in that information. The review also includes identifying fluctuations and relationships that do not appear consistent with other relevant information or results. (ii) Types of analytical procedures Analytical procedures can be used as: (iii) – Comparison of comparable information to prior periods to identify unusual changes or fluctuations in amounts. – Comparison of actual or anticipated results of the entity with budgets and/or forecasts, or the expectations of the auditor in order to determine the potential accuracy of those results. – Comparison to industry information either for the industry as a whole or by comparison to entities of similar size to the client to determine whether receivable days, for example, are reasonable. Use of analytical procedures Risk assessment procedures Analytical procedures are used at the beginning of the audit to help the auditor obtain an understanding of the entity and assess the risk of material misstatement. Audit procedures can then be directed to these ‘risky’ areas. Analytical procedures as substantive procedures 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 (balance sheet). Analytical procedures in the overall review at the end of the audit Analytical procedures help the auditor at the end of the audit in forming an overall conclusion as to whether the financial statements as a whole are consistent with the auditor’s understanding of the entity. (b) Net profit Overall, Zak’s result has changed from a net loss to a net profit. Given that sales have only increased by 17% and that expenses, at least administration expenses, appear low, then there is the possibility that expenditure may be understated. Sales – increase 17% According to the directors, Zak has had a ‘difficult year’. Reasons for the increase in sales income must be ascertained as the change does not conform to the directors’ comments. It is possible that the industry as a whole, has been growing allowing Zak to produce this good result. Cost of sales – fall 17% A fall in cost of sales is unusual given that sales have increased significantly. This may have been caused by an incorrect inventory valuation and the use of different (cheaper) suppliers which may cause problems with faulty goods in the next year. Gross profit (GP) – increase 88% This is a significant increase with the GP% changing from 33% last year to 53% in 20X3. Identifying reasons for this change will need to focus initially on the change in sales and cost of sales. Administration – fall 6% © Emile Woolf International 105 The Institute of Chartered Accountants of Pakistan Audit and Assurance (c) 47 A fall is unusual given that sales are increasing and so an increase in administration to support those sales would be expected. Expenditure may be understated, or there has been a decrease in the number of administration staff. Selling and distribution – increase 42% This increase does not appear to be in line with the increase in sales – selling and distribution would be expected to increase in line with sales. There may be a misallocation of expenses from administration or the age of Zak’s delivery vans is increasing resulting in additional service costs. Interest payable – small fall Given that Zak has a considerable cash surplus this year, continuing to pay interest is surprising. The amount may be overstated – reasons for lack of fall in interest payment e.g. loans that cannot be repaid early, must be determined. Investment income – new this year This is expected given cash surplus on the year, although the amount is still very high indicating possible errors in the amount or other income generating assets not disclosed on the balance sheet extract. Obtaining a bank letter – Review the need to obtain a bank letter from the information obtained from the preliminary risk assessment of Zak. – Prepare a standard bank letter in the format agreed with banks in your jurisdiction. – Obtain authorisation on that letter from a director of Zak for the bank to disclose information to the auditor. – Where Zak has provided their bank with a standing authority to disclose information to the auditors, refer to this authority in the bank letter. – The auditor sends the letter directly to Zak’s bank with a request to send the reply directly back to the auditors. Educational University (EU) Audit risk There is a risk that revenue from fees income and sale of goods is misstated due to following reasons: Fees income may be recognized immediately on receipt of fees rather than recognized on monthly basis as the services are rendered. Discounts given to students may not be accounted for properly, resulting in overstatement of revenue. There is a risk that revenue related to sale of course material is in appropriately classified as part of the university fees, as a result of which it may have been recognized proportionately on the basis of time (services provided). Entire revenue from sale of course material may not be recognized. Audit procedures and test Understand and test the system of recording revenue i.e. between sale of books and university fees. Review global reconciliation keeping into consideration of number of students registered, semester fees, and discount allowed, cost of course material etc. Ensure that revenue is booked for course material in respect of all registered students irrespective of whether course material is taken by them or not. Ensure that cost of books not yet claimed has been charged off in the accounts. 48 Hajira (a) Audit risk Audit risk is the risk that an auditor gives an inappropriate opinion on the financial statements being audited. © Emile Woolf International 106 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Inherent risk is the susceptibility of an assertion to a misstatement that could be material individually or when aggregated with misstatements, assuming that there are no related controls. The risk of such misstatement is greater for some assertions and related classes of transactions, account balances, and disclosures than for others. Control risk is the risk that a material error could occur in an assertion that could be material, individually or when aggregated with other misstatements, will not be prevented or detected on a timely basis by the company’s internal control systems. Detection risk is the risk that the auditors’ procedures will not detect a misstatement that exists in an assertion that could be material, individually or when aggregated with other misstatements. (b) Inherent risks in charity Area of inherent risk Income is from voluntary donations only. There is a risk that donations will fall, especially where donors’ own income is limited by the ‘credit crunch’ etc. Completeness of income – where there are no controls to ensure income is complete for example sales invoices are not raised to obtain donations and donations could be stolen by staff. Funds can only be spent in accordance with the aims of the charity. There is a risk that funds are spent outside the aims of the charity. Taxation rules relevant to charities. There is a risk that the rules will be broken due to lack of correct analysis of income/expenditure. Requirement to report expenditure in accordance with the constitution – administration expenditure can be no more than 10% of total income. Risks here include income being overstated to allow expenditure to be overstated. Donations to charity for specific activities for example provision of sports equipment. There is a risk that donations are not spent in accordance with donors’ instructions. (c) Effect on audit approach It is difficult to estimate that income in the future will be sufficient to meet the expenditure of the charity. Audit of the going concern concept (as in ensuring that the charity can still operate) will therefore be quite difficult. Audit tests are unlikely to be effective to meet the assertion of completeness. The audit report may need to be modified and qualified to explain the lack of evidence stating that completeness of income cannot be confirmed. Careful review of expenditure will be necessary to ensure that expenditure is not ‘ultra vires’ the objectives of the charity. The auditor will need to review the constitution of the Hajira charity carefully in this respect. The auditor will need to ensure that staff familiar with the taxation rules affecting the charity are on the audit team. The trustees may attempt to hide ‘excessive’ expenditure on administration under other expense headings. As the auditor has to report on the accuracy of income and expenditure then audit procedures must focus on the accuracy of recording of expenditure. Documentation for any donation will need to be obtained and then expenditure agreed to the terms of the documentation. Any discrepancies will have to be reported to management Weak control environment Lack of segregation of duties/responsibilities There is normally a limited number of staff working in the charity meaning that a full system of internal control including segregation of duties cannot be implemented. Staff are likely to be unclear as to their exact responsibilities as they are not formal ‘employees’ and are not part of the formal authority structure in the charity. Volunteer staff Many staff are volunteers and so will only work at the charity on an occasional basis. Controls will be performed by different staff on different days making the system unreliable. © Emile Woolf International 107 The Institute of Chartered Accountants of Pakistan Audit and Assurance Lack of qualified staff (human resource issues) Selection of staff is limited – people tend to volunteer for work when they have time – and so they are unlikely to have professional qualifications or experience to implement or maintain good control systems. No internal audit department (lack of organisational structure) Any control system will not be monitored effectively, mainly due to the lack of any internal audit department. The charity will not have the funds or experience to establish internal audit. Attitude of the trustees It is not clear how the charity’s trustees view risk. However, where trustees are not professionally trained or have little time to devote to the charity, then there may be an impression that controls are not important. The overall control environment may therefore be weak as other charity workers do not see the importance of maintaining good controls. 49 Tahir Co (a) (b) Valuation of aviation inventory – 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. – Calculate the difference in valuation. The error in inventory valuation is Rs.1,050 * 6,000 barrels or Rs.6.3m, which is a material amount compared to profit. – Review prior year working papers to determine whether a similar situation occurred last year and ascertain the outcome at that stage. – Discuss the matter with the directors to obtain reasons why they believe that market value should be used for the inventory this year. – Warn the directors that in your opinion, aviation fuel should be valued at the lower of cost or net realisable value (that is Rs.150/barrel) and that using market value will result in a modification to the audit report. – 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. – If the directors will not amend the financial statements, quantify the effect of the disagreement in the valuation method – the sum of Rs.6.3m is material to the financial statements as Tahir Co.’s income statement figure is converted from a profit to a loss of Rs.1.3m although net assets decrease by only about 0·3%. – Obtain a written representation letter from the directors of Tahir Co confirming that market value is to be used for the emergency inventory of aviation fuel. – 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. (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. © Emile Woolf International 108 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 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. 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. (ii) Groups to report fraud to 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. Report to government As Tahir Co is acting under a government contract, and the over-statement of inventory will mean Tahir 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 Tahir Co needs to review the contract to confirm the reporting required under that contract. 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 Tahir 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. 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. (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. © Emile Woolf International 109 The Institute of Chartered Accountants of Pakistan Audit and Assurance 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. 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. Resignation If the matter is serious, then the auditor can consider resignation rather than not being reappointed. 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. 50 Elegant Limited (a) In determining the need to send an engagement letter, the firm should assess whether: circumstances require a revision in the terms of engagement. management need to be reminded of the existing terms of the engagement. The following factors may indicate that the above is appropriate: Any indication that the entity misunderstands the objective and scope of the audit. Any revised or special terms of the audit engagement. A recent change of senior management. A significant change in ownership. A significant change in nature or size of the entity’s business. A change in legal or regulatory requirements. A change in other reporting requirements. (b) We would consider whether the request is “reasonable”. If the request is reasonable then revised terms should be agreed and recorded in engagement letter. If the request is unreasonable, we should discuss the matter with the management and if the management agrees with our view point, then there is no need for amendment in the existing terms of engagement. If we are unable to agree to the changes and management also do not agree with our viewpoint then we would consider withdrawing from the engagement and consider whether there is any obligation to report the circumstances to those charged with governance, owners or regulators. © Emile Woolf International 110 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers INTERNAL CONTROL 51 Training Manager (a) Control Environment and its elements The ‘control environment’ is often referred to as the general ‘attitude’ to internal control of management and employees in the organization. The elements of control environment include the following: Communication and enforcement of integrity and ethical values Commitment to competence Participation of those charged with governance. Management’s philosophy and operating style Organizational structure Assignment of authority and responsibility Human resource policies and practices (b) Walk through tests: Auditor is required to gain an understanding of the various elements of the internal control system operating within an entity. Once this understanding has been gained, the auditor should confirm that his understanding is correct by performing ‘walk-through’ tests on each major transaction type (for example, revenue, purchases and payroll). Walk-through testing involves the auditor selecting a small sample of transactions and following them through the various stages in their processing in order to establish whether his understanding of the process is correct. (c) Materiality: Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of financial statements. The auditor keeping in view the concept of materiality gives his opinion i.e. whether the financial statements present fairly in all material respects the financial position and performance of the entity. Performance Materiality: Performance materiality means the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. If applicable, performance materiality also refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances or disclosures. Performance materiality recognizes the fact that errors/omissions detected in a particular area may not breach the overall materiality level but when all the errors/omissions in all the areas is combined or added together, the overall materiality could be breached. 52 Vision Limited Control Type of controls General IT controls / Application controls (i) The general ledger system is automatically updated with sub-ledger transactions (e.g., Accounts Receivable) every night through batch processing. Preventive Application controls (ii) The system automatically maintain second copies of all programs and data files. Corrective © Emile Woolf International 111 Application controls The Institute of Chartered Accountants of Pakistan Audit and Assurance 53 Control Type of controls General IT controls / Application controls (iii) Access to programs and data files is restricted using passwords. Preventive General IT controls (iv) Invoices are physically counted that are entered into the system. Detective Application controls (v) Firewalls (software and hardware are installed to restrict unauthorized access). Preventive General IT controls (vi) Screen warnings about incomplete processing. Detective Application controls (vii) Service level agreements. Corrective General IT controls (viii) Review of output against expected values. Detective Application controls Types of Controls (i) Training on applicable policies, department policy/ procedures: It is a preventive controls, as the individuals are trained to perform their duties as per the applicable policies and procedures that are in place. (ii) Batch totals: It is a detective control as program will report any discrepancy between the manually counted batch total and its own batch total, as an error report. (iii) Segregation of duties: It is a preventive control as it involves assigning different people the responsibilities of authorising and recording transactions and maintaining the custody of assets. This reduces the likelihood of an employee being able to both carry out and conceal errors or fraud. (iv) Contingency planning: It is a corrective control as it involves the corrective measures to be adopted in case of any mishap. (v) System logs: It is a detective control as this generates an audit trail that can be used to understand the activity of the system and to diagnose problems. (vi) System backup: It is a corrective control as it will involve any retrieval measures in case of any damage to the original data. © Emile Woolf International 112 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 54 Deehan Super Stores start Items entered. Bill processed Yes Yes Is customer a loyalty card holder? Yes Does customer want to redeem the points? Does customer has enough reward points? No No No Updation of points to the loyalty card Payment of bill partly through redemption and partly through casg Payment of bill through cash or credit card Payment of bill through redemption of points Updating the loyalty points Printing of bill Yes Session card End No Next customer 55 IT Department (a) Controls over data transmission may include the following: Firewalls to prevent intrusion into the programs that send and receive data Only using secured Wi-Fi with password protection Data encryption © Emile Woolf International 113 The Institute of Chartered Accountants of Pakistan Audit and Assurance (b) If management refuse to allow the auditor to send a confirmation request the auditor should: inquire as to management’s reasons for the refusal, and seek audit evidence as to the validity and reasonableness of those reasons; evaluate the implications of management’s refusal on the auditor’s assessment of the relevant risks of material misstatement, including the risk of fraud, and on the nature, timing and extent of other audit procedures; and perform alternative audit procedures designed to obtain relevant and reliable audit evidence. The auditor shall communicate with those charged with governance if: the auditor concludes that management’s refusal to allow the auditor to send a confirmation request is unreasonable; or the auditor is unable to obtain relevant and reliable audit evidence from alternative audit procedures, (c) Performance reviews – In the context of control activities, performance review includes: analyses of actual performance against budget and forecasts; analyses of actual performance against prior period performance control reporting and variance analysis (d) Communications protocol A communications protocol is set of digital rules for message exchange within or between computers. When systems communicate they use pre-defined formats for exchanging the messages. This ensures that each part of the message is recognized and interpreted by the recipient in the intended fashion. For each communication a protocol must define: Syntax – the arguments used to create the message Semantics – how each argument is to be interpreted Synchronization – how the sender and receiver will actually exchange the message Communication protocols are implemented through a combination of hardware and software. (e) The main categories of general controls that an auditor would expect to find in a computer-based information system are: i. controls over the development of new computer information systems and applications ii. controls over the documentation and testing of changes to programs iii. the prevention or detection of unauthorised changes to programs (for example, by an employee committing fraud or by a ‘hacker’ accessing the system) iv. controls to prevent the use of incorrect data files or programs 56 Controls Controls over data transmission include: firewalls to prevent intrusion into the programs that send and receive data. restricting access to source data that is transmitted. only using secured Wi-Fi with password protection. using check sums and check digits to ensure that data received is intact. data encryption. © Emile Woolf International 114 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 57 Bhurbhan Limited (a) Risks: Risks related to receiving of goods and invoice from suppliers are as follows: Goods may be accepted from a supplier without having been ordered. The company may fail to claim discounts from suppliers despite being due. Supplier may raise invoices for goods that have not actually been received / purchased. Goods received from suppliers are of inferior quality. (b) Related controls Suitable controls may be as follows: A copy of all delivery notes should be retained, with a signature of the member of staff who took receipt and checked the goods. Goods received notes should be produced for each delivery, from the delivery note or after a physical count of the items received. A member of the accounts staff or purchasing staff must be responsible for checking discounts allowed by suppliers. There should be a segregation of duties between the individuals who take delivery of goods, those who place the orders and those who record the purchase invoices in the accounting system. All purchase invoices should be checked against a purchase order and a goods received note. (c) Tests of control Ensure that goods received notes, purchase orders and purchase invoices are matched with each other. Confirm from documentary evidence that discounts are claimed from suppliers when available. Check that the segregation of duties does exist. © Emile Woolf International 115 The Institute of Chartered Accountants of Pakistan Audit and Assurance 58 Audit trail (a) Audit Trail in a computerized environment: An audit trail refers to the ability of the auditor to trace a transaction through all its processing stages. An audit trail can be provided by a record (‘log’) of how the computer has processed any transaction. An audit trail may not exist in ‘paper form’ in an online system, but the computer program should be written so as to generate the audit trail on request for any transaction. (b) Embedded Audit Facilities: It is an audit software that is built into the client’s IT system, either temporarily or permanently. The purpose of embedded audit facilities is to allow the audit to carry out tests at the time the particular transactions are being processed, in ‘real time’. This can be very useful for the audit of online systems where: 59 data is continually processed and master files are being continually updated, and/or it is difficult, if not impossible, for the system to provide a satisfactory audit trail for the transactions, through the system. an embedded audit facility may also print details of the transactions it has monitored, or copy them to a computer file, so that the auditor can study the transactions. Supermarkets (a) Key controls on cash sales and cash handling: (i) Responsibility to receive cash should be clearly identified. (ii) Proper locks should be provided to each person responsible for handling cash. (iii) Cash should be kept in a locked and secure area until it is deposited. (iv) Cash registers and credit card machines should be balanced at least once a day. (v) Proper policies should be made to deal with cash shortages/excesses. (vi) Timely deposit of cash should be ensured. (vii) Cash register should be used to record cash sales. (viii) Transfers of cash from one person to another should be kept at a minimum. (b) (i) Adequate segregation of duties or independent checks. (ii) Adequate system of authorization and approval of transactions (for example, in purchasing, movement between locations etc.) (iii) Use of door locks and surveillance cameras. (iv) Surprise physical count and timely reconciliation of inventory items. (v) Mandatory vacations for employees performing key control functions. (vi) Periodic rotation of employees. (vii) Restricted storage area. (viii) Different entry and exit doors. (ix) Access controls over automated records, including controls over and review of computer systems event logs. (x) Job applicant screening of employees with access to assets. © Emile Woolf International 116 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 60 Controls (a) On account of the following factors, the auditor may decide, not to rely on audit evidence obtained in prior audits: (b) A weak control environment. Weak monitoring of controls. A significant manual element to the relevant controls. Changes in the personnel that significantly affect the application of the controls. Change in circumstances that indicate the need for changes in the control. The components of internal controls are as follows: (i) Control Environment: The control environment includes the attitudes, awareness and actions of management and those charged with governance concerning the entity’s internal control and their importance in the entity. (ii) Entity’s Risk assessment process: The entity’s risk assessment process includes how management identifies risks relevant to the preparation of financial statements to ensure that it gives a true and fair view in accordance with the entity’s applicable financial reporting framework, estimates their significance, assesses the likelihood of their occurrence, and decides upon action to manage them. (iii) Information System, Including the related business processes, relevant to financial reporting, and communication: An information system consists of infrastructure (physical and hardware components). Software, people, procedures, and data. (iv) Control activities: These are the policies and procedures that help ensure that management’s directives are carried out, for example, that necessary actions are taken to address risks that threaten the achievement of the entity’s objectives. (v) Monitoring of Controls: Management’s monitoring of controls includes considering whether they are operating as intended and that they are modified as and when appropriate. 61 Shahzad Limited (a) The components of internal controls are as follows: (i) Control environment: The control environment includes the attitudes, awareness and actions of management and those charged with governance concerning the entity’s internal control and their importance in the entity. (ii) Entity’s risk assessment process: It is the entity’s process for identifying business risks relevant to financial reporting objectives and deciding about actions to address those risks, and the results thereof. (iii) Information system, including the related business processes, relevant to financial reporting, and communication. (iv) Control activities: These are the policies and procedures that help ensure that management’s directives are carried out. © Emile Woolf International 117 The Institute of Chartered Accountants of Pakistan Audit and Assurance (v) Monitoring of controls: It is a process of assessing the design and operation of controls on a timely basis and taking necessary corrective actions on account of change in conditions. (b) Following weaknesses in inventory count are identified from audit senior’s observations: (i) Lack of segregation of duties The Inventory Controller is responsible for the physical control of the inventory and is also supervising the stock count. (ii) Non availability of detailed plan Allocation of counting area by the teams themselves indicates non availability of detailed plan which may lead to certain inventory items being counted more than once while some items may not be counted at all. (iii) No system of marking on counted items This again may lead to double counting or omission completely. (iv) Perpetual inventory records available on count sheets The person responsible for counting may try to match the numbers provided instead of carrying out an independent count. (v) Additional count sheets are not pre-numbered If the separate sheets are numbered as they are used, there is no means of identifying that all sheets issued have been returned and the last count sheet(s) may go unnoticed. 