ACCA F8 PAST YEAR Q&A 07-13

Fundamentals Level – Skills Module

Time allowedReading and planning: 15 minutesWriting: 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

Do NOT open this paper until instructed by the supervisor.

During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.

This question paper must not be removed from the examination hall.

Pape

r F8

(M

YS)

Audit and Assurance(Malaysia)

Wednesday 5 December 2007

The Association of Chartered Certified Accountants

ALL FIVE questions are compulsory and MUST be attempted

1 DinZee Co assembles fridges, microwaves, washing machines and other similar domestic appliances from partsprocured 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 orderto that supplier using Electronic Data Interchange (EDI). A copy of the EDI order is filed in the order database by thecomputer system. The order is identified by a unique order number.

When goods are received at DinZee, the stores clerk confirms that the inventory agrees to the delivery note and checksthe order database to ensure that the inventory were in fact ordered by DinZee. (Delivery is refused where goods donot have a delivery note.)

The order in the order database is updated to confirm receipt of goods, and the perpetual inventory system updatedto show the receipt of inventory. The physical goods are added to the parts store and the paper delivery note isstamped with the order number and is filed in the goods inwards department.

The supplier sends a purchase invoice to DinZee using EDI; invoices are automatically routed to the accountsdepartment. On receipt of the invoice, the accounts clerk checks the order database, matches the invoice details withthe 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 automaticallyupdated.

Required:

(a) List SIX audit procedures that an auditor would normally carry out on the purchases system at DinZee Co,explaining the reason for each procedure. (12 marks)

(b) List FOUR audit procedures that an auditor will normally perform prior to attending the client’s premises onthe day of the inventory count. (2 marks)

(c) On the day of the inventory count, you attended depot nine at DinZee. You observed the following activities:

1. Prenumbered count sheets were being issued to client’s staff carrying out the count. The count sheetsshowed the inventory ledger balances for checking against physical inventory.

2. All count staff were drawn from the inventory warehouse and were counting in teams of two.3. Three counting teams were allocated to each area of the stores to count, although the teams were allowed

to decide which pair of staff counted which inventory within each area. Staff were warned that they had toremember which inventory had been counted.

4. Information was recorded on the count sheets in pencil so amendments could be made easily as required.5. Any inventory not located on the pre-numbered inventory sheets was recorded on separate inventory sheets

– which were numbered by staff as they were used.6. At the end of the count, all count sheets were collected and the numeric sequence of the sheets checked;

the sheets were not signed.

Required:

(i) List the weaknesses in the control system for counting inventory at depot nine. (3 marks)

(ii) For each weakness, explain why it is a weakness and state how that weakness can be overcome.(9 marks)

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(d) (i) State the aim of a test of control and the aim of a substantive procedure.

(ii) In respect of your attendance at DinZee Co’s inventory count, state one test of control and onesubstantive procedure that you should perform. (4 marks)

(30 marks)

2 (a) Explain each of the FIVE fundamental principles of ACCA’s Code of Ethics and Conduct. (5 marks)

(b) AI 570 Going Concern (Revised) provides guidance to auditors in respect of ensuring that an entity can continueas a going concern.

Required:

Explain the actions that an auditor should carry out to try and ascertain whether an entity is a going concern.(5 marks)

(10 marks)

3 Matalas Co sells cars, car parts and petrol from 25 different locations in one country. Each branch has up to 20 staffworking there, although most of the accounting systems are designed and implemented from the company’s headoffice. All accounting systems, apart from petty cash, are computerised, with the internal audit department frequentlyadvising and implementing controls within those systems.

Matalas has an internal audit department of six staff, all of whom have been employed at Matalas for a minimum offive years and some for as long as 15 years. In the past, the chief internal auditor appoints staff within the internalaudit department, although the chief executive officer (CEO) is responsible for appointing the chief internal auditor.The chief internal auditor reports directly to the finance director. The finance director also assists the chief internalauditor in deciding on the scope of work of the internal audit department.

You are an audit manager in the internal audit department of Matalas. You are currently auditing the petty cashsystems at the different branches. Your initial systems notes on petty cash contain the following information:

1. The average petty cash balance at each branch is RM5,000.2. Average monthly expenditure is RM1,538, with amounts ranging from RM1 to RM500.3. Petty cash is kept in a lockable box on a bookcase in the accounts office.4. Vouchers for expenditure are signed by the person incurring that expenditure to confirm they have received

re-imbursement from petty cash.5. Vouchers are recorded in the petty cash book by the accounts clerk; each voucher records the date, reason for

the expenditure, amount of expenditure and person incurring that expenditure.6. Petty cash is counted every month by the accounts clerk, who is in charge of the cash. The petty cash balance

is then reimbursed using the ‘imprest’ system and the journal entry produced to record expenditure in the generalledger.

7. The cheque to reimburse petty cash is signed by the accountant at the branch at the same time as the journalentry to the general ledger is reviewed.

Required:

(a) Explain the issues which limit the independence of the internal audit department in Matalas Co. Recommenda way of overcoming each issue. (8 marks)

(b) Explain the internal control weaknesses in the petty cash system at Matalas Co. For each weakness,recommend a control to overcome that weakness. (12 marks)

(20 marks)

3 [P.T.O.

4 Delphic Co is a wholesaler of furniture (such as chairs, tables and cupboards). Delphic buys the furniture from sixmajor manufacturers and sells them to over 600 different customers ranging from large retail chain stores to smallerowner-controlled businesses. The receivables balance therefore includes customers owing up to RM125,000 tosmaller balances of about RM5,000, all with many different due dates for payments and credit limits. All informationis stored on Delphic’s computer systems although previous audits have tended to adopt an ‘audit around thecomputer’ approach.

You are the audit senior in charge of the audit of the receivables balance. For the first time at this client, you havedecided to use audit software to assist with the audit of the receivables balance. Computer staff at Delphic are happyto help the auditor, although they cannot confirm completeness of systems documentation, and warn that the systemshave very old operating systems in place, limiting file compatibility with more modern programs.

The change in audit approach has been taken mainly to fully understand Delphic’s computer systems prior to newinternet modules being added next year. To limit the possibility of damage to Delphic’s computer files, copy files willbe provided by Delphic’s computer staff for the auditor to use with their own audit software.

Required:

(a) Explain the audit procedures that should be carried out using audit software on the receivables balance atDelphic Co. For each procedure, explain the reason for that procedure. (9 marks)

(b) Explain the potential problems of using audit software at Delphic Co. For each problem, explain how it canbe resolved. (8 marks)

(c) Explain the concept of ‘auditing around the computer’ and discuss why this increases audit risk for theauditor. (3 marks)

(20 marks)

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5 (a) You are the audit manager in JonArc & Co. One of your new clients this year is Galartha Co, a company havingnet assets of RM15 million. The audit work has been completed, but there is one outstanding matter you arecurrently investigating; the directors have decided not to provide depreciation on buildings in the financialstatements, although applicable approved accounting standards suggest that depreciation should be provided.

Required:

State the additional audit procedures and actions you should now take in respect of the above matter.(6 marks)

(b) Unfortunately, you have been unable to resolve the matter regarding depreciation of buildings; the directors insiston not providing depreciation. You have therefore drafted the following extracts for your proposed audit report.

1. ‘We conducted our audit in accordance with Malaysian Approved Standards on Auditing. Those Standardsrequire that we comply with ethical requirements and plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of material misstatement (remaining words arethe same as a normal unmodified report).

2. As discussed in Note 15 to the financial statements, no depreciation has been provided in the financialstatements which practice, in our opinion, is not in accordance with applicable approved accountingstandards.

3. The charge for the year ended 30 September 2007, should be RM420,000 based on the straight-linemethod of depreciation using an annual rate of 5% for the buildings.

4. Accordingly, the non-current assets should be reduced by accumulated depreciation of RM1,200,000 andthe profit for the year and accumulated reserve should be decreased by RM420,000 and RM1,200,000,respectively.

5. In our opinion, except for the effect on the financial statements of the matter referred to in the precedingparagraph, the financial statements give a true and fair view ... (remaining words are the same as for anunmodified opinion paragraph).’

The extracts have been numbered to help you refer to them in your answer.

Required:

Explain the meaning and purpose of each of the above extracts in your draft audit report. (10 marks)

(c) State the effect on your audit report of the following alternative situations:

(i) Depreciation had not been provided on any non-current asset for a number of years, the effect of whichif corrected would be to turn an accumulated profit into a significant accumulated loss.

(ii) JonArc & Co were appointed auditors after the end of the financial year of Galartha Co. Consequently,the auditors could not attend the year end inventory count. Inventory is material to the financialstatements.

Note: you are not required to draft any audit reports.(4 marks)

(20 marks)

End of Question Paper

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Answers

Fundamentals Level – Skills Module, Paper F8 (MYS)Audit and Assurance (Malaysia) December 2007 Answers

1 (a) Audit procedures procurement and purchases system

(b) Audit procedures prior to inventory count attendance

Procedure– 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.

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Procedure Reason for procedure

Obtain a sample of e-mails from the store manager’scomputer. Trace details to the order database.

Ensure that all orders are recorded and that the orderdetails are correct.

Obtain a sample of orders in the order database, recorddetails of the order and trace to the paper delivery notefiled in the goods inwards department.

To confirm that all goods ordered were received.

For the sample of orders above, agree to the inventorydatabase.

To confirm that goods received were completely andaccurately recorded in the inventory database.

Obtain a sample of paper delivery notes and agree to theorder database and inventory database.

To confirm that inventory received has been recorded inDinZee’s accounting system and that liabilities aretherefore not understated.

For a sample of orders in the orders database, agreedetails to the payables ledger database, confirming detailsagainst the purchase invoice.

To confirm complete and accurate recording of theinventory liability in the payables database.Note: To ensure goods received have been recorded as apayables liability the sample selected from the orderdatabase should be only those orders that have beenreceived. The invoice number in the order database isthen noted and traced to the payables ledger in thepurchase database.

Within the purchase database, obtain a sample of invoicesrecorded in the purchase day book, agree details of priceand supplier to the purchase invoice record in thedatabase.

To confirm that purchase invoice details have beencorrectly recorded in the payables database.

For a sample of purchase invoices in the purchase daybook, agree details to the delivery notes for items on thatinvoice.

To confirm that the purchase liability has been recordedonly for goods actually received.

For the sample of purchase invoices above, agree detailsto the individual payables account in the payablesdatabase.

To confirm that the liability has been recorded in thecorrect payables account.

For a sample of supplier invoices, cast and cross castinvoice price and quantities confirming price to theoriginal order.

To confirm the arithmetical accuracy of invoices andensure the company was charged the correct price forgoods received.

Select increases in the purchase daybook and vouch tothe order database.

To ensure that invoiced goods have been ordered,confirming the occurrence assertion.

Using computer-assisted audit techniques, cast thepurchase day book and agree total of liability incurred tothe general ledger.

To confirm the completeness and accuracy of the liabilityrecorded in the general ledger.

(c) Weaknesses in counting inventory

(d) (i) 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’sfinancial statements.

(ii) Regarding the inventory count:

Test of controlObserve the count teams ensuring that they are counting in accordance with the client’s inventory count instructions.

Substantive procedureRecord the condition of items of inventory to ensure that the valuation of those items is correct on the final inventorysummaries.

2 (a) 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 tooverride objectivity.

Professional competence and due care. When performing professional services, a professional accountant should showcompetence and duty of care by keeping up-to-date with developments in practice, legislation and techniques.

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Weakness Reason for weakness How to overcome weakness

Inventory sheets stated the quantity ofitems expected to be found in thestore

Count teams will focus on finding thatnumber of items makingundercounting of inventory more likely– teams stop counting when ‘correct’number of items found.

Count sheets should not state thequantity of items so as not to pre-judge how many units will befound.

Count staff were all drawn from thestores

Count staff are also responsible for theinventory. There could be a temptationto hide errors or missing inventory thatthey have removed from the storeillegally.

Count teams should include staff whoare not responsible for inventory toprovide independence in the count.

Count teams allowed to decide whichareas to count

There is a danger that teams willeither omit inventory from the count oreven count inventory twice due to lackof precise instructions on where tocount.

Each team should be given a precisearea of the store to count.

Count sheets were not signed by thestaff carrying out the count

Lack of signature makes it difficult toraise queries regarding items countedbecause the actual staff carrying outthe count are not known.

All count sheets should be signed toconfirm who actually carried out thecount of individual items.

Inventory not marked to indicate it hasbeen counted

As above, there is a danger thatinventory will be either omitted orincluded twice in the count.

Inventory should be marked in someway to show that it has been countedto avoid this error.

Recording information on the countsheets in pencil

Recording in pencil means that thecount sheets could be amended afterthe count has taken place, not justduring the count. The inventorybalances will then be incorrectlyrecorded.

Count sheets should be completed inink.

Count sheets for inventory not on thepre-numbered count sheets were onlynumbered when used

It is possible that the additionalinventory sheets could be lost as thereis no overall control of the sheetsactually being used. Sheets may notbe numbered by the teams, againgiving rise to the possibility of loss.

All inventory sheets, including thosefor ‘extra’ inventory, should be pre-numbered.

Confidentiality. A professional accountant should respect the confidentiality of information acquired during the course ofproviding professional services and should not use or disclose such information without obtaining client permission.

Professional behaviour. A professional accountant should act in a manner consistent with the good reputation of the professionand refrain from any conduct which might bring discredit to the profession.

(b) Audit work – going concern

– Review management’s plans for future actions based on its going concern assessment.

– Gather additional sufficient and appropriate audit evidence to confirm or dispel whether or not a material uncertaintyexists regarding the going concern concept.

– Seek written representations from management regarding its plans for future action.

– Obtain information from company bankers regarding continuance of loan facilities.

– Review receivables ageing analysis to determine whether there is an increase in days – which may also indicate cashflow problems.

3 (a) Factors limiting independence of internal audit

Reporting system

The chief internal auditor reports to the finance director. This limits the effectiveness of the internal audit reports as the financedirector will also be responsible for some of the financial systems that the internal auditor is reporting on. Similarly, the chiefinternal auditor may soften or limit criticism in reports to avoid confrontation with the finance director.

To ensure independence, the internal auditor should report to an audit committee.

Scope of work

The scope of work of internal audit is decided by the finance director in discussion with the chief internal auditor. This meansthat the finance director may try and influence the chief internal auditor regarding the areas that the internal audit departmentis auditing, possibly directing attention away from any contentious areas that the director does not want auditing.

To ensure independence, the scope of work of the internal audit department should be decided by the chief internal auditor,perhaps with the assistance of an audit committee.

Audit work

The chief internal auditor appears to be auditing the controls which were proposed by that department. This limitsindependence as the auditor is effectively auditing his own work, and may not therefore identify any mistakes.

To ensure independence, the chief internal auditor should not establish control systems in Matalas. However, where controlshave already been established, another member of the internal audit should carry out the audit of petty cash to provide somelimited independence.

Length of service of internal audit staff

All internal audit staff at Matalas have been employed for at least five years. This may limit their effectiveness as they will bevery familiar with the systems being reviewed and therefore may not be sufficiently objective to identify errors in thosesystems.

To ensure independence, the existing staff should be rotated into different areas of internal audit work and the chief internalauditor independently review the work carried out.

Appointment of chief internal auditor

The chief internal auditor is appointed by the chief executive officer (CEO) of Matalas. Given that the CEO is responsible forthe running of the company, it is possible that there will be bias in the appointment of the chief internal auditor; the CEO mayappoint someone who he knows will not criticise his work or the company.

To ensure independence, the chief internal auditor should be appointed by an audit committee or at least the appointmentagreed by the whole board.

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(b) Internal control weaknesses – petty cash

4 (a) Audit procedures using audit software

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Weakness Suggested control

The petty cash balance is approximately three monthsexpenditure. This is excessive and will increase thepossibility of petty cash being stolen or errors not beingidentified.

The petty cash balance should be RM2,000, being aboutone month’s expenditure.

The petty cash box itself is not secure; it is placed on abookcase where any member of staff could steal it.

When not in use, the petty cash box should be kept in thebranch safe, or at least a locked drawer in theaccountant’s desk.

Petty cash appears to be used for some larger items ofexpenditure (up to RM500). Vouchers are only authorisedafter expenditure is incurred indicating that somesignificant expenditure can take place withoutauthorisation.

A maximum expenditure limit (e.g. RM50) should be setbefore which prior authorisation is required.

Petty cash vouchers are only signed by the personincurring the expenditure, indicating a lack of authorisationcontrol for that expenditure.

All vouchers should be signed by an independent officialshowing that the expenditure has been authorised.

Petty cash only appears to be counted by the accountsclerk, who is also responsible for the petty cash balance.There is no independent check that the petty cash balanceis accurate.

The counting of petty cash should be checked by theaccountant to ensure that the clerk is not stealing thecash.

When the imprest cheque is signed, only the journal entryfor petty cash is reviewed, not the petty cash vouchers.The accountant has no evidence that the journal entryactually relates to the petty cash expenditure incurred.

The petty cash vouchers should be available for review toprovide evidence of petty cash expenditure.

Petty cash vouchers are not pre-numbered so it isimpossible to check the completeness of vouchers;unauthorised expenditure could be blamed on ‘missing’vouchers.

Petty cash vouchers should be pre-numbered and thenumbering checked in the petty cash book to confirmcompleteness of recording of expenditure.

Procedure Reason for procedure

Cast the receivables ledger to ensure it agrees with thetotal on the receivables control account.

To ensure the completeness and accuracy of recording ofitems in the receivables ledger and control account.

Compare the balance on each receivable account with itscredit limit to ensure this has not been exceeded.

To check for violation of system rules.

Review the balances in the receivables ledger to ensure nobalance exceeds total sales to that customer.

To check for unreasonable items in the ledger.

Calculate receivables days for each month end to monitorcontrol of receivables over the year.

To obtaining new/relevant statistical information.

Stratify receivables balances to show all material items andselect appropriate sample for testing.

To select items for audit testing.

Produce an aged receivables analysis to assist with theidentification of irrecoverable receivables.

To assist with receivables valuation testing.

(b) Problems of using audit software

CostThere may be substantial setup costs to use the software, especially where the computer systems of the client have not beenfully documented, as is the situation in Delphic Co. A cost benefit analysis from the audit point-of-view should be carried outprior to deciding to use audit software.

Lack of software documentationThe computer audit department at Delphic cannot confirm that all system documentation is available, especially for the older‘legacy’ systems currently in use. This again confirms the view that use of audit software should be deferred until next yearto avoid extensive setup costs which cannot be recouped due to system changes.

Change to clients’ systemsChanges to clients’ computer systems can result in costly amendments to the audit software. Given that Delphic’s systemswill change next year, this is almost certain to result in amendments to the software. Starting to use audit software this yearis therefore not advisable.

Outputs obtainedThe audit manager needs to be clear exactly what audit assertions are to be tested with the audit software and what outputsare expected. Starting testing just to obtain knowledge of the system is inappropriate as testing may be too detailed and outputproduced that is not required, increasing the cost for the client.

Use of copy filesThe use of copy files means that the auditor will not be certain that these are the actual files being used within Delphic’scomputer systems, especially as the provenance of those files will not be checked. To ensure that the files are genuine eitherthe auditor should supervise the copying or the ‘live’ files on Delphic’s computer systems should be used.

(c) Auditing around the computer

This term means that the ‘internal’ software of the computer is not documented or audited by the auditor, but that the inputsto the computer are agreed to the expected outputs from the computer.

This method of auditing increases audit risk because:

– The actual computer files and programs are not tested; the auditor has no direct evidence that the programs are workingas documented.

– Where errors are found in reconciling inputs to outputs, it may be difficult or even impossible to determine why thoseerrors occurred. Constructive amendments to clients’ systems cannot be made and there is an increased likelihood ofaudit qualifications.

5 (a) Audit procedures regarding non-depreciation of buildings

– Review audit file to ensure that sufficient appropriate audit evidence has been collected in respect of this matter. – Ensure that GAAP does apply to the specific buildings owned by Galartha Co and that a departure from GAAP is not

needed in order for the financial statements to show a true and fair view.– Meet with the directors to confirm their reasons for not depreciating buildings.– Warn the directors that in your opinion buildings should be depreciated and that failure to provide depreciation will result

in a modified audit report.– Determine the effect of the disagreement on the audit report in terms of the modified opinion being material or of

pervasive materiality to the financial statements.– Draft the appropriate sections of the modified audit report.– Obtain a letter of representation from the directors confirming that depreciation will not be charged on buildings.

(b) Audit report extracts

Extract 1.

The meaning of the extract. It confirms that audit work has been carried out in accordance with external Auditing Standards– not arbitrary standards made up by the audit firm and that audit planning was carried out to detect material errors.

The purpose of the extract. It provides the readers of the financial statements with that the auditor can be trusted to carry outthe audit because the auditor has followed the ISAs and the ethical standards of the ACCA.

Extract 2.

The meaning of the extract. It states that the auditor has compared the normal accounting treatment for depreciation (in theIAS) to that used by the directors and found the directors’ method to be different to the standard.

The purpose of the extract. It informs readers that the company is not following the IAS in this particular matter and so thefinancial statements may be incorrect in this respect.

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Extract 3.

The meaning of the extract. It shows how the IAS would normally be applied to non-current tangible assets – in this case astandard 5% depreciation rate has been used.

The purpose of the extract. Enables the reader of the financial statements to quantify the impact of the IAS non-compliance– in this case RM420,000.

Extract 4.

The meaning of the extract. It shows the overall impact of non-compliance with the IAS – with specific focus on theoverstatement on non-current assets of RM1,200,000.

The purpose of the extract. It enables the reader to see the overall quantified impact on the financial statements – that is non-current assets and profit are both overstated. The members’ perception of the ‘value’ of their company may therefore bealtered.

Extract 5.

The meaning of the extract. That the auditor disagrees with the depreciation figure provided by the directors – the auditor’scalculation of depreciation is materially different from this hence the auditor’s disagreement with the financial statementsfigure. However, this is the only matter that the auditor disagrees about.

The purpose of the extract. To communicate to the members that that auditor does not believe that the financial statementsshow a true and fair view in respect of depreciation.

(c) Other reporting options

(i) – The auditor would still disagree with the lack of depreciation on non-current assets so a modified opinion on thegrounds of disagreement would be required.

– As the financial statements need significant amendment (profit becoming a large loss) then the auditor mayconclude that the financial statements do not show a true and fair view and issue an adverse report (rather thanan ‘except for’ report).

(ii) – The auditors normally attend the inventory count to confirm the existence of inventory. As the count was notattended, the existence of inventory cannot be confirmed.

– The auditor will be uncertain regarding existence and consequently valuation of inventory. An ‘except for’ auditreport will be issued noting that adjustments may be necessary to the inventory value.

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Fundamentals Level – Skills Module, Paper F8 (MYS)Audit and Assurance (Malaysia) December 2007 Marking Scheme

Marks1 (a) Audit procedures procurement and purchases system

1 for stating procedure and 1 for the reason for that procedure. Limit marks to 0·5 where the reason is not fully explained. Maximum 2 marks per point.

Procedure– E-mails to order database– Order database to delivery note– Orders to inventory database– Paper goods receipt notes to inventory database– Orders database to payables ledger database– Computerised purchase invoice details to record of purchase invoice– Details of purchase invoice database to EDI purchase invoice received– Purchase invoice record to payables database– CAATs – cast PDB, trace to general ledger– Walk through test– Observing goods being received– Other relevant procedures

–––Maximum marks 12

––––––

(b) Audit procedures prior to inventory count attendance

0·5 for each procedure

Procedures– Review prior year working papers for problems – Contact client to obtain stocktake 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– Obtain prior year management letter for evidence of stocktake problems– Other relevant points


––––––

(c) Weaknesses in counting inventory

1 for each weakness, up to 1·5 for explaining the reason for the weakness and up to 1·5 for stating how to overcome weakness. 4 max therefore per weakness.

Weaknesses– Inventory sheets stating the quantity of items expected to be found in the store– Count staff all drawn from the stores– Count teams allowed to decide which areas to count– Count sheets not signed by the staff carrying out the count– Inventory not marked to indicate it has been counted– Recording information on the count sheets in pencil– Count sheets for inventory not on the pre-numbered count sheets where only numbered when used– Other relevant points


––––––

(d) 1 mark each for:

Test of control aimSubstantive procedure aimStating test of control relevant to inventory countStating substantive procedure relevant to inventory count


–––––––––Total marks 30

––––––

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Marks2 (a) 1 mark for each principle. 0·5 for stating the principle and 0·5 for brief explanation

– Integrity– Objectivity– Professional competence and due care– Confidentiality– Professional behaviour


––––––

(b) 1 mark per action

– Review management plans– Review cash flow forecasts– Additional audit procedures– Written representations– Loans from bank– Receivables ageing– Other relevant points



––––––

Note to markers – allow 0·5 mark where candidate lists audit procedures such as review cash flow forecasts, reviewmanagement accounts post year end, etc.

3 (a) 2 marks for each independence factor. 1 for explaining the issue and 1 for mitigating that factor.

– Reporting system– Scope of work– Actual audit work– Length of service of internal audit staff– Appointment of chief internal auditor– External auditor assistance with internal audit? (additional to answer)– Other relevant points


––––––

(b) 2 marks for each control weakness. 1 for explaining the weakness and 1 for control over that weakness.

– Size of petty cash balance– Security of petty cash box– High value petty cash expenditure – individual items– Authorisation of petty cash expenditure– Counting of petty cash– No review of petty cash vouchers – signing of imprest cheque– Vouchers not pre-numbered– Other relevant points



––––––

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Marks4 (a) Up to 2 marks for each procedure and explanation. 1 for the procedure and 1 for the

explanation. Limit procedure to 0·5 if cannot be sustained from Delphic’s systems.

– Cast receivables ledger– Compare ledger balance to credit limit– Review balances ensure not excessive– Calculation of receivables days– Stratification of balances/audit sample selection– Verify items in ledger– Aged receivables analysis– Other valid tests


––––––

Note to markers – no distinction is made between test of control and substantive procedures for this question. Marks can beobtained from either type of test or other relevant uses of audit software e.g. sample selection.

(b) 2 marks for each point. 1 for explaining the problem and 1 for showing how it can be resolved. Tests ideally must be related to the scenario; allow half marks if not related.

– Cost– Lack of software documentation– Change in client’s system next year– Outputs obtained– Use of copy files– Old system– File compatibility– Other relevant points


––––––

(c) Explanation of auditing around computer = 1 mark

1 mark for max two problems 1

– Actual computer files not tested– Difficult to track errors– Other relevant points

2–––

Maximum marks 3–––––––––

Total marks 20––––––

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Marks5 (a) 1 mark each for:

– Review of audit file– Ensure true and fair override not required– Meet with directors– Warn directors about qualification– Effect on audit report (material or pervasive materiality)– Draft report– Letter of representation– Assets may not need depreciation (see accounting standard)– Discuss with audit committee– Other relevant points


––––––

(b) 1 mark per point

Para 1Work in accordance with external standardsWork to identify material misstatementsMay be other material misstatements

Para 2Shows auditor disagrees with directorsShows auditor view based on standards

Para 3Quantifies effect of non-complianceShows what depreciation policy normally is

Para 4Confirms quantification of effect on financial statementsSo members can see total effect

Para 5‘Except for’ = material qualificationEverything else OK in FS

Other relevant points–––

Maximum marks 10––––––

(c) 1 mark per point

(i) Still disagree – modify report (+ reason)Qualification = ‘fundamental’

(ii) Uncertainty on one item only = modify reportQualification = material ‘except for adjustments that may be necessary’



––––––

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Pape

r F8

(M

YS)


Wednesday 4 June 2008



1 Introduction – audit firmYou are an audit senior in Brennon & Co, a firm providing audit and assurance services. At the request of an auditpartner, you are preparing the audit programme for the income and receivables systems of Seeley Co.

Audit documentation is available from the previous year’s audit, including internal control questionnaires and auditprogrammes for the despatch and sales system. The audit approach last year did not involve the use of computer-assisted audit techniques (CAATs); the same approach will be taken this year. As far as you are aware, Seeley’s systemof internal control has not changed in the last year.

Client background – sales systemSeeley Co is a wholesaler of electrical goods such as kettles, televisions, MP3 players, etc. The company maintainsone large warehouse in a major city. The customers of Seeley are always owners of small retail shops, where electricalgoods are sold to members of the public. Seeley only sells to authorised customers; following appropriate creditchecks, each customer is given a Seeley identification card to confirm their status. The card must be used to obtaingoods from the warehouse.

Despatch and sales systemThe despatch and sales system operates as follows:

1. Customers visit Seeley’s warehouse and load the goods they require into their vans after showing their Seeleyidentification card to the despatch staff.

2. A pre-numbered goods despatch note (GDN) is produced and signed by the customer and a member of Seeley’sdespatch staff confirming goods taken.

3. One copy of the GDN is sent to the accounts department, the second copy is retained in the despatchdepartment.

4. Accounts staff enter goods despatch information onto the computerised sales system. The GDN is signed.

5. The computer system produces the sales invoice, with reference to the inventory master file for product detailsand prices, maintains the sales day book and also the receivables ledger. The receivables control account isbalanced by the computer.

6. Invoices are printed out and sent to each customer in the post with paper copies maintained in the accountsdepartment. Invoices are compared to GDNs by accounts staff and signed.

7. Paper copies of the receivables ledger control account and list of aged receivables are also available.

8. Error reports are produced showing breaks in the GDN sequence.

Information on receivablesThe 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 Range of debt Total debt RM Current RM 1 to 2 More than 2receivables months old RM months old RM015 Less than RM0 (87,253) (87,253)197 RM0 to RM20,000 2,167,762 548,894 643,523 975,345153 RM20,001 to RM50,000 5,508,077 2,044,253 2,735,073 728,751023 RM50,001 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.

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Required:

(a) Explain the steps necessary to check the accuracy of the previous year’s internal control questionnaires.(4 marks)

(b) Using information from the scenario, list SIX tests of control that an auditor would normally carry out on thedespatch and sales system at Seeley Co and explain the reason for each test. (12 marks)

(c) State and explain the meaning of FOUR assertions that relate to the direct confirmation of receivables.(4 marks)

(d) (i) Describe the procedures up to despatch of letters to individual receivables in relation to a directconfirmation of receivables. (5 marks)

(ii) Discuss which particular categories of receivables might be chosen for the sample. (5 marks)

(30 marks)

2 (a) List and explain FOUR factors that will influence the auditor’s judgement regarding the sufficiency of theevidence obtained. (4 marks)

(b) AI 580 Management Representations provides guidance on the use of management representations as auditevidence.

Required:

List SIX items that could be included in a management representation letter. (3 marks)

(c) After performing tests of controls, the auditor is of the opinion that audit evidence is not sufficient to support theaudit opinion; in other words many control errors were found.

Required:

Explain THREE actions that the auditor may now take in response to this problem. (3 marks)

(10 marks)

3 [P.T.O.

3 (a) With reference to AI 520 Analytical Procedures explain

(i) what is meant by the term ‘analytical procedures’; (2 marks)

(ii) the different types of analytical procedures available to the auditor; and (3 marks)

(iii) the situations in the audit when analytical procedures can be used. (3 marks)

Zak Co sells garden sheds and furniture from 15 retail outlets. Sales are made to individuals, with income being inthe 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 thecompany 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

31 March 2008 31 March 2007RM000 RM000

Revenue 7,482 6,364Cost of sales (3,520) (4,253)

–––––– ––––––Gross profit 3,962 2,111

Operating expenses Administration (1,235) (1,320)Selling and distribution (981) (689)Interest payable (101) (105)Investment income 145 –

–––––– ––––––Profit/(loss) before tax 1,790 (3)

–––––– –––––––––––– ––––––

Balance sheet extract–––––– ––––––

Cash and bank 253 (950)–––––– –––––––––––– ––––––

Required:

(b) As part of your risk assessment procedures for Zak Co, identify and provide a possible explanation for unusualchanges in the income statement. (9 marks)

(c) Confirmation of the end of year bank balances is an important audit procedure.

Required:

Explain the procedures necessary to obtain a bank confirmation letter from Zak Co’s bank. (3 marks)

(20 marks)

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4 (a) Discuss the advantages and disadvantages of outsourcing an internal audit department. (8 marks)

(b) MonteHodge Co has a sales income of RM253 million and employs 1,200 people in 15 different locations.MonteHodge Co provides various financial services from pension and investment advice to individuals, tomaintaining cash books and cash forecasting in small to medium-sized companies. The company is owned bysix shareholders, who belong to the same family; it is not listed on any stock-exchange and the shareholders haveno intention of applying for a listing. However, an annual audit is required by statute and additional regulation ofthe financial services sector is expected in the near future.

Most employees are provided with on-line, real-time computer systems, which present financial and stock marketinformation to enable the employees to provide up-to-date advice to their clients. Accounting systems recordincome, which is based on fees generated from investment advice. Expenditure is mainly fixed, being salaries,office rent, lighting and heating, etc. Internal control systems are limited; the directors tending to trust staff andbeing more concerned with making profits than implementing detailed controls.

Four of the shareholders are board members, with one member being the chairman and chief executive officer.The financial accountant is not qualified, although has many years experience in preparing financial statements.

Required:

Discuss the reasons for and against having an internal audit department in MonteHodge Co. (12 marks)

(20 marks)

5 Smithson Co provides scientific services to a wide range of clients. Typical assignments range from testing food forillegal additives to providing forensic analysis on items used to commit crimes to assist law enforcement officers.

The annual audit is nearly complete. As audit senior you have reported to the engagement partner that Smithson ishaving some financial difficulties. Income has fallen due to the adverse effect of two high-profile court cases, whereSmithson’s services to assist the prosecution were found to be in error. Not only did this provide adverse publicity forSmithson, but a number of clients withdrew their contracts. A senior employee then left Smithson, stating lack ofinvestment in new analysis machines was increasing the risk of incorrect information being provided by the company.

A cash flow forecast prepared internally shows Smithson requiring significant additional cash within the next 12 months to maintain even the current level of services. Smithson’s auditors have been asked to provide a negativeassurance report on this forecast.