62 Waheed Engineering (a) (b) (c) Control Purpose Payroll data is approved by a senior official. To prevent any unauthorised inaccurate deductions being made. Payroll transactions should be recalculated. The correct amount is paid over to employees or the relevant authorities. Official notification of starters and leavers i.e. tax documentation. To prevent employees being paid after they have left or before they have started. All hours worked are authorised. To prevent the company paying for work not done. All employees to collect their wages in person. To prevent loss/theft. Verifying that employees are not paid prior to commencing work (i) Two payrolls should be selected from different periods in the year. (ii) Employees not listed on the second payroll should have left during the year and employees not listed on the first payroll should have started during the period. (iii) This can then be verified by examining the permanent payroll information where there should be a copy of each employee’s contract of employment. (iv) Also tax authority official forms should confirm departure and start dates. The main reason for carrying out this exercise is to ensure that all employees are bona fide i.e. payments are being made to authorised employees. Attendance at the wages pay-out (i) Before attendance I will review the payroll to ensure that a pay packet exists for all employees. (ii) Each employee should sign for the pay package when they collect it. As they sign, the auditor should verify the signature to the contract of employment. © Emile Woolf International 118 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (d) (e) 63 (iii) It should be ensured that no one employee collects more than one pay packet. (iv) All unclaimed wages should be listed; the payroll date, name and amount noted. (v) The unclaimed wages should then be stored in the safe until collected. Procedures re unclaimed wages (i) All unclaimed wages should be recorded in an unclaimed wages book and it should be checked that a wage packet physically exists for each entry in the book. (ii) If someone has collected wages on behalf of somebody else then it should be ensured that a letter of authorisation exists allowing the pay packet to be collected. (iii) After a certain period, say a month, all unclaimed wages should be returned to the bank so the details for each pay package should be agreed from the unclaimed wages book to the banking slip. (iv) Any significant delay in banking unclaimed wages should be noted and investigated. Verification of direct bank payments (i) Carry out a physical verification of employees to ensure that they actually exist. (ii) Check employee details to the personal records from payroll information. (iii) The finance directors could be asked to sign a copy of the payroll to verify that all the employees are bona fide. (iv) Employees’ existence can be verified by confirmation of signatures on expense claims. (v) Also, annual tax authority returns can be reviewed. Danish (a) (b) Problems expected at Danish resulting from poor internal control (i) I would expect the company to experience some level of over-ordering, leading to reduced profitability as a result of inventory going past its ‘best before’ date. (ii) Inventory that is not well-controlled in a supermarket may result in a breach of health and safety regulations which may result in fines or even closure of the supermarkets. (iii) I would expect there to be stock-outs leading to the potential loss of business to other supermarkets. (iv) I would expect there to be inefficiencies as a result of a lack of central ordering system resulting from quality discounts not being obtained. (v) All of the problems noted above are likely to be exacerbated where local managers or staff are either inexperienced or possibly dishonest – the question states that poorer quality staff have been recruited recently. (vi) Supermarket inventory is very easily pilfered either by staff or customers even where it is well-controlled. The lack of regular inventory counts in particular means that pilferage is very easy to hide. (vii) I would expect there to be a lack of understanding in 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. Four recommendations to improve internal controls (i) Recommendation 1: that an integrated system be introduced across all supermarkets that links sales, purchases and inventory records. Advantages This would provide the company with an overall view of what inventory is held at any particular time, enable it to order centrally and reduce the scope for pilferage. It would result in reduced stock-outs and reduced inventory obsolescence. © Emile Woolf International 119 The Institute of Chartered Accountants of Pakistan Audit and Assurance Disadvantages This would require considerable capital investment in hardware, software and training. It would also take control away from local managers which would almost certainly cause resentment. (ii) Recommendation 2: the imposition of regular or continuous inventory counting procedures together with the prompt update of inventory records for discrepancies found and investigation of the reason for the discrepancies. Advantages This would further reduce the possibility of stock-outs and provide evidence of overordering, which would enable purchasing patterns to be refined. Disadvantages There are costs in terms of staff time and, again, a certain level of resentment among staff who may feel that they are being ‘spied on’, or that they are no longer trusted. Training would also be required and additional administrative work would need to be undertaken by local managers. (iii) Recommendation 3: that management accounts are produced on at least a quarterly basis that figures relating to each supermarket are provided to head office on a monthly basis, and that an analysis is undertaken by head office on the performance of individual supermarkets and inventory lines. Advantages This would enable the company to determine which supermarkets are performing better than others. It would also enable the company to identify those inventory lines that well and those that are profitable. Disadvantages The production of more regular and detailed information will be time-consuming. Local managers may feel that they are unable to service the particular needs of their customers if decisions are made on a global basis; customers may feel the same way. (iv) Recommendation 4: that sales price decisions are made by head office. Advantages This would enable the company to experiment with the use of ‘loss leaders’, for example, and to impose a degree of consistency across supermarkets to prevent inappropriate pricing decisions being taken by local managers. 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. To the extent that head office have less experience of local conditions than local staff, it is possible that inappropriate pricing decisions may be made by head office. 64 Roses Anytime (a) Key procedures (i) Documentation of accounting and internal control systems Auditors document accounting and internal control systems in order to evaluate them for their adequacy as a basis for the preparation of the financial statements and to make a preliminary risk assessment of internal controls. In very simple systems with few internal controls where auditors do not intend to perform tests of internal controls, it is not necessary to document the internal control system in detail. It is always necessary, however, to have sufficient knowledge of the business to perform an effective audit. For large entities, where the client has already documented the system, it is not necessary for the auditors to repeat the process if they can satisfy themselves that the client’s documentation is adequate. © Emile Woolf International 120 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (ii) Walk-through tests The purpose of walk-through tests is for the auditors to establish that their recording of the accounting and internal control system is adequate. Auditors trace a number of transactions from source to destination in the system, and vice versa. For example, customer orders can be traced from the initial documentation recording the order, through to the related entries in the daybooks and ledgers. It is common for walk-through tests to be performed at the same time as tests of controls, where auditors are reasonably confident that systems are recorded adequately. (iii) Audit sampling Auditors perform tests of controls and tests of detail on a sample basis in order to form conclusions on the populations from which the samples are drawn. It is not possible in anything but the very smallest of entities to take any other approach, as testing 100% of a population may be impractical, not cost effective and not accurate because populations are too large and because of human error. Samples can be selected in a number of ways – either statistically or on the basis of auditor judgement. In all cases, the sample selected must be representative of the population as a whole. (iv) Testing internal controls Auditors test internal controls in order to establish whether they are operating effectively throughout the period under review. If controls are operating effectively, auditors can reduce the level of substantive testing on transactions and balances that would otherwise be required. In testing internal controls, auditors are checking to ensure that the stated control has been applied. For example, auditors may check that there is a grid stamp on a sales invoice with various signatures inside it that show that the invoice has been approved by the credit controller, that it has been checked for arithmetical accuracy, that the price has been checked, and that it has been posted to the sales ledger. The signatures provide audit evidence that the control has been applied. Auditors are not checking to ensure that the invoice is, in fact, correct. This would be a substantive test. Nevertheless, it is possible to perform tests of control and substantive tests on the same document at the same time. (v) Dealing with deviations from the application of control procedures Where it appears that an internal control procedure has not been applied, it is necessary to form an opinion as to whether the deviation from the application of the procedure is an isolated incident, or whether the deviation represents a systematic breakdown in the application of the control procedure. This is usually achieved by selecting a further sample for testing. If it cannot be shown that the non-application of the procedure is isolated (i.e. there are no further instances in which the control has failed), it is necessary either to find a compensating control that can be tested, or to abandon testing of controls and to take a wholly substantive approach. Where there is a breakdown in internal controls it is also necessary to reassess the auditor’s preliminary risk assessment. Abandoning tests of control may place strains on the budget for the audit and auditors should always consider the possibility of compensating controls before abandoning tests of controls. (b) Internal controls (i) Receipt, processing and recording of orders © Emile Woolf International All orders taken should be recorded on a pre-numbered multi-part document generated by the computer. One part might be a copy for the customer, one might form the invoice, one might be for the despatch department and one might be retained for accounts receivable ledger purposes. Manual or computer systems should perform checks on the completeness of the sequence of pre-numbered documents at various stages. Any documents unaccounted for should be traced and investigated. 121 The Institute of Chartered Accountants of Pakistan Audit and Assurance (ii) 65 The computer system should apply the credit limits set by the credit controller and the system should reject any orders that exceed customer credit limits at the point at which the order is taken, so that the customer can be advised. Any override of credit limits should be authorised by the credit controller. From time to time, there should be a check to ensure that the credit limits within the system are being properly calculated and properly applied to individual transactions. Similar considerations apply to prices maintained within the system. The computer system should also reject any order for which there are no Roses available so that orders cannot be taken for Roses that cannot be delivered. All invoices should be posted to the sales daybook, the accounts receivable ledger and the accounts receivable control account automatically by the system and the accounts receivable ledger and that accounts receivable control account should be reconciled each month in order for sales and receivables records to be kept up to date. There should be controls in place to deal with credit notes and other discrepancies involving the price, type or quality of Roses delivered in order to maintain the accuracy of records and customer goodwill. Collection of cash At the end of each period, the system should produce a list of overdue receivables. There should be procedures for chasing these customers and for putting a ‘stop’ on accounts where amounts are significant in order to control bad debts. When bank transfers are received from customers, they should be input into the system and matched with individual transactions and controls should ensure that the correct amounts are allocated to the correct customers and transactions. An exception report should be produced for any unallocated bank transfers. Exceptions should be promptly investigated. This will ensure that receivables information is accurate and up to date and that customers are not chased for amounts that have been paid. A bank reconciliation should be performed on a monthly basis in order to ensure that the company’s cash records are complete, accurate and up to date. Trade Receivables (a) (b) Types of error, omission and misappropriation receivables (i) Where internal controls are weak, the errors that occur may include the issue of invoices and credit notes for the wrong amounts, the issue of invoices and credit notes to the wrong customers, the incorrect recording of invoices, credit notes, cash and contras in the ledgers and daybooks, and the incorrect setting of credit limits. (ii) Where internal controls are weak, invoices, credit notes cash and contras may simple go unrecorded. (iii) The effect of this will be that receivables may be under or over-stated in the records and that the company will not receive that money that is due to it, or that goodwill with customers is damaged. (iv) The assets that may be misappropriated include cash and inventory. If records are poor, it will be easy to hide the misappropriation of cash that is received from customers. It will also be possible for inventory to be misappropriated and hidden by the issue of false or incorrect invoices, credit notes or contras. Inherent weaknesses in any internal control system (i) No internal control system is perfect and all internal control systems are subject to inherent weaknesses. This means that auditors can never rely on the proper operation of the internal control systems alone. Even if their tests show that the system appears to be working perfectly, it will be necessary to perform some substantive testing. © Emile Woolf International 122 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (c) (d) (ii) Inherent weaknesses include human error. people make mistakes. People operate the control systems and (iii) Other inherent weaknesses include the abuse of authority. For example, false invoices may be issued towards the year-end to improve the sales figure and false credit notes to cancel them out may be issued just after the year-end. This is sometimes known as ‘window dressing’. (iv) Fraudulent collusion can happen both within the company and outside the company. Those who have the right to authorise the issue of credit notes may authorise false credit notes for customers who are their friends. Those who have access to cash and the receivables records may collude to misappropriate cash, and make entries in the accounting records to hide the misappropriation. This is sometimes known as ‘teeming and lading’. Main internal controls over receivables (i) Segregation of duties between those who control the accounting records, those who receive the cash, those who authorise the issue of invoices and credit notes and those who issue the goods to customers. (ii) Two people should be involved wherever cash or inventories are being handled in order to prevent both the misappropriation of assets and to prevent false accusations of misappropriation. (iii) The maintenance of a separate receivables ledger showing the individual balances owing from customers. This ledger should be reconciled at least monthly to the total figure in the nominal ledger. (iv) The issue of statements to customers at the end of each month (from the ledger) showing how much is owed by the customer. (v) Arithmetical and accounting controls over the issue of invoices and credit notes, some of which may be computerised, in order to ensure that they are calculated correctly in accordance with authorised prices. (vi) The use of batch and hash totals, document counts and sequence checks in the input of transactions into the computer system to ensure completeness and accuracy. (vii) The appointment of a credit controller who limits the credit available to customers, together with restricted access to those sections of the system that contain credit limits. (viii) The use of exception reporting to highlight overdue accounts and accounts where the credit limits have been exceeded, together with a system for investigating and dealing with such accounts. (ix) The regular review by the financial controller of amounts receivable and the independent authorisation of the write-off of bad debts. Reliance on proper operation of internal controls (i) Auditors seek to rely on the proper operation of internal controls wherever possible because where internal controls are operating properly, reliance on internal controls is the most efficient method of auditing. (ii) If the auditor’s tests showing that internal controls are operating properly, the volume of substantive testing on transactions and balances can be reduced. (iii) It is always possible (in theory) to perform an audit on the basis of substantive testing alone, but given the volume of transactions in all but the smallest of businesses, such an approach would be prohibitively expensive for the audited entity. © Emile Woolf International 123 The Institute of Chartered Accountants of Pakistan Audit and Assurance 66 Granger (a) (i) Inadequate segregation of duties and proposed reassignment A basic principle of segregation of duties is that an individual employee should not be able to make errors and be in a position to conceal the fact. Proper segregation means that, if an error or misstatement is made, it will be detected by another employee in the ordinary course of his or her duties. A general rule of segregation is that the funtions of processing transactions, recording transactions and maintaining records over the subsequent assets or liabilities, should be performed by different individuals. The receptionist’s duties should be restricted to processing cash receipts transactions. All other functions should be assigned to other staff members. Function to be reassigned Possible misstatement Reassignment Checking the numerical continuity of invoices, determining the total cash sales and entering the cash receipts journal. The receptionist could deliberately understate the total in order to misappropriate the cash or conceal a shortage of cash. This should be assigned to Clerk 1. (See additional procoedure 1.) Posting the accounts receivable ledger. An invoice could be deliberately omitted and the subsequent cash receipt misapprpriated if done by the same person. Clerk 1 should post the accounts receivable ledger from credit sales invoices whose numerical sequence is checked. Errors, such as transaction errors, made in entering the sales journal are likely to be repeated in entering the accounts receivable ledger. Cash receipts could be temporarily misappropriated and the shortgage concealed by delaying recording the receipt. (See the answer to part (b)). Sending out monthly statements and chasing overdue accounts. If there are errors in the accounts receivable ledger the monthly statements could be altered or suppressed. If payments by customers have been misappropriated and not credited to the customer account, customers’ suspicions would not be aroused by chasing apparent overdue balances. Reconciling accounts receivable with the control account in the general ledger. © Emile Woolf International This procedure detects errors, deliberate or accidental, in the maintenance of accounts receivable records. If the receiptionist has made errors in processing sales and cash receipts transactions to accounts 124 This function should be assigned to Clerk 2 since Clerk 1 could also falsify statements to conceal errors in recording sales in the accounts receivable ledger. (See additional procedure 2.) Clerk 2 should perform the reconciliation as having no responsibility for recording either cash or sales transactions or maintaining the accounts receivable ledger. (See additional procedure 3.) The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Function to be reassigned Possible misstatement Reassignment receivable then he would have an incentive to conceal their discovery by falsifying the reconciliation. Writing off uncollectible balances. (ii) (b) (i) (ii) If errors have been made resulting in an understatement of cash received from credit customers, their accounts will appear to be overdue. The error can be concealed by writing off the balance. Such an error could arise from the deliberate misappropriation of cash received from credit customers. Clerk 2 should advise the manager of overdue balances that may need to be written off. (see additional procedure 4.) Other control procedures needed 1. A bank reconciliation should be performed at least monthly by Clerk 1 to ensure that cash deposited is in agreement with amounts recorded in the cash receipts book. the bank reconciliation should be scrutinised and signed by the manager. 2. The garage manager should review the list of customer account balances (which should, if practicable, be aged), enquire into steps being taken to collect overdue balances and consider whether further credit may be allowed. 3. The reconciliation of accounts receivable balances with the control account in the general ledger should be scrutinised by the garage manager to ensure that it appears to be properly drawn up. 4. Final decisions on bad debt write offs must be approved in writing by the garage manger. 5. The opening of mail should be done in the presence of a second clerk who should confirm the total amount of cash receipts enclosed therein to minimise the likelihood of such receipts being misappropriated. Procedures to be followed in making cash count Control all cash funds until completion of the count to prevent cash from a counted fund being transferred to an uncounted fund to conceal a deficiency. Count funds in the presence of the custodian to prevent any suggestion, in the event of a shortage, that the funds were complete when released to the auditors. List each item in the fund, such as the denominations of notes, details of cheques and, for petty cash funds, of vouchers so that the count can subsequently be agreed with the deposit slip and other accounting records. Have the custodian sign the record of the count as being in agreement in the event of any subsequent disagreement. Discrepancy If the details of the items counted differ from the cash receipts book I would suspect a misappropriation of cash by failing to record a receipt from a receivable. To conceal this from the receivable, cash received several days later from another customer is credited to the first customer’s account. The first customer will not notice anything wrong, the delay in the receipt being attributed to postal delays or just delays in processing cash receipts. Failure to credit payment by the second customer will be concealed by using a payment received from a third customer and so on. Providing the amounts involved are reasonable, the perpetrator can usually conceal the fraud indefinitely. Such a fraud is only possible if © Emile Woolf International 125 The Institute of Chartered Accountants of Pakistan Audit and Assurance the person responsible for maintaining the accounts receivable ledger also has access to cash received from customers before any control is established over that cash. This fraud is sometimes called ‘teeming and lading’ or ‘lapping’. It will be necessary to undertake a further investigation by comparing deposit slips receipted by the bank with details recorded in the cash receipts book and postings to the accounts receivable ledger for a series of consecutive days. If a pattern of differences emerges consistent with the pattern associated with this type of fraud, then the existence of the fraud must be suspected. AUDIT EVIDENCE 67 Verification of Evidences (a) Ways in which debtors population may be stratified are as under: By product By customers or category of customers Geographically Terms of sales such as credit terms/Aging By values (b) Views expressed by the team member: i. The view that if verification of balances of category A and B is carried out than there is no need to perform further procedures is not correct as the results of audit procedures applied to items in category A and B will only provide evidence about the items that make up that category (stratum). The auditor should obtain sufficient appropriate audit evidence regarding items in categories C & D as these can also be material. ii. The view that sampling should be carried out on haphazard basis to ensure equal chance of selection is not correct as such assurance is only ensured by using random sampling, i.e. use of random numbers to select items. iii. The view related to systematic sampling is not correct, as selection of 10% items is not systematic sampling. Systematic sampling involves, selection of first item on random basis and then items are selected with a standard gap between them (for example, every 10th item). Suggestion: Both haphazard and systematic sampling may be used in the normal manner, either with or without stratification. However, these methods cannot be used in the manner as suggested by the team members because it may result in extensive testing on immaterial items, thereby increasing the cost which may not be efficient. It may also be appropriate to use random sampling to ensure all items in a population have an equal chance of selection. 68 Rehan Limited (a) (b) (i) The approach of not sending confirmation requests to balances below Rs. 100,000 is not correct unless the total of such balances is clearly immaterial. (ii) The conclusion documented by the team is not correct as the confirmation received from creditors only confirms the recorded amount and is not relevant for the purpose of testing of unrecorded liabilities. (i) The audit team is required to discuss the matter with client’s management and ask them to send confirmation as per the normal sampling procedure of the audit firm. In case the management does not agree, the audit team should evaluate the implications of management's refusal on the auditor's assessment of the relevant risks of material misstatement, including the risk of fraud, and on the nature, timing and extent of other audit procedures; © Emile Woolf International 126 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (ii) 69 Following information should be tested by the audit team to draw conclusion related to unrecorded liabilities: subsequent disbursements unmatched receiving reports (Inventory Cutoff) Sehat Pharmaceutical Limited (a) (i) Hospitals and clinics: The decision to send negative confirmation was appropriate as all the conditions for sending negative confirmation i.e. Large number of small account balances, low risk of material misstatement, low exception rate as only four customers have disagreed with the balances due and that have been also reconciled and there was no knowledge of circumstances that would cause recipient to disregard the confirmation request. (ii) Retailers: Results of confirmations depict high risk of material misstatement and high exception rate. However, since the decision to send negative confirmation was taken on the basis of initial assessment, the decision under the circumstances seems correct. (b) Balance agreed: No further audit work is required. Balance not agreed: In this case: The client should be asked to review the replies and reconcile the balances in its records with the balances confirmed by the customer. The reconciliation prepared by the client should be checked. The reconciling items depicting errors in the client’s records should be investigated and corrected. The client should be asked to resolve the difference in case the reconciling items depicting errors on part of the customers. No reply received: In these cases, alternative procedures should be performed (e.g. subsequent payments and checking of invoices/ dispatch notes in order to obtain evidence to confirm the customer’s balances. (c) From the winding up event it appears that the amount receivable from SDPL is irrecoverable. Therefore, the auditor needs to ensure that the amount of irrecoverable receivables are written off or is duly provided for. The following substantive procedures should also be performed: Review any correspondence of the SPL with the liquidator/management of SDPL (if any), relating to recovery of the amount due. Review the calculation of amount of provision/write off and basis thereof. 70 Nobel The audit evidences which may be gathered in the cases referred to in the question are as follows: (i) Legal Opinion. The terms and conditions of the contract related to defective material and liability thereof. Quality Control procedures prevalent in the company. Documentation of response of other customers, to whom similar items have been supplied. © Emile Woolf International 127 The Institute of Chartered Accountants of Pakistan Audit and Assurance (ii) 71 Opinion of independent experts. Documentation of the Evaluation of the basis of provision. Industry standards. Opinion of independent experts (regarding useful life, pattern of wear tear etc.) The environment (production load, maintenance policies etc.) under which the company is operating and its comparison with other firms in the industry. The reasons for sale of equipment (normal case or otherwise) Masoom Limited Using the work of an expert An auditor may need the opinion of an expert on matters which require professional expertise, other than accounting and audit. Example of such circumstances are: Valuation of assets such as plants, work of art etc.; Determination of quantities such as stockpile, underground mineral etc.; Determination of amount using specialized methods like actuarial valuation; Measurement of work completed; Legal opinions. Auditor’s Responsibility while using the work of expert 72 Evaluate the professional competence of the expert; Evaluate the objectivity of the expert; Obtain sufficient appropriate audit evidence that the scope of the expert’s work is adequate; Evaluate the appropriateness of expert’s work regarding the assertion being confirmed; Resolve the inconsistency, if any, between results of the expert and other audit evidence. Sky blue The investigation of unusual fluctuations and relationships ordinarily begins with inquiries of management, followed by: 73 (a) Corroboration of management’s responses, for example, by comparing them with the auditor’s understanding of the entity and other audit evidence obtained during the course of the audit; and (b) Consideration of the need to apply other audit procedures, if management is unable to provide adequate explanation. Direct confirmations 1 (a) A positive external confirmation request asks the respondent to reply to the auditor in all cases, whether he agrees with the information provided in the confirmation request or not. A negative external confirmation request asks the respondent to reply only in the event of disagreement with the information provided in the request. (b) Associated risks and necessary steps to be taken by the auditor. Positive External Confirmation The risk associated with such type of confirmation is that the respondent may reply to the confirmation request without verifying that the information is correct. The auditor is not ordinarily © Emile Woolf International 128 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers able to detect whether this has occurred. The auditor may reduce this risk, by using positive confirmation requests that do not state the amount (or other information) on the confirmation request, but asks the respondent to fill in the amount or furnish other information. Negative External Confirmation Risk associated is that when no response is received, there is no explicit audit evidence that intended third parties have received the confirmation requests and verified that the information contained therein is correct. Accordingly, the use of negative confirmation requests ordinarily provides less reliable audit evidence than the use of positive confirmation requests. The auditor considers performing other substantive procedures to supplement the use of negative confirmations. (c) Negative confirmation requests may be used under one or more of the following circumstances: (i) The assessed risk of material misstatement is lower; (ii) A large number of small balances is involved; (iii) Substantial number of errors are not expected; and (iv) The auditor has no reason to believe that respondents will disregard their requests. A combination of positive and negative external confirmations may be used, for example, where the accounts receivables comprise a small number of large balances and a large number of small balances. The auditor may then decide that it is appropriate to confirm all or a sample of the large balances with positive confirmation requests and a sample of the small balances using negative confirmation requests. 74 Chill When planning to use the report the auditor should evaluate the professional competence of the expert. This will involve considering the expert’s: Professional certification or licensing by, or membership in, an appropriate professional body; and Experience and reputation in the field in which the auditor is seeking audit evidence. The auditor should also evaluate the objectivity of the expert. The risk that the expert’s objectivity will be impaired increases when the expert is in some way related to or dependent on the entity. 75 Sales sampling (a) (i) Audit efficiency may be improved as the auditor has stratified a population by dividing it into discrete sub-populations which have an identifying characteristic. The stratification reduces the variability of items within each stratum and therefore allows the sample size to be reduced without a proportional increase in sampling risk (ii) Other ways by which sales population may be stratified are as under: By product By customers or category of customers Geographically Terms of sales such as credit, cash, advance etc. Precaution: sub-categorization/sub-populations need to be carefully defined such that any sampling unit can only belong to one stratum. © Emile Woolf International 129 The Institute of Chartered Accountants of Pakistan Audit and Assurance (iii) Views expressed by Sohail His view that if verification of total transaction of category A is carried out than there is no need to perform further procedures is not correct due to the following reasons: The results of audit procedures applied to all the items within category A can only provide evidence about the items that make up that category (stratum). The auditor should obtain sufficient appropriate audit evidence regarding items in Categories B & C as these are also material. Views expressed by other audit team members Their view that proper sampling should be carried out from the total population of 640 million and categorization should be ignored altogether is not correct because stratification helps in improving the efficiency of the audit. (b) Circumstances in which an auditor may decide to examine entire population of items that make up an account balance. The auditor may decide to examine the entire population in the following circumstances: 76 when the population constitutes a small number of large value items. when there is a significant risk and other means do not provide sufficient appropriate audit evidence; or when the repetitive nature of a calculation or other process performed automatically by an information system makes a 100% examination cost effective. PQR (a) For the purpose of determining the extent of reliance that may be placed on the work of internal auditor in specified areas, it may be evaluated by: (i) Inspecting the adequacy of the scope of the work and related programs. (ii) Determining by means of inspection whether the preliminary assessment of Internal audit function remains appropriate. (iii) Obtain evidence that: The work is performed by staff having adequate technical training and proficiency as internal auditors and the work of assistants are properly supervised, reviewed and documented. Sufficient appropriate audit evidence was obtained to serve as a reasonable basis for conclusions reached. Conclusions reached are appropriate in the circumstances and any reports prepared are consistent with the results of work performed. Any exceptions/unusual matters disclosed by internal audit are properly resolved. (b) Important differences between Internal Audit and the External Audit Independence Since internal audit is a part of the entity, no matter how autonomous and objective it is., it cannot reach the level of independence enjoyed by the external auditors. Objectives The objectives of internal audit function vary according to management’s requirements. Whereas, the primary objective of external auditor is to ascertain whether or not the financial statements are free of material misstatements. Reporting Report of external auditor is addressed to the members (shareholders) / owners / those charged with the governance of the entity. © Emile Woolf International 130 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 77 Internal audit reports are addressed to the management and those charged with the governance. The reporting requirement of the external auditor is determined by the framework under which the audit is being carried out and by applicable legal and regulatory requirements. Reporting requirement of internal audit is based on the objectives/scope of work determined by the management and those charged with governance. Hard Stone Limited (a) (b) 78 Substantive procedures for verification of trade debts (excluding receipt from customers) Investigate any unexpected or unusual movement/differences between current and prior period as regards the amounts of trade debts, debtor’s turnover, ageing of receivable and ratio of debtors to credit sale etc. Review of period end reconciliation of subsidiary and general ledger and investigate large and unusual items. Reviewing the period-end bank reconciliation statements with specific reference to the list of cheques deposited but not credited in the bank. Review the following: Large or unusual postings in the general ledger. Large or unusual balances in subsidiary records including, credit balances, past due balances and balances exceeding credit limits etc. Circularization of confirmations and performance of appropriate follow-up of selected customer balances at the period end and obtaining and testing reconciliation of balances confirmed with the book balance. Review the ageing schedule and ensure reasonableness of provision based on: Discussion with the credit manager. Examination of the subsequent collections made. Past practice and consistency. Substantive procedures for verification of stores and spares (i) Obtain the listing of stores and spares balances at period-end and investigate large or unusual quantities or amounts. (ii) Review large or unusual entries in the ledger account. (iii) Review period end reconciliation of subsidiary and general ledger and investigate large and unusual items. (iv) Attend inventory counts at period end and ensure that physical differences are appropriately recorded and resolved and damaged items if any are identified. (v) Check valuation of selected items using one or more of the recommended sampling techniques. (vi) Identify slow moving items and discuss/determine the impact thereof. Related parties Procedure to identify Related Parties The auditor may perform the following audit procedures to ensure the completeness of the information provided by management about related parties: (i) Review prior year working papers for names of known related parties; (ii) Review the entity’s procedures for identification of related parties; © Emile Woolf International 131 The Institute of Chartered Accountants of Pakistan Audit and Assurance 79 (iii) Inquire as to the affiliation of those charged with governance and officers with other entities; (iv) Review shareholder records to determine the names of principal shareholders or, if appropriate, obtain a listing of principal share-holders from the share register; (v) Review minutes of the meetings of shareholders and those charged with governance and other relevant statutory records such as the register of directors’ interests; (vi) Inquire of other auditors currently involved in the audit, or predecessor auditors, as to their knowledge of additional related parties; and (vii) Review the entity’s income tax returns and other information supplied to regulatory agencies. Kamil Limited In the scenario, a previously undisclosed related party has been identified. I shall: 80 communicate the relevant information to the audit team. assess as to why the entity’s system failed to identify or disclose the related party relationship. request management to identify all transactions with NL and disclose them accordingly. perform appropriate substantive procedures on the newly identified related parties or significant related party transactions. assess the reasonableness of the management’s explanation and; evaluate the implications on the audit, if the non-disclosure appears intentional. Direct confirmations 2 (a) (b) (c) The auditor may consider not to circulate the direct confirmation to the customers where: (i) accounts receivables are immaterial to the financial statements; or (ii) the response rate is not expected to be adequate; or (iii) the responses are not expected to be reliable; or (iv) inherent and control risk in aggregate are assessed at low level. (v) audit evidence expected to be gathered through other substantive procedures (e.g. analytical procedures) is sufficient to reduce the audit risk to an acceptable level. (vi) management requests not to send the confirmation and auditor after satisfying himself from the reason and explanation given by the management. While designing the confirmation request, the auditor considers the following factors: (i) Assertions being addressed through the direct confirmation. (ii) Form of the external confirmation requests (i.e. positive or negative or combination of both) (iii) Prior experience on the audit of similar engagements. (iv) The nature of the information being confirmed. (v) The intended respondent. (vi) Type of information respondents will be able to confirm readily. The auditor may perform one or more of the following steps: (i) Check receipt from customers after balance sheet date. (ii) When there is no receipt from customers after balance sheet date, the auditor should consider the following audit procedures: © Emile Woolf International 132 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (iii) (iv) 81 Verify validity of purchase orders, if any. Verify goods dispatched note other documents duly acknowledged by the customers. Obtain explanations for invoices remaining unpaid, if any, after subsequent one have been paid. Examine sales near the period end to provide audit evidence about cut-off assertion. Working papers The auditor should consider the following factors while determining the form, content and extent of audit working papers. 82 (i) The nature of the audit procedures to be performed; (ii) The identified risks of material misstatement; (iii) The extent of judgment required in performing the work and evaluating the results; (iv) The significance of the audit evidence obtained; (v) The nature and extent of exceptions identified; (vi) The need to document a conclusion or the basis for a conclusion not readily determinable from the documentation of the work performed or audit evidence obtained; and (vii) The audit methodology and tools used. Al-Shams (a) (i) Evaluate the company’s procedures for identifying and for properly accounting for related-party transactions. (ii) Inquire of management regarding: the identity of the entity’s related parties, including changes from prior period; the nature of relationship between the entity and these related parties; and whether entity entered into any transaction with these related parties during the period and, if so, the type and purpose of the transactions. (iii) Inspect information supplied by the entity to regulatory authorities (e.g. SECP, FBR, SBP, etc.) (iv) Identify all employee benefit plans and the names of the officers and trustees thereof. (v) Review shareholder registers to identity the entity’s principal shareholders. (vi) Review material investment transactions during the audit period to determine whether the nature and extent of investments during the period create related parties. (vii) Review contracts and agreements with key management or those charged with governance. (viii) Review significant contracts re-negotiated by the entity during the period. (ix) Review significant contracts and agreements not in the entity’s ordinary course of business. (x) Review of internal auditor’s report (xi) Review of third party confirmations obtained by the auditor (xii) Minutes of meetings of shareholders and of those charged with governance. © Emile Woolf International 133 The Institute of Chartered Accountants of Pakistan Audit and Assurance (b) 83 Indicators of dominant influence exerted by a related party include the following: (i) Significant transactions are referred to the related party for final approval. (ii) There is little or no debate among management and those charged with governance regarding business proposals initiated by the related party. (iii) Transactions involving the related party (or a close family member of the related party) are rarely independently reviewed and approved. (iv) The related party has vetoed significant business decisions taken by management or those charged with governance. Auditor’s expert Information regarding the competence, capabilities and objectivity of an auditor’s expert may come from a variety of sources, such as: 84 - Personal experience with previous work of that expert. - Discussions with that expert. - Discussions with other auditors or others who are familiar with that expert’s work. - Knowledge of the expert’s qualifications, membership of a professional body or industry association, license to practice or other forms of external recognition. - Published papers or books written by that expert. - The auditor’s firm’s quality control policies and procedures. ADL (a) (i) Statistical and non-statistical sampling An approach to sampling that has the following characteristics is called statistical sampling: Random selection of the sample items; and The use of probability theory to evaluate sample results, including measurement of sampling risk. A sampling approach that does not have above characteristics is considered non-statistical sampling. (ii) Sampling and non-sampling risk Sampling risk is the risk that the auditor’s conclusion based on a sample may be different from the conclusion if the entire population were subjected to the same audit procedure. Non sampling risk is the risk that the auditor may reach an erroneous conclusion for any reason not related to sampling risk. (b) (i) The following shortcomings have been observed in the approach adopted by the Audit Team: © Emile Woolf International By ignoring less than Rs. 5,000 debtors, the government debtors and some of the related parties, for the purpose of sampling, the following important principles have not been complied with. That the auditor should consider the risk of material misstatement on the entire population. That the auditor should attempt to ensure that all items in the population have a chance of selection. In stratification, the audit efforts are directed towards larger value items. However, the audit planning documentation should explain why the only 10 debtors out of 50 largest debtors were selected. 134 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (ii) Alternative means of sampling material balances are as follows: Stratification This would involve dividing the sample into discrete sub-populations (stratum) which have an identifying characteristic. In our case, the population may be stratified by monetary value. For example, following strata may be created: Above Rs. 1,000,000 Between Rs. 500,000 and Rs. 1,000,000 Below Rs. 500,000 The sample may be made from each strata allowing effort to be directed to the larger value items. Value weighted selection (Monetary unit sampling) When performing test of details, it may be efficient to identify sampling as the individual monetary units that make up the population. In this method, each monetary unit in a population has an equal chance of being selected for testing. Audit effort is directed to the larger value items because they have a greater chance of selection, and can result in smaller sample sizes. 85 Guava & Co (a) After the assembly of the final audit file has been completed, the auditor shall not delete or discard audit documentation of any nature before the end of the retention period. The firm should establish its own policies and procedures for the retention of engagement documentation. The retention period for audit engagement ordinarily is no shorter than five years from the date of auditor’s report. (b) (c) Changes in the audit documentation during the final file assembly process may only be made if they are administrative in nature. Examples of such changes include: (i) Deleting or discarding superseded documentation; (ii) Sorting, collating and cross referencing working papers; (iii) Signing off on completion checklist relating to file assembly process; (iv) Documenting audit evidence that the auditor has obtained, discussed and agreed with the relevant members of the engagement team before the date of the auditor’s report. The auditor must respond appropriately to facts that become known to the auditor after the date of the auditor’s report, that, had they been known to the auditor at that date, may have caused the auditor to amend the auditor’s report. Examples might include: - Evidence as to the valuation of assets e.g. the agreement of a sale price significantly lower than previously recorded for the disposal of a large property portfolio. - Evidence that brings into question the appropriateness of the going concern assumption, for example the non-renewal of financing. - The resolution of a legal case for an amount that is materially different from the expected liability recorded in the financial statements. - The bankruptcy of a major client. In this relation the auditor should document: (i) The circumstances encountered. (ii) The new or additional audit procedures performed, audit evidence obtained, and conclusion reached, and their effect on the auditor’s report. (iii) When and by whom the resulting changes to audit documentation were made and reviewed. © Emile Woolf International 135 The Institute of Chartered Accountants of Pakistan Audit and Assurance 86 RP planning The steps that I as an auditor would consider as part of the audit planning to ensure that all related party relationships and transactions are identified and disclosed in the financial statements are as follows: (a) Obtaining an understanding of the controls, if any, that management has established to identify, account for, and disclose related party relationships and transactions in accordance with the applicable financial reporting framework. (b) Inquiring of the management regarding: (i) The identity of the entity’s related parties, including changes from the prior period; (ii) The nature of relationships between the entity and these related parties; and (iii) Whether the entity entered into any transactions with these related parties during the period and, if so, the type and purpose of the transactions. (c) Inspecting the following documents for indications of the existence of related party relationships or transactions that management has not previously identified or disclosed: (i) Bank and legal confirmations (ii) Minutes of meetings of shareholders and of those charged with governance; and (iii) Any other records or documents as the auditor considers necessary (e.g. Form A, Form 29, Register of members etc.). (d) Reviewing the extent and nature of business transacted with major customers, suppliers, borrowers and lenders for indications of previously undisclosed relationships. (e) Reviewing the significant transactions outside the normal course of business, paying particular attention to the transaction recognized at or near end of the reporting period and inquire of management: (f) 87 The nature of these transactions Whether related parties are involved in these transactions Once related parties have been identified, the client should provide the details of transactions with such parties. I as auditor would ensure that these transactions are disclosed appropriately in the financial statements as per applicable financial reporting framework. Manufacturing inventories Substantive Procedures Physical verification: (i) Evaluate the client’s physical inventory taking instructions and procedures to their staff. (ii) Attend physical inventory count to observe the inventory count procedures. (iii) Ascertain whether the staff members are carrying out the physical inventory count as per approved instructions issued to them. (iv) Perform test counts to ensure the efficiency and effectiveness of the physical count procedures. (v) Observe the physical inventory count and identify the matters for appropriate follow-up during the audit. These matters may include the following: Excess/ Shortages found in test count performed by the auditors. Items of inventory identified as obsolete, slow moving, damaged or defective. Details of instances where the approved inventory count procedures are not followed by the staff members of the client. © Emile Woolf International 136 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Instances where the stock records (bin cards, stock and stores ledger etc.) do not contain adequate details relating to balance of inventory in hand, minimum level, maximum level, ordering level, specification of inventory and location of inventory etc. Cut-off procedures and adherence thereto. (vi) Check that the adjustments arising out of the physical count have been made in the stock count sheets. (vii) Check final stock sheets for quantity, pricing, extensions, casting, summarization, and signatures of the stock taking staff. Finished Goods: (i) Obtain a list of items (schedule) shown as finished goods, with full particulars, quantity and value (ii) Compare the list with physical count sheet balances and with stock ledger balances (iii) On test basis check the items and quantities in the stock ledger with the bin card. (iv) With regard to cut-off procedures performed during the attendance at the physical inventory count, check the ‘goods outward book’ or ‘delivery outwards’ book for the last few days of the year, and early few days of the succeeding financial year. (v) If goods are sold on consignment, check the closing stock with the consignment account. Work in Process: (i) Obtain a list of items shown as work in progress, with full particulars, quantity and value. (ii) Compare the list with physical count sheet balances and with stock ledger balances (iii) Check the quantity and items included in the list with the production reports and job cards etc. (iv) Check records showing the work in progress opening balances, raw material and other material issued and labour and overheads charged to production and closing balance of work in process. (v) Where it is not possible to quantify or value the work in process for technical reasons, the auditor should consider to use an expert. Raw material: (i) Obtain a list of items shown as Raw material, with full particulars, quantity and value. (ii) Compare the list with physical count sheet balances and with stock ledger balances. (iii) Verify the cost of raw material appearing in the financial statements by matching with them with the purchase invoices etc. Valuation of Inventories: (i) Ensure that stock has been valued in accordance with the valuation policy. (ii) Ensure that inventories have been valued at the lower of cost and net realizable value. (iii) Ensure that the cost of inventories comprise of purchase price, cost of conversion and other costs incurred in bringing the inventories to their present location and condition. (iv) Check that the following costs have not been included in the cost of inventories: Abnormal wastes in labour, material or other production overheads. Storage costs unless considered necessary for the production process/ inventory. Administrative overheads Selling and distribution costs Financial charges © Emile Woolf International 137 The Institute of Chartered Accountants of Pakistan Audit and Assurance (v) Examine and perform test checks to verify the proper allocation of overheads is in accordance with the requirements of IAS 2. (vi) Where the inventories are valued at net realizable value, check that valuation is correct and is based on the most reliable evidence. (vii) Check that the cost of obsolete and damaged items is properly written down. (viii) Test arithmetical accuracy of the calculation of the stock sheets. Disclosure: Ensure that inventories have been disclosed in accordance with the requirements of International Financial Reporting Standards and the Companies Act, 2017. General: 88 (i) Trace opening balance from last years working papers. (ii) Agree closing balance appearing in the financial statements with books of accounts. (iii) Ensure that inventories have been appropriately classified. (iv) Obtain direct confirmation for stocks held by third parties. (v) Check reconciliations of opening and closing balances with production/ sale records, wherever possible. Framework (i) Fair presentation framework and compliance framework: The term fair presentation framework is used to refer to a financial reporting framework that requires compliance with the requirements of the framework and: Acknowledges explicitly or implicitly that, to achieve fair presentation of the financial statements, it may be necessary for management to provide disclosures beyond those specifically required by the framework; or Acknowledges explicitly that it may be necessary for management to depart from a requirement of the framework to achieve fair presentation of the financial statements. Such departures are expected to be necessary only in rare circumstances. The term ‘compliance framework’ is used to refer to a financial reporting framework that requires compliance with the requirements of the framework, but does not contain the acknowledgements of fair presentation framework. (ii) Tolerable misstatement and performance materiality A Tolerable misstatement is a monetary amount set by the auditor in respect of which the auditor seeks to obtain an appropriate level of assurance that the monetary amount set by the auditor is not exceeded by the actual misstatement in the population. Performance materiality means the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. Performance materiality also refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances or disclosures. © Emile Woolf International 138 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 89 MWL (a) Selection of Accounts Receivable for circulation at year-end (i) The debtors listing will be stratified in accordance with the different market segments (Super markets, whole sellers, retailers and five star hotels) (ii) For positive circulation the selection may be as follows: (iii) (b) All twelve super markets, as well as the seven five star hotels will be purposely selected (59% of the total debtors balance will be covered in this manner). Whole sellers and retailers will be stratified further according to value and days outstanding. A sample will be made from the above-mentioned sub-populations, with greater focus on the high value and long-outstanding populations. Debtors with nil and credit balances, as well as overdue debtors should also be selected. A negative circulation of non-selected debtors may be considered on sample basis. Situation where a debtor confirms a balance which is different from the amount appearing in the confirmation request: A response that indicates a difference between information requested to be confirmed and information provided by the confirming party is termed as exception. The exception may be on account of: 90 (i) Timing difference (ii) Misstatement In case of timing differences, the auditor will need to reconcile the amount confirmed by the confirming party and the amount sent for confirmation. If the amount cannot be reconciled, the auditor is required to evaluate whether it is indicative of a fraud or deficiency or deficiencies in the entity’s internal control over financial reporting. In either case, the auditor will consider whether he needs to revise his risk assessment and audit procedures. BPR (a) (b) Substantive Procedures for verification of Bank reconciliation statements: Trace and agree balances per books of accounts (ledger or bank book) as appearing in the bank reconciliation statement with the general ledger/ bank book. Trace and agree balances per bank statement as appearing in the bank reconciliation statement with the bank statements. Trace reconciling items appearing in the previous month’s bank reconciliation into current month’s ledger/ bank statement/ bank reconciliation statement. Check subsequent clearance of current months reconciling items. Review and discuss long outstanding items appearing in the bank reconciliation statement. Ensure that all outstanding items requiring adjustments are properly accounted for in the books of accounts. Check arithmetical accuracy of reconciliation statements. Substantive Procedures for Payroll: From the payroll record: © Emile Woolf International Select a sample of newly appointed staff and check their salaries with the appointment letter. 139 The Institute of Chartered Accountants of Pakistan Audit and Assurance (c) Select a sample of other staff (appointed in previous years) and check their salaries with the increment letter. In both the above cases check that allowances and deductions are in accordance with the company’s policies or the relevant legal requirements. Select a sample of payroll summaries and: Check that payroll summary has been approved by an appropriate authority. Trace totals of payroll summaries to appropriate general ledger accounts. Check allocation of payroll to cost of sales and operating expenses. Compare net payroll after deductions with transfer letter issued to the bank. Carryout analytical review by comparing the monthly and annual payroll and inquire reasons for significant fluctuations. Ensure that payroll costs have been properly disclosed in the financial statements. Substantive Procedures for Raw material purchases: Select a sample of transactions and carryout the following tests. Check weather appropriate measures have been taken as per the company’s policy to ensure that purchases are made from most competitive sources. Check the relevant invoices. Match invoices with goods receiving notes to ensure that goods have been received for all billings made by supplier. Match supplier’s invoices with purchase orders to ensure that: Purchases were duly authorized. Rates and quantities mentioned on the invoice are same as those mentioned on the purchase order. 