Required:

(a) Define ‘going concern’ and discuss the auditor’s responsibilities in respect of going concern. (4 marks)

(b) State the audit procedures that may be carried out to try to determine whether or not Smithson Co is a goingconcern. (8 marks)

(c) Explain the audit procedures the auditor may take where the auditor has decided that Smithson Co is unlikelyto be a going concern. (4 marks)

(d) In the context of the cash flow forecast, define the term ‘negative assurance’ and explain how this differsfrom the assurance provided by an audit report on statutory financial statements. (4 marks)

(20 marks)


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Answers

Fundamentals Level – Skills Module, F8 (MYS)Audit and Assurance (Malaysia) June 2008 Answers

1 (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 theaudit 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 controlquestionnaires produced last year are correct.

– Perform walk-through checks. Trace a few transactions through the sales system to ensure that the internal controlquestionnaires 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.

(b) – Tests of control

(c) Assertions – receivables

Assertion Application to direct confirmation of receivablesExistence The receivable actually exists which is confirmed by the receivable replying to the

receivables confirmation.

Rights and obligations The receivable belongs to Seeley Co. The receivable confirms that the amount is owed toSeeley again by replying to the confirmation.

Valuation and allocation Receivables are included in the financial statements at the correct amount – the receivablewill dispute any amounts that do not relate to that account.

Cut-off Transactions and events have been recorded in the correct accounting period. Thecircularisation will identify reconciling items such as sales invoices/cash in transit.

(d) (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 theyear. Ageing of receivables may also be verified at this time.

– Determine an appropriate sampling method (cumulative monetary amount, value-weighted selection, random, etc.)using materiality for the receivable balance to determine the sampling interval or number of receivables to includein the sample.

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Test of control Reason for test

Review a sample of goods despatch notes (GDN)for signatures of the goods despatch staff andcustomer.

Ensures that the goods despatched are correctlyrecorded on the GDNs.

Review a sample of GDNs for signature of theaccounts staff.

Ensures that the GDN details have been enteredonto the computer system.

Observe despatch system ensuring Seeley staffhave seen the customers’ identification card priorto goods being loaded into customers’ vans.

Ensures that goods are only despatched toauthorised customers.

Review the error report on numeric sequence ofGDNs produced in the accounts department andenquire action taken regarding omissions.

Ensures that the sequence of GDNs is complete.

Observe despatch process to ensure that thecustomers’ credit limit is reviewed prior to goodsbeing despatched.

Ensures that goods are not despatched to poor/badcredit risks.

Note: reviewing credit limits is not specificallystated in the scenario; however, most despatch/sales systems will have this control and mostcandidates mentioned this in their answers. Hencemarks were awarded for this point.

Review a selection of invoices ensuring they havebeen signed by accounts staff.

Ensures the accurate transfer of goods despatchedinformation from the GDN to the invoice.

– 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 Seeley Co (or other responsible official) to sign the letters.

– The auditor posts or faxes the letters to the individual receivables.

(ii) Specific receivables for selection:

1. Large or material items. These will be selected partly to ensure that no material error has occurred and partly toincrease the overall value of items tested.

2. Negative balances. There are 15 negative balances on Seeley’s list of receivables. Some of these will be tested toensure the credit balance is correct and to ensure that payments have not been posted to the wrong ledger account.

3. Receivables in the range RM0 to RM20,000. This group is unusual because it has a relatively higher proportionof older debts. Additional testing may be necessary to ensure that the receivables exist and to confirm that Seeleyis not overstating sales income by including many smaller receivables balances in the ledger.

4. Receivables with balances more than two months old. Receivables with old balances may indicate a provision isrequired for non-payment. The lack of analysis in Seeley Co’s receivable information indicates a high risk of non-payment as the age of many debts is unknown.

5. Random sample of remaining balances to provide an overall view of the accuracy of the receivables balance.

2 (a) Sufficiency of evidence

– Assessment of risk at the financial statement level and/or the individual transaction level. As risk increases then moreevidence is required.

– The materiality of the item. More evidence will normally be collected on material items whereas immaterial items maysimply be reviewed to ensure they appear correct.

– The nature of the accounting and internal control systems. The auditor will place more reliance on good accounting andinternal control systems limiting the amount of audit evidence required.

– The auditor’s knowledge and experience of the business. Where the auditor has good past knowledge of the businessand trusts the integrity of staff then less evidence will be required.

– The findings of audit procedures. Where findings from related audit procedures are satisfactory (e.g. tests of controls overreceivables) then substantive evidence will be collected.

– The source and reliability of the information. Where evidence is obtained from reliable sources (e.g. written evidence)then less evidence is required than if the source was unreliable (e.g. verbal evidence).

(b) Management representation letter contents

– No irregularities involving management or employees that could have a material effect on the financial statements

– All books of account and supporting documentation have been made available to the auditors

– Information and disclosures with reference to related parties is complete

– Financial statements are free from material misstatements including omissions

– No non-compliance with any statute or regulatory authority

– No plans that will materially alter the carrying value or classification of assets or liabilities in the financial statements

– No plans to abandon any product lines that will result in any excess or obsolete inventory

– No events, unless already disclosed, after the balance sheet date that need disclosure in the financial statements.

(c) Additional audit procedures

– The auditor could expand the amount of test of controls in that audit area. This may indicate that the control weaknesswas not as bad as initially thought.

– The problem could be raised with the directors, either verbally or in a management letter, to ensure that they are awareof the problem.

– The auditor could perform additional substantive procedures on the audit area. This action will help to quantify the extentof the error and makes the implicit assumption that the control system is not operating correctly.

– If the matter is not resolved, then the auditor will also need to consider a qualification in the audit report; the exactwording depending on the materiality of the errors found.

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3 (a) (i) Explanation of analytical procedures

Analytical procedures are used in obtaining an understanding of an entity and its environment and in the overall reviewat the end of the audit.

‘Analytical procedures’ actually means the evaluation of financial and other information, and the review of plausiblerelationships in that information. The review also includes identifying fluctuations and relationships that do not appearconsistent with other relevant information or results.

(ii) Types of analytical procedures

Analytical procedures can be used as:

– 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 theauditor 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 sizeto the client to determine whether receivable days, for example, are reasonable.

(iii) 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 entityand 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 theassertion level during work on the income statement and 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 financialstatements 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 thatexpenses, 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 thechange does not conform to the directors’ comments. It is possible that the industry as a whole, has been growing allowingZak 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 incorrectinventory 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 2008. Identifying reasons for this changewill need to focus initially on the change in sales and cost of sales.

Administration – fall 6%

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 increasein line with sales. There may be a mis-allocation of expenses from administration or the age of Zak’s delivery vans isincreasing 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 beoverstated – 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 amountor other income generating assets not disclosed on the balance sheet extract.

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(c) 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, if applicable.

– 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 authorityin 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.

4 (a) Outsourcing internal audit

Advantages of outsourcing internal audit

Staff recruitment

There will be no need to recruit staff for the internal audit department; the outsourcing company will provide all staff andensure staff are of the appropriate quality.

Skills

The outsourcing company will have a large pool of staff available to provide the internal audit service. This will provide accessto specialist skills that the company may not be able to afford if the internal audit department was run internally.

Set up time

The department can be set up in a few weeks rather than taking months to advertise and recruit appropriate staff.

Costs

Costs for the service will be agreed in advance. This makes budgeting easier for the recipient company as the cost andstandard of service expected are fixed.

Flexibility (staffing arrangements)

Staff can be hired to suit the workloads and requirements of the recipient company rather than full-time staff being idle forsome parts of the year.

Disadvantages of outsourcing internal audit

Staff turnover

The internal audit staff allocated to one company may change frequently; this means that company systems may not alwaysbe fully understood, decreasing the quality of the service provided.

External auditors

Where external auditors provide the internal audit service there may be a conflict of interest (self-review threat), where internalaudit work is then relied upon by external auditors.

Cost

The cost of the outsourced service may be too high for the company, which means that an internal audit department is notestablished at all. There may be an assumption that internal provision would be even more expensive.

Confidentiality

Knowledge of company systems and confidential data will be available to a third party. Although the service agreement shouldprovide confidentiality clauses, this may not stop breaches of confidentiality e.g. individuals selling data fraudulently.

Control

Where internal audit is provided in-house, the company will have more control over the activities of the department; there isless need to discuss work patterns or suggest areas of work to the internal audit department.

(b) Need for internal audit

For establishing an internal audit department

Value for money (VFM) audits

MonteHodge has some relatively complex systems such as the stock market monitoring systems. Internal audit may be ableto offer VFM services or review potential upgrades to these systems checking again whether value for money is provided.

Accounting system

While not complex, accounting systems must provide accurate information. Internal audit can audit these systems in detailensuring that fee calculations, for example, are correct.

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Computer systems

Maintenance of computer systems is critical to MonteHodge’s business. Without computers, the company cannot operate.Internal audit could review the effectiveness of backup and disaster recovery arrangements.

Internal control systems

Internal control systems appear to be limited. Internal audit could check whether basic control systems are needed,recommending implementation of controls where appropriate.

Effect on audit fee

Provision of internal audit may decrease the audit fee where external auditors can place reliance on the work of internal audit.This is unlikely to happen during the first year of internal audit due to lack of experience.

Image to clients

Provision of internal audit will enable MonteHodge Co to provide a better ‘image’ to its clients. Good controls imply clientmonies are safe with MonteHodge.

Corporate governance

Although MonteHodge does not need to comply with corporate governance regulations, internal audit could still recommendpolicies for good corporate governance. For example, suggesting that the chairman and chief executive officer roles are split.

Compliance with regulations

MonteHodge is in the financial services industry. In most jurisdictions, this industry has a significant amount of regulation.An internal audit department could help ensure compliance with those regulations, especially as additional regulations areexpected in the future.

Assistance to financial accountant

The financial accountant in MonteHodge is not qualified. Internal audit could therefore provide assistance in compliance withfinancial reporting standards, etc as well as recommending control systems.

Against establishing of internal audit department

No statutory requirement

As there is no statutory requirement, the directors may see internal audit as a waste of time and money and therefore notconsider establishing the department.

Accounting systems

Many accounting systems are not necessarily complex so the directors may not see the need for another department to reviewtheir operations, check integrity, etc.

Family business

MonteHodge is owned by a few shareholders in the same family. There is therefore not the need to provide assurance to othershareholders on the effectiveness of controls, accuracy of financial accounting systems, etc.

Potential cost

There would be a cost of establishing and maintaining the internal audit department. Given that the directors consider focuson profit and trusting employees to be important, then it is unlikely that they would consider the additional cost of establishinginternal audit.

Review threat

Some directors may feel challenged by an internal audit department reviewing their work (especially the financial accountant).They are likely therefore not to want to establish an internal audit department.

5 (a) Going concern

Going concern means that the enterprise will continue in operational existence for the foreseeable future without the intentionor necessity of liquidation or otherwise ceasing trade. It is one of the fundamental accounting concepts used by auditors andstated in FRS 101 Presentation of Financial Statements.

The auditor’s responsibility in respect of going concern is explained in AI 570 Going Concern (Revised). The AI states ‘whenplanning and performing audit procedures and in evaluating the results thereof, the auditor should consider theappropriateness of management’s use of the going concern assumption in the preparation of the financial statements’.

The auditor’s responsibility therefore falls into three areas:

(i) To carry out appropriate audit procedures that will identify whether or not an organisation can continue as a goingconcern.

(ii) To ensure that the organisation’s management have been realistic in their use of the going concern assumption whenpreparing the financial statements.

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(iii) To report to the members where they consider that the going concern assumption has been used inappropriately, forexample, when the financial statements indicate that the organisation is a going concern, but audit procedures indicatethis may not be the case.

(b) Audit procedures regarding going concern

– Obtain a copy of the cash flow forecast and discuss the results of this with the directors.

– Discuss with the directors their view on whether Smithson can continue as a going concern. Ask for their reasons andtry and determine whether these are accurate.

– Enquire of the directors whether they have considered any other forms of finance for Smithson to make up the cashshortfall identified in the cash flow forecast.

– Obtain a copy of any interim financial statements of Smithson to determine the level of sales/income after the year-endand whether this matches the cash flow forecast.

– Enquire about the possible lack of capital investment within Smithson identified by the employee leaving. Review currentlevels of non-current assets with similar companies and review purchase policy with the directors.

– Consider the extent to which Smithson relied on the senior employee who recently left the company. Ask the humanresources department whether the employee will be replaced and if so how soon.

– Obtain a solicitor’s letter and review to identify any legal claims against Smithson related to below standard servicesbeing provided to clients. Where possible, consider the financial impact on Smithson and whether insurance is availableto mitigate any claims.

– Review Smithson’s order book and client lists to try and determine the value of future orders compared to previous years.

– Review the bank letter to determine the extent of any bank loans and whether repayments due in the next 12 monthscan be made without further borrowing.

– Review other events after the end of the financial year and determine whether these have an impact on Smithson.

– Obtain a letter of representation point confirming the directors’ opinion that Smithson is a going concern.

(c) Audit procedures if Smithson is not considered to be a going concern

– Discuss the situation again with the directors. Consider whether additional disclosures are required in the financialstatements or whether the financial statements should be prepared on a ‘break up’ basis.

– Explain to the directors that if additional disclosure or restatement of the financial statements is not made then theauditor will have to modify the audit report.

– Consider how the audit report should be modified. Where the directors provide adequate disclosure of the going concernsituation of Smithson, then an emphasis of matter paragraph is likely to be appropriate to draw attention to the goingconcern disclosures.

– Where the directors do not make adequate disclosure of the going concern situation then qualify the audit report makingreference to the going concern problem. The qualification will be an ‘except for’ opinion or an adverse opinion dependingon the auditor’s opinion of the situation.

(d) Negative assurance

Negative assurance means that nothing has come to the attention of an auditor which indicates that the cash flow forecastcontains any material errors. The assurance is therefore given on the absence of any indication to the contrary.

In contrast, the audit report on statutory financial statements provides positive or reasonable assurance; that is the financialstatements do show a true and fair view.

Using negative assurance, the auditor is warning users that the cash flow forecast may be inaccurate. Less reliance cantherefore be placed on the forecast than the financial statements, where the positive assurance was given.

With negative assurance, the auditor is also warning that there were limited audit procedures that could be used; the cashflow relates to the future and therefore the auditor cannot obtain all the evidence to guarantee its accuracy. Financialstatements relate to the past, and so the auditor should be able to obtain the information to confirm they are correct; hencethe use of positive assurance.

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Fundamentals Level – Skills Module, F8 (MYS)Audit and Assurance (Malaysia) June 2008 Marking Scheme

Marks1 (a) Accuracy of internal control questionnaires

1 for each well-explained step.

– Prior year audit file– System weaknesses identified not actioned by client– Review system documentation– Interview client staff– Walk-through check– Identify controls in above– Other relevant procedures


–––

(b) Tests of control despatch and sales system

1 for stating procedure and 1 for the reason for that procedure. Limit marks to 0·5 where the reason is not fully explained.Maximum 2 marks per point.

Procedure– GDN signature – despatch staff– GDN signature – accounts staff– Observe despatch system– Error report GDN numeric sequence– Credit limit control– Invoices – signed– Credit checking – either account setup or prior to despatch of goods– GDN signed by customer – shows receipt of goods– Observe the despatch system– Other relevant procedures


–––

(c) Assertions – direct confirmation of receivables

1 for each good explanation. (Note any asssertion is allowed if showed linked to receivables circularisation)

Assertions– Existence– Rights and obligations– Valuation and allocation (normally needs links to liquidator)– Completeness (where linked to invoices not recorded by client co)– Other relevant points


–––

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Marks(d) Receivables circularisation procedures

1 mark per procedure

(i) Procedure– List of receivables– Sampling method– Select balances for testing– Extract details from ledger– Prepare letters – client sign– Post letters– Choose date if not year end– Confirm with management can circularise receivables– Other relevant points

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(ii) Specific receivables for selection – 1 mark each explained point (must include reason for selection for full mark)

– Negative balances– Material balances– RM0 to RM20,000 balances– Old balances– Random sample remaining balances– Other relevant points

5–––

Maximum marks 10–––30––––––

2 (a) Sufficiency of evidence

1 for each point

– Financial statement risk– Materiality– Accounting/internal control systems– Auditor’s knowledge– Audit procedures– Source and reliability– Sampling method used– Other relevant points


–––

(b) Management representation letter contents

0·5 mark per valid point–––

Maximum marks 3–––

(c) 1 for each point with explanation

– Increase tests of controls– Discuss with management– Substantive procedures– Qualification of audit report– Include in management letter– Discuss with audit committee


–––10––––––

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Marks3 (a) Analytical procedures

1 mark for each valid, well-explained, point

(i) – Obtain information on client situation– Evaluation financial information

(ii) – Comparison prior periods– Comparison actual/anticipated results– Comparison industry information– Specific procedures for individual account balances (e.g. receivables)– Ratio analysis e.g. GP% year on year– Proof in total e.g. total wages = employees * average wage

(iii) – Risk assessment procedures– Substantive procedures– End of audit analytical procedures


–––

(b) Risks – income statement

0·5 mark, for identifying unusual changes in income statement. Award up to 1 more mark. Total 1·5 marks per point.