91 Check posting of supplier’s invoices to creditor’s accounts/ general ledger. Perform cut-off procedures on purchases. Perform analytical procedures on purchases made during the year by comparing current year purchases with the last year and investigate significant differences, if any. Taskeen Co (a) Sampling risk Sampling risk is the possibility that the auditor’s conclusion, based on a sample, may be different from the conclusion reached if the entire population were subjected to the audit procedure. The auditor may conclude from the results of testing that either material misstatements exist, when they do not, or that material misstatements do not exist when in fact they do. Sampling risk is controlled by the audit firm ensuring that it is using a valid method of selecting items from a population and/or increasing the sample size. Non-sampling risk Non-sampling risk arises from any factor that causes an auditor to reach an incorrect conclusion that is not related to the size of the sample. Examples of non-sampling risk include the use of inappropriate procedures, misinterpretation of evidence or the auditor simply ‘missing’ an error. Non-sampling risk is controlled by providing appropriate training for staff so they know which audit techniques to use and will recognise an error when one occurs. © Emile Woolf International 140 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (b) Sample selection methods The audit manager suggests checking all invoices, effectively ignoring any statistical sampling; in other words this is not statistical sampling. Audit tests will be applied to all of the sales invoices. This approach may be appropriate for the audit of Tam because: The population is relatively small and it is likely to be quicker to test all the items than spend time constructing a sample. All the transactions are not large but could be considered material in their own right, e.g. compared to project. As all the transactions are material, then they all need to be tested. The audit senior suggests using statistical sampling. This will mean selecting a limited number of sales invoices from the population using probability theory ensuring a random selection of the sample and then applying audit tests to those invoices only. This approach may be appropriate because: The population consists of similar items (i.e. it is homogeneous) and there are no indications of the control system failing or changing during the year. There is the query about how long it will take to determine and produce a sample, which may make statistical sampling inappropriate in this situation. The audit junior suggests using ‘random’ sampling, which the junior auditor appears to understand as manually choosing which invoices to look at. The approach therefore involves an element of bias and is not statistical or true ‘random’ sampling. While this approach appears to save time, it is not appropriate because: (c) The sample selected will not be chosen ‘randomly’ but on the whim of the auditor. Human nature will tend to avoid difficult items for testing. Also, as invoices will not have been chosen using statistical sampling, no valid conclusion can be drawn from the results of the test. If an error is found it will be difficult extrapolating that error on to the population. Materiality 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 of the item or error judged in the particular circumstances of its omission or misstatement. It is important that the auditors of Tam ensure that the financial statements are free from material error for the following reasons: There is a legal requirement to audit financial statements and present an opinion on those financial statements. If the auditors do not detect a material error then their opinion on the financial statements could be incorrect There are only two owner/directors who will be the initial users of the financial statements. While the owners/directors maintain the accounting records, the directors will want to know if there are material errors resulting from any mistakes financial statements are materially correct There are also other users of the financial statements who will include the taxation authorities and the bank who have made a loan to the company. They will want to see ‘true and fair’ accounts. The auditors must therefore ensure that the financial statements are free from material misstatement to avoid any legal liability to third parties if they audit the financial statements negligently. © Emile Woolf International 141 The Institute of Chartered Accountants of Pakistan Audit and Assurance 92 Wings (a) Use of the work of the internal auditors by external auditors Sales and ticketing (i) The sales function is likely to be integrated with the accounting and internal control system used to produce the figure in the financial statements for revenue, on which the external auditor reports. (ii) The internal auditors' work on the ticketing system is less likely to be useful because it relates to an operational area which does not have a direct impact on the financial statements. There are, however, regulatory matters that may need to be considered by the external auditor. Ticketing may also have an indirect effect, because it is likely to be integrated with the sales system and there is likely to be some crossover between the controls over ticketing and controls over sales generally. The work of the internal auditors is therefore likely to be of some use to the external auditor. Fleet acquisition and maintenance (iii) The internal auditors' work on the fleet acquisition system is likely to be very relevant to the external auditors because owned aircraft and leased aircraft will constitute a substantial element of statement of financial position assets and liabilities, and depreciation and finance charges in the income statement, (iv) Much of the internal auditors' work is likely to relate to ensuring that company policy has been complied with. Policy will relate to the authorisation for and acquisition of aircraft, and accounting for aircraft in terms of the correct classification of leases (operating or financing) and depreciation policy, for example. Company policy is likely to be extensive and detailed for such material items and external auditors will be concerned to ensure that it is both appropriate and has been complied with. (v) It is also possible that the internal auditors' work may involve some verification of the income statement/statement of comprehensive income and statement of financial position entries at the year-end. Given the likely materiality of the amounts involved, this work will also be of interest to the external auditors. (vi) It is possible that the internal auditors' work may also relate to the quality of aircraft, and other operational aspects of fleet management. These issues may also be relevant to the external auditors, at least insofar as they relate to compliance with laws and regulations. (vii) In relation to maintenance, the internal auditors' work is likely to relate to the authorisation and correct accounting for maintenance expenditure (capitalisation or expensing), and on the operational side, to the quality thereof, as for fleet acquisition (above). Maintenance expenditure in the income statement/statement of comprehensive income may well be material and the work of the internal auditors is therefore of interest to external auditors. Trade payables and long-term debt financing (viii) The extent of the external auditor's interest in the internal auditors' work on trade payables and long-term financing will depend on the materiality of the amounts involved. Trade payables (for certain types of routine maintenance, and payables due to the service organisations, for example) may be material. Long-term debt financing is very likely to be material as many airlines have substantial debt financing. (ix) Internal audit work on trade payables is likely to involve ensuring that routine internal controls are properly designed and are operating. The external auditors may well be interested in the internal auditors' work in this area. (x) There are substantial financial statement disclosures required for debt financing. The internal auditors' assistance with ensuring that disclosures are properly made, as well as with ensuring that any covenants have been complied with and that the accounting for the financing is appropriate, may also be helpful to the external auditors. © Emile Woolf International 142 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (b) (c) 93 Quality of internal audit function: extent of reliance (i) The quality of the internal audit function will have a significant effect on the extent of the external auditor's reliance. If the quality of work is not adequate, reliance will not be possible, regardless of the extent and relevance of the work performed. (ii) The firm will seek to ensure that there is an appropriate structure within the department itself, with appropriate reporting lines outside the department, preferably reporting to the audit committee. (iii) The internal audit function has recently been expanded and there are likely to be changes in the way that it is organised. The function should have operational independence within the organisation and formal terms of reference that encompass the recent changes made. (iv) The function should have a clearly defined set of operating procedures, as well as a work program. Proper documentation of all work performed is essential. (v) Staff should be appropriately trained, experienced and qualified. The head of such an important department should preferably be professionally qualified. Audit evidence: outsourced functions (i) Internal controls exercised by the company over in-flight catering and payroll must be properly designed and operated. The firm will seek to review documentation of controls and internal audit reports. It will seek to obtain evidence that controls have been applied. (ii) A breach of regulations or deterioration in the quality of catering could both have a significant effect on the financial statements, particularly if fines were payable or adverse publicity was likely. Enquiries into both areas and a review of relevant documentation provided by, for example, food licensing authorities to the company or the service organisation, and company lawyers (in relation to passenger complaints, perhaps) will be necessary. (iii) Evidence of controls sought by the firm will include: controls over the selection of the service organisations selected (by competitive tendering, for example); evidence relating to the completeness, accuracy and timeliness of information provided to, and received from, the payroll organisation (batch summaries and exception reports, for example); evidence relating to the security measures taken by the payroll organisation to ensure that confidential information is kept confidential; evidence relating to the security measures taken by the catering organisation to ensure that health and safety standards are maintained and that no 'sabotage' of the food can take place. Glasses2Go (a) Purposes of audit working papers The purposes of audit working papers include: (b) To assist with the planning and performance of the audit. To assist in the supervision and review of audit work, and To record the audit evidence resulting from the audit work performed to support the auditor’s opinion. Documentation Information obtained Memorandum and articles of association Details of the objectives of Specs4You, its permitted capital structure and the internal constitution of the company. Most recent published financial statements Provide detail on the size of the company, profitability, etc. as well as any unusual factors such as loans due for repayment © Emile Woolf International 143 The Institute of Chartered Accountants of Pakistan Audit and Assurance (b) (c) Documentation Information obtained Most recent management accounts/budgets/ cash flow information Determine the current status of the company including ongoing profitability, ability to meet budget, etc. as well as identifying any potential going concern problems. Organisation chart of Spec4You To identify the key managers and employees in the company and other people to contact during the audit. Industry data on spectacles sales To find out how Specs4You is performing compared to the industry standards. This will help to highlight any areas of concern for example, higher than expected cost of sales, for investigation on the audit. Financial statements of similar entities To compare the accounting policies of Specs4You and obtain additional information on industry standards. Prior year audit file To establish what problems were encountered in last year’s audit, how those problems were resolved and identify any areas of concern for this year’s audit. Internet news sites To find out whether the company has any significant news stories, (good or bad) which may affect the audit approach. Working paper The audit working paper does not meet the standards normally expected in a working paper because: The page reference is unclear making it very difficult to either file the working paper in the audit file or locate the working paper should there be queries on it. It is not clear what the client year end date is – the year is missing. The working paper could easily be filed in the wrong year’s audit file. There is no signature of the person who prepared the working paper. This means it is unclear who to address queries to regarding the preparation or contents of the working paper. There is evidence of a reviewer’s signature. However, given that the reviewer did not query the lack of preparer’s signature or other omissions noted below, the effectiveness of the review must be put in question. The test ‘objective’ is vague – it is not clear what ‘correct’ means for example, it would be better to state the objective in terms of assertions such as completeness or accuracy. The test objective is also stated as an audit assertion. This is not the case as no audit assertions are actually listed here. It is not clear how the number for testing was determined. This means it will be very difficult to determine whether sufficient audit evidence was obtained for this test. Stating that details of testing can be found on another working paper is insufficient – time will be wasted finding the working paper, if it has, in fact, been included in the audit working paper file. Information on the results of the test is unclear – the working paper should clearly state the results of the test without bias. The preparer appears to have used personal judgement which is not appropriate as the opinion should be based on the facts available, not speculation. The conclusion provided does not appear to be consistent with the results of the test. Five errors were found therefore it is likely that there are some systems weaknesses. © Emile Woolf International 144 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 94 ISA 620 Reliance on the work of an auditor’s expert (i) (ii) Likely areas of reliance Legal opinions, for example, the expert’s view on the likely outcome of an ongoing court case. Specialist valuation areas, such as property. Determination of stage of completion of complex work-in-progress in the audit of inventories. Determination of likely realisable value of assets, such as plant which is possibly obsolete, to see if a write-down is needed. Assessing the work of an expert The audit firm should carry out the following procedures. Assess the competence, capabilities and objectivity of the expert. Obtain an understanding of the expert’s field of expertise. This must be sufficient to allow the auditor to determine the nature, scope and objectives of the expert’s work and evaluate the adequacy of that work. Agree the terms of engagement with the expert, including: - the nature, scope and objectives of the expert’s work - the respective responsibilities of the expert and the auditor - the form of the expert’s report - confidentiality requirements Evaluate the adequacy of the expert’s work, including the: 95 - reasonableness of the expert’s conclusions - consistency of those conclusions with other audit evidence - reasonableness of significant assumptions and methods used - relevance, completeness and accuracy of source data. Cuddly World (a) Procedures (i) Use in gathering audit evidence Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and non-financial data. Inquiry means to seek relevant information from sources, both financial and non-financial, either inside or outside the company being audited. Evidence may be obtained orally or in writing. Inspection is the physical review or examination of records, documents and tangible assets. It may include examination of records for evidence of controls in the form of a compliance test. Observation involves looking at a process or procedure as it is being performed to ensure that the process actually works as documented. Recalculation means the checking of the mathematical accuracy of documents or records. © Emile Woolf International 145 The Institute of Chartered Accountants of Pakistan Audit and Assurance (ii) One example for each method (1) Analytical procedures Review of sales income year on year to try to identify whether income has been under-stated, possibly by cash being taken prior to banking. There is no control over the opening of post so cash could be withdrawn by one assistant, and the deficit made up by a fraud on customers. (2) Inquiry Obtain statements from suppliers to check the completeness of liabilities at the end of the year. As there is no control over purchases, invoices could have been misplaced resulting in a lower purchases and suppliers figure. (3) Inspection The assets of the company, namely cuddly toys in inventory at the end of the year, can be inspected to ensure all inventory is recorded and that the toys are saleable in their current condition. (4) Observation Procedures such as the opening of cash and recording of customer orders can be observed to ensure that the administrator is recording all orders in the sales day book and cash books. (5) Recalculation Checking additions in the cash book to confirm that the total amount of cash recorded is accurate and can be included in the sales figure (cash receipts normally equal sales because there are no receivables). (b) Suitability for Cuddly World (1) Analytical procedures This method of collecting evidence will be useful in Cuddly World because it will help to identify unusual changes in income and expenditure. As Cuddly World is a relatively small company, monitoring gross profit will show relatively small changes in sales margin or purchasing costs. Decisions by Mr Kabir to amend margins can therefore be traced into the actual sales made. However, the technique may be limited in its application because it will not detect errors or omissions made consistently year on year. If either assistant is defrauding the company (for example by removing cash) each year, then analytical procedures will not detect this. (2) Inquiry Inquiry evidence will be very useful in the audit of Cuddly World, especially where this is derived from third parties. Third party evidence is generally more reliable than client originated evidence as there is a decreased likelihood of bias. Suppliers can therefore be verified using statement reconciliations. A review of any customer complaints file (if those letters are kept) will also help to identify any orders that have not been despatched. External inquiry evidence will be less useful in the audit of sales and receivables because goods are paid for prior to despatch – there are no receivables. Internal evidence will be available from Mr Kabir and the assistant; however the lack of segregation of duties means that this will not be so reliable. (3) Inspection Inspection of documents within Cuddly World will be useful, particularly regarding checking whether expenses are bona fide. All purchase invoices, for example, should be addressed to Cuddly World and relate to purchases expected from that company e.g. cuddly toys for resale, office expense etc. Inspection of documents can take a long time, however, given the poor internal control system within Cuddly World, the auditor may have no choice but to use this method of gathering evidence. © Emile Woolf International 146 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers The fact that an invoice is addressed to the company does not confirm completeness of recording so inspection of the cash book for unusual payments verified by checking the purchase invoice will also be required. Additional substantive testing would also be required due to poor controls. (4) Observation Observation may be useful because it will show how the assistants check documents. However, no information is provided on any internal controls with Cuddly World so simply viewing how documents are checked without any evidence of checking has limited benefit. Observation tests will be of limited usefulness because the assistants may act differently when an auditor is present. The same problem will apply to any observation checking carried out by Mr Kabir. (5) Recalculation Recalculation evidence is very useful for checking additions on invoices, balancing of control accounts etc. This means that the arithmetical accuracy of the books and records in Cuddly World can be confirmed. The main weakness of recalculation checking is that calculations can only be carried out on figures that have been recorded. If there are any omissions then checks cannot be carried out. 96 Auditors (a) (b) Key substantive procedures for verification of provisions include the following: (i) Ensure that all provisions have been recognized in accordance with the IAS 37. (ii) Review the measurement of the closing balance for each provision and discuss these with management if appropriate. Consider whether it might be appropriate to take expert advice on the existence or measurement of a provision. (iii) Review the board approval related to provisions booked in the financial statements. (iv) Review the list of provisions for possible omissions, based on the auditor’s knowledge of the business and the industry in which it operates. (v) Relate the testing of provisions to other areas of the audit work, such as correspondence with lawyers/minutes of Board of director’s meeting (which might reveal more information about matters to which the provisions relate). (vi) Compare provisions for the current financial year with provisions in previous years, and investigate any major differences or omissions. (vii) R eview the subsequent events to ensure completeness of provisions. Factors to be considered by auditor in deciding sufficiency of audit evidence: The decision relating to sufficiency of audit evidence depends upon the judgment of the auditor. Apart from professional judgment, following factors are also relevant in determining the sufficiency of audit evidence. (c) (i) the seriousness of the risk that the financial statements might not give a true and fair view; when this risk is high, more audit evidence will be required (ii) the materiality of the item (iii) the strength of the internal controls in the client’s accounting systems In order to evaluate the adequacy of internal audit function, the external auditor should assess whether: (i) The work was properly planned, performed, supervised, reviewed and documented; (ii) Sufficient, appropriate evidence was obtained to enable internal auditors to draw reasonable conclusions; © Emile Woolf International 147 The Institute of Chartered Accountants of Pakistan Audit and Assurance (d) (e) (iii) Appropriate conclusions were reached, consistent with any reports prepared; (iv) Any exceptions or unusual matters were properly resolved. Physical access controls over an IT System might include: (i) Doors and door-locks (ii) Alarms (iii) Surveillance camera or video (iv) Cables that allow a user to lock a laptop to a desk (v) Fingerprints readers to log-in to a system (vi) Lockable briefcase Professional Skepticism: It refers to an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence. However, it does not mean that the auditors should disbelieve everything they are told, but they should view what they are told with a skeptical attitude, and consider whether it appears reasonable and whether it conflicts with any other evidence. 97 Analytical procedures and materiality (a) Possible reasons for changes in ratios All of the changes noted below may also be due to simple accounting errors or, in some cases, misappropriation of inventory or cash. (i) Increase in current ratio An increase in the current ratio may indicate increased inventory, cash or receivables levels. The implications of this may be that the company is expanding, or alternatively that it is experiencing trading difficulties and is unable to sell its inventory or to collect its receivables. An increase may also be due to a decrease in trade payables or other current liabilities. (ii) Decrease in gross profit margin A decrease in the gross profit margin may indicate that the cost of raw materials or boughtin goods has increased, or that discounts or selling prices have decreased. This may not be a bad thing if the reason for this is an overall increase in revenue. (iii) Increase in inventory holding period The inventory holding period indicates the number of days the company could continue to trade if supplies were to cease. The longer the period, the higher the level of inventory held. Inventory holding involves expenditure. Generally, the lower the figure the better provided that the company does not run out of inventory. An increase can indicate that the company is unable to sell its inventory. An increase can also indicate that the company is expecting additional sales, or simply that the business is expanding. Many businesses are cyclical and increases and decreases are to be expected. (b) Materiality Concept Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. So what might be material in one year might not be material the next, and what might be material to one company might not be to another. © Emile Woolf International 148 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Effect on audit work The quantitative aspects of materiality are often, in practice, calculated as percentage of revenue, profit before tax or assets, or a particular class thereof. Auditors calculate materiality for the financial statements as a whole and calculate performace materialty for individual account areas. They look at the aggregate (net) effects of misstatements and omissions for the financial statements as a whole. Companies sometimes adjust the accounting records and financial statements for immaterial items, sometimes they do not. Materiality is related to risk and used in the calculation of sample sizes and tolerable misstatement, and in the performance of analytical procedures. Less work is performed in immaterial areas than in material areas, although some work is always performed because an area that may appear to be immaterial may, when tested, provide to be material. 98 Tahira Transporters (a) Audit test Reason for test Discuss with booking clerk how orders are recorded from the customer. The main problem with the sales system in TT is the lack of evidence for the receipt of the telephone order. checks are therefore required to ensure that orders are completely and accurately recorded in the VMS where no input document is available. Discuss with the directors the recruitment and training of booking clerks. To check on the personnel controls in TT which will be designed to minimise loss of customer orders. With client’s permission, attempt to enter orders into the VMS from an input terminal. To confirm the completeness and accuracy of recording of orders by the computer system. For the sample of confirmed e-mail orders held in the e-mail programme, trace details onto the VMS ensuring that details of vehicle hire regarding time and dates are accurately recorded. To check for accuracy of transfer of information from the e-mail to the VMS. Review hard copy customer complaint files and e-mail files on computer for evidence of unfilled orders. To check for evidence of orders being sent by customers but not entered into TT’s sales system. For a sample of bookings in the VMS, trace details to the list of sales invoices raised maintained in the receivables ledger programme. To check for completeness of transfer of information between the two programmes. The test can be carried out manually or using test data. Manual testing may be difficult where there is no obvious audit trail between the two systems. For a sample of sales invoices in the VMS, trace details to the list of sales invoices raised maintained in the receivables ledger programme. To check for accuracy of charging for each individual vehicle hire. Evidence of undercharge would indicate that sales are understated. Cast the list of invoices in the receivables ledger programme for one month. Trace total sales to the general ledger programme. To ensure that the total sales for that month are accurate. Transfer of data to the nominal ledger ensures that the total sales amount is recorded correctly in the ledger. © Emile Woolf International To ensure that staff have appropriate skill and training to operate the ordering system without losing customer orders. The method of filling of the e-mails means that completeness of e-mail orders cannot easily be determined. Audit software may be able to re-sort the orders. 