– Net profit– Revenue– Cost of sales– Gross profit– Administration– Selling and distribution– Interest payable– Interest receivable (must be linked to the change in bank balance – not enough cash for interest received)– Other relevant points


–––

(c) Bank letter

1 mark for each audit procedure

– Evaluate need for letter– Prepare bank letter – standard form– Client permission– Refer to standing authority at bank– Letter direct to bank


–––20––––––

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Marks4 (a) 1 mark for each well-explained point

For outsourcing internal audit– Staff recruitment– Skills– Set up time– Costs– Flexibility of staffing arrangements– Independence of external firm– Other valid points

Against outsourcing internal audit– Staff turnover– External auditors– Cost– Confidentiality– Control– Independence (where services provided by same firm)– Other valid points


–––

Note to markers – there is no split of marks between advantages and disadvantages.

(b) Up to 2 marks for each well-explained point

For internal audit– VFM audits– Accounting system– Computer systems– Internal control systems– Effect on audit fee– Image to clients– Corporate governance– Lack of control– Law change– Assistance to financial accountant– Nature of industry (financial services)– Other relevant points

Against internal audit– No statutory requirement– Family business– Potential cost– Review threat– Other relevant points


–––20––––––

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Marks5 (a) Going concern meaning

1 mark each for:

– Definition– AI 570 explanation (don’t need the AI number)– Audit procedures– Realistic use of assumption– Report to members– Report to audit committee and/or directors– Discussion with management on going concern– Other relevant points


–––

(b) Audit procedures on going concern

1 mark per procedure (0·5 if brief or unclear e.g. ‘check the cash flow’)

– Cash flow– Directors’ view going concern– Other finance– Interim financial statements– Lack of non-current assets– Reliance on senior employee– Solicitor’s letter– Review order book– Review bank letter– Review other events after the reporting period– Management representation– Other relevant points


–––

(c) Audit procedures company may not be a going concern

1 mark per action (0·5 if brief or unclear e.g. ‘discuss with directors’)

– Discuss with directors– Need to modify audit report– Possible emphasis of matter– Possible qualification– Letter of representation– Other relevant points


–––

(d) Negative assurance

1 mark per action (0·5 if brief or unclear e.g. ‘warning cash flow may be inaccurate’)

– Definition– Audit report = positive assurance– Level of reliance– Limited audit procedures– Other relevant points


–––20––––––

19







Pape

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(M

YS)





1 Introduction

Blake Co assembles specialist motor vehicles such as lorries, buses and trucks. The company owns four assemblyplants 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 normallywork a standard eight hour day, although this is supplemented by overtime on a regular basis as Blake has a full orderbook. There is one shift per day; mass production and around the clock working are not possible due to the specialistnature 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 isscanned by the time recording system and each production shift-worker’s identification number is read from their cardby the scanner. The worker is then logged in as being at work. Shift-workers are paid from the time of logging in. Thelogging in process is not monitored as it is assumed that shift-workers would not work without first logging in on thetime 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 bemanufactured 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 ensureworkers are not taking unnecessary or prolonged breaks which would automatically increase the amount of overtimeworked. Shift-workers log off at the end of each shift by re-scanning their identification card.

Payment of wages

Details of hours worked each week are sent electronically to the payroll department, where hours worked are allocatedby the computerised wages system to each employee’s wages records. Staff in the payroll department compare hoursworked from the time recording system to the computerised wages system, and enter a code word to confirm theaccuracy of transfer. The code word also acts as authorisation to calculate net wages. The code word is the name ofa domestic cat belonging to the department head and is therefore generally known around the department.

Each week the computerised wages system calculates: (i) gross wages, using the standard rate and overtime rates per hour for each employee, (ii) statutory deductions from wages, and(iii) net pay.

The list of net pay for each employee is sent over Blake’s internal network to the accounts department. In the accountsdepartment, an accounts clerk ensures that employee bank details are on file. The clerk then authorises and makespayment to those employees using Blake’s online banking systems. Every few weeks the financial accountant reviewsthe total amount of wages made to ensure that the management accounts are accurate.

Termination of employees

Occasionally, employees leave Blake. When this happens, the personnel department sends an e-mail to the payrolldepartment detailing the employee’s termination date and any unclaimed holiday pay. The receipt of the e-mail by thepayroll 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.

2

Required:

(a) List FOUR control objectives of a wages system. (2 marks)

(b) As the external auditors of Blake Co, write a management letter to the directors in respect of the shift-workerswages recording and payment systems which:

(i) Identifies and explains FOUR weaknesses in that system;(ii) Explains the possible effect of each weakness;(iii) Provides a recommendation to alleviate each weakness.

Note up to two marks will be awarded within this requirement for presentation. (14 marks)

(c) List THREE substantive analytical procedures you should perform on the shift managers’ salary system. Foreach procedure, state your expectation of the result of that procedure. (6 marks)

(d) Audit evidence can be obtained using various audit procedures, such as inspection.

APART FROM THIS PROCEDURE, in respect of testing the accuracy of the time recording system at BlakeCo, explain FOUR procedures used in collecting audit evidence and discuss whether the auditor will benefitfrom using each procedure. (8 marks)

(30 marks)

2 (a) AI 620 Using the Work of an 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 andobjectivity of the expert. (3 marks)

(b) Auditors have various duties to perform in their role as auditors, for example, to assess the truth and fairness ofthe financial statements.

Required:

Explain THREE rights that enable auditors to carry out their duties. (3 marks)

(c) List FOUR assertions relevant to the audit of tangible non-current assets and state one audit procedure whichprovides appropriate evidence for each assertion. (4 marks)

(10 marks)

3 [P.T.O.

3 You are a manager in the audit firm of Ali & Co; and this is your first time you have worked on one of the firm’sestablished clients, Stark Co. The main activity of Stark Co is providing investment advice to individuals regardingsaving for retirement, purchase of shares and securities and investing in tax efficient savings schemes. Stark isregulated by the relevant financial services authority.

You have been asked to start the audit planning for Stark Co, by Mr Son, a partner in Ali & Co. Mr Son has been theengagement partner for Stark Co, for the previous nine years and so has excellent knowledge of the client. Mr Sonhas informed you that he would like his daughter Zoe to be part of the audit team this year; Zoe is currently studyingfor her first set of fundamentals papers for her ACCA qualification. Mr Son also informs you that Mr Far, the auditsenior, received investment advice from Stark Co during the year and intends to do the same next year.

In an initial meeting with the finance director of Stark Co, you learn that the audit team will not be entertained onStark Co’s yacht this year as this could appear to be an attempt to influence the opinion of the audit. Instead, he hasarranged a balloon flight costing less than one-tenth of the expense of using the yacht and hopes this will beacceptable. The director also states that the fee for taxation services this year should be based on a percentage of taxsaved and trusts that your firm will accept a fixed fee for representing Stark Co in a dispute regarding the amount ofsales tax payable to the taxation authorities.

Required:

(a) (i) Explain the ethical threats which may affect the auditor of Stark Co. (6 marks)

(ii) For each ethical threat, discuss how the effect of the threat can be mitigated. (6 marks)

(b) Discuss the benefits of Stark Co establishing an internal audit department. (8 marks)

(20 marks)

4 (a) Explain the term ‘audit risk’ and the three elements of risk that contribute to total audit risk. (4 marks)

The EuKaRe charity was established in 1960. The charity’s aim is to provide support to children from disadvantagedbackgrounds who wish to take part in sports such as tennis, badminton and football.

EuKaRe has a detailed constitution which explains how the charity’s income can be spent. The constitution also notesthat 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 mustbe spent on specific activities, for example, provision of sports equipment.

The rules regarding the taxation of charities in the country EuKaRe is based are complicated, with only certainexpenditure being allowable for taxation purposes and donations of capital being treated as income in some situations.

Required:

(b) Identify areas of inherent risk in the EuKaRe charity and explain the effect of each risk on the audit approach.(12 marks)

(c) Explain why the control environment may be weak at the charity EuKaRe. (4 marks)

(20 marks)

4

5 The date is 3 December 2008. The audit of ZeeDiem Co is nearly complete and the financial statements and the auditreport are due to be signed next week. However, the following additional information on two material events has justbeen presented to the auditor. The company’s year end was 30 September 2008.

Event 1 – Occurred on 10 October 2008

The springs in a new type of mattress have been found to be defective making the mattress unsafe for use. Therehave been no sales of this mattress; it was due to be marketed in the next few weeks. The company’s insurersestimate that inventory to the value of RM750,000 has been affected. The insurers also estimate that the mattressesare now only worth RM225,000. No claim can be made against the supplier of springs as this company is inliquidation with no prospect of any amounts being paid to third parties. The insurers will not pay ZeeDiem for the fallin value of the stock as the company was underinsured. All of this stock was in the finished goods store at the endof the year and no movements of stock have been recorded post year-end.

Event 2 – Occurred 5 November 2008

Production at the ShamEve factory was halted for one day when a truck carrying dye used in colouring the fabric onmattresses reversed into a metal pylon, puncturing the vehicle allowing dye to spread across the factory premises andinto a local river. The Environmental Agency is currently considering whether the release of dye was in breach ofenvironmental legislation. The company’s insurers have not yet commented on the event.

Required:

(a) For each of the two events above:

(i) Explain whether the events are adjusting or non-adjusting according to FRS110 Events after the BalanceSheet Date. (4 marks)

(ii) Explain the auditors’ responsibility and the audit procedures and actions that should be carried outaccording to AI 560 Subsequent Events. (12 marks)

(b) Assume that the date is now 20 December 2008, the financial statements and the audit report have just beensigned, and the annual general meeting is to take place on 10 January 2009. The Environmental Agency hasissued a report stating that ZeeDiem Co is in breach of environmental legislation and a fine of RM900,000 willnow be levied on the company. The amount is material to the financial statements.

Required:

Explain the additional audit work the auditor should carry out in respect of this fine. (4 marks)

(20 marks)


5

Answers


1 (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 DirectorsBlake Co1701 Any StreetBig Town 31911Acountry

3 December 2008

Dear Sirs

Management letter

We write to bring to your attention weaknesses in your company’s internal control systems and provide recommendations toalleviate those weaknesses.

9

(i) Weakness: (ii) Possible effect: (iii) Recommendation:

The logging in process for employees isnot monitored.

Employees could bring cards for absentemployees to the assembly plant andscan that card for the employee; absentemployees would effectively be paid forwork not done.

The shift manager should reconcile thenumber of workers physically presenton the production line with thecomputerised record of the number ofemployees logged in for work eachshift.

Overtime is not authorised by aresponsible official.

Employees may get paid for work notdone e.g. they may clock-off late inorder to receive ‘overtime’ payments.

All overtime should be authorised,either by the shift manager authorisingan estimated amount of overtime priorto the shift commencing or by themanager confirming the recorded hoursin the payroll department computersystem after the shift has beencompleted.

The code word authorising theaccuracy of time worked to the wagessystem is the name of the cat of thedepartment head.

The code word is not secure and couldbe easily guessed by an employeeoutside the department (names of petsare commonly used passwords).

The code word should be based on arandom sequence of letters andnumbers and changed on a regularbasis.

The total amount of net wagestransferred to employees is not agreedto the total of the list of wagesproduced by the payroll department.

‘Dummy’ employees – payments thatdo not relate to any real employee –could be added to the payroll paymentslist in the accounts department.

Prior to net wages being sent to thebank for payment, the financialaccountant should agree the total of thepayments list to the total of wages fromthe payroll department.

Details of employees leaving thecompany are sent on an e-mail fromthe personnel department to payroll.

There is no check to ensure that all e-mails sent are actually received in thepayroll department.

There needs to be a control to ensureall e-mails are received in personnel –prenumbering of e-mails or tagging thee-mail to ensure a receipt is sent backto the personnel department will helpmeet this objective.

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

(d)

10

(i) Weakness: (ii) Possible effect: (iii) Recommendation:

In the accounts department, theaccounts clerk authorises payment ofnet wages to employees.

It is inappropriate that a junior memberof staff should sign the payroll; theclerk may not be able to identify errorsin the payroll or could even haveincluded ‘dummy employees’ and isnow authorising payments to those‘people’.

The payroll should be authorised by asenior manager or finance director.

Substantive analytical procedure Expectation

Compare total salaries cost this year to total salaries costlast year.

Assuming that the number of shift managers has remainedunchanged, the total salary expenditure should haveincreased by inflation only.

Ascertain how many shift managers are employed by Blakeand the total salary from the personnel department.Calculate total salary and compare to the salary disclosedin the financial statements.

Total salary should be approximately number of managersmultiplied by average salary.

Obtain a listing of total salary payments made each month. The total payments should be roughly the same apart fromJuly onwards when salaries increased and November whenthe annual bonus was paid.

Audit procedure Benefit to auditor in testing accuracy of time recordingsystem

Confirmation

Confirmation is the process of obtaining a representation ofinformation or of an existing condition directly from a thirdparty.

Obtaining information from a third party will be difficult.The manufacturer of the time recording system could beapproached to discuss known errors with the system;however, information provided may be limited by the needto protect the manufacturer’s integrity.

It is therefore unlikely that the auditor will benefit from thisprocedure.

Observation

This procedure involves watching a procedure beingperformed by others – in this case watching shift-workersusing the time recording system.

Testing will be limited to ensuring all shift-workers actuallyclock in and out when they arrive to and depart from work.The procedure has limited use as it only confirms it workedwhen shift-workers were observed. It also cannot confirmthat hours have been recorded accurately.

Inquiry

Inquiry involves obtaining information from client staff orexternal sources.

Inquiry only confirms that shift-workers confirm they clock-in or out. It does not directly confirm the actionactually happened or the accuracy of the recording of hoursworked.

2 (a) Competence and objectivity of experts

– The expert’s professional qualification. The expert should ideally be a member of a relevant professional body or havethe 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.

(b) Auditor rights

– Right of access to the company’s books and records at any reasonable time to collect the evidence necessary to supportthe audit opinion.

– Right to require from the company’s officers the information and explanations the auditor considers necessary to performtheir 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.

(c) Non-current assets – assertions

– Completeness – ensure that all non-current assets are recorded in the non-current asset register by agreeing a sampleof 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 depreciationcalculations.

– Rights and obligations – ensure the company owns the asset by seeing appropriate documentation of ownership forexample, a purchase invoice.

– Presentation and disclosure assertions – ensure all necessary financial statements disclosures have been made byreviewing the financial statements and ensure non-current assets are correctly categorised in those financial statements.

Note: only four assertions were required.

11

Audit procedure Applicability in testing accuracy of time recording system

Recalculation

Recalculation means re-checking the arithmetical accuracyof the client’s records; in this case the hours worked by thetime-recording system.

Recalculation can confirm the hours worked are correctlycalculated as the difference between the clocking in andout times in the time recording system. When used withreperformance evidence this will confirm the overallaccuracy of the time recording system.

Reperformance

This is the auditor’s independent execution of procedures orcontrols that were originally performed as part of theentity’s internal control.

If the auditor notes the time of clocking in and out, thenthese times can be agreed to the time recording systemconfirming the accuracy of recording (or confirm that clientstaff acutally perform this control). Reperformance istherefore a good source of audit evidence.

Analytical procedures

Analytical procedures involve comparing financial or non-financial data for plausible relationships.

This procedure will be useful for the auditor as the totaltime recorded for each employee should be standard hoursplus any estimate of the overtime worked.

3 (a) Ethical threats

(b) Benefits of internal audit

Regulation

Stark Co operates in a regulated sector and is under the supervision of a regulatory authority. It is very likely that there areregulatory controls and reports that Stark must produce or comply with. Establishing an internal audit department will enableStark to produce those reports more efficiently and show compliance with the regulatory regime. Even if internal audit is notrequired now, codes of governance increasingly suggest that it is good practice to have an internal audit department.

Reports to the board

As a financial services provider, staff in Stark Co will be producing various financial reports for their board. The internal auditdepartment will be able to monitor the accuracy of those reports, especially those not audited by the external auditors. Thisfunction will help enhance the accuracy and reliability of the reports.

Liaison with external auditors

The internal auditors can liaise with the external auditors, especially where it is possible for the external auditors to placereliance on the work of internal audit. This will decrease the time and cost of the external audit.

Internal audit can also monitor the external audit to ensure they are carrying out an efficient and effective service.

Monitor effectiveness of internal controls

It is likely that Stark has to maintain a strong internal control system as the company is regulated and will be handlingsignificant amounts of client cash. Internal audit can review the effectiveness of those controls and make recommendationsto management for improvement where necessary.

12

Ethical threat Mitigation of threat

Mr Son, the engagement partner has been involved withthe client for the last nine years.

This means he may be too familiar with the client to beable to make objective decisions due to this longassociation.

Mr Son should be rotated from being engagement partner.He can still contact the client but should not be in theposition of signing the audit report.

There is no ethical rule which stops Mr Son recommendingZoe for the audit, or letting Zoe take part in the audit.

However, there may be the impression of lack ofindependence as Zoe is related to the engagement partner.Zoe could be tempted not to identify errors in case thisprejudiced her father’s relationship with the client.

To show complete independence, Zoe should not be part ofthe audit team. However, if Mr Son is no longer theengagement partner then this removes the ethical threatand Zoe could be included in the audit team.

As long as Mr Far paid a full fee to Stark Co for theinvestment advice, then there is no ethical threat. Thiswould be a normal commercial transaction and Mr Farwould not gain any benefit.

However, continued use of client services could imply alack of independence especially as Mr Far is not paying afull fee and therefore receiving a benefit from the client.

To show independence from the client, Mr Far could beasked not to use the services of Stark Co again unless thisis first agreed with the engagement partner.

The audit team have been offered a balloon flight at theend of the audit.

Acceptance of gifts from a client, unless of an insignificantamount, is not allowed. The fact that the flight costs lessthan the yacht expense is irrelevant, independence couldstill be impaired.

The balloon flight should not be accepted. Investigationwould also be needed to find out why hospitality wasaccepted in previous years.

Agreeing to accept taxation work on the percentage of thetax saved is essentially accepting a contingent fee.

There will be pressure to gain the highest tax refund for theclient and this could tempt the audit firm to suggest illegaltax avoidance schemes.

The audit firm must confirm that assistance with taxationwork is acceptable, although the fee must be based ontime and experience for the job, not the contingent fee.

Representing Stark Co in court could be seen as anadvocacy threat – that is the audit firm is promoting theposition of the client.

Objectivity could be compromised because the audit firm isseen to take the position that the client is correct, affectingjudgement on the tax issue.

To remain independent, the audit firm should decline torepresent the client in court.

Value for Money Audit

Internal audit can carry out value for money audits within Stark Co. For example, a review could be undertaken on the cost-effectiveness of the various control systems or whether investment advice being provided is cost-effective given the nature ofproducts being recommended and the income/commission generated from those products.

Risk assessment

Internal audit could also carry out risk assessments on the portfolios being recommended to clients to ensure the portfoliomatched the client’s risk profile and Stark Co’s risk appetite. Any weaknesses in this area would result in a recommendationto amend investment policies as well as decreasing Stark’s exposure to unnecessary risk.

Taxation services

Stark Co require assistance with the preparation of taxation computations and specialist assistance in court regarding ataxation dispute. Internal audit could assist in both areas as long as appropriate specialists were available in the department.Provision of these services would remove any conflict of interest that Stark’s auditors have as well as ensuring expertise wasavailable in house when necessary.

4 (a) Audit risk

Audit risk is the risk that an auditor gives an inappropriate opinion on the financial statements being audited.

Inherent risk is the susceptibility of an assertion to a misstatement that could be material, individually or when aggregatedwith misstatements, assuming that there are no related controls. The risk of each misstatement is greater for some assertionsand 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 aggregatedwith other misstatements, which will not be prevented or detected on a timely basis by the company’s internal controlsystems.

Detection risk is the risk that the auditors’ procedures will not detect a misstatement that exists in an assertion that could bematerial, individually or when aggregated with other misstatements.

(b) Inherent risks in charity

13

Area of inherent risk Effect on audit approach

Income is from voluntary donations only. There is a riskthat donations will fall, especially where donors’ ownincome is limited by the ‘credit crunch’ etc.

It is difficult to estimate that income in the future will besufficient to meet the expenditure of the charity.

Audit of the going concern concept (as in ensuring that thecharity can still operate) will therefore be quite difficult.

Completeness of income – where there are no controls toensure income is complete for example sales invoices arenot raised to obtain donations and donations could bestolen by staff.

Audit tests are unlikely to be effective to meet the assertionof completeness. The audit report may need to be modifiedand qualified to explain the lack of evidence stating thatcompleteness of income cannot be confirmed.

Funds can only be spent in accordance with the aims ofthe charity. There is a risk that funds are spent outside theaims of the charity.

Careful review of expenditure will be necessary to ensurethat expenditure is not ‘ultra vires’ the objectives of thecharity.

The auditor will need to review the constitution of theEuKaRe charity carefully in this respect.

Taxation rules relevant to charities. There is a risk that therules will be broken due to lack of correct analysis ofincome/expenditure.

The auditor will need to ensure that staff familiar with thetaxation rules affecting the charity are on the audit team.

Requirement to report expenditure in accordance with theconstitution – administration expenditure can be no morethan 10% of total income. Risks here include income beingoverstated to allow expenditure to be overstated.

The trustees may attempt to hide ‘excessive’ expenditure onadministration under other expense headings.

As the auditor has to report on the accuracy of income andexpenditure then audit procedures must focus on theaccuracy of recording of expenditure.

Donations to charity for specific activities for exampleprovision of sports equipment. There is a risk thatdonations are not spent in accordance with donors’instructions.

Documentation for any donation will need to be obtainedand then expenditure agreed to the terms of thedocumentation. Any discrepancies will have to be reportedto management.

(c) 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 includingsegregation of duties cannot be implemented. Staff are likely to be unclear as to their exact responsibilities as they are notformal ‘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 differentstaff on different days making the system unreliable.

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 haveprofessional 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 willnot 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 timeto devote to the charity, then there may be an impression that controls are not important. The overall control environmentmay therefore be weak as other charity workers do not see the importance of maintaining good controls.

5 (a) Event 1

(i) The problem with the mattress stock provides additional evidence of conditions existing at the end of the reporting periodas the stock was in existence and the faulty springs were included in the stock at this time.

The value of the inventory is overstated and should be reduced to the lower of cost and net realisable value in accordancewith FRS 102 Inventories.

An adjustment for this decrease in value must be made in the financial statements.

The mattresses should therefore be valued at RM225,000 being the net realisable value.

(ii) The decrease in value of inventory took place after the end of the reporting period but before the financial statementsand the audit report were signed.

The auditor is therefore still responsible for identifying material events that affect the financial statements.

Audit procedures are therefore required to determine the net book value of the inventory and check that the RM225,000is the sales value of the mattresses.

Audit procedures will include:

– Obtain documentation from the insurers confirming their estimate of the value of the mattresses and that no furtherinsurance claim can be made for the loss in value.

– Contact solicitors/administrators of the spring supplier to confirm no refund can be expected for the defectivesprings.

– Obtain the amended financial statements and ensure that the directors have included RM225,000 as at the endof the reporting period and that the year-end value of inventory has been decreased to RM225,000 on thestatement of financial position, statement of financial position note and the income statement.

– Review inventory lists to ensure that the defective springs were not used in any other mattresses and that furtheradjustments are not required to any other inventory.

– Obtain an additional management representation point confirming the accuracy of the amounts written-off andconfirming that no other items of inventory are affected.

– Finally, assessing the effect on the audit opinon after the decision of the directors regarding the inventory value isknown. A qualified opinon may be required where appropriate adjustments are not made to the financialstatements.

Event 2

(i) The release of dye occurred after the end of the reporting period, so this is indicative of conditions existing after the endof the reporting period – the event could not be foreseen at the end of the reporting period.

In this case, no adjustment to the financial statements appears to be necessary.

However, the investigation by the Environmental Agency could result in a legal claim against the company for illegalpollution. So as a material event it will need disclosure in the financial statements.

14

(ii) As with event 1, the event takes place before the signing of the audit report, therefore the auditors have a duty to identifymaterial events affecting the financial statements.


– Obtain any documentation on the event, for example board minutes, copies of environmental legislation andpossibly interim reports from the Environmental Agency to determine the extent of the damage.

– Inquire of the directors whether they will disclose the event in the financial statements.

– If the directors plan to make disclosure of the event, ensure that disclosure appears appropriate.

– If the directors do not plan to make any disclosure, consider whether disclosure is necessary and inform thedirectors accordingly.

– Where disclosure is not made and the auditor considers disclosure is necessary, modify the audit opinion on thegrounds of disagreement and explain the reason for the qualification in the report. This will be for lack of disclosure(not provision) even though the amount cannot yet be determined.

– Alternatively, if the auditor considers that the release of dye and subsequent fine will affect ZeeDiem’s ability tocontinue as a going concern, draw the members’ attention to this in an emphasis of matter paragraph.

(b) The notification of a fine has taken place after the audit report has been signed.


– Discuss the matter with the directors to determine their course of action.

– Where the directors decide to amend the disclosure in the financial statements, audit the amendment and then re-draftand re-date the audit report as appropriate.

– Where the directors decide not to amend the disclosure in the financial statements, the auditor can consider othermethods of contacting the members. For example, the auditor can speak in the upcoming general meeting to inform themembers of the event.

– Other options such as resignation seem inappropriate due to the proximity of the annual general meeting (AGM).Resignation would allow the auditor to ask the directors to convene an extraordinary general meeting, but this could nottake place before the AGM so the auditor should speak at the AGM instead.

15


Marks1 (a) 0·5 mark for each valid objective


–––

(b) Management letter – 1 mark for each weakness, 1 for each possible effect and 1 for each recommendation = 3 marks * 4 sets of points = 12 marks

Logging in process not monitoredOvertime not authorisedPoor password control (cat’s name)Transfer total wages not checkedEmployees leaving details sent on e-mailOther valid points

4 points * 3 marks each = 12

Letter format (that is not a report or memo at beginning) 1Overall presentation 1


–––

(c) 1 mark for each valid procedure and 1 for expectation of result of procedure = 2 marks for each procedure

Total salary costAverage salaryList of payments each monthOther valid points


–––

(d) 0·5 mark for stating each procedure, 0·5 for explaining each procedure and 1 mark for discussing the use of that procedure (can include an example audit procedure as part ofanswer to obtain this mark) = 2 marks for each procedure

Confirmation (note limited use)ObservationInquiryRecalculationReperformanceAnalytical procedures

Note inspection procedure not valid as stated in question.–––

Maximum marks 8–––

Total marks 30–––

17

Marks2 (a) 1 mark for each factor

Professional qualificationExperience and reputationIndependenceOther valid points(including but not limited toReputationNot employed by clientNot related to client)


–––

(b) 1 mark for each right of the auditor

Access to company booksObtain information/explanation company officersReceive notice of/attend certain meetingsSpeak at certain meetingsReceive copies certain resolutionsOther valid points


–––

(c) 0·5 for each assertion and 0·5 for each procedure

CompletenessExistenceValuationRights and obligationsPresentation and disclosure


–––Total marks 10

–––

Note ISA 500 mentions that any valid procedure may be used with statement of financial position items –for example cut-off would be allowable where explaining recording of the asset in the correct accountingperiod. Allow therefore any valid asssertion.

18

Marks3 (a) 1 for each ethical threat and 1 for explanation of how to mitigate that threat = 2 marks

per linked points.Part (i) therefore is 6 marks total and part (ii) is 6 marks total

Engagement partner – time providing serviceEngagement partner’s daughter takes part in auditPayment for investment adviceGift of balloon flight from clientContingent fee – taxation workRepresenting client in courtSelf-review threat from taxation serviceFixed fee – normally calculate on time and experience?Other valid points


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(b) Up to 2 marks per well-explained point

RegulationReports to the boardLiaison with external auditorsMonitor effectiveness of internal controlsValue for money auditRisk assessmentTaxation servicesDecrease external audit feeMonitor overall strategy of companyImprove customer confidence in companyOther valid points



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4 (a) 1 mark for explanation of each term

Audit riskInherent riskControl riskDetection risk


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(b) 1 mark for each area of inherent risk and 1 mark for explaining the effect on the audit approach = 2 marks per linked points

Income voluntary onlyCompleteness of incomeFunds spent in accordance with charity objectivesTaxation rulesReporting of expenditureDonation for specific activitiesAdministration not exceed 10% of incomeMisallocation of capital donationsOther valid points


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(c) 1 mark for each point on weak control environment

Lack of segregation of dutiesVolunteer staffLack of qualified staffNo internal auditAttitude of trustees



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Marks5 (a) (i) Explanation of whether events adjusting or not. 2 marks for each event

Defective inventoryRelease of dye


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(ii) 1 mark for each point regarding auditor responsibility and for each valid audit procedure. Maximum 6 marks for each event

Auditors general responsibilities

From statement of financial position date to audit reportFrom audit report date to AGM

Defective inventory

Audit must identify material events post balance sheetNeed to check value of RM225,000 is receivable

Documentation from insurersPayment from third partyDisclosure in financial statementsTotal inventory value end of yearOther inventory affected?Management representation pointDiscuss with directorsMay be a going concern issueOther valid points

Release of dye

Ensure that material event is disclosed appropriately in financial statements

Documentation of eventExtent of disclosure in financial statementsAction if disagree with amount of disclosurePossibility of modified audit reportManagement representation letterContact insurance companyGoing concern may be impairedOther valid points


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(b) 1 mark for each audit procedure

Discuss with directorsAudit any amendment to financial statementsProduce revised audit reportInform members in other methods – speak at meetingResignation? Note not effective.



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20







Pape

r F8

(M

YS)





1 Background information

B-Star is a theme park based on a popular series of children’s books. Customers pay a fixed fee to enter the park,where they can participate in a variety of activities such as riding roller-coasters, playing on slides and purchasingthemed souvenirs from gift shops.

The park is open all year and has been in operation for the last seven years. It is located in a country which has verylittle rainfall – the park is open-air so poor weather such as rain results in a significant fall in the number of customersfor that day (normally by 50%). During the last seven years there have been on average 30 days each year with rain.

B-Star is now very successful; customer numbers are increasing at approximately 15% each year.

Ticket sales

Customers purchase tickets to enter the theme park from ticket offices located outside the park. Tickets are only validon the day of purchase. Adults and children are charged the same price for admission to the park. Tickets are pre-printed and stored in each ticket office.

Tickets are purchased using either cash or credit cards.

Each ticket has a number comprising of two elements – two digits relating to the ticket office followed by six digits toidentify the ticket. The last six digits are in ascending sequential order.

Cash sales

1. All ticket sales are recorded on a computer showing the amount of each sale and the number of tickets issued.This information is transferred electronically to the accounts office.

2. Cash is collected regularly from each ticket office by two security guards. The cash is then counted by twoaccounts clerks and banked on a daily basis.

3. The total cash from each ticket office is agreed to the sales information that has been transferred from each office. 4. Total cash received is then recorded in the cash book, and then the general ledger.

Credit card sales

1. Payments by credit cards are authorised online as the customers purchase their tickets. 2. Computers in each ticket office record the sales information, which is transferred electronically to the accounts

office. 3. Credit card sales are recorded for each credit card company in a receivables ledger. 4. When payment is received from the credit card companies, the accounts clerks agree the total sales values to the

amounts received from the credit card companies, less the commission payable to those companies. Thereceivables ledger is updated with the payments received.

You are now commencing the planning of the annual audit of B-Star. The date is 3 June 2009 and B-Star’s year endis 30 June 2009.

2

Required:

(a) List and explain the purpose of the main sections of an audit strategy document and for each section, providean example for that section relevant to B-Star. (8 marks)

(b) (i) For the cash sales system of B-Star, identify the risks that could affect the assertion of completeness ofsales and cash receipts; (4 marks)

(ii) Discuss the extent to which tests of controls and substantive procedures could be used to confirm theassertion of completeness of income, in B-Star. (6 marks)

(c) (i) List the substantive analytical procedures that may be used to give assurance on the total income fromticket sales for one day in B-Star;

(ii) List the substantive analytical procedures that may be used to give assurance on the total income fromticket sales for the year in B-Star. (8 marks)

(d) List the audit procedures you should perform on the credit card receivables balance. (4 marks)

(30 marks)

3 [P.T.O.

2 (a) List and explain FOUR methods of selecting a sample of items to test from a population in accordance withAI 530 Audit Sampling and Other Selective Testing Procedures. (4 marks)

(b) List and explain FOUR assertions from AI 500 Audit Evidence (Revised) that relate to the recording of classesof transactions. (4 marks)

(c) In terms of audit reports, explain the term ‘modified’. (2 marks)

(10 marks)

3 Following a competitive tender, your audit firm Cal & Co has just gained a new audit client Tirrol Co. You are themanager in charge of planning the audit work. Tirrol Co’s year end is 30 June 2009 with a scheduled date to completethe audit by 15 August 2009. The date now is 3 June 2009.

Tirrol Co provides repair services to motor vehicles from 25 different locations. All inventory, sales and purchasingsystems are computerised, with each location maintaining its own computer system. The software in each location isthe same because the programs were written specifically for Tirrol Co by a reputable software house. Data from eachlocation is amalgamated on a monthly basis at Tirrol Co’s head office to produce management and financial accounts.

You are currently planning your audit approach for Tirrol Co. One option being considered is to re-write Cal & Co’saudit software to interrogate the computerised inventory systems in each location of Tirrol Co (except for head office)as part of inventory valuation testing. However, you have also been informed that any computer testing will have tobe on a live basis and you are aware that July is a major holiday period for your audit firm.

Required:

(a) (i) Explain the benefits of using audit software in the audit of Tirrol Co; (4 marks)

(ii) Explain the problems that may be encountered in the audit of Tirrol Co and for each problem, explainhow that problem could be overcome. (10 marks)

(b) Following a discussion with the management at Tirrol Co you now understand that the internal audit departmentare prepared to assist with the statutory audit. Specifically, the chief internal auditor is prepared to provide youwith documentation on the computerised inventory systems at Tirrol Co. The documentation provides details ofthe software and shows diagrammatically how transactions are processed through the inventory system. Thisdocumentation can be used to significantly decrease the time needed to understand the computer systems andenable audit software to be written for this year’s audit.

Required:

Explain how you will evaluate the computer systems documentation produced by the internal auditdepartment in order to place reliance on it during your audit. (6 marks)

(20 marks)

4

4 (a) Contrast the role of internal and external auditors. (8 marks)

(b) Conoy Co designs and manufactures luxury motor vehicles. The company employs 2,500 staff and consistentlymakes a net profit of between 10% and 15% of sales. Conoy Co is not listed; its shares are held by 15individuals, most of them from the same family. The maximum shareholding is 15% of the share capital.