149 The Institute of Chartered Accountants of Pakistan Audit and Assurance (a) (b) Audit test Reason for test Cast the monthly sales figures in the general ledger and agree to the financial statements. Investigage any discrepancies. The final cast and checking ensures that the financial accounts figure is accurate. Casting tests can be carried out manually or using computer audit software. Audit work Obtain non-current asset register from client. Cast the cost, depreciation and net book value columns of the register and agree to the financial statements of TT. For a sample of new additions in the non-current asset register: Agree to board minute or similar documentation for evidence of authority to purchase vehicle. (Occurrence assertion) Agree to the physical asset to confirm existence of the vehicle. Where the vehicle is on hire during the audit visit, obtain alternative evidence of existence such as payment from customer near year end for hire (Existence assertion) Check the physical condition of the vehicle to ensure that repairs and renewal expenditure is not being understated. (Existence of repair expenditure) Agree details to purchase invoice or similar document for evidence of ownership. (Ownership assertion) Test the calculation of depreciation in the non-current asset register, ensuring that the rates used are those disclosed in the financial statements. (Valuation assertion) Review profits and losses generated on sale of vehicles and ensure these are not excessive. If they are check the accuracy of the depreciation rates used as this may indicate over or under charge of depreciation. (Valuation assertion). Compare sales income to sale of similar vehicles with similar mileage and ensure comparable. For a sample of disposals during the year (for occurrence assertion): Ensure asset has been removed from the non-current register Check calculation of profit or loss on sale Agree receipt on sale to the cash book For a sample of vehicles purchased durin the year, agree details to purchase invoice and purchase day book (PDB) ensuring details recorded in the correct year. (Occurrence assertion) For a sample of vehicle purchases in the PBD, agree details to the non-current asset register. (Completeness assertion) Agree totals in non-current asset register to the financial statements, ensuring vehicles are disclosed separately in the non-current asset note (material item). (Disclosure assertion) Ensure that the accounting policy for depreciation is clearly stated in the financial statements and is the same as last year. (Disclosure assertion) 99 Willow (a) Initial audit procedures Clerical accuracy This schedule has been prepared by the company’s accountant. If I am to use the schedule as the basis for planning and performing my audit. I must first ensure that it is correct in accordance with the company’s books and records. I would, therefore: verify the schedule to and from accounts recorded in the nominal ledger and with the draft financial statements; check the correctness of additions and other calculations on the schedule. © Emile Woolf International 150 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers The basis for this procedure is that of professional scepticism which requires making no presumption as to the accuracy of information provided by management. Opening balances I would check that the opening balances are in agreement with the balances in the previous year’s audit file. This is for two reasons: (b) To ensure that any amendments to the previous year’s closing balance agreed at audit had been properly recorded in the company’s books and records. With plant and equipment most audit procedures are applied to transactions that change the balance. Reliance is placed on audit procedures performed in previous years in verifying assets brought forward at the beginning of the year. Audit procedures additions Existence Vouch additions to suppliers’ invoices. Examine goods inward notes or evidence confirming delivery of the items prior to the year end. Examine purchase orders, requisitions and other evidence, such as Board approval, that the purchase had been properly authorised. Physically examine some of the items confirming description and serial numbers to the invoice. Completeness Analyse repairs and maintenance to ensure that no items charged to this account should not have been capitalised. Scrutinise the company’s capital budget and capital commitments recorded in the previous year’s financial statements for details of proposed additions and enquire as to why any such items are not recorded as additions. Rights and obligations Ensure that the purchase documentation assigns ownership rights to the company. Valuation Ensure that the amount recorded as additions is in accordance with the cost on the purchase invoice including all matters properly included, such as delivery, but excluding amounts that should not be capitalised, such as the cost of removal of plant being replaced. Where other costs are capitalised, such as own labour for assembly and testing, I would verify the amounts as appropriate. Presentation and disclosure (c) Ensure that the items properly meet the definition of plant and equipment and are properly recorded as such. Revaluation Competence and objectivity of the valuer My prime concern would be that the valuer is an employee of the entity. Nevertheless, I may be prepared to accept the valuation although I would need to be satisfied that the valuation has been performed with sufficient objectivity that it represents sufficient, appropriate audit evidence. This depends on factors such as the materiality of the amounts involved and the available of corroboratory evidence. The revaluation is certainly substantial representing a gain of Rs 144m on property, plant and equipment having a written down value of Rs.603m. It is a common practice for interim valuations to be undertaken by valuers employed by the entity providing they are confirmed by less frequent independent valuations, such as every five years. If this is the practice I would examine the record of past valuations to see if the employee’s valuations tended to be confirmed by the independent valuations. © Emile Woolf International 151 The Institute of Chartered Accountants of Pakistan Audit and Assurance I would also enquire into the professional qualifications and experience of the valuer to ensure that he or she is both suitably qualified to perform valuations and sufficiently experienced in valuations of the type undertaken. Scope of work I would obtain a copy of the valuer’s report and: check that the valuation given in the report is consistent with the valuation recorded in the financial statements; check that the basis of valuation is consistent with an acceptable basis of financial statement valuations, such as open market value and, in particular, that it relates to the property as it is and does not anticipate future uncertain events such as rezoning for planning, new roads etc. and form a view as to how thoroughly the valuer has undertaken his or her work. Although the valuer was an employee of the company I would need to ensure that no undue restriction was placed on the valuer’s access to relevant information having a bearing on the valuation. Assessing the work of the valuer When reviewing the work of the valuer I would expect to see the basis of the valuation explained and justified in the report. Where practicable I could confirm any data used such as recent transactions involving similar property. I could also consider the reasonableness of any assumptions made concerning which I have some knowledge, such as the effect of recent changes in legislation or in the economic climate. Conclusion If I find that: the valuer is professionally qualified, and sufficiently experienced, the scope of the work is adequate; and other evidence corroborates the reliability of the valuation I would probably be prepared to accept the work of the valuer as an expert providing sufficient appropriate evidence as to the valuation of the property. My confidence in the valuation would be enhanced if it were an interim valuation subject to periodic confirmation by independent valuers. (d) Accumulated depreciation According to IAS 8 the correction of errors which are the natural result of estimates inherent in the accounting process are normally dealt with in the income statement in the period in which they are identified. This would appear to be the accountant’s argument. An alternative view is that this is a fundamental error and the cumulative adjustments applicable to prior periods have no bearing on the results of the current period. In this case, as a prior period adjustment, the benchmark treatment required by IAS 8 is to adjust the opening balance of retained earnings of retained earnings and to amend the comparative figures for the previous accounting period. However, the accountant’s proposed treatment is consistent with the allowed alternative treatment providing it is accompanied by additional pro forma information as required by the benchmark treatment. 100 Sparkle Forever (a) Audit procedures and reasons in relation to inventory count Audit procedure Reason Perform an overall review with client staff to ensure that they are following the client’s physical count instructions. Specifically ensure that: To check that client’s physical count instructions are being followed as this will help to ensure that the count is complete and accurate. © Emile Woolf International 152 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Audit procedure (b) Reason Inventory is divided into appropriate sections for recording – perhaps by type of jewellery To ensure there is a clear layout of inventory, ensuring items are not missed. Staff are counting in pairs with one person checking the inventory and another recording. Prevents collusion and provides a check over security of inventory (jewellery is high value) and that the count sheets are not falsified. Appropriate checks are in place to ensure that each item of jewellery is only counted once. To ensure that inventory is not double-counted The shop is closed during the count. To ensure that there is no confusion regarding which items are sold. Count sheets are pre-numbered. To ensure that no count sheets are lost. Obtain a sample of inventory items already recorded on the count sheets and agree to the jewellery inventory. To ensure that the inventory recorded on the count sheets actually exists. For a sample of jewellery in the shop, agree to the count sheets. To ensure that all inventory is recorded on the count sheets – check for completeness of recording. Obtain a sample of count sheets, photocopy and place on the audit file. To check that details on the count sheets are not subsequently amended and for agreement to the final inventory sheets to ensure quantities are recorded correctly. Check all count sheets are returned after the physical inventory count. Ensures that all sheets are accounted for and inventory is therefore not understated. Obtain last inventory receipt note and sales invoice numbers. To ensure that cut off is correct. Subsequent checking should show that goods received notes post physical count are not included in payables for the year, and sales invoices after the physical inventory are not included in sales for the year. Review the condition of the jewellery with the independent valuer. Ensure that there are no reasons why the inventory could be obsolete (e.g. due to changes in fashion) or damaged. To check that any inventory which is damaged or unsellable is correctly valued. Form an opinion regarding the overall accuracy of the physical count. To confirm that inventory quantities have been correctly recorded. Factors to consider when placing reliance on the work of JJ: Dandy & Co need to confirm that they actually need an expert. It is not clear whether Dandy & Co have the necessary skills in-house. However, given that Sparkle Forever is the only client in the diamond industry, then some assistance would be expected as valuing diamonds is difficult. Check that the specialist has relevant experience in valuing diamond jewellery. Part of the appointment process will include checking the work portfolio of JJ to show that they have valued diamonds in other situations. Ensure that JJ is a member of an appropriate professional body. This will help ensure that JJ follows the appropriate ethical standards as these will be enforced by their professional body. Check that JJ cannot be influenced by the client – for example because they are employed by Sparkle Forever. Being employed by the client would imply less independence and limit the value of the specialist’s report. © Emile Woolf International 153 The Institute of Chartered Accountants of Pakistan Audit and Assurance Check that the report produced by the specialist regarding the valuation of the diamonds appears to be reasonable. Although Dandy & Co do not have any other clients retailing diamonds, basic price comparisons for a given weight of diamond could still be obtained from other shops or Internet site to prove the accuracy of JJ’s figures. (c) Audit procedures to ensure that jewellery inventory is correctly valued The jewellery inventory should be valued at the lower of cost and net realisable value. For a sample of jewellery on the final inventory sheets, trace the cost of those items to the original purchase invoice, ensuring that the description of goods on the invoice matches the jewellery. For jewellery sold after the end of the year, check a sample of sales invoices back to the final inventory sheets ensuring that the sales value exceeds the cost. Where sales value is less than cost, ensure that the jewellery is stated at the realisable value on the inventory sheet. Review the report of the professional valuer. Ensure that the inventory is genuine. For the items checked by the valuer, agree the valuation to the items of jewellery on the inventory statements. Where there is a difference, for example due to age of the inventory or where it is unlikely to be sold due to changes in fashion, discuss with the client and agree a realistic valuation. In these situations, the value should be that provided by the professional valuer. Where an item has been in inventory for a long period of time (perhaps over one year), check the valuer’s report to find out whether any allowance is required. 101 Bubbles (a) Audit tests on ‘Stockpop’ system during the year (i) There are two main aspects to the audit of the Stockpop system; those relating to quantities and those relating to costs, in order to rely on the system as a basis for the figure in the financial statements I would need to ensure that management had a system for ensuring that: the system was accurate and up-to-date; errors were investigated and corrected on a regular basis; and each item of inventory was counted at least once a year (in practice items are likely to be counted more often that this as such systems are often relied on to produce figures for management accounts). (ii) I would ask management about the procedures for inventory counting and review the related documentation, including inventory counting instructions, and form a view as to whether the system was adequate in principle. I would also review the results of any internal audit work on the system design (assuming that I considered the internal audit function to be adequate). (iii) I would need to obtain evidence relating to the three items noted in (i) above. I would therefore visit the warehouses during the year, possibly on a rotational basis, to ensure that the system was being operated in the manner prescribed. (iv) I would perform certain preliminary analytical procedures to establish which warehouses to visit (such as those where the records indicated that large volumes of inventories were held, warehouses that were experiencing problems or had experienced problems in the past, or warehouses that were considered high risk or other reasons). I might use different offices of my own firm for these purposes, and/or I would enlist the help of internal audit. I would review the results of the work already performed by internal audit. (v) I would ask local staff about the procedures performed, especially about any variations from the procedures prescribed. I would observe procedures being performed. (vi) I would test check records of goods received and goods despatched and trace them through the Stockpop system to ensure that records were accurate and input on a timely © Emile Woolf International 154 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers basis. I would ensure that the correct corresponding entries for costs had been made in the purchases and sales systems. (b) (vii) I would perform my own test checks of inventory and trace my counts through the Stockpop, sales and purchases systems. (viii) I would consider using CAATs (computer assisted audit techniques), including test data and audit software to establish whether, for example, the system is rejecting entries outside certain pre-determined parameters (cost per unit for example), and that the system highlights any old inventory, or any exceptions such as negative inventory quantities. (ix) I would review all exception reports produced by the system to see if there were any recurring or old items and to ensure that all errors and exceptions were being dealt with on a timely basis. Audit tests on records at year end (i) I would analytically review the year-end records to establish the overall quantities and costs of inventories and the quantities and costs of raw materials and finished goods. (ii) I would ask management about any problems experienced with the system at, or close to, the period-end and about how they had been dealt with to ensure that they had been appropriately resolved. (iii) I would also ask management about the likely level of write-down of either raw materials or finished goods (inventory being of inadequate quality or spoiled, for example). I would compare this with prior years and form an opinion as to its appropriateness. I would check the calculation of the allowance for damaged inventory and review exception reports close to the period-end. (iv) I would obtain schedules of the costs and quantities to be included in the financial statements and trace these back to the output of the Stockpop system noting and substantiating any significant adjustments. (v) I would enquire as to how accurate cut-off had been achieved. I would perform cut-off tests on the records by tracing samples of goods received and despatch notes just before and just after the year-end to the Stockpop, sales and purchases systems in order to ensure that costs had been correctly allocated to the correct accounting period. I would also perform this test in reverse, from the Stockpop, sales and purchases systems through to goods received and despatch notes. (vi) I would ensure that the valuation method used by Bubbles was in accordance with IAS 2 Inventories and that, for example, the system was adequate to ensure that finished goods included an appropriate element of labour and overhead costs. 102 ISA 500 (a) Four examples of external confirmations Four examples of external confirmations are: (b) Accounts receivable letter Solicitor letter Bank report letter Inventory held by third parties. Assertions achieved and not achieved by each example (only one example of each required). Accounts receivable letter This letter provides evidence of the existence of the receivable when a reply is returned from that receivable direct to the auditor. The letter provides evidence on cut-off because sales or cash receipts recorded in the incorrect accounting period will have to be reconciled to the balance provided by the receivable. © Emile Woolf International 155 The Institute of Chartered Accountants of Pakistan Audit and Assurance The letter does not provide evidence of completeness of the receivables balance because receivables may not query balances which are understated. The letter does not provide evidence of the valuation of the receivables balance because the receivable cannot be expected to list all outstanding balances and external confirmation of the debt does not mean it will be paid. Solicitor letter A solicitor letter provides evidence as to the existence of claims at the period end as the solicitor will confirm specific claims. However, the letter does not necessarily confirm the valuation of claims due to uncertainty about the future or the completeness of any legal claims as solicitors do not normally provide a list of all claims – they prefer to comment only on claims they are actually asked about. Bank report letter A bank confirmation letter provides good evidence on the existence of the company’s bank accounts as the bank has confirmed this information in writing. A bank letter cannot necessarily be relied on to provide complete or accurate information. Most banks place a disclaimer on the letter of ‘errors and omissions excepted’ indicating that the auditor must review this evidence against other cash and bank evidence obtained. Inventory held by third parties A letter from the third party holding the inventory will provide evidence of the existence of that inventory because the third party has confirmed this in writing. However, the letter does not provide evidence regarding the valuation of the inventory; confirming something exists does not necessarily mean it is in good condition. 103 Javeria Co (a) Procedure for obtaining a bank letter The auditor should consider if a bank letter is required. For the audit of Javeria Co the letter is required as the company has significant cash transactions and a loan from the bank. The auditor will produce an external confirmation letter in accordance with local audit regulations and practices. The letter will be sent to the client to sign and authorise disclosure and then it will be forwarded on to Javeria’s bank. Alternatively, the client may already have provided a standard authority for the bank to respond to a bank letter each year. In this case separate authority would not be required. Ideally the letter should be sent before the end of the accounting period to enable the bank to complete it on a timely basis e.g. at the year-end. The bank will complete the letter and send it back directly to the auditor. Audit procedures on the bank letter include: (b) Agree the balances for each bank account to the relevant bank reconciliation and the yearend balance in the financial statements. Agree total interest charges on the letter to the interest expense account in the general ledger. For any details of loans, ensure repayment terms are correctly disclosed in the financial statements between current and non-current liabilities. Substantive procedures for the audit of bank balances (1) Obtain a copy of the year-end trial balance. Agree the bank balance on the trial balance to the year-end bank balance on the computer system, and the balance on the financial statements. © Emile Woolf International 156 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (2) Obtain a copy of Javeria Co.’s bank reconciliation. Cast the reconciliation Agree the bank balance to the trial balance. Agree the bank statement balance to the year-end bank statement. Agree any unpresented lodgements to the bank statement after the end of the year Agree any unpresented cheques or similar expenses to the cash book before the end of the year and the bank statements after the end of the year. 104 Porridge (a) Inherent risk – trade payables In my audit of trade payables I would regard completeness as presenting the greatest level of inherent risk for the following reasons: (b) (i) Management has an incentive to understate purchases and thus payables in order to improve profits. This applies not only to senior management but to line managers who are close to budgetary limits on certain expenditures and are under pressure to withhold recording of suppliers’ invoices until after the year end. (ii) Senior management may be under pressure to understate payables in order to improve the company’s apparent liquidity. This would be the case if the company were seeking to raise additional finance or to renew existing borrowing agreements. The more liquid the statement of financial position shows the company to be the more favourable the terms are likely to be. (iii) Principal control procedures placed in operation by the company relate to the occurrence assertion in order to prevent improper purchasing by employees or overpayments to suppliers. (iv) The primary source of information initiating recognition of a liability is the supplier’s invoice. During the year the company has no incentive to accelerate the receipt of suppliers’ invoices. This means that, as at the end of the reporting period, there could be outstanding claims not yet invoiced by suppliers which the entity has no formalised procedures for identifying promptly. (v) Valuation is rarely a problem except in complex contractual situations where the amount due is contingent upon some future event such as a volume discount dependent on total purchases at some future date exceeding some agreed amount. Accounts payable circularisation In my audit of Porridge I would not normally undertake a payables’ circularisation for the following reasons. (i) For payables, much of the documentary evidence available is in the form of third party sourced suppliers’ invoices and statements, in contrast to accounts receivable for which most of the available documentation is entity prepared. (ii) Examination of documentary evidence is usually a cheaper form of substantive evidence than external confirmation. (iii) Although examination of third party sourced documentary evidence is less reliable than external confirmations received directly by the auditor, it usually provides sufficient evidence. I would, however, consider an accounts payable circularisation in the following situations. (iv) A substantial proportion of the company’s suppliers does not issue monthly statements. (v) Statements from suppliers with whom the company does substantial business are unexpectedly unavailable for the last month of the year. (vi) Only fax or photocopies of statements are available whose authenticity is doubtful. © Emile Woolf International 157 The Institute of Chartered Accountants of Pakistan Audit and Assurance (vii) (c) I have reasons to suspect that the company, or a member of the company’s staff, may be deliberately understating liabilities and there is a possibility that some of the suppliers’ statements may be forgeries given the ease of replicating documents with modern scanning and desk top publishing technology. Assessment of control risk as slightly less than high, the limited segregation of duties, and the failure to routinely reconcile all statements with the accounts payable ledger mean that this is not necessarily a remote possibility. Substantive procedures applicable to production payables Initial procedures (i) Obtain a list of such accounts payable and test its accuracy by testing it to and from the computer records and adding it and agreeing it to the control account. (If production payables are not segregated from other payables this procedure will apply to all payables.) Analytical procedures (ii) Perform analytical procedures on accounts payable and compare the results with expectations: compare current year’s balance with previous years; compare the average age of payables with previous years; compare gross profit with previous year and industry average. Tests of details of transactions (iii) Ascertain cut-off data for goods received notes (GRNs) (probably obtained during attendance at the physical inventory count). (iv) Check cut-off by obtaining GRNs for two weeks prior to the year end and: checking their numerical continuity; tracing GRNs to the purchases recorded before 31 October or the accrual journal entry. (v) For a smaller sample I would verify the existence of recorded purchases prior to the year end by vouching a sample of purchases and purchase accruals to GRN’s in the sequence issued prior to the year end. (vi) For a sample of the closing accruals I would verify the amount of the accrual by vouching the amount to a subsequently received supplier’s invoice. Tests of details of balances (vii) (d) Select a sample of accounts payable using criteria such as: all suppliers from whom the entity bought more than 1% of its purchases during the year; a random sample of all other suppliers including nil and credit balances; (viii) For each supplier in the sample I would compare the balance with the supplier’s statement and investigate differences. (ix) If any supplier’s statements were unavailable I would consider confirming the balance directly with the supplier. Verifying the completeness of non-production payables Detection risk over the completeness assertion must be set as low because of the assessment of control risk as only just less than high and from problems identified in obtaining the understanding of the accounting system in that: (i) there are no goods received notes to determine the date of receipt of the goods; (ii) invoices are not recorded until after approval by the department manager which could cause considerable delay and even a failure to record liability for invoices mislaid or even lost before being recorded; © Emile Woolf International 158 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (iii) suppliers’ statements are not reconciled which would otherwise detect most delayed or missing invoices. My audit procedures would be centred on cut-off and the search for unrecorded liabilities. (i) Vouch purchases entered in the purchase journal as at 31 October (including those entered while the journal was held open after the year-end) to invoices to verify that they are properly recorded as accounts payable at the end of the reporting period. (ii) Vouch larger purchases recorded in the first two weeks of the subsequent year to invoices to ensure that they are properly recorded after the year-end. (iii) Obtain suppliers’ statements from major suppliers and reconcile them with the balance in accounts payable for evidence of invoices missing or mislaid. (iv) Review outstanding purchase orders for evidence of goods or services received prior to the year-end not yet invoiced by the supplier. (v) Similarly vouch cash payments for the first two weeks after the end of the reporting period for payments for goods and services received before the year-end not processed as payables. (vi) Review both purchases and cash payments for items that may relate to goods or services received prior to the end of the reporting period. This review should be continued up to the date of signing the auditors’ report. (vii) Compare prepayments and accruals with the previous year for items such as rent or utility bills normally paid in advance or arrears of receipt of goods and services and investigate differences. (viii) Analyse expense accounts for significant differences either in absolute amounts or relative to sales. Any unexpected difference could be due to unrecorded purchases at the end of the reporting period. 105 Trembridge Engineering (a) Checking suppliers' statements to the balances on the purchase ledger (i) Assess the system of control in the purchases system and its reliability. If discrepancies are found in the audit tests, increase the sample of items checked. If the company's staff regularly perform checks on the supplier's statements then perform fewer checks and instead rely on their work as evidence. (ii) Generally, check a larger proportion of suppliers where the balances are large, or where there are a large number of transactions. If no statements are available from a particular supplier then consider telephoning to confirm the balance instead. (iii) If the balance on the supplier's statement agrees to the balance on the purchase ledger then no further work needs to be carried out. (iv) If differences arise they will be due to a number of occurrences, such as: goods in transit; cash in transit; and other differences such as incorrect treatment of discounts. (v) Goods in transit are invoices on the supplier's statement which are not on the customer's purchase ledger. If these differences have been included in purchase accruals no further checks are necessary. However, for large value items, check the goods received note (GRN) to ensure they were received before the year-end. (vi) Cash in transit may be verified by checking against the following month's supplier’s statement. (vii) Other differences, such as discounts, need only be investigated if they are material. © Emile Woolf International 159 The Institute of Chartered Accountants of Pakistan Audit and Assurance (b) Verification of purchases cut-off In order to complete an adequate cut-off test for purchases and goods inwards the ideal starting point is the population of goods received notes. A sample should be selected that includes items from both before and after the year end. For each item, it will be ensured that the date included in inventory, the purchase invoice date and the date posted to the purchase ledger all correspond. For example a goods received note dated before the year end means the following. (i) the items should be in inventory; (ii) the purchase invoice should be included in the income statement/statement of comprehensive income and dated before the year end; (iii) the purchase ledger should include the purchase invoice before the year end. A cut-off error will exist if the items are not recognised in the correct accounting period. (c) Audit work on sundry payables and accruals (i) Compare to the previous year's figures and identify any material fluctuations. (ii) Net wages accruals and tax/social insurance payables can be verified by referring to the monthly payroll. Normally it would be expected that one month of each may be outstanding. (iii) The sales tax payable is verified by agreeing the amount to the tax return and then agreeing the tax return calculation by checking input tax to the purchase day book, output tax to the sales day book and any sundry amounts to either cash book or petty cash book (iv) Accrued interest on the bank loan and overdraft will be checked to the bank letter. (v) Other accruals will be checked to invoices received after the year-end (or if no invoices have been received after the year end, then invoices received before the year end will be used). (vi) Consider whether there are any circumstances which have arisen in the year which may result in new accruals, and check if these accruals have been included. 106 ISA 620: Using the Work of an Auditor’s Expert (a) (b) Competence and objectivity of experts – The expert’s professional qualification. The expert should ideally be a member of a relevant professional body or have the necessary licence to perform the work. – The experience and reputation of the expert in the area in which the auditor is seeking audit evidence. – The independence of the expert from the client company. The expert should not normally be employed by the client. Auditor rights – Right of access to the company’s books and records at any reasonable time to collect the evidence necessary to support the audit opinion. – Right to require from the company’s officers the information and explanations the auditor considers necessary to perform their duties as auditors. – Right to receive notice of and attend meetings of the company in the same way as any member of the company. – Right to speak at general meetings on any matter affecting the auditor or previous auditor. – Where the company uses written resolutions, a right to receive a copy of those resolutions. © Emile Woolf International 160 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (c) Tangible non-current assets – assertions – Completeness – ensure that all non-current assets are recorded in the non-current asset register by agreeing a sample of assets physically verified back to the register. – Existence – ensure non-current assets exist by taking a sample of assets from the register and physically seeing the asset. – Valuation and allocation – ensure assets are correctly valued by checking the reasonableness of depreciation calculations. – Rights and obligations – ensure the company owns the asset by seeing appropriate document of ownership for example, a purchase invoice. – Presentation and disclosure assertions – ensure all necessary financial statements disclosures have been made by reviewing the financial statements and ensure non-current assets are correctly categorised in those financial statements. Note: only four assertions were required. 