The executive directors are drawn mainly from the shareholders. There are no non-executive directors. Theexecutive directors are very successful in running Conoy Co, partly from their training in production andmanagement techniques, and partly from their ‘hands-on’ approach providing motivation to employees.

The board are considering a significant expansion of the company. However, the company’s bankers areconcerned with the standard of financial reporting as the financial director (FD) has recently left Conoy Co. Theboard are delaying provision of additional financial information until a new FD is appointed.

Conoy Co does have an internal audit department, although the chief internal auditor frequently comments thatthe board of Conoy Co do not understand his reports or provide sufficient support for his department or theinternal control systems within Conoy Co. The board of Conoy Co concur with this view. Anders & Co, the externalauditors have also expressed concern in this area and the fact that the internal audit department focuses workon control systems, not financial reporting. Anders & Co are appointed by and report to the board of Conoy Co.

The board of Conoy Co are considering a proposal from the chief internal auditor to establish an audit committee.The committee would consist of one executive director, the chief internal auditor as well as three new appointees.One appointee would have a non-executive seat on the board of directors.

Required:

Discuss the benefits to Conoy Co of forming an audit committee. (12 marks)

(20 marks)

5 [P.T.O.

5 One of your audit clients is Tye Co a company providing petrol, aviation fuel and similar oil based products to thegovernment. Although the company is not listed on any stock exchange, it does follow best practice regardingcorporate governance regulations. The audit work for this year is complete, apart from the matter referred to below.

As part of Tye Co’s service contract with the government, it is required to hold an emergency inventory reserve of6,000 barrels of aviation fuel. The inventory is to be used if the supply of aviation fuel is interrupted due to unforeseenevents such as natural disaster or terrorist activity.

This fuel has in the past been valued at its cost price of RM15 a barrel. The current value of aviation fuel is RM120a barrel. Although the audit work is complete, as noted above, the directors of Tye Co have now decided to show the‘real’ value of this closing inventory in the financial statements by valuing closing inventory of fuel at market value,which does not comply with relevant accounting standards. The draft financial statements of Tye Co currently showa profit of approximately RM500,000 with net assets of RM170 million.

Required:

(a) List the audit procedures and actions that you should now take in respect of the above matter. (6 marks)

(b) For the purposes of this section assume from part (a) that the directors have agreed to value inventory atRM15/barrel.

Having investigated the matter in part (a) above, the directors present you with an amended set of financialstatements showing the emergency reserve stated not at 6,000 barrels, but reported as 60,000 barrels. The finalfinancial statements now show a profit following the inclusion of another 54,000 barrels of oil in inventory. Whenqueried about the change from 6,000 to 60,000 barrels of inventory, the finance director stated that this changewas made to meet expected amendments to emergency reserve requirements to be published in about six monthstime. The inventory will be purchased this year, and no liability will be shown in the financial statements for thisfuture purchase. The finance director also pointed out that part of Tye Co’s contract with the government requiresTye Co to disclose an annual profit and that a review of bank loans is due in three months. Finally the financedirector stated that if your audit firm qualifies the financial statements in respect of the increase in inventory, theywill not be recommended for re-appointment at the annual general meeting. The finance director refuses toamend the financial statements to remove this ‘fictitious’ inventory.

Required:

(i) State the external auditor’s responsibilities regarding the detection of fraud; (4 marks)

(ii) Discuss to which groups the auditors of Tye Co could report the ‘fictitious’ aviation fuel inventory; (6 marks)

(iii) Discuss the safeguards that the auditors of Tye Co can use in an attempt to overcome the intimidationthreat from the directors of Tye Co. (4 marks)

(20 marks)


6

Answers

Fundamentals Level – Skills Module, Paper F8 (MYS)Audit and Assurance (Malaysia) June 2009 Answers

1 (a) Audit strategy document

(b) (i) Risk affecting completeness

– The computer system does not record sales accurately and/or information is lost or transferred incorrectly from theticket office computer to the accounts department computer.

– Cash sales are not recorded in the cash book; cash is stolen by the accounts clerks.– Tickets are issued but no payment is received – that is the sale is not recorded.– Cash is removed by the ticket office personnel, by the security guards or by the account clerks.– The account clerks miscount the amount of cash received from a ticket office.

(ii) Use of tests of controls and substantive procedures

Tests of controls

Tests of control are designed to ensure that documented controls are operating effectively. If controls over thecompleteness of income were expected to operate correctly, then the auditor would test those controls.

In B-Star, while controls could be in operation, e.g. the account clerks agreeing physical cash to computer summaries,there is no indication that the control is documented; that is the computer summary is not signed to show thecomparison has taken place. The auditor could use the test of inquiry – asking the clerks whether the control has beenused, and observation – actually watching the clerks carry out the controls. As noted above though, lack ofdocumentation of the control does mean relying on tests of control for the assertion completeness of income has limitedvalue.

Substantive procedures

Substantive procedures include analytical procedures and other procedures.

Analytical procedures include the analysis of significant ratios and trends and subsequent investigation of any trends orrelationships that appear to be abnormal. These procedures can be used effectively in B-Star as an approximation ofincome that can be obtained from sources other than the cash receipt records.

Other procedures, or tests of detail, are normally used to verify balance sheet assertions and include obtaining auditevidence relevant to specific assertions. However, they could be used in B-Star to trace individual transactions throughthe sales/cash systems to ensure all ticket sales have been recorded (completeness assertion). The use of otherprocedures will be time consuming.

(c) (i) Substantive analytical procedures – completeness of income for one day

– Obtain proof in total. Tickets sold times price should equal day’s income.– Compare daily sales to budgeted daily sales (for example weekends and bank holidays would expect more income).– Compare sales with previous days and account for changes such as variations for weather.

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Section of document Purpose Example from B-Star

Understanding the entity’s environment Provides details of the industry area thatthe company is in along with specificinformation about the activities andstrategies of the individual client.

Size of the theme park sector andexpected growth over the next few years.

Understand the accounting and internalcontrol systems

Details of accounting policies of theclient and previous assessments ofinternal control systems indicating theexpected extent of reliance on thosesystems.

Accounting policy for sales – sales arestated net of sales taxes.

Reliance on control systems in B-Starmay be limited due to lack ofdocumentation of controls.

Risk and materiality The assessment of risk for the client andrisk of fraud and error and theidentification of significant audit areas.

The materiality level for audit planningpurposes.

Materiality for sales to be 5% of turnover.

B-Star receives cash sales – audit workrequired to determine the completenessof sales.

Consequent nature, timing and extent ofaudit procedures

Details of the focus on audit work onspecific areas. Detail on the extent of useof audit software and possible relianceon internal audit.

Audit software could be used to provideanalytical procedures on the sales of B-Star.

Co-ordination, supervision and review ofaudit work

Details the extent of involvement ofexperts, client locations and staffingrequirements for the audit.

B-Star has only one location – audit staffwill be required to work there for Xweeks.

– Compare sales to souvenirs sales (more people in park means more souvenir sales).– Compare ticket offices day-by-day and staff rotation to see if sales lower some day/some staff (attempt to identify

fraud also).– Compare the expected sales from ticket numbers to the total sales amount from cash and credit sales for each ticket

office.

(ii) Substantive analytical procedures – completeness of income for the year

– Obtain the sales income from the previous year. Multiply this by 115% to provide a rough estimate of the incomefor this year.

– Obtain information on the number of days with rain during the last year. Where this is more or less than 30, adjustthe income estimate by 1/730 down for each day of rain above 30 or 1/730 up for each day of rain less than 30.(Note: B-Star only attracts 50% of the normal number of customers on a rainy day; hence one day of rain decreasestotal customers by 1/730 in the year.)

– Compare actual income to budgeted income for the year. Ask the directors to explain any significant deviations.– Obtain industry information on the popularity of theme parks, and change in customer numbers. Compare these

trends to the results obtained by B-Star. Where B-Star performed significantly better or worse than average, obtainexplanations from the directors.

(d) Audit of year end credit card receivable

– Agree the balances on each credit card company’s ledger account to the list of receivables.– Cast the list of receivables and agree the total to the total on the receivables ledger control account.– For the last day of the financial year and the first day of the new financial year, agree total sales income from ticket office

records to the cash book and receivables ledger ensuring they are recorded in the correct period.

For a sample of material balances and a random sample of immaterial items,

– Obtain direct confirmation from the credit card company of the amount due to B-Star using a receivables confirmationletter.

– Where direct confirmation is not possible, obtain evidence of cash receipt after the end of the financial year. Agree theamount on the bank statements post year end of B-Star to the amount due in the receivables ledger (less anycommission due).

– Review after date sales day book for debit notes indicating that sales may have been overstated in the prior year.– Obtain the financial statements of B-Star and ensure that the receivables amount is disclosed as a current asset net of

commission due to the credit card companies.

2 (a) Sampling methods

Methods of sampling in accordance with AI 530 Audit Sampling and Other Selective Testing Procedures

Random selection. Ensures each item in a population has an equal chance of selection, for example by using random numbertables.

Systematic selection. In which a number of sampling units in the population is divided by the sample size to give a samplinginterval.

Haphazard selection. The auditor selects the sample without following a structured technique – the auditor would avoid anyconscious bias or predictability.

Sequence or block. Involves selecting a block(s) of contiguous items from within the population.

Tutorial note: Other methods of sampling are as follows:

Monetary Unit Sampling. This selection method ensures that each individual RM1 in the population has an equal chance ofbeing selected.

Judgemental sampling. Selecting items based on the skill and judgement of the auditor.

(b) Assertions – classes of transactions

Occurrence. The transactions and events that have been recorded have actually occurred and pertain to the entity.

Completeness. All transactions and events that should have been recorded have been recorded.

Accuracy. The amounts and other data relating to recorded transactions and events have been recorded appropriately.

Cut-off. Transactions and events have been recorded in the correct accounting period.

Classification. Transactions and events have been recorded in the proper accounts.

(c) Audit report term

Modified. An auditor modifies an audit report in any situation where it is inappropriate to provide an unmodified report. Forexample, the auditor may provide additional information in an emphasis of matter (which does not affect the auditor’s opinion)or qualify the audit report for limitation of scope or disagreement.

10

3 (a) (i) Benefits of using audit software

Standard systems at client

The same computerised systems and programs is used in all 25 branches of Tirrol Co. This means that the same auditsoftware can be used in each location providing significant time savings compared to the situation where client systemsare different in each location.

Use actual computer files not copies or printouts

Use of audit software means that the Tirrol Co’s actual inventory files can be tested rather than having to rely on printoutsor screen images. The latter could be incorrect, by accident or by deliberate mistake. The audit firm will have moreconfidence 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 testedfor obsolescence rather than a sample using manual techniques. The auditor will therefore gain more evidence and havegreater 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 yearcould be offset against the audit fees in future years when the actual expense will be less.

(ii) Problems on the audit of Tirrol

Timescale – six week reporting deadline – audit planning

The audit report is due to be signed six weeks after the year end. This means that there will be considerable pressureon 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 suchas 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 andtest audit software, let alone use the software and evaluate the results of testing.

This problem can be alleviated by careful planning. Access to Tirrol Co’s software and data files must be obtained assoon as possible and work commenced on tailoring Cal & Co’s software following this. Specialist computer audit staffshould be booked as soon as possible to perform this work.

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 ascertainingclient 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 auditprocess carefully, ensuring that any additional work caused by the client not providing access to systems informationincluding 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 annualholiday. This means that there will be a shortage of audit staff, particularly as audit work for Tirrol Co is being bookedwith 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

Tirrol Co’s computer software is non-standard, having been written specifically for the organisation. This means thatmore 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 Tirrol Co’s permission) to see if they can assist with provision of information on data structures for the inventorysystems. Provision of this information will decrease the time taken to tailor audit software for use in Tirrol 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 accidentalamendment 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 whenTirrol 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.

11

Computer systems

The client has 25 locations, with each location maintaining its own computer system. It is possible that computersystems 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 andfocusing audit work on material branches.

Usefulness of audit software

The use of audit software at Tirrol Co does appear to have significant problems this year. This means that even if theaudit 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 managermay need to investigate whether a manual audit is feasible and if so whether it could be completed within the necessarytimescale 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 thedocumentation 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.

– Ensuring that this and similar documentation is produced using a recognised plan and that the documentation is testedprior to use. The use of different staff in the internal audit department to produce and test documentation will increaseconfidence in its accuracy.

– Ensuring that the documentation is actually used during internal audit work and that problems with documentation arenoted and investigated as part of that work. Being given access to internal audit reports on the inventory software willprovide appropriate evidence.

Regarding the actual documentation:

– Reviewing the documentation to ensure that it appears logical and that terms and symbols are used consistentlythroughout. 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. Thiscomparison 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 processesinventory system data accurately. However, this stage may be limited due to the need to use live files at Tirrol Co.

4 (a) Role of internal and external auditors – differences

Objectives

The main objective of internal audit is to improve a company’s operations, primarily in terms of validating the efficiency andeffectiveness of the internal control systems of a company.

The main objective of the external auditor is to express an opinion on the truth and fairness of the financial statements, andto confirm that the financial statements comply with the reporting requirements of the Companies Act, 1965.

Reporting

Internal audit reports are normally addressed to the board of directors, or other people charged with governance such as theaudit committee. Those reports are not publicly available, being confidential between the internal auditor and the recipient.

External audit reports are provided to the shareholders of a company. The report is attached to the annual financial statementsof the company and is therefore publicly available to the shareholders and any reader of the financial statements.

Scope of work

The work of the internal auditor normally relates to the operations of the organisation, including the transaction processingsystems and the systems to produce the annual financial statements. The internal auditor may also provide other reports tomanagement, such as value for money audits which external auditors rarely become involved with.

The work of the external auditor relates only to the financial statements of the organisation. However, the internal controlsystems of the organisation will be tested as these provide evidence on the completeness and accuracy of the financialstatements.

Relationship with company

In most organisations, the internal auditor is an employee of the organisation, which may have an impact on the auditor’sindependence. However, in some organisations the internal audit function is outsourced.

The external auditor is appointed by the shareholders of an organisation, providing some degree of independence from thecompany and management.

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(b) Benefits of audit committee in Conoy Co

Assistance with financial reporting (no finance expertise)

The executive directors of Conoy Co do not appear to have any specific financial skills – as the financial director has recentlyleft the company and has not yet been replaced. This may mean that financial reporting in Conoy Co is limited or that theother non-financial directors spend a significant amount of time keeping up to date on financial reporting issues.

An audit committee will assist Conoy Co by providing specialist knowledge of financial reporting on a temporary basis – atleast one of the new appointees should have relevant and recent financial reporting experience under codes of corporategovernance. This will allow the executive directors to focus on running Conoy Co.

Enhance internal control systems

The board of Conoy Co do not necessarily understand the work of the internal auditor, or the need for control systems. Thismeans that internal control within Conoy Co may be inadequate or that employees may not recognise the importance ofinternal control systems within an organisation.

The audit committee can raise awareness of the need for good internal control systems simply by being present in Conoy Coand by educating the board on the need for sound controls. Improving the internal control ‘climate’ will ensure the need forinternal controls is understood and reduce control errors.

Reliance on external auditors

Conoy Co’s internal auditors currently report to the board of Conoy Co. As previously noted, the lack of financial and controlexpertise on the board will mean that external auditor reports and advice will not necessarily be understood – and the boardmay rely too much on external auditors

If Conoy Co report to an audit committee this will decrease the dependence of the board on the external auditors. The auditcommittee can take time to understand the external auditor’s comments, and then via the non-executive director, ensure thatthe board take action on those comments.

Appointment of external auditors

At present, the board of Conoy Co appoint the external auditors. This raises issues of independence as the board may becometoo familiar with the external auditors and so appoint on this friendship rather than merit.

If an audit committee is established, then this committee can recommend the appointment of the external auditors. Thecommittee will have the time and expertise to review the quality of service provided by the external auditors, removing theindependence issue.

Corporate governance requirements – best practice

Conoy Co do not need to follow corporate governance requirements (the company is not listed). However, not following thoserequirements may start to have adverse effects on Conoy. For example, Conoy Co’s bank is already concerned about the lackof transparency in reporting.

Establishing an audit committee will show that the board of Conoy Co are committed to maintaining appropriate internalcontrol systems in the company and providing the standard of reporting expected by large companies. Obtaining the new bankloan should also be easier as the bank will be satisfied with financial reporting standards.

Given no non-executives – independent advice to board

Currently Conoy Co does not have any non-executive directors. This means that the decisions of the executive directors arenot being challenged by other directors independent of the company and with little or no financial interest in the company.

The appointment of an audit committee with one non-executive director on the board of Conoy Co will start to provide somenon-executive input to board meetings. While not sufficient in terms of corporate governance requirements (one-third of theboard must be independent non-executive directors) it does show the board of Conoy Co are attempting to establishappropriate governance systems.

Advice on risk management

Finally, there are other general areas where Conoy Co would benefit from an audit committee. For example, lack of corporategovernance structures probably means Conoy Co does not have a risk management committee. The audit committee can alsoprovide advice on risk management, helping to decrease the risk exposure of the company.