107 Heidi Co (a) (i) Benefits of using audit software Standard systems at client The same computerised systems and programs as used in all 25 branches of Heidi 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. Use actual computer files not copies or printouts Use of audit software means that the Heidi Co.’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. 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. 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. (ii) Problems on the audit of Heidi 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. 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 Heidi Co.’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. © Emile Woolf International 161 The Institute of Chartered Accountants of Pakistan Audit and Assurance 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. 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 Heidi 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. Non-standard systems Heidi Co.’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 Heidi Co.’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 Heidi Co. 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 Heidi 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. 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. Usefulness of audit software The use of audit software at Heidi 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. (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: – Ensuring that the department has staff who have appropriate qualifications. Provision of a relevant qualification e.g. membership of a computer related institute would be appropriate. © Emile Woolf International 162 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers – 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. – Ensuring that the documentation is actually used during internal audit work and that 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. Regarding the actual documentation: – 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. – 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. – 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 Heidi Co. SCENARIOS 108 Zeedin Co (a) Audit procedures procurement and purchases system Procedure Reason for procedure Obtain a sample of e-mails from the store manager’s computer. Trace details to the order database. Ensure that all orders are recorded and that the order details are correct. Obtain a sample of orders in the order database, record details of the order and trace to the paper delivery note filed in the goods inwards department. To confirm that all goods ordered were received. For the sample of orders above, agree to the inventory database. To confirm that goods received were completely and accurately recorded in the inventory database. Obtain a sample of paper delivery notes and agree to the order database and inventory database. To confirm that inventory received has been recorded in Zeedin’s accounting system and that liabilities are therefore not understated. For a sample of orders in the orders database, agree details to the payables ledger database, confirming details against the purchase invoice. To confirm complete and accurate recording of the inventory liability in the payables database. For a sample of orders in the orders database, agree details to the payables ledger database, confirming details against the purchase invoice. To confirm complete and accurate recording of the inventory liability in the payables database. © Emile Woolf International 163 Note: To ensure goods received have been recorded as a payables liability the sample selected from the order database should be only those orders that have been received. The invoice number in the order database is then noted and traced to the payables ledger in the purchase database. Note: To ensure goods received have been recorded as a payables liability the sample selected from the order database should be only those orders that have been received. The Institute of Chartered Accountants of Pakistan Audit and Assurance (b) (c) Procedure Reason for procedure The invoice number in the order database is then noted and traced to the payables ledger in the purchase database. Within the purchase database, obtain a sample of invoices recorded in the purchase day book, agree details of price and supplier to the purchase invoice record in the database. To confirm that purchase invoice details have been correctly recorded in the payables database. For a sample of purchase invoices in the purchase day book, agree details to the delivery notes for items on that invoice. To confirm that the purchase liability has been recorded only for goods actually received. For the sample of purchase invoices above, agree details to the individual payables account in the payables database. To confirm that the liability has been recorded in the correct payables account. For a sample of supplier invoices, cast and cross cast invoice price and quantities confirming price to the original order. To confirm the arithmetical accuracy of invoices and ensure the company was charged the correct price for goods received. Select increases in the purchase daybook and vouch to the order database. To ensure that invoiced goods have been ordered, confirming the occurrence assertion. Using computer-assisted audit techniques, cast the purchase day book and agree total of liability incurred to the general ledger. To confirm the completeness and accuracy of the liability recorded in the general ledger. Audit procedures prior to inventory count attendance Review prior year working papers Contact client to obtain stocktaking instructions Book audit staff to attend the inventory counts Obtain copy of inventory count instructions from client Ascertain whether any inventory is held by third parties Obtain last year’s inventory count memo Prepare audit programme for the count. (i) Aims The aim of a test of control is to check that an audit client’s internal control systems are operating 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) Regarding the inventory count Test of control Observe the count teams ensuring that they are counting in accordance with the client’s inventory count instructions. Substantive procedure Record the condition of items of inventory to ensure that the valuation of those items is correct on the final inventory summaries. © Emile Woolf International 164 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (d) 109 Weaknesses in counting inventory Weakness Reason for weakness How to overcome weakness: Inventory sheets stated the quantity of items expected to be found in the store Count teams will focus on finding that number of items making undercounting of inventory more likely – teams stop counting when ‘correct’ number of items found. Count sheets should not state the quantity of items so as not to prejudge how many units will be found. Count staff were all drawn from the stores Count staff are also responsible for the inventory. There could be a temptation to hide errors or missing inventory that they have removed from the store illegally. Count teams should include staff who are not responsible for inventory to provide independence in the count. Count teams allowed to decide which areas to count There is a danger that teams will either omit inventory from the count or even count inventory twice due to lack of precise instructions on where to count. Each team should be given a precise area of the store to count. Count sheets were not signed by the staff carrying out the count Lack of signature makes it difficult to raise queries regarding items counted because the actual staff carrying out the count are not known. All count sheets should be signed to confirm who actually carried out the count of individual items. Inventory not marked to indicate it has been counted As above, there is a danger that inventory will be either omitted or included twice in the count. Inventory should be marked in some way to show that it has been counted to avoid this error. Recording information on the count sheets in pencil Recording in pencil means that the count sheets could be amended after the count has taken place, not just during the count. The inventory balances will then be incorrectly recorded. Count sheets should be completed in ink. Count sheets for inventory not on the pre-numbered count sheets were only numbered when used It is possible that the additional inventory sheets could be lost as there is no overall control of the sheets actually being used. Sheets may not be numbered by the teams, again giving rise to the possibility of loss. All inventory sheets, including those for ‘extra’ inventory, should be prenumbered. Sahito Co (a) Prior year internal control questionnaires Obtain the audit file from last year’s audit. Ensure that the documentation on the sales system is complete. Review the audit file for indications of weaknesses in the sales system and note these for investigation this year. Obtain system documentation from the client. Review this to identify any changes made in the last 12 months. Interview client staff to ascertain whether systems have changed this year and to ensure that the internal control questionnaires produced last year are correct. Perform walk-through checks. Trace a few transactions through the sales system to ensure that the internal control questionnaires on the audit file are accurate and can be relied upon to produce the audit programmes for this year. During walk-through checks, ensure that the controls documented in the system notes are actually working, for example, verifying that documents are signed as indicated in the notes. © Emile Woolf International 165 The Institute of Chartered Accountants of Pakistan Audit and Assurance (b) (c) (d) Tests of control Test of control Reason for test Review a sample of goods despatch notes (GDN) for signatures of the goods despatch staff and customer. Ensures that the goods despatched are correctly recorded on the GDNs. Review a sample of GDNs for signature of the accounts staff. Ensures that the GDN details have been entered onto the computer system. Observe despatch system ensuring Sahito staff have seen the customers’ identification card prior to goods being loaded into customers’ vans. Ensures that goods are only despatched to authorised customers. Review the error report on numeric sequence of GDNs produced in the accounts department and enquire action taken regarding omissions. Ensures that the sequence of GDNs is complete. Observe despatch process to ensure that the customers’ credit limit is reviewed prior to goods being despatched. Ensures that goods are not despatched to poor/bad credit risks. Note: reviewing credit limits is not specifically stated in the scenario; however, most despatch/ sales systems will have this control and most candidates mentioned this in their answers. Hence marks were awarded for this point. Review a selection of invoices ensuring they have been signed by accounts staff. Ensures the accurate transfer of goods despatched information from the GDN to the invoice. Assertions – receivables Assertion Application to direct confirmation of receivables Existence The receivable actually exists which is confirmed by the receivable replying to the receivables confirmation. Rights and obligations The receivable belongs to Sahito Co. The receivable confirms that the amount is owed to Sahito again by replying to the confirmation. Valuation and allocation Receivables are included in the financial statements at the correct amount – the receivable will dispute any amounts that do not relate to that account. Cut-off Transactions and events have been recorded in the correct accounting period. The circularisation will identify reconciling items such as sales invoices/cash in transit. (i) Receivables circularisation – procedures – Obtain a list of receivables balances, cast this and agree it to the receivables control account total at the end of the year. Ageing of receivables may also be verified at this time. – Determine an appropriate sampling method (cumulative monetary amount, valueweighted selection, random, etc.) using materiality for the receivable balance to determine the sampling interval or number of receivables to include in the sample. – Select the balances to be tested, with specific reference to the categories of receivable noted below. – Extract details of each receivable selected from the ledger and prepare circularisation letters. – Ask the chief accountant at Sahito Co (or other responsible official) to sign the letters. – The auditor posts or faxes the letters to the individual receivables. © Emile Woolf International 166 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (ii) Specific receivables for selection: Large or material items. These will be selected partly to ensure that no material error has occurred and partly to increase the overall value of items tested. Negative balances. There are 15 negative balances on Sahito’s list of receivables. Some of these will be tested to ensure the credit balance is correct and to ensure that payments have not been posted to the wrong ledger account. Receivables in the range Rs 0 to Rs 20,000. This group is unusual because it has a relatively higher proportion of older debts. Additional testing may be necessary to ensure that the receivables exist and to confirm that Sahito is not overstating sales income by including many smaller receivables balances in the ledger. Receivables with balances more than two months old. Receivables with old balances may indicate a provision is required for non-payment. The lack of analysis in Sahito Co.’s receivable information indicates a high risk of non-payment as the age of many debts is unknown. Random sample of remaining balances to provide an overall view of the accuracy of the receivables balance. 110 Bashir Co (a) Control Objectives – wages system Employees are only paid for work that they have done Gross pay has been calculated correctly Gross pay has been authorised Net pay has been calculated correctly Gross and net pay have been recorded accurately in the general ledger Only genuine employees are paid Correct amounts are paid to taxation authorities. (b) The Directors Bashir Co 1701 Any Street Big Town 12345 Pakistan 3 December 20X3 Dear Sirs Management letter We write to bring to your attention weaknesses in your company’s internal control systems and provide recommendations to alleviate those weaknesses. (i) Weakness: (ii) Possible effect: (iii) Recommendation: The logging in process for employees is not monitored. Employees could bring cards for absent employees to the assembly plant and scan that card for the employee; absent employees would effectively be paid for work not done. The shift manager should reconcile the number of workers physically present on the production line with the computerised record of the number of employees logged in for work each shift. Overtime is not Employees may get paid for All overtime should be authorised, © Emile Woolf International 167 The Institute of Chartered Accountants of Pakistan Audit and Assurance (i) Weakness: (ii) Possible effect: (iii) Recommendation: authorised by a responsible official. work not done e.g. they may clock-off late in order to receive ‘overtime’ payments. either by the shift manager authorising an estimated amount of overtime prior to the shift commencing or by the manager confirming the recorded hours in the payroll department computer system after the shift has been completed. The code word authorising the accuracy of time worked to the wages system is the name of the cat of the department head. The code word is not secure and could be easily guessed by an employee outside the department (names of pets are commonly used passwords). The code word should be based on a random sequence of letters and numbers and changed on a regular basis. The total amount of net wages transferred to employees is not agreed to the total of the list of wages produced by the payroll department. ‘Dummy’ employees – payments that do not relate to any real employee – could be added to the payroll payments list in the accounts department. Prior to net wages being sent to the bank for payment, the financial accountant should agree the total of the payments list to the total of wages from the payroll department. Details of employees leaving the company are sent on an e-mail from the personnel department to payroll. There is no check to ensure that all e-mails sent are actually received in the payroll department. There needs to be a control to ensure all e-mails are received in personnel – pre-numbering of e-mails or tagging the e-mail to ensure a receipt is sent back to the personnel department will help meet this objective. In the accounts department, the accounts clerk authorises payment of net wages to employees. It is inappropriate that a The payroll should be authorised by a junior member of staff should senior manager or finance director. sign the payroll; the clerk may not be able to identify errors in the payroll or could even have included ‘dummy employees’ and is now authorising payments to those ‘people’. If you require any further information on the above, please do not hesitate to contact us. Yours faithfully Global Audit Co. (c) Substantive analytical procedures Substantive analytical procedure Compare total salaries cost this year to total salaries cost last year. Ascertain how many shift managers are employed by Bashir and the total salary from the personnel department. Calculate total salary and compare to the salary disclosed in the financial statements. Obtain a listing of total salary payments made each month. © Emile Woolf International 168 Expectation Assuming that the number of shift managers has remained unchanged, the total salary expenditure should have increased by inflation only. Total salary should be approximately number of managers multiplied by average salary. The total payments should be roughly the same apart from July onwards when salaries increased and November when the annual bonus was paid. The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (d) Audit procedure Benefit to auditor in testing accuracy of time recording system Confirmation Confirmation is the process of obtaining a representation of information or of an existing condition directly from a third party. Obtaining information from a third party will be difficult. The manufacturer of the time recording system could be approached to discuss known errors with the system; however, information provided may be limited by the need to protect the manufacturer’s integrity. It is therefore unlikely that the auditor will benefit from this procedure. Observation This procedure involves watching a procedure being performed by others – in this case watching shift-workers using the time recording system. Testing will be limited to ensuring all shift-workers actually clock in and out when they arrive to and depart from work. The procedure has limited use as it only confirms it worked when shift-workers were observed. It also cannot confirm that hours have been recorded accurately. Inquiry Inquiry involves obtaining information from client staff or external sources. Inquiry only confirms that shift-workers confirm they clock-in or out. It does not directly confirm the action actually happened or the accuracy of the recording of hours worked. Recalculation Recalculation means re-checking the arithmetical accuracy of the client’s records; in this case the hours worked by the time-recording system. Recalculation can confirm the hours worked are correctly calculated as the difference between the clocking in and out times in the time recording system. When used with reperformance evidence this will confirm the overall accuracy of the time recording system. Reperformance This is the auditor’s independent execution of procedures or controls that were originally performed as part of the entity’s internal control. If the auditor notes the time of clocking in and out, then these times can be agreed to the time recording system confirming the accuracy of recording (or confirm that client staff actually perform this control). Re-performance is therefore a good source of audit evidence. Analytical procedures Analytical procedures involve comparing financial or non-financial data for plausible relationships. © Emile Woolf International 169 This procedure will be useful for the auditor as the total time recorded for each employee should be standard hours plus any estimate of the overtime worked. The Institute of Chartered Accountants of Pakistan Audit and Assurance 111 Multiple Situations (a) (b) (c) (d) (e) (f) The term ‘expectation gap’ refers to the fact that the public perception of the role and responsibilities of the external auditor is different from his statutory role and responsibilities. The expectations of the public are often set at a level higher than that at which the external auditor actually operates. Some examples of the misunderstandings inherent in the public’s expectations are as follows: The public believes that the audit opinion in the audit report amounts to a ‘certificate’ that the financial statements are correct and can be relied upon for all decision-making purposes. The public also believes that the auditor has a duty to prevent and detect fraud and that this is one reason for an audit. The public assumes that, in carrying out his audit work, the auditor tests 100% of the transactions undertaken during the accounting period. In evaluating the control environment, the auditor should consider such factors as: management participation in the control process, including participation by the board of directors management’s commitment to a control culture the existence of an appropriate organisation structure with clear divisions of authority and responsibility; an organisation culture that expects ethically-acceptable behaviour from its managers and employees; and appropriate human resources policies, covering recruitment, training, development and motivation, which reflect a commitment to quality and competence in the organisation. If the auditor discovers significant related party transactions outside the entity’s normal course of business he must: Inspect the underlying contracts or agreements to evaluate whether: – the contracts etc. were entered into in order to engage in fraudulent financial reporting or to hide the misappropriation of assets (a lack of business rationale might indicate this) – the terms of the contracts etc. are consistent with management’s explanations, and – the transactions have been properly accounted for and disclosed. Obtain evidence that the transactions were properly authorised. The key features of review engagement that distinguish it from statutory audit are as follows: Review engagement requires less evidence than an audit Opinion in the review engagement is expressed in negative terms Two types of review engagements: Attestation engagement Direct reporting engagement Following factors are considered in determining the independence of internal auditors: To whom does the internal auditor reports to Who decides the scope of internal audit work Frequency of rotation of internal audit staff Appointing authority of chief internal auditor Conflict of interest i.e. they should not be responsible for designing internal controls Audit procedures for verification of share premium account: Obtain an analysis of movements in share premium account during the period. Check the accuracy of these movements by checking supporting documentation. Ensure that any specific legal requirements relating to share premium have been complied with. (For example, check that the entity has not breached legal restrictions on use of the share premium account.) Check authorization in respect of all movements during the year. © Emile Woolf International 170 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (g) (h) Reasonable Assurance: A high (but not absolute) level of assurance provided by the practitioner’s conclusion expressed in a positive form. The reasonable assurance is usually expressed in case of statutory audits. Limited Assurance A moderate level of assurance provided by the practitioner’s conclusion expressed in a negative form. The negative form of assurance is usually expressed in case of review engagements. A negative confirmation can be used, where any of the following condition is met: The risk of material misstatement has been assessed as low and controls have been tested. The population is comprised of large number of small account balances. A very low exception rate is expected. The auditor is not aware of the circumstances which would cause the respondent to ignore the request for confirmation. COMPLETION 112 Final Audit File (a) (b) The auditor is required to assemble the final audit file(s) on a timely basis after the date of the auditor’s report. This usually excludes drafts of working papers or financial statements, or notes that reflect incomplete or preliminary thinking. After the assembly of the final audit file has been completed, the auditor must not delete or discard audit documentation before the end of its retention period. In such case the auditor is required to document: the circumstances; the new or additional procedures performed, audit evidence obtained, conclusions reached and their effect on the auditor’s report; and when and by whom the resulting changes to audit documentation were made and who reviewed them. 113 Energy Limited (a) (b) In order to ensure the completeness of list of related parties provided by the client, your audit procedures could include the following: Review working papers for previous years, to look for names of known related parties. Review the company’s procedures for identifying related parties. Inquire about the relationships between directors and other entities i.e. whether any director is a director, CEO, major shareholder etc. in another company. Review shareholder records for the names of major shareholders. Review minutes of BOD meetings and general meetings of the company. Get confirmation from any other audit firms involved in the audit about related parties. (e.g. in case of audit of a group of companies, more than one firm of auditors are involved) According to the International Standard on Auditing (ISAs) the auditor is required to obtain written representations from management and, where appropriate, those charged with governance that: they have disclosed to the auditor the identity of the entity's related parties and all the related party relationships and transactions of which they are aware; and they have appropriately accounted for and disclosed such relationships and transactions in accordance with the requirements of the framework.. In view of the above, the auditor should not accept the argument given by the management. If management does not provide one or more of the requested written representations, the auditor shall: © Emile Woolf International 171 The Institute of Chartered Accountants of Pakistan Audit and Assurance discuss the matter with management/ those charged with governance; re-evaluate the integrity of management and evaluate the effect that this may have on the reliability of representations (oral or written) and audit evidence in general; and take appropriate actions, including determining the possible effect on the opinion in the auditor's report 114 XYZ & Company In this case, the representation provided by the management contradicts with the audit evidence obtained later and therefore we should: consider whether his risk assessment of that area is still appropriate consider whether additional audit procedures are needed assess the impact on auditors assessment of management’s integrity, document those concerns and consider withdrawing from the audit. The written representation from the management must cover: (b) the completeness of the information that has been provided about the identity of related parties and related party relationships and transactions, and the adequacy of accounting for and disclosure of such related party relationships and transactions in the financial statements. The audit report should not be signed unless the written representation has been received. If management does not provide the written representation, it will result in limitation of scope and we would take appropriate actions, including determining the possible effect on the opinion in the auditor’s report. (a) 115 XYZ Limited (i) (ii) (iii) (iv) After the assembly of the final audit file has been completed, the auditor must not delete or discard audit documentation before the end of its retention period. However the changes to document can be made if: the changes are deemed necessary. there are exceptional circumstances in which the auditor has to perform new or additional procedures or reaches new conclusions. If it appears that it was necessary to modify existing or add new documentation after this stage, the auditor is required to document: when and by whom the modifications were made. the reasons for making them. If exceptional circumstances arise after the date of the audit report; the auditor is required to document: the circumstances the new or additional procedures performed, audit evidence obtained, conclusions reached and their effect on the auditor’s report, and when and by whom the resulting changes to audit documentation were made and who reviewed them. 116 Noncurrent assets Test of details for verification of valuation assertion of tangible non-current assets: Check the cost in the financial statements against the purchase invoices/contracts for the assets. Check that the purchase expenditure is analysed reasonably between land, buildings and equipment. Review the allocation of total expenditure on non-current assets between capital and revenue amounts. © Emile Woolf International 172 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Verify amounts in the financial statements with the valuer’s report. Obtain an understanding of the work of the expert through considering the reasonableness of valuations/assumptions used in valuations. Evaluating the competence, capabilities and objectivity of the expert. Check that valuations are regularly updated. Check that all the assets of the similar class are revalued. 117 Customized Machinery Limited (CML) The imposition of restriction by foreign country is an adjusting event as the inventory prepared for the order cannot be supplied to any other customer, without considerable expense of Rs. 105 million. The revised net realizable value of the inventory would therefore be approximately Rs. 395 million (500105), as against the cost of Rs. 416.67 million (500÷1.2), resulting in an adjustment of Rs. 21.67 million which is approximately 6.19% of the profit before tax. As an auditor we have no obligation to perform any audit procedures after the date of the audit report. However, in view of the fact that the above situation has come to our knowledge, we are required to discuss the matter with management and inquire how it intends to address the matter in the financial statements. If the financial statements are amended, the auditor is required to: carry out the necessary audit procedures on the amendment extend his review of subsequent events up to the date of the new audit report. If management do not amend the financial statements for the event identified, then the auditor should take appropriate action to prevent reliance on the audit report after taking legal advice. 