5 (a) Valuation of aviation inventory

– Review GAAP to ensure that there are no exceptions for aviation fuel or inventory held for emergency purposes whichwould suggest a market valuation should be used.

– Calculate the difference in valuation. The error in inventory valuation is RM105 * 6,000 barrels or RM630k, which isa material amount compared to profit.

– Review prior year working papers to determine whether a similar situation occurred last year and ascertain the outcomeat that stage.

– Discuss the matter with the directors to obtain reasons why they believe that market value should be used for theinventory this year.

13

– Warn the directors that in your opinion, aviation fuel should be valued at the lower of cost or net realisable value (thatis RM15/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 issuein 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 RM630,000 is material to the financial statements as Tye Co’s income statement figure is decreased froma small loss to a loss of RM130,000 although net assets decrease by only about 0·3%.

– Obtain a management representation letter from the directors of Tye Co confirming that market value is to be used forthe emergency inventory of aviation fuel.

– If the directors will not amend the financial statements, draft the relevant sections of the audit report, showing aqualification on the grounds of disagreement with the accounting policy for valuation of inventory.

(b) (i) External auditor responsibilities regarding detection of fraud

Overall responsibility of auditor

The external auditor is primarily responsible for the audit opinion on the financial statements following the auditingstandards issued in Malaysia (AIs). AI 240 (Redrafted) The Auditor’s Responsibilities Relating to Fraud in an Audit ofFinancial 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 detectionof fraud is therefore not the main focus of the external auditor’s work. An auditor is responsible for obtaining reasonableassurance that the financial statements are free from material misstatement, whether caused by fraud or error.

The auditor is responsible for maintaining an attitude of professional scepticism throughout the audit, considering thepotential for management override of controls and recognising the fact that audit procedures that are effective fordetecting error may not be effective in detecting fraud.

Materiality

AI 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 conceptof materiality. In other words, the external auditor is not responsible for checking all the transactions. Audit proceduresare planned to have a reasonable likelihood of identifying material fraud.

Discussion among the engagement team

A discussion is required among the engagement team placing particular emphasis on how and where the entity’sfinancial 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 theentire audit. In other words, the external auditor has a responsibility to extend testing into other areas because the riskof 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 thecompany.

The committee should be able to discuss the situation with the directors and recommend that they take appropriateaction e.g. amend the financial statements.

Report to government

As Tye Co is acting under a government contract, and the over-statement of inventory will mean Tye Co breaches thatcontract (the reported profit becoming a loss), then the auditor may have to report the situation directly to thegovernment. The auditor of Tye 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 ofTye Co. The audit report will be qualified with an except for or adverse opinion (depending on materiality) andinformation concerning the reason for the disagreement given. In this case the auditor is likely to state factually theproblem 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, althoughresignation and the convening of an extraordinary general meeting is another reporting option.

14

(iii) Intimidation threat – safeguards

In response to the implied threat of dismissal if the audit report is modified regarding the potential fraud/error, thefollowing safeguards are available to the auditor.

Discuss with audit committee

The situation can be discussed with the audit committee. As the audit committee should comprise non-executivedirectors, 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 therecommendation of the audit committee. If the recommendation of the audit committee is rejected by the board, goodcorporate 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 issueof possible fraud. While this action does not resolve the issue, it does provide additional assurance that the findings andactions of the engagement partner are valid.

Resignation

If the matter is serious, then the auditor can consider resignation rather than not being re-appointed. Resignation hasthe additional safeguard that the auditor can normally require the directors to convene an extraordinary general meetingto consider the circumstances of the resignation.

15

Fundamentals Level – Skills Module, Paper F8 (MYS)Audit and Assurance (Malaysia) June 2009 Marking Scheme

1 (a) Audit strategy document

0·5 for each section of audit strategy document, 0·5 for explaining the purpose of that section, 1 for the relevant examplefrom B-Star scenario.

Procedure– Understand the entity’s environment– Understand the accounting and control systems– Risk and materiality– Timing and extent of audit procedures– Co-ordination, supervision and review of work– Other relevant points


–––

(b) (i) Risks re completeness of sales and cash receipts

1 for each risk

Procedures– The computer system does not record sales accurately – Cash not recorded – Tickets are issued but no payment is received – that is the sale is not recorded– Cash is removed by the ticket office personnel, etc– The account clerks miscount the amount of cash received from a ticket office– Other relevant points.


–––

(ii) Use of tests of controls and substantive procedures

Up to 1 for each valid response and up to 2 for showing whether the procedure is valid for B-Star case.

Weaknesses– Tests of controls– Substantive procedures


–––

(c) Analytical procedures

1 mark each for each valid procedure

(i) Ticket sales for one day

– Proof in total– Compare sales day-by-day– Compare sales to souvenirs sales– Compare ticket offices day-by-day and staff rotation– Compare cash receipts to ticket sales– Other relevant points


–––

(ii) Ticket sales for year

– Prior year income * 15%– Adjust for rainy days– Compare actual and budget– Industry trends– Other relevant points


–––

17

(d) Year end receivables

– Individual balances to list of receivables– Cast list– Cut-off– Direct confirmation– Alternative procedures to direct confirmation– After date sales – debit notes– Presentation in financial statements– Other relevant points


–––Maximum 30

––––––

2 (a) 1 mark for each method. 0·5 for stating the method and 0·5 for brief explanation.

– Random– Systematic– Haphazard– Sequence– MUS– Judgemental


–––

(b) 1 mark per assertion. 0·5 for stating the assertion and 0·5 for explaining the assertion.

– Occurrence– Completeness– Accuracy– Cut-off– Classification


–––

(c) Up to 2 marks for valid explanation of.

– Modified–––

Maximum marks 2–––10––––––

18

3 (a) (i) Benefits of audit software

1 mark per benefit – 0·5 for identifying the benefit and 0·5 for explaining the benefit.

– Standard systems– Use actual computer files– Test more items– Cost– Other relevant points


–––

(ii) Problems in the audit of Tirrol

2 marks for each problem. 1 for explaining the problem and 1 for explaining how to alleviate the problem.

– Six week reporting deadline– Timescale – software issues– First year audit costs– Staff holidays– Non-standard systems– Live testing– Usefulness of audit software– Other relevant points


–––

(b) Reliance on internal audit documentation

1 mark per point – Appropriate qualifications– Produced according to plan– Problems with use noted– Documentation logical– Compare to live system– Use documentation to amend audit software– Other relevant points


–––20––––––

4 (a) Difference – internal and external audit

2 marks for each point. 1 for point in relation to internal audit and 1 for explaining the point in relation to external audit.

– Objectives– Reporting– Scope of work– Relationship with company– Other relevant points


–––

(b) Benefits of audit committee

Up to 2 marks for each point. 1 for the benefit and 1 for applying that benefit to Conoy Co. 1 mark only where point stated in general terms

– Assistance with financial reporting– Enhance internal control systems– Reliance on external auditors– Appointment of external auditors– Best practice – corporate governance– Independent advice to board– Advice on risk management– Other valid points e.g. may be cost benefits over time.


–––20––––––

19

20

5 (a) Aviation fuel inventory

1 mark each for each valid procedure or action:

– Any alternative treatments in GAAP– Materiality calculation– Review prior year working papers– Discuss with directors– Warn directors possible qualification– Quantify amount– Management representation– Draft audit report– Other relevant points


–––

(b) (i) Auditor and fraud

1 mark each for each valid responsibility:

– Overall responsibility– Materiality– Approach to audit– Identification of fraud– Other relevant points


–––

(ii) Reporting options regarding fraud

Up to 2 marks each for each valid explained option. 0·5 for each body – then up to 2 if good reasons given for reporting to that body.

– Audit committee– Government– Members– Professional body– Other relevant points


–––

(iii) Safeguards

Up to 2 marks per valid point. 1 for explaining the safeguard and 1 for the effectiveness of the safeguard

– Audit committee– Second partner review– Resignation– Other relevant points


–––20––––––


The Association of Chartered Certifi ed Accountants



Time allowed

Reading and planning: 15 minutesWriting: 3 hours



During reading and planning time only the question paper may

be annotated. You must NOT write in your answer booklet until

instructed by the supervisor.


Pape

r F8

(M

YS)

2


1 (a) Explain the importance of audit planning and state TWO matters that would be included in an audit plan.

(6 marks)

Redburn Co, a publisher and producer of books of poetry, has been a client of your fi rm of Chartered Accountants for a number of years. The manager in overall charge of the audit has been discussing the audit plan with the audit team, of which you are a member, prior to commencement of the work. The audit manager has informed the team, among other things, that there has been a growing interest in poetry generally and that the company has acquired a reputation for publishing poets who are still relatively unknown.

During your audit you determine:

(i) Contracts with the poets state that they are given a royalty of 10% on sales. Free copies of the books are provided to the poets and to some organisations such as copyright libraries and to others, such as reviewers and university lecturers. No royalties are given on these free copies.

(ii) The computerised customer master fi le contains a code indicating whether a despatch is to earn a royalty for the author. This code is shown on the sales invoice and despatch note when they are prepared.

(iii) A computerised royalties fi le is held, all entries therein bearing the invoice number and date.

(iv) The company keeps detailed statistics of sales made, including trends of monthly sales by type of customer, and of colleges where its books are recommended as part of course material, based on reports from sales staff.

(v) Bookshops have the right to return books which are not selling well, but about 10% of these are slightly damaged when returned. The company keeps similar records of returns as it does for sales.

Required:

(b) Describe TWO procedures used to ensure that the sales statistics kept by the company may be relied upon.

(4 marks)

(c) Describe THREE substantive tests you should perform to ensure that the royalties charge is accurate and

complete, stating the objective of each test. (6 marks)

(d) A material fi gure in the balance sheet of Redburn Co is the amount attributed to inventory of books.

Required:

State TWO inherent risks that may affect the inventory fi gure and suggest ONE control to mitigate each risk.

(4 marks)

(e) The management of Redburn Co have told you that inventory is correctly valued at the lower of cost and net realisable value. You have already satisfi ed yourself that cost is correctly determined.

Required:

(i) Defi ne net realisable value; (2 marks)

(ii) State and explain the purpose of FOUR procedures that you should use to ensure that net realisable value

of the inventory is at or above cost. (8 marks)

(30 marks)

3 [P.T.O.

2 (a) AI 500 Audit Evidence requires audit evidence to be reliable.

Required:

List FOUR factors that infl uence the reliability of audit evidence. (4 marks)

(b) AI 260 (Revised and Redrafted) Communication with Those Charged with Governance deals with the auditor’s responsibility to communicate with those charged with governance in relation to an audit of fi nancial statements.

Required:

(i) Describe TWO specifi c responsibilities of those charged with governance; (2 marks)

(ii) Explain FOUR examples of matters that might be communicated to them by the auditor. (4 marks)

(10 marks)

4

3 AI 315 (Redrafted) Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity

and Its Environment requires auditors to obtain an understanding of the entity and its environment, including its internal control.

Required:

(a) Explain why obtaining an understanding of the entity and its environment is important for the auditor.

(4 marks)

Letham Co is a large engineering company with ten manufacturing units throughout the country in which it is located. The manufacturing process is capital intensive and the company holds a wide variety of plant and equipment.

The fi nance director is responsible for the preparation of a detailed non-current assets budget annually, which is based on a fi ve-year budget approved by the whole board of directors after consultation with the audit committee. This annual budget, which is also approved by the full board, is held on computer fi le and is the authority for the issue of a purchase order.

When the item of plant and equipment is delivered to the company, a pre-numbered goods received note (GRN) is prepared, a copy of which is sent to the accounting department, and used to update the non-current assets budget to refl ect the movement. The equipment is carefully inspected by production personnel and tested for proper operation. An operational certifi cate is prepared by the production department and this is used by the accounting department, together with the GRN, to check against the purchase invoice when it is received.

At the same time as the purchase invoice enters the purchasing system, a computerised non-current assets register is updated. Access to the non-current assets register is restricted to personnel in the accounting department. On a rolling basis throughout the year the non-current assets register is compared to plant and equipment on site by accounting department personnel, using identifi cation numbers in the register and permanently marked onto each item in the factory.

The internal audit department also tests on a sample basis the operation of the system from budget preparation to entry in the non-current assets register. Internal audit staff also compare a sample of entries in the non-current assets register with equipment on the shop fl oor.

Required:

(b) Identify SIX STRENGTHS in Letham’s control environment in respect of non-current assets and explain why

they may reduce control risk. (12 marks)

(c) As part of your work as external auditor you are reviewing the non-current assets audit programme of the internal auditors and notice that the basis of their testing is a representative sample of purchase invoices. They use this to test entries in the non-current assets register and the updating movements on the annual budget.

Required:

(i) Explain why this is not a good test for completeness;

(ii) State a more appropriate test to prove completeness of the non-current assets records, including the

non-current assets register. (4 marks)

(20 marks)

5 [P.T.O.

4 (a) Explain the difference between the interim audit and the fi nal audit. (4 marks)

You are the senior in charge of the audit of Brampton Co for the year ending 31 January 2010 and are currently planning the year-end audit. Brampton specialises in the production of high quality bread of various kinds.

During the interim audit you noted that, in the present economic down-turn, the company has suffered as its costs are increasing and its prices have been higher than its competitors because of lower production runs. One indicator of the problems facing the company is that it has consistently used a bank overdraft facility to fi nance its activities.

At the time of the interim audit you had discussed with company management what actions were being taken to improve the liquidity of the company and you were informed that the company plans to expand its facilities for producing white bread as this line had maintained its market share. The company has asked its bank for a loan to fi nance the expansion and also to maintain its working capital generally.

To support its request for a loan, the company has prepared a cash fl ow forecast for the two years from the end of the reporting period and the internal audit department has reported on the forecast to the board of directors. However, the bank has said it would like a report from the external auditors to confi rm the accuracy of the forecast. Following this request the company has asked you to examine the cash fl ow forecast and then to report to the bank.

Required:

(b) Explain whether you would be able to rely on the work of the internal auditors. (6 marks)

(c) Describe THREE procedures you would adopt in your examination of the cash fl ow forecast. (6 marks)

(d) Explain the kind of assurance you could give in the context of the request by the bank. (4 marks)

(20 marks)

6

5 (a) Identify and explain FOUR assertions relevant to accounts payable at the year-end date. (6 marks)

You are the audit senior responsible for the audit of Have A Bite Co, a company that runs a chain of fast food restaurants. You are aware that a major risk of their sector is that poor food quality might result in damage claims by customers.

You had satisfi ed yourself at the interim audit that the company’s control risk as regards purchases of food and its preparation in the kitchen was low. However, during your fi nal audit it comes to your attention that one month before the year-end, a customer has sued the company for personal injury caused by food poisoning, claiming an amount of RM200,000 in compensation. This amount is material to the stated profi t of the company, but management believes that it has good defences against the claim.

Required:

(b) (i) State TWO controls that the company should have in place to reduce the risk associated with purchases

of food and its preparation in the kitchen; and

(ii) State TWO audit procedures you should carry out during controls testing to satisfy yourself that control

risk in this area is low. (4 marks)

(c) In respect of the potential claim state THREE items of evidence you should obtain and explain how they might

enable you to form a conclusion on the likelihood of the claim being successful. (6 marks)

Following your audit you have concluded that there is a possibility, but not a probability, that the claim will be successful. However, management have decided not to make a provision or disclosure in the fi nancial statements in respect of this matter.

Required:

(d) Describe how the matter should be reported in the fi nancial statements and explain the effect on your audit

report. (4 marks)

(20 marks)


Answers

9

Fundamentals Level – Skills Module, Paper F8 (MYS)

Audit and Assurance (Malaysia) December 2009 Answers

1 (a) Audit planning is addressed by AI 300 (Redrafted) Planning an Audit of Financial Statements. The standard notes that an audit plan will be developed after the overall audit strategy has been established and then states that adequate planning benefi ts the audit of fi nancial statements in several ways, including the following:

– Helping the auditor to devote appropriate attention to important areas of the audit. – Helping the auditor identify and resolve potential problems on a timely basis. – Helping the auditor properly organise and manage the audit engagement so that it is performed in an effective and

effi cient manner. – Assisting in the selection of engagement team members with appropriate levels of capabilities and competence to respond

to anticipated risks and the proper assignment of work to them. – Facilitating the direction and supervision of engagement team members and the review of their work. – Assisting, where applicable, in coordination of work done by experts.

The following are examples of matters that would be included in the audit plan:

(i) A description of the nature, timing and extent of planned risk assessment procedures suffi cient to assess the risks of material misstatement.

(ii) This would include assessment of inherent risk and control risk at both the entity and assertion level. An important element of the plan would be the understanding and assessment of the control environment of the organisation.

(iii) A description of the nature, timing and extent of planned further procedures at the assertion level for each material class of transactions, account balance, and disclosure.

(iv) This would include an explanation of the decision – whether to test the operating effectiveness of controls (an important decision is whether reliance is to be placed on

controls). – on the nature, timing and extent of planned substantive procedures (this would depend on the decision as to the

level of control risk). (v) Audit procedures required to be carried out for the engagement in order to comply with AIs, for example, the use of

external confi rmations to obtain suffi cient appropriate evidence at the assertion level.

(Tutorial note: Marks would also be available for additional points such as:

– Materiality

– Timetable of detailed audit work

– Allocation of work to team members.)