118 Nadeem Limited (a) The argument that the written representation is not necessary because the provision is incorporated on the basis of expert’s advice is not correct. The recognition of provision on basis of expert’s advice will not preclude management from assuming responsibility for the warranty provision. If the management do not provide the written representation, the auditor will require to reevaluate the effect which may have on reliability of representations and audit evidence in general. The auditor may qualify or disclaim the opinion on the financial statements depending on the materiality and pervasiveness of the matter. (b) The argument of management relating to additional disclosures is not valid, as this disclosure will make the financial statements misleading, as IAS allows disclosure of only those contingent assets which are probable. If the amount is material and the management refuses to remove the disclosures from the financial statements, then the auditor may qualify the audit report. (c) It is not a change in Accounting policy. However, if the revenue for the customers to whom the goods are to be delivered to their premises, is material to the financial statements, the auditor will ask the management to revise the accounting policy for revenue recognition to cover all types of sales contracts. If the management refuses to revise the policy accordingly and record the sales based on such policy then the audit report will be qualified. © Emile Woolf International 173 The Institute of Chartered Accountants of Pakistan Audit and Assurance 119 System logs (a) Symmetric key ciphers: These use related (often identical) keys to both encrypt and decrypt information. This is sometimes called ‘shared secret’ between two or more parties. Asymmetric key ciphers: These use different keys to encrypt and decrypt information (one to lock, the other to unlock). This is sometimes called ‘public/private’ key. (b) Information that can be extracted from system logs include: (i) Which user logged-in, when and where from (ii) Failed log-in attempts (iii) Who accessed and amended data in a file (iv) Changes made to a program – what, when and by whom 120 Overtime payments (a) Following are the possible weaknesses that may exist in overtime payments: There may be weaknesses in the system for recording time spent at work. When employees are paid on the basis of time, there will be a system of ‘time-in’ and ‘timeout’, typically using employee identity cards and a time recording device. The risk is that employees will ‘clock on’ on behalf of a colleague, using the identity card that the colleague has given him. Overtime payments may not be properly authorized which includes situation where a person works overtime without proper authorisation. Incorrect rates of overtime may be used. (b) Principal controls over payment of overtime: List of overtime payment (time or the amount) should be signed by person duly authorised in this regard by the organisation. A overtime rates should be checked by a person authorised in this regard by the organisation. The process of recording time should be monitored either by an authorized supervisor or by the use of bio-metric machine. It should be ensured that the amount of overtime is correctly incorporated in the salary sheets and deductions therefore if any have been appropriately made. 121 Khanewal Limited In order to establish whether the preconditions for an audit are present, I will: (i) determine whether the financial reporting framework to be applied in the preparation of financial statements is acceptable; (ii) obtain the agreement of management that it acknowledges and understands its responsibility: for the preparation of the financial statements in accordance with the applicable financial reporting framework. for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. to provide us with all relevant and requested information and unrestricted access to all personnel. © Emile Woolf International 174 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 122 ABD Limited (a) Procedures to be followed and formalities to be complied with for removal of existing auditors and appointment of new auditors: ABDL shall give a notice at least 07 days before the annual general meeting to the company, for a resolution for appointment of your firm as an auditor at a Company’s annual general meeting. HGM shall forthwith send a copy of such notice to the retiring auditor and shall also post it on the website. HGM shall, within fourteen days from the date of appointment of our firm, send to the registrar intimation thereof, together with our consent in writing. Rights of the existing auditors: The retiring auditor shall have the right to make a representation in writing to the company at least two days before the date of general meeting. Such representation shall be read out at the meeting before taking up the agenda for the appointment of the auditor. Where such representation is made, it shall be mandatory for the auditor or a person authorized by him in writing to attend the general meeting in person. (b) Responsibilities of our firm and of the existing auditors: Our firm will communicate with the existing auditors to establish if there are any matters that it should be aware of when deciding whether or not to accept the appointment. The following points should be noted in connection such communication: HGM permission is required for any such communication. If HGM refuses to give its permission, the appointment as auditor should not be accepted. If HGM does not give the existing auditor the permission to reply to any relevant questions of our firm, the appointment as auditor should not be accepted. If existing auditor provides the required information, our firm should assess all the available information and take a decision about whether or not to accept the audit engagement. If the existing auditor does not provide any information relevant to the appointment, we may accept or reject the engagement based on other available knowledge. Even if the existing auditor provides professional reasons to suggest that we should not accept the audit, the final decision in this regard shall be based on our professional judgment. 123 Cell Phones (Private) Limited (a) Fraud Risk Factors: Rapid Changes in Technology: Products like mobile phones are likely to become obsolete very quickly, as more advanced products come on to the market. The company faces a threat due to rapid changes in technology; therefore the management may be inclined to manipulate the accounting records. Lack of Segregation of Duties/ Dominance of management by a single person: As Anwar is the Chief Executive and is also responsible for finance and operations of the company, this gives him a personal motivation to misstate figures to show improved performance. Long Term Loan: As the company has applied for long term loan, it may be inclined to manipulate the figure to show better financial position to the bank. © Emile Woolf International 175 The Institute of Chartered Accountants of Pakistan Audit and Assurance Demand for early completion of audit: The demand by Anwar for early completion of audit creates undue suspicion because such pressures are sometime applied to distract the auditor from his responsibilities. (b) Whether it would be advisable to use the internal audit working papers in the above situation and give three distinct reasons to support your decision: It is not advisable to use the work of internal audit for external audit purposes due to following reasons: Status of the internal audit function within the entity Administratively all the internal audit staff are under the influence of Anwar and hence their independence is impaired. Conflicting responsibilities: The internal audit staff’s responsibilities for preparing bank reconciliation statement is in conflict with its responsibility as a member of the internal audit function. Qualifications of internal audit staff: All the internal audit personnel are graduates and do not have required competence about various aspects of the internal audit function 124 Substantive Procedures The audit approach to gathering evidence on contingencies and commitments is as follows: (i) Accrued expenses: Obtain or prepare a listing of accrued expenses as at the end of the reporting period. Check the calculations and additions for arithmetical accuracy. Check the amounts in the listing against the balances in the relevant main ledger expense accounts and ensure that the amounts are the same. Verify the invoices received or payments made after the year end and ensure that the amount accrued appears reasonable in relation to this evidence. Compare the list of accrued expenses with the list that was prepared at the same date in the previous financial year, and enquire about items not listed in the current year that were in the list in the previous year. Review the list of accruals for completeness, based on the auditor’s knowledge of the business. Relate items on the list of accruals to other audit areas, such as the bank confirmation letter (which might provide details of unpaid/accrued bank charges). Perform analytical procedures on accrued expenses. For example, the auditor might measure the ratio of accrued payroll expenses to total payroll costs for the year, and compare this with the similar ratio in previous years. Significant differences should be investigated. (ii) Contingencies: Ascertain the approach taken by the client’s management for identifying contingencies. Review the minutes of board meetings (where such matters are likely to be discussed). Review relevant material related to the industry as a whole such as financial statements of major companies in the industry to identify possible industrywide contingencies. Review the client’s correspondence with lawyers. Review the invoices for legal services to identify undisclosed contingencies and additional information about contingencies © Emile Woolf International 176 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Consider direct confirmation from the company’s lawyers and legal advisors. Consider whether expert advice may be required from outside sources other than lawyers. Ensure that provisions has been made in case the relevant condition as specified in IFRS are met. 125 Pioneer Textile Limited (PTL) The management representation regarding disclosure of non compliance with law does not remain appropriate, as it contradicts with the audit evidence obtained. To address the contradiction, we should: consider whether his risk assessment of that area is still appropriate. consider whether additional audit procedures are needed. consider the integrity of management, document those concerns and consider the possible course of action. 126 Multiple Questions (a) Integrity: Members should be straightforward and honest in all professional and business relationships. Integrity implies not just honesty but also fair dealing and truthfulness. A chartered accountant should not be associated with reports, returns, communications or other information which according to him is materially false or misleading. (b) Advocacy threat: Advocacy threat occurs when members promote a position or opinion on behalf of a client to the point that subsequent objectivity may be compromised. Example: Acting as an advocate for an assurance client in litigation or dispute with third parties. (c) Actual Independence: Actual independence means that the auditor should not be influenced by anything which results in compromising his professional judgement while expressing an opinion. Perceived independence: The auditor must be seen to be independent, i.e. the auditor should avoid facts and circumstances due to which a third party may conclude that his integrity, objectivity or professional skepticism had been compromised. (d) The following are circumstances where chartered accountants are or may be required to disclose confidential information: Disclosure is permitted by law and is authorized by the client. Disclosure is required by law. There is a professional duty or right to disclose, when not prohibited by law: (e) Systematic sampling: It is a method of sampling whereby a random starting point is chosen from the population and then items are selected with a standard gap between them (for example, every 10th item). (f) Conditions required to be met for sending external confirmations: It may be appropriate to send negative confirmation request if all of the following conditions are met: The risk of material misstatement is low and controls have been tested. © Emile Woolf International 177 The Institute of Chartered Accountants of Pakistan Audit and Assurance The population comprises of large number of small account balances or transactions. A very low exception rate is expected. There is no specific reason which would cause the respondent to ignore the confirmation request. (g) Procedures of review engagement: The procedures for the review of financial statements will usually include: Inquiry analytical procedures Agree and reconcile Interim Financial Information with the accounting records. (h) Auditor’s responsibility with respect to events between the end of the reporting period and the date of the auditor’s report: The auditor is required to obtain sufficient appropriate evidence that all subsequent events that require adjustment or disclosure in the financial statements: have been identified, and are suitably reported in the financial statements. (i) Audit procedures to ensure completeness of related parties The procedures to ensure completeness of related parties will generally include: review of prior year working papers review of company’s procedures for identification of related parties review shareholder’s records (j) The auditor should consider the source of audit evidence, effectiveness of related controls, form of audit evidence etc. 127 Analytical procedures (a) (i) Analytical procedures include the consideration of comparisons of the entity’s financial information with, for example: Comparable information for prior periods. Anticipated results of the entity. Similar industry information, such as a comparison of the entity’s ratio of sales to accounts receivable with industry averages or with other entities of comparable size in the same industry. Analytical procedures also include consideration of relationships: Among elements of financial information that would be expected to conform to a predictable pattern based on the entity’s experience, such as gross margin percentages. Between financial information and relevant non-financial information, such as payroll costs to number of employees. Analytical procedures are used for the following purposes: As risk assessment procedures to obtain an understanding of the entity and its environment. As substantive procedures when their use can be more effective or efficient than tests of details. © Emile Woolf International 178 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers As an overall review of the financial statements at the end of the audit. (ii) When designing and performing analytical procedures as substantive procedures, the auditor will need to consider a number of factors such as: The suitability of using substantive analytical procedures given the assertions. These procedures are generally more applicable to large volumes of transaction that tend to be predictable over time. The reliability of the data, whether internal or external, from which the expectation of recorded amounts or ratios is developed. Whether the expectation is sufficiently precise to identify a material misstatement at the desired level of assurance. The acceptable amount of difference between the recorded amounts and the expected values. (iii) The auditor should apply analytical procedures at or near the end of the audit in order to form an overall conclusion as to whether the financial statements as a whole are consistent with the auditor’s understanding of the entity. Corroborate the conclusions drawn through other procedures. To identify unusual or unexpected balances (if any) in order to identify a previously unrecognized risk of material misstatement. In such circumstances, the auditor may need to re-evaluate the planned audit procedures. (b) Basic Elements of a Written Representation Letter: Address: It should be addressed to the auditor. Date: Ordinarily the date should be the same as the date of auditors’ report. Signature: It should ordinarily by signed by the members of management who have primary responsibility for the entity i.e. CEO and CFO. Contents: It should contain information as may be specified by the auditor. 128 Auditor responsibility (a) The statement of responsibility should state the following: (i) It is the responsibility of the auditor to express an opinion on the financial statements. (ii) The audit was conducted in accordance with International Standards on Auditing. (iii) Those standards require that : the auditor complies with ethical requirements. the auditor plans and performs the audit to obtain reasonable assurance whether the financial statements are free from material misstatement. (iv) That an audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. (v) As part of an audit in accordance with ISAs, we exercise professional judgment and maintain professional skepticism throughout the audit (vi) That while selecting the procedures to be performed the auditor exercises judgment, including the assessment of risks of material misstatements and whether due to fraud or error. (vii) In making the risk assessment the auditor considers internal controls relevant to fair presentation of financial statements in order to design audit procedures that are appropriate in the circumstances but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. © Emile Woolf International 179 The Institute of Chartered Accountants of Pakistan Audit and Assurance (viii) That an audit includes evaluation of the appropriateness of the accounting policies used, the reasonableness of estimates and the overall presentation of information in the financial statements. (ix) That auditor has concluded on the appropriateness of management’s use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the Company’s ability to continue as a going concern. That an audit involves evaluating the overall presentation, structure and content of the financial statements, including the disclosures That auditor communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit and significant audit findings, including any significant deficiencies in internal control that auditor identify during the audit. That auditor also provide those charged with governance with a statement that auditor have complied with relevant ethical requirements regarding independence, and to communicate with them all relationships and other matters that may reasonably be thought to bear on auditor’s independence, and where applicable, related safeguards. 129 Al-Badr (i) Audit report should be addressed to the members of the company instead of directors. (ii) In the introductory paragraph and opinion paragraph, the word “cash flow statement” has been omitted. (iii) In the opinion paragraph, the words “its cash flows” have been omitted. (iv) The paragraph explaining the responsibilities of management and auditors has been omitted. This paragraph should come after the introductory paragraph. (v) After the statement “We conducted our audit in accordance with the auditing standards” in the audit responsibility paragraph, the words “as applicable in Pakistan” have been omitted. (vi) In the auditor’s responsibility paragraph, the words “on test basis” have been omitted. (vii) In the auditor’s responsibility paragraph, the word “all estimates....” should be replaced with the words “significant estimates”. (viii) The opinion paragraph whether proper books of account have been kept by the company as required under the Companies Ordinance, 1984 has been omitted. (ix) In paragraph (b) of the opinion, the financial statements have incorrectly been referred to have been drawn up in accordance with International Financial Reporting Standards instead of the requirement i.e. approved accounting standards as applicable in Pakistan. (x) Name of the engagement partner has not been mentioned. 130 Shahrukh and Company (i) In the introductory paragraph the word “Income and expenditure account” should be replaced with “profit and loss account". (ii) In the introductory paragraph the phrase “to the best of our knowledge and belief” is to be inserted before the phrase “were necessary for the purpose of an audit”. (iii) In the responsibility paragraph the word “auditing standard” is to be replaced with “accounting standard”. (iv) In the responsibility paragraph the phrase “of the fourth schedule” is to be omitted. (v) At the end of responsibility paragraph the phrase; “Our responsibility is to audit these statements” is to be replaced with the phrase “Our responsibility is to express an opinion on these statements based on our audit”. © Emile Woolf International 180 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers (vi) In the scope paragraph the phrase “and limited” is incorrect and be omitted. (vii) In the scope paragraph the word “material” be added before the word misstatement. (viii) In the scope paragraph the phrase “on a test basis” should be added before the phrase “evidence supporting the amounts and disclosures in the above said statements”. (ix) In point (a) the phrase “as required by the Companies Ordinance, 1984” be added. (x) In para (b) point (ii) the phrase “was in accordance with the objects of the Company” be replaced with “was for the purpose of the Company’s business” (xi) In para (b) point (iii) the phrase “was for the purpose of the Company’s business” be replaced with “were in accordance with the objects of the Company” (xii) In para (c) the phrase “of the profit or loss, its cash flows and changes in equity for the year then ended”; be added at the end. (xiii) The place of signing of accounts is to be mentioned after the signature of the firm (xiv) Name of the engagement partner has not been mentioned. 131 The engagement partner (a) The audit report will be modified on ground of limitation of scope. Either a qualified or disclaimer of opinion will be given depending upon the materiality and pervasiveness of the matter. We may have to mention that “proper books of accounts as required by the Companies Act, 2017 have not been kept by the Company”. (b) There will be no impact on the audit report as the change of depreciation method is a change in accounting estimate. (c) The auditor will include an other matter paragraph in the auditor’s report, referring to the fact that the financial statements of Samarkand Limited for the Previous year, were audited by another auditor, who expressed an un-modified opinion on those financial statements. 132 Different audit clients (a) (b) Two significant uncertainties exist for ZTL i.e. recoverability of balance due from SEL and whether the going concern assumption is appropriate in light of the possible termination of the contract by SEL. The Accounts receivable balance is material to the financial statements as it is 12.48% of profit after tax. The possible loss of contract from SEL is material to the financial statements as the revenue from SEL contributes about 25% of total revenue. It appears that the uncertainty relating amount receivable balance and termination of contract will not be resolved till the time of signing off the financial statements and audit report. If uncertainties are adequately disclosed in the financial statements then an unqualified opinion can be given, however an emphasis of matter paragraph is to be included in the auditor’s report to draw user’s attention to the significant uncertainties. In case appropriate disclosure is not given a qualified opinion or adverse opinion as appropriate. If there are material inconsistencies in the other information presented with the financial statements the auditor should discuss the reasons thereof with the management and ask them to revise the other information. In case of disagreement, the auditor shall communicate the matter to those charged with governance. © Emile Woolf International 181 The Institute of Chartered Accountants of Pakistan Audit and Assurance (c) Include in the auditor’s report an ‘other matter paragraph’ describing the material inconsistencies. A provision of Rs. 30 million has been made in the financial statements and it represents 37.5% of the profit after tax and is material to the financial statements. A constructive obligation to restructure arises only when an entity has a detailed formal plan for the restructuring identifying at least the principal locations affected. In this case it is unlikely that a constructive obligation exists in respect of third factory because the factory which is to be closed is not identified. The auditor shall determine whether provision of Rs. 30 million pertains to two factories which are identified or it pertains to three factories (including one which is not identified). If the provision relates to three factories, auditor will ask the management to adjust the amount of provision to reflect the provision for two factories Moreover, the plan for closure of the third factory should be disclosed. If the management refuses to do so, a qualified or adverse opinion may be issued depending upon the materiality and pervasiveness. 133 Situations have arisen on different clients (a) (b) (c) (i) If there are material inconsistencies in the additional disclosures the auditor should discuss the reasons thereof with the management and ask them to revise the other information or the financial statements, as may be appropriate. (ii) If the revision of other information is necessary and the management refuses to revise the same, the auditor shall communicate the matter to those charged with governance and; (iii) Include in the auditor’s report an ‘other matter paragraph’ describing the material inconsistencies, if they persist. (iv) If the revision of the draft financial statements is necessary and management refuses to make the revision, the auditor shall consider giving a qualified opinion or adverse opinion as may be appropriate. (v) The auditor should also consider that whether the supplementary information that is not required by the applicable financial reporting framework, is clearly differentiated from the audited financial statements. (vi) If it is not clearly differentiated, he shall ask the management to change the way in which the unaudited supplementary information has been presented. (vii) In case of disagreement in respect of the above, the auditor shall explain in the auditor’s report that such supplementary information has not been audited. (i) The amount of Rs. 9.6 million which is due from MIL is material to the financial statements. (ii) With respect to job in progress ,if the auditor can satisfy himself that management would be able to recover the cost of work in process from another customer, he may conclude that a provision is not required in this respect. (iii) In making the above decision the auditor should also consider the expenses that are required to be incurred on the job, subsequent to year end. (iv) The auditor should ask the management to provide for the loss of Rs. 9.6 million or any part thereof depending upon the estimated amount of default, plus any further provision that may be necessary in respect of the work in process. In case of management’s refusal, the auditor shall qualify his report. The auditor shall qualify the audit report by mentioning that investment of Rs. 150 million was not in accordance with the objects of the company with a clarification that the object clause was amended a week before the issuance of audit report, to include the said objective. © Emile Woolf International 182 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers 134 Hafiz Limited (i) In this case of reporting on more than one set of financial statements,the auditor will need to determine that whether the reporting requirements of other framework are acceptable to the auditor in the prevailing circumstances. Impact on Audit Report If the framework is acceptable then the auditor will include an other matter paragraph in the auditor’s report, which will include a reference that he has also issued an audit report on another set financial statements which has been prepared as per the reporting requirements of a different accounting framework. (ii) Evaluate the reasons provided by the management for making this payment, to assess whether the amount paid in the circumstances was reasonable. If the management is unable to provide satisfactory explanation it may be indicative of the following: That the amount paid was not for the purposes of the company’s business. There was a non-compliance with a law as has been unofficially claimed by an employee. In either case, the auditor should consider the impact thereof on his initial risk assessment and to revise the audit procedures accordingly. The indication of non-compliance with laws and regulations may require the auditor to consider the potential financial consequences of the non-compliance, on the financial statements including, the imposition of fines and penalties and the impact thereof on the company’s ability to carry out its business. The auditor may discuss his findings with those charged with governance if the auditor considers that they will be able to provide with additional audit evidence in relation to the transaction. If management or those charged with governance do not provide sufficient appropriate audit information to the auditor, the auditor may consider it appropriate to consult with the entity’s legal counsel or auditor’s own legal counsel if the auditor is not satisfied with the entity’s legal counsel. The auditor may also consider whether it is necessary for him under the relevant laws and regulations to report the matter to the concerned authorities. Impact on Audit Report If the auditor concludes that the non compliance has a material effect on the financial statements which has not been adequately reflected therein, the auditor shall express a qualified opinion or an adverse opinion. If the auditor concludes that the expenditure incurred is not for the purpose of the business, the auditor shall express a qualified opinion or an adverse opinion depending upon the materiality of the transaction. If the auditor is precluded by management or those charged with governance from obtaining sufficient appropriate audit evidence to evaluate whether non-compliance that may be material to the financial statements has, or is likely to have occurred, the auditor shall express a qualified opinion or disclaim an opinion on account of scope limitation. 135 An ‘emphasis of matter’ paragraph and an ‘other matter’ paragraph (a) Emphasis of Matter Paragraph and Other Matter Paragraph: Emphasis of matter paragraph is a paragraph that is included in the auditor’s report that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements. © Emile Woolf International 183 The Institute of Chartered Accountants of Pakistan Audit and Assurance Other Matter paragraph is a paragraph that is included in the auditor’s report that refers to a matter other than those presented or disclosed in the financial statements that, in the auditor’s judgment, is relevant to the users’ understanding of the audit, the auditor’s responsibilities or the auditor’s report. (b) (i) (ii) Examples of circumstances which necessitate the inclusion of emphasis of matter paragraph: An uncertainty relating to the future outcome of exceptional litigation or regulatory action. Early application (where permitted) of a new accounting standard that has a pervasive effect on the financial statements. A major catastrophe that has had, or continues to have, a significant effect on the entity’s financial position. A significant subsequent event that occurs between the date of the financial statements and the date of the auditor’s report Examples of circumstances which necessitate the inclusion of Other matter paragraph: Any matter which in the auditor’s opinion is relevant to user’s understanding of the Audit Any matter which in the auditor’s opinion is relevant to User’s Understanding of the Auditor’s responsibilities or the Auditor’s Report When the auditor is required to report on more than one set of financial statements. When there is restriction on distribution or use of the auditor’s report. 136 MM Electronics (Private) Limited (a) (b) (c) Revaluation of Properties: (i) In accordance with IAS 16, Property, Plant and Equipment, if a policy of revaluation is to be applied, it should be applied to all the non current assets in a particular class of assets. (ii) Since compliance with (i) above is not possible, the auditor should advise the client to not to change the accounting policy and state the values of the property at cost. (iii) In case of disagreement the auditor may consider issuing a qualified report. Suit for damages: (i) The reliability of audit evidence provided by the legal advisor is high because it has been obtained from an independent source outside the entity. As management is also of the view that no liability exists at the balance sheet date, therefore in the presence of legal advisor’s confirmation a conclusion should not be drawn on the basis of manager’s legal email. (ii) However, since there is inconsistency in audit evidence obtained and the auditor is unaware of the context in which the manager (legal) sent the email, he shall investigate the reasons thereof and may need modification or addition to the audit procedures. (iii) The auditor should analyze the situation, in the light of IAS 37, Provisions, Contingent Liabilities and Contingent Assets, and assess whether a disclosure of the event as a contingent liability is required or not. (iv) If disclosure of contingent liability is required, and the client disagrees the audit report may be qualified. Warranty Provision: (i) The management’s claim that the amount cannot be measured reliably is not correct because they were charging the customers at 25% above cost prior to July 01, 2010 i.e. when there was no warranty on the sale of television sets and hence they must be in a position to make a reliable estimate based on their past experience and records available with them. (ii) If a provision is not made for the warranty then if the amount of provision is material to the © Emile Woolf International 184 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers financial statements then the audit report should be qualified (d) Non Disclosure of Earnings per share in the financial statements: International Accounting Standards 33, Earnings per share does not apply to non listed entities; therefore there is no requirement of disclosing earnings per share in the financial statements. 137 Ranjha Limited (a) (i) Significant matter In view of the decline in production capacity, it has become necessary to recalculate the value in use and recoverable amount in order to assess the impairment in the value of plant. The value of plant is material to the financial statements in terms of total assets as well as profit before tax of the company. Impact on audit report If the impairment test indicates a decline in the value of plant, the management should be advised to make appropriate adjustments. In case of disagreement with the management, the auditor should give a qualified opinion. (ii) Significant matter Amount claimed by the customer is material to the financial statements in terms of total assets as well as profit before tax of the company. Impact on audit report (iii) If management agrees to explain the issue in the note on contingent liabilities, the report will not be qualified but in view of the material uncertainty an emphasis of matter paragraph would have to be added to the auditor’s report to draw the user’s attention to the note in the financial statements. In case of disagreement on making appropriate disclosure, the auditor should give a qualified opinion. Significant matter It is a fundamental error within the meaning of IAS-8 and its effect should be taken into account retrospectively. All comparatives figures should be restated accordingly. The management’s decision to adjust the short amortization in the future years is in contravention to the requirements of IAS-8. Impact on audit report Since the error is material in terms of profit after tax, it should be discussed with the management. They should be advised to make appropriate adjustment and disclosure in accordance with the requirements of IAS-8. In case of disagreement, the auditor should give a qualified opinion. 138 Pervasive effects (a) Pervasive is a term used to describe the effects of misstatement on the financial statements or the possible effects thereon if any misstatement remains undetected due to the auditor’s inability to obtain sufficient appropriate audit evidence. Pervasive effects on the financial statements are those that, in the auditor’s judgments: (b) (i) are not confined to specific elements, account or items of the financial statements, (ii) if so confined, represent or could represent a substantial proportion of the financial statements or (iii) in relation to disclosures, are fundamental to user’s understanding of the financial statements. (i) Issuance of bank guarantee after the year end does not require any adjustment or © Emile Woolf International 185 The Institute of Chartered Accountants of Pakistan Audit and Assurance disclosure. Therefore, there will be no effect on the audit report on this issue. (ii) The audit report shall state that “Zakat deductible at source under the Zakat & Ushr Ordinance, 1980, was deducted and deposited in the Central Zakat Fund established under section 7 of that Ordinance”. (iii) The auditor should consider the materiality of the amount. If the amount is material, the auditor should express a qualified or adverse opinion. (iv) The audit report shall mention the exception to the consistent application of accounting policies and whether the auditor concurs with it or not. The financial statements shall be adjusted accordingly and the effect of change in estimate shall be disclosed in the notes to the financial statements unless the differences are material and auditor has reasons to differ with the reviewed estimate. There would be no impact on the audit report on this issue. 139 Audit report at the end of the audit (a) (b) The statement of responsibility should state the following: (i) It is the responsibility of the auditor to express an opinion on the financial statements. (ii) The audit was conducted in accordance with International Standards on Auditing. (iii) Those standards require that : the auditor complies with ethical requirements. the auditor plans and performs the audit to obtain reasonable assurance whether the financial statements are free from material misstatement. (iv) That an audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. (v) That while selecting the procedures to be performed the auditor exercises judgment, including the assessment of risks of material misstatements and whether due to fraud or error. (vi) In making the risk assessment the auditor considers internal controls relevant to fair presentation of financial statements in order to design audit procedures that are appropriate in the circumstances but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. (vii) That an audit includes evaluation of the appropriateness of the accounting policies used, the reasonableness of estimates and the overall presentation of information in the financial statements. (viii) The auditor believes that the audit evidence the auditor has obtained is sufficient and appropriate to provide a basis for the auditor’s opinion. The situations in which a report is modified without affecting the auditor’s opinion are as follows: (i) If there is a significant uncertainty (other than going concern or multiple uncertainties), the resolution of which is dependent upon future events and which may affect the financial statements. (ii) In case, other information attached with the financial statements are inconsistent with the information in the financial statements. How modification is presented: (i) By adding an emphasis of matter paragraph to highlight an important matter affecting the financial statements. (ii) The above paragraph is required to refer to the note to the financial statements that more © Emile Woolf International 186 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers extensively discusses the matter. (iii) The paragraph should preferably be included after the paragraph containing the auditor’s opinion but before the section on any other reporting responsibilities. (iv) The emphasis of matter paragraph should ordinarily refer to the fact that the auditor’s opinion is not qualified in this respect. 140 Iqra Industries Limited Significant uncertainty regarding litigation The ultimate outcome of the matter cannot presently be determined and therefore there is a significant uncertainty the resolution of which is dependent upon future events. Since it is not possible to reliably estimate the amount of loss accounting treatment of not recognizing the provision and giving of disclosure is correct. The auditor should consider modifying the auditor’s report by adding an emphasis of matter paragraph referring to the detailed note in the financial statements. 141 Blue Sky Limited On September 30, 2007, the inventory of a subsidiary was overvalued by Rs. 5.7 million. The overvaluation was adjusted to the extent of Rs. 1.9 million during each of the years ended September 30, 2008 and 2009. Consequently the inventory as appearing in the consolidated financial statements for the year ended September 30, 2009 has been overstated by Rs. 1.9 million. In our opinion, the above adjustment is not in accordance with the International Accounting Standards which requires that the overstatement should be rectified retrospectively. Accordingly, the inventory should be reduced by Rs. 1.9 million in the year 2009 and by Rs. 3.8 million in the year 2008, profit for the year should be increased by Rs. 1.9 million in the year 2009 and by Rs. 0.475 million in 2008, accumulated retained earnings should be increased by Rs. 2.1375 million in the year 2009 and by Rs. 0.4275 million in the year 2008, goodwill should be increased by Rs. 3.8475 million in both the years i.e. 2009 and 2008 and minority interest should be reduced by Rs. 0.19 million in the year 2009 and by Rs. 0.38 million in the year 2008. In our opinion, except for the effect on the consolidated financial statements of the matter referred to in the preceding paragraph, the consolidated financial statements present fairly the financial position of Blue Sky Limited and its subsidiary as at September 30, 2009 and the result of their operation for the year then ended. 142 Form 35A in the Companies The report specified in form 35A in the in the Companies (General Provisions and Forms) Rules, 1985 covers the following additional reporting responsibilities. (i) that proper books of accounts are being maintained by the company as required by the Companies Ordinance, 1984. (ii) that the balance sheet and the profit and loss account together with notes thereonare in conformity with the Companies Ordinance, 1984 and in agreement with the books of accounts and are further in accordance with the accounting policies consistently applied. (iii) Opinion as regards the following: (iv) whether expenditure incurred during the year was for the purposes of the company’s business and whether the business conducted, investments made and expenditure incurred during the year were in accordance with the objects of the company. Opinion as regards the following: whether Zakat deductible at source under the Zakat and Usher Ordinance, 1980; was deducted and whether the zakat deducted (if any) was deposited in the Central Zakat Fund. © Emile Woolf International 187 The Institute of Chartered Accountants of Pakistan Audit and Assurance 143 Written representations Under the following situations, the auditor would have doubt as to the reliability of written representation: (a) When the auditor has concerns about the competence, integrity, ethical values or diligence of management, or about its commitment to or enforcement of these. (b) When written representations are inconsistent with other audit evidence obtained. Course of action in situation (a) (i) The auditor shall determine the effect that such concerns may have on the reliability of representations and audit evidence in general. (ii) If the auditor concludes that the risks related to management representations on the financial statements is such that an audit cannot be conducted, the auditor may consider withdrawing from the engagement Course of action in situation (b) (i) The auditor may consider whether the risk assessment remains appropriate and, if not, revise the risk assessment and determine the nature, timing and extent of further audit procedures to respond to the assessed risks. (ii) If the matter remains unresolved, the auditor shall reconsider the assessment of the competence, integrity, ethical values or diligence of management, or of its commitment to or enforcement of these, and shall determine the effect that this may have on the reliability of other representations and audit evidence in general. (iii) If the auditor concludes that the written representations are not reliable, the auditor shall take appropriate actions, including determining the possible effect on the opinion in the auditor’s report. 144 Kazmi-Wassan (a) Purpose of a written representation letter Written representations are a form of audit evidence. They are usually contained in a letter, written by the company’s directors and sent to the auditor, just prior to the completion of audit work and before the audit report is signed. Representations are required for two reasons: firstly, so the directors can acknowledge their collective responsibility for the preparation of the financial statements and to confirm that they have approved those statements; secondly, to confirm any matters, which are material to the financial statements where representations are crucial to obtaining sufficient and appropriate audit evidence. In the latter situation, other forms of audit evidence are normally unavailable because knowledge of the facts is confined to management and the matter is one of judgement or opinion. Obtaining representations does not mean that other evidence does not have to be obtained. Audit evidence will still be collected and the representation will support that evidence. Any contradiction between sources of evidence should, as always, be investigated. (b) Matters (i) Tiger’s Purr The amount of the claim is material being 50% of profit before taxation. There is also a lack of definite supporting evidence for the claim. The two main pieces of evidence available are the claim from Tiger’s Purr itself and the legal advice from KazmiWassan’s solicitors. However, any claim amount cannot be accurately determined because the dispute has not been settled. The directors have stated that they believe the claim not to be justified, which is one possible outcome of the dispute. However, in order to obtain sufficient evidence to show how the treatment of the potential claim was decided for the financial statements, the auditor must © Emile Woolf International 188 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers obtain this opinion in writing. Reference must therefore be made to the claim in the representation letter. Paragraph for inclusion in representation letter. ‘A legal claim against Kazmi-Wassan by Tiger’s Purr has been estimated at Rs 4 million by Tiger’s Purr. However, the directors are of the opinion that the claim is not justified on the grounds of breach of product specification. No provision has been made in the financial statements, although disclosure of the situation is adequate. No similar claims have been received or are expected to be received.’ (ii) Depreciation This matter is unlikely to be included in the letter of representation because the auditor appears to have obtained sufficient evidence to confirm the accounting treatment. The lack of profit or loss on sale confirms that the depreciation charge is appropriate – large profits would indicate over-depreciation and large losses, under-depreciation. The amount also meets industry standards confirming the Kazmi-Wassan’s accounting policy is acceptable. Including the point in the representation letter is inappropriate because the matter is not crucial and does not appear to be based on judgment or opinion. The only opinion here appears to be that of the auditor – unless the ‘feelings’ can be turned into some appropriate audit evidence, the matter should be closed. (c) Lack of representation letter The auditor may take the following actions: (i) Discuss the situation with the directors to try and resolve the issue that the directors have raised. 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). (ii) Ascertain exact reasons why the directors will not sign the letter. Consider whether amendments can be made to the letter to incorporate the directors’ concerns that will still provide the auditor with appropriate and sufficient audit evidence. (iii) The discussion must clearly explain the fact that if the auditor does not receive sufficient and appropriate audit evidence, then the audit report will have to be qualified. The reason for the audit qualification will be uncertainty regarding the amounts and disclosures in the financial statements. (iv) Even if the letter is subsequently signed, the auditor must still evaluate the reliability of the evidence. If, in the auditor’s opinion, the letter no longer provides sufficient or reliable evidence, then a qualification may still be required. 145 RK Resourcing (a) Audit procedures to be used prior to the audit report being signed Reviewing procedures established by management to try and ensure that subsequent events are identified. Reading minutes of the meetings of directors, the audit committee and shareholders and enquiring into unusual items. Obtaining and reading the company’s latest interim accounts as well as any budgets and cash flow forecasts. Obtaining additional evidence if possible from the company’s lawyers concerning litigation and claims. Asking management as to whether any subsequent events have occurred such as New borrowing commitments Significant sales of assets New shares or debentures issued Assets being destroyed by flood, fire etc. or impounded by the government © Emile Woolf International 189 The Institute of Chartered Accountants of Pakistan Audit and Assurance Unusual accounting adjustments made or being contemplated (b) Checking whether any events have occurred that could call into question the validity of the going concern assumption. The three dates 15 August 20X3 (i) Adjusting or non-adjusting? The bankruptcy of a major customer provides additional evidence of conditions existing at the end of the reporting period. The customer will not be able to pay debts due, therefore receivables are overstated and the bad debt expense in the profit and loss account is understated. An adjustment for the amount of the receivable should be made in the financial statements. (ii) Auditor’s responsibility and audit procedures to be carried out The bankruptcy of the major customer takes place after the end of the year but before the financial statements and the auditor’s report are signed. As the auditor’s report has not been signed, the auditor is responsible for identifying material events that affect the financial statements. This means that audit procedures should be carried out which are designed to identify this event. Specific procedures undertaken include the following: Confirming that the customer will not pay to a letter from the receiver or similar authorised person. Confirming the amount due from the customer to invoices raised prior to the year end, and if possible to a positive confirmation request. Auditing the adjustment to the financial statements decreasing the receivable balance and increasing the bad debt write off in the profit and loss account. Including the amount in the written representation letter to confirm no other amounts are due from the customer. 1 November 20X3 (i) Adjusting or non-adjusting? The accidental release of toxic chemicals occurred after the reporting period. Assuming that the inventory was not on the statement of financial position at the year end, then the spill is indicative of conditions that arose subsequent to the year end. No adjustment appears to be necessary. However, the event may be significant in terms of the operations of the company (a large legal claim could arise) and so disclosure of the event would be expected. (ii) Auditor’s responsibility and audit procedures to be carried out The accidental release of toxic chemicals takes place after the auditor’s report has been signed but before the financial statements are sent to the members. At this stage of the audit, the auditor does not have any responsibility to perform procedures or make enquiries regarding the financial statements. The management of RK Resourcing are responsible for telling the auditor about any significant events, such as this one. However, as the auditor is now aware of the event and this materially affects the financial statements in terms of disclosure being required, the auditor does have to discuss the event with management. Specific procedures to be undertaken include the following: Obtain information concerning the chemical release from management, reading local press and if possible the company’s lawyers – the latter may be able to indicate whether there is any legal liability. Discuss the appropriate accounting treatment with the directors, confirming that disclosure is required in the circumstances. © Emile Woolf International 190 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers Read the disclosure note to confirm that the matter is adequately explained in the financial statements. Obtain an updated letter of representation from the directors confirming that there are no other events requiring disclosure. Amend the auditor’s report to include an emphasis of matter paragraph to draw attention to the full disclosure noted in the financial statements. Date the new auditor’s report no earlier than the date of the amended financial statements and update “active” subsequent events review to that date. 30 November 20X3 (i) Adjusting or non-adjusting? The fire at an oil well means that RK Resourcing’s oil production and presumably profits will fall in the next financial year. The fire though does not provide additional evidence of conditions existing at the end of the reporting period as at this time there was no indication that this would occur. The event is therefore non-adjusting in the financial statements. However, disclosure of the event should be made so that the financial statements do not give a misleading position. (ii) Auditor’s responsibility and audit procedures to be carried out The fire at an oil well takes place after the financial statements have been issued. At this time, the auditor has no obligation to make any inquiry at all regarding the financial statements. However, if the auditor becomes aware of the event, then the potential effect on the auditor’s report must be considered. Specific procedures undertaken include the following: Checking the board minutes, insurance claims and similar documents to ensure that the fire will be covered by insurance and there is no contingent liability for replacing non-current assets or clearing up any environmental damage. Enquiring of the directors how the members will be informed of the situation. If the directors plan to re-issue the financial statements, ensure that appropriate disclosure is made of the event, date the new auditor’s report no earlier than the date of the amended financial statements and update “active” subsequent events review to that date. If the directors do not intend to amend the financial statements, and the auditor considers the matter to be material to understanding the accounts, consider attempting to contact the members directly, depending on the methods available in your country. If necessary, take legal advice to discuss what action can be taken regarding the lack of disclosure. 146 Rake Enterprises (a) Comparison of directors’ and auditors’ responsibilities (i) Preparation of financial statements The directors are normally required to prepare the financial statements of the company using the appropriate law of their country and in accordance with the International Accounting/Financial Reporting Standards (IASs/IFRSs). The auditors are normally required to check or audit those financial statements, again in accordance with the legislation of their country and the International Statements on Auditing. (ii) Fraud and error The directors are responsible for preventing and detecting fraud and error in the financial statements, no matter how immaterial this may be. Auditors are responsible for ensuring that the financial statements show a true and fair view; in other words that the financial statements are materially correct. Auditors are not required to detect immaterial fraud or error. © Emile Woolf International 191 The Institute of Chartered Accountants of Pakistan Audit and Assurance (iii) Disclosure The directors must ensure that there is adequate disclosure of all matters required by statute or IASs/IFRSs in the financial statements. The auditor will check that disclosure provisions have been complied with, and where certain disclosures have not been made (e.g. ISA 550 regarding related party transactions) provide this information in the audit report. (iv) Going concern The directors are responsible for ensuring that the company will continue in operational existence for the foreseeable future, and report to the members in the published financial statements if this is unlikely to be the case. The auditor will check the accuracy of the directors' workings and assumptions and if these are considered incorrect or inappropriate, then the audit report or opinion may be modified to bring the situation to the attention of the members of the company. (b) Errors The auditor’s responsibility paragraph does not meet the requirements of ISA 700 for the following reasons: (i) It does not follow the standard wording set out in ISA 700. For example, it does not state at the outset that the auditor’s responsibitly is to express an opinion on the financial statements based on his audit. (ii) The use of the term Auditing Standards is not clear, because the report does not state which auditing standards have been used (e.g. ISAs). This provides uncertainty regarding the actual standard of work performed. (iii) The assessment of estimates and judgements made by the directors normally relates to material amounts only, rather than all of those estimates and judgements. The correct wording from ISA 700 would state that the procedures selected took into account ‘ the risks of material misstatement’ i.e. showing that the audit testing was probably focused on material amounts only. (iv) Stating that time was a factor in obtaining information and explanations for the audit is not correct as this implies some factor which could have been avoided and that the audit may therefore be incomplete. The auditor has to plan the audit carefully and ensure that all the information and explanations considered necessary are obtained to form an opinion, not simply stop work when time runs out. (v) The auditor does not confirm that the financial statements are free from material misstatement as this implies a degree of accuracy that the auditor simply cannot provide. Making the statement could also leave the auditor liable to claims from members or third parties should errors be found in the financial statements later. Rather than make such a categorical statement, the correct wording from ISA 700 states that the auditor provides reasonable assurance that the financial statements are free from material misstatement, which clearly implies that audit techniques are limited. (vi) The disclaimer regarding errors appears to be useful in that it limits the auditor's liability. However, it does not belong in the auditor’s responsibility paragraph as it appears to severely limit the auditor's responsibilities stating that the directors are responsible for all errors. Management’s responsibility is also clearly outlined in another section of the report, and this statement also appears to extend those responsibilities making the audit report overall less clear. This could also imply that the auditor has done little or no work. (vii) Fisrt paragraph of the auditor’s responsibility is wrongly given under this heading; it should have been classified under the basis of opinion section of the report as per ISA 700 (Revised) (viii) Some other information decribed by the ISA 700 (Revised) undrer the section of Auditor’s Responsibility is not provided in the given scenerio. (ix) Heading should be “Auditor’s Responsibilities for the Audit of the Financial Statements” instead of “Auditor’s Responsibility” © Emile Woolf International 192 The Institute of Chartered Accountants of Pakistan Answer bank: Objective test and long-form answers REVIEW ENGAGEMENTS 147 ISRE 2400 (a) Meaning and types of assurance Meaning ‘Assurance’ means confidence. In an assurance engagement, an ‘assurance firm’ is engaged by one party to give an opinion on a piece of information that has been prepared by another party. The opinion is an expression of assurance about the information that has been reviewed. It gives assurance to the party that hired the assurance firm that the information can be relied on. Types There are two main types of assurance: audit: this may be external audit, internal audit or a combination of the two; and review. An audit provides a high, but not absolute, level of assurance that the audited information is free from any material misstatement. This is often referred to as reasonable assurance. The opinion is usually expressed as positive assurance that, in the opinion of the auditors, the financial statements do present fairly the financial position and performance of the company. A review is a ‘voluntary’ investigation. In contrast to the “reasonable” level of assurance provided by an audit, a review into an aspect of the financial statements would provide only a moderate level of assurance that the information under review is free of material misstatement. The resulting opinion is usually (although not always) expressed in the form of negative assurance. Negative assurance is an opinion that nothing is obviously wrong: in other words, ‘nothing has come to our attention to suggest that the information is misstated’. (b) Review procedures The accountant should obtain an understanding of the entity’s business and the industry in which it operates. The accountant should make enquiries into: the entity’s accounting policies, practices and procedures, including the preparation of financial statements; material assertions in the financial statements that are subject to the review; decisions taken at board meetings and other meetings of the entity that may affect the financial statements; the completeness of the accounting records that were used to prepare the financial statements. The accountant should use analytical procedures to identify unusual relationships between items in the financial statements, and individual items that appear unusual. Other procedures such as: discussions with the company’s auditors; obtaining representations from management; considering the appropriateness of the accounting policies employed by the entity; making enquiries into subsequent events; reviewing the statements as a whole. © Emile Woolf International 193 The Institute of Chartered Accountants of Pakistan
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