(b) Appropriate procedures would include:

– Reconcile the sales statistics to the recorded sales in the accounting records. (Tutorial note: Other audit procedures

should already have proven the validity of the recorded sales.)

– Compare trends this year to those of prior years to ensure they are reasonable. – In this connection consider any changes in client circumstances and exercise professional scepticism as these statistics

are produced internally. – Discuss with management the analyses they have made and the actions they have taken as a result of the statistical

information available to them. They would probably use them, for example, in deciding whether reprints of books are necessary.

– On a test basis check that the customer codes on the customer master fi le are properly entered to ensure that the type of customer is properly identifi ed.

– Review reports from sales staff to ensure that information on college take-up of books is accurate.

(Tutorial note: As a general rule statistics that are kept on a day-to-day basis for the company’s own purposes, will be much

more reliable than those prepared especially for the auditor. However, the auditor should carry out procedures to ensure that

they are accurate enough for audit purposes.)

10

(c) Appropriate substantive tests to satisfy the auditor that the royalties charge is accurate and complete include:

Test Objective (i) Compare the royalties charge with stated sales income To satisfy the auditor that the royalties charge in the and obtain explanations from management if the fi gures income statement is reasonable in relation to stated do not appear reasonable. sales income.

(ii) Compare budgeted royalties fi gure with actual fi gures. To satisfy the auditor that the actual fi gures had been If variations are signifi cant, obtain explanations from anticipated by management, thus providing evidence management. as to their reliability.

(iii) Review the sales statistics (proven in (b) above) to This would be evidence that the royalties charge was ascertain those despatches that attract royalties. soundly based.

(iv) Take a sample of recorded sales entries and check: These are detailed tests to prove that royalties were – whether royalties are due in respect of the due on despatches and that the calculation of the customer. royalty was accurate. – if they are, that the entry in the computerised royalties fi le has been calculated at 10% according to the contracts agreed with the published poets.

(v) Take a sample of royalty payments and agree to This is a test to prove that recorded royalty payments supporting despatch and sales documentation, have resulted from despatches and sales attracting checking in particular that all despatches are to royalties. individuals and organisations attracting royalties.

(vi) Select sales for 15 days before the year end and This is to check that cut-off is accurate. The royalties 15 days afterwards and compare with the dates of charge should only include royalties on sales up to the despatch notes. cut-off date.

(vii) Calculate the expected level of royalty payments based This test should provide the auditor with evidence as to on monthly trend information for type of customer. the completeness and accuracy of royalties paid. Obtain sales fi gures and multiply by 10%. Compare expectation to actual royalties and obtain explanations from management for any signifi cant variations.

This list is not exhaustive and other procedures may be appropriate.

(d) There are many inherent risks that may affect the inventory of books and some of these are set out below, together with controls that would mitigate each risk.

Inherent risks Mitigating controls Risk of deterioration. Books should be stored in a location with air conditioning to keep them in saleable state.

Some books may not be saleable because of lack of demand. Maintenance of movement records to identify slow-moving items.

Books may be defective and therefore not saleable. Inspection of books returned from customers to identify those that are not in good condition. Identifi cation of defective items at interim or period-end inventory counts.

Books may be attractive and easily transportable, making Books to be kept in a secure location with restriction of attempted theft likely. entry to authorised personnel.

Poor counting of inventory at the period end. The use of independent and experienced inventory counters. The use of teams to cover specifi c areas of the locations where inventory is held. The use of pre-numbered inventory count sheets. And other inventory count procedures.

Poor cut-off as there may be movements of goods during Movement of books out stopped during the count or the inventory count. only allowed by permission of authorised offi cial in charge of the count. Book returns received during count held in separate area. Identifi cation of last movements in and out.

Goods on sale or return are held by customers but should be Detailed records should be maintained of goods on sale included within inventory until the return period is passed. or return and this should be reviewed at the year end to ensure that any goods within the return period have been included in inventory.

11

(e) (i) Net realisable value is defi ned in FRS 102 Inventories as: ‘the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.’

(ii) Appropriate procedures to determine that net realisable value of book inventory is above cost would include:

(1) Assessment of estimated proceeds from the sale of items of inventory. Sales price in the period following the year-end is one important element of net realisable value. Procedures to determine sales prices include:

– Obtain actual sales prices by reference to invoices issued after the year-end and determine that the sales were genuine by vouching sales invoices to orders, despatch notes and subsequent receipt of cash.

– If actual sales prices are not available, the auditor should obtain estimated sales prices from management. It would be necessary to assess how reasonable these estimated prices were. The auditor might be aided in this respect by reviewing the reports from sales staff backed up by discussions with management.

– Particular attention should be paid to sales prices of books identifi ed as slow-moving. (Tutorial note: Slow-

moving books might be identifi ed by obtaining lists of sales made in the preceding (say) six months and

reviewing reports from sales staff. The sales statistics would also be useful in this respect.)

– For damaged books disposal price may be nil or very low and the auditor should examine records of disposal of such books in the past. (Tutorial note: Damaged books should have been identifi ed during the inventory

count.)

(2) Determine estimated costs to completion. These costs represent another important element of net realisable value. Relevant procedures include:

– Some books may still be in production and will initially be included in inventory at cost to date; for example, they may have been printed but not bound. The auditor should examine production budgets and actual costs (for binding, for example) to determine actual costs to completion. (Tutorial note: It is not uncommon for

publishers to print books but leave them unbound until sales in the immediate future are expected.)

– Books returned may incur extra costs before they can be made ready for resale and the auditor should examine cost records to obtain a reasonable estimate of such costs.

(3) Determine costs to be incurred in marketing, selling and distributing directly related to the items in question.

– In general terms the auditor may determine the percentage relationship between sales and selling and distribution expenses.

– However, the distribution costs of heavy books are likely to be higher than for (say) light paperback books and the auditor should assess whether the cost weighting is reasonable.

(4) All of the above matters should be discussed with management bearing in mind that, although they represent an internal source of evidence, they are the most informed people regarding the saleability of books on hand and regarding determination of the various elements of net realisable value.

(5) Discuss with management the need for an inventory provision for slow moving and/or obsolete books.

2 (a) The following fi ve factors that infl uence the reliability of audit evidence are taken from AI 500 Audit Evidence:

(i) Audit evidence is more reliable when it is obtained from independent sources outside the entity. (ii) Audit evidence that is generated internally is more reliable when the related controls imposed by the entity are effective. (iii) Audit evidence obtained directly by the auditor (for example, observation of the application of a control) is more reliable

than audit evidence obtained indirectly or by inference (for example, inquiry about the application of a control). (iv) Audit evidence is more reliable when it exists in documentary form, whether paper, electronic, or other medium. (For

example, a contemporaneously written record of a meeting is more reliable than a subsequent oral representation of the matters discussed.)

(v) Audit evidence provided by original documents is more reliable than audit evidence provided by photocopies or facsimiles.

Other examples are:

(vi) Evidence created in the normal course of business is better than evidence specially created to satisfy the auditor. (vii) The best-informed source of audit evidence will normally be management of the company (although management’s lack

of independence may reduce its value as a source of such evidence). (viii) Evidence about the future is particularly diffi cult to obtain and is less reliable than evidence about past events.

(b) (i) Those charged with governance are responsible for overseeing:

– the strategic direction of the entity – obligations related to the accountability of the entity. This includes overseeing the fi nancial reporting process. – promotion of good corporate governance – risk assessment processes – the establishment and monitoring of internal controls – compliance with applicable law and regulations – implementation of controls to prevent and detect fraud and errors.

12

(ii) General audit matters that might be communicated to those charged with governance are addressed in AI 260:

(1) The auditor’s responsibilities in relation to fi nancial statement audit.

This would include:

– A statement that the auditor is responsible for forming and expressing an opinion on the fi nancial statements. – That the auditor’s work is carried out in accordance with ISAs and in accordance with local laws and

regulations.

(2) Planned scope and timing of the audit.

This would include – The audit approach to assessing the risk of serious misstatement, whether arising from fraud or error. – The audit approach to the internal control system and whether reliance will be placed on it. – The timing of interim and fi nal audits, including reporting deadlines.

(3) Signifi cant fi ndings from the audit.

This heading could include:

– Signifi cant diffi culties encountered during the audit, including delays in obtaining information from management.

– Material weaknesses in internal control and recommendations for improvement. – Audit adjustments, whether or not recorded by the entity, that have, or could have, a material effect on the

entity’s fi nancial statements. For example, the bankruptcy of a material receivable shortly after the year-end that should result in an adjusting entry.

(4) A statement on independence issues affecting the audit.

This would include:

– That the audit fi rm has ensured that all members of the audit team have complied with the ethical standards of ACCA.

– That appropriate safeguards are in place where a potential threat to independence has been identifi ed.

(Tutorial note: The lists of examples listed under the above headings are not exhaustive and in practice many more

specifi c matters would be communicated to those charged with governance such as:

– Modifi cations to the audit report.

– Any management representation points requested.

– Cases of suspected/actual fraud.)

3 (a) The auditor obtains an understanding of the entity, its control environment and its detailed internal controls:

(i) to identify and assess the risks of material misstatements, whether due to fraud or error, at the fi nancial statement and assertion levels. Risks would include inherent risk and control risk. An important objective would be to determine the extent to which the auditor would rely on the internal control system.

(ii) to provide a basis for designing and implementing responses to the assessed risks of material misstatement in the fi nancial statements. This would involve the design and performance of the audit procedures required to form an opinion on the truth and fairness of the fi nancial statements. An important objective would be to determine the extent and nature of audit procedures to reduce detection risk, and therefore audit risk, to an acceptable level.

(iii) to set the scene for identifying assertions and collecting suffi cient appropriate evidence to prove that the assertions are reasonable.

(Tutorial note: Marks would also be available for additional points such as:

– To assess the adequacy of the accounting system as a basis for preparing fi nancial statements

– To assess whether competent to perform the audit

– To understand relevant law and regulations impacting the entity

– To consider the reliability of various evidence sources.)

(b) Strong points in the control environment of Letham Co in respect of non-current assets are set out below, together with explanations as to their impact on control risk:

Strengths Impact on control risk (i) Approval of the fi ve-year and annual budgets by the The annual budget is the ‘trigger’ for placing orders for board of directors. equipment. Its approval by the board will ensure that only authorised non-current assets are purchased.

(ii) The budget is updated when the order for new The company can use the updated budget at any time equipment is placed. to anticipate cash outfl ows. It will also ensure that there is no duplication of assets purchased.

13

Strengths Impact on control risk (iii) Pre-numbered goods received notes and operational Only goods that have been received and are operating certifi cates are available to the accounting department effectively will be paid for. for comparison with the purchase invoice.

(iv) Informed people in the production department carefully This will help to ensure the operational effectiveness of assess the proper operation of the equipment. plant and equipment.

(v) The accounting department, independent of the The potential for fraudulent entries to cover theft/ production facility, updates the non-tangible assets unauthorised purchases will be reduced and the register and only the accounting department has access non-current assets register, an important non-current to it. assets control document, cannot be manipulated by the people who hold the assets.

(vi) Accounting department personnel, independent of The risk of theft and loss of plant and equipment is production, perform rolling tests to ensure that the reduced and the likelihood that all items in the register non-current assets register and non-current assets on existing increased. hand are in agreement with each other.

(vii) The internal audit department tests on a sample The internal auditing department will be more independent basis that recorded non-current assets are in than the accounting department and hence will provide existence, but see (c) below. further comfort that the non-current assets register is not overstated.

(viii) Internal audit test the operation of the entire Any controls which are not operating effectively are likely non-current assets recording system. to be identifi ed and rectifi ed before signifi cant errors can (Tutorial note: Marks would also be available for occur. additional strengths:

– Pre-numbered goods received notes used to update

the budget

– Permanent identifi cation numbers recorded on assets

– Purchase invoice automatically updates the

non-current assets register.)

(c) (i) Great care must be taken in selecting the starting point for audit testing. The test that the internal auditors performed, namely, selecting a representative sample of purchase invoices for testing to the non-current assets register and to the updating movements on the annual budget, proves merely that register and budget are in agreement with the purchase invoices issued. It is therefore not a good test to prove the completeness of purchase invoices and therefore of the entries in the register and budget. In addition, the purchase invoices are issued by many different suppliers and there is no common serial number to enable the company to ensure that all purchases are accounted for.

(ii) A more appropriate test would be to make the selection from goods received notes (GRNs), as the issue of a GRN is normally the point at which liability is accepted and is in any event the document used to update the non-current assets budget. In other words, it is important to identify your audit objective and then to decide on what sample will be the most appropriate to aid you in meeting that objective. The GRNs would be traced to the recorded purchase invoices to ensure that the latter were complete and then to the entries in the non-current assets register and to the updating entries in the budget to ensure that these too were complete.

An additional appropriate test would be to select a sample of plant and equipment visible on the shop fl oor and trace them to the non-current assets register to identify whether they have been:

– included in the register – noted against the budget as purchased – paid for by tracing purchase invoice through to payment.

(Tutorial note: The auditor would of course wish to prove that the GRNs are complete and might select a sample of

purchase orders and trace them to the GRNs to ensure GRNs have been prepared in each case or the order rejected

for good reason. Another appropriate test on the GRNs would be to prove that the numbering sequence was complete.

This list is not exhaustive and other completeness procedures may be appropriate.)

4 (a) The interim audit, as its name suggests, is that part of the whole audit that takes place before the year-end. The auditor uses the interim audit to carry out procedures that would be diffi cult to perform at the year-end because of time pressure. The fi nal audit, on the other hand, will take place after the year-end and concludes with the auditor forming and expressing an opinion on the fi nancial statements for the whole year subject to audit. It is important to note that the fi nal opinion takes account of conclusions formed at both the interim and fi nal audit.

Typical work carried out at the interim audit includes:

– consideration of inherent risks facing the company. (Tutorial note: risk would be initially considered at the planning stage,

but is, in fact, reassessed at all audit stages.)

– recording the system of internal control.

14

– carrying out tests of control on the company’s internal control system and evaluating its effectiveness to determine the level of control risk.

– performing suffi cient substantive testing of transactions and balances to be satisfi ed that the books and records are a reliable basis for the preparation of fi nancial statements.

– identifi cation of potential problems that may affect the fi nal audit work. A basic aim is to ensure as far as possible that there are no undetected problems at the year-end.

Typical work carried out at the fi nal examination includes:

– Follow up of items noted at the inventory count. – Obtaining confi rmations from third parties, such as bankers and lawyers. – Analytical reviews of fi gures in the fi nancial statements. – Reviews of events after the reporting period. – Consideration of the going concern status of the organisation.

(Tutorial note: At the fi nal audit the auditor would carry out tests to ensure that the conclusions formed at the interim audit

were still valid.)

(b) The external auditors would normally be able to use the work of the internal auditors provided that:

– they are independent (in this case, of the accounting department and fi nance director to whom the accounting department reports). It appears that they have reported to the whole board, which would be a factor increasing their independence. It would be even better if they had strong links with the audit committee (if applicable).

– they are competent. Your fi rm would have formed a view in past years of their reliability by considering the background (including qualifi cations and experience, particularly as regards forecasting) of the internal audit staff and by examining their reports and working papers. You may also have reviewed some aspects of their work in the current year to the same end.

– effective communication exists; whether there is likely to be effective communication between the internal auditors and the external auditors.

– they have exercised due professional care, the work would need to have been properly planned including detailed work programmes, supervised, documented and reviewed.

– the company is experiencing diffi culties due to the economic down turn and it requires the loan in order to expand. Management might place pressure upon the internal auditors to present the cash fl ow forecast in a more favourable light. This would impact the independence of the internal auditors.

You would still take full responsibility for any report that you issue.

(c) Audit procedures adopted in the examination of the cash fl ow forecast would include:

(1) Check that the opening balance of the cash forecast is in agreement with the closing balance of the cash book, to ensure the opening balance of the forecast is accurate.

(2) Consider how accurate company forecasts have been in the past by comparing past forecasts with actual outcomes. If forecasts have been reasonably accurate in the past, this would make it more likely that the current forecast is reliable.

(3) Determine the assumptions that have been made in the preparation of the cash fl ow forecast. For example, the company is experiencing a poor economic climate, so you would not expect cash fl ows from sales and realisation of receivables to increase, but either to decrease or remain stable. You are also aware that costs are rising so you would expect cost increases to be refl ected in the cash forecasts.

(4) Examine the sales department detailed budgets for the two years ahead and, in particular, discuss with them the outlets that they will be targeting. This would help the auditor determine whether the cash derived from sales is soundly based.

(5) Examine the production department’s assessment of the non-current assets required to increase the production of white bread to the level required by the sales projections. Obtain an assessment of estimated cost of non-current assets, reviewing bids from suppliers, if available. This would provide evidence on material cash outfl ows.

(6) Consider the adequacy of the increased working capital that will be required as a result of the expansion. Increased working capital would result in cash outfl ows and it would be important to establish its adequacy.

(7) If relevant review the post year end period to compare the actual performance against the forecast fi gures.

(8) Recalculate and cast the cash fl ow forecast balances.

(9) Review board minutes for any other relevant issues which should be included within the forecast.

(10) Review the work of the internal audit department in preparing the cash fl ow forecast.

(d) You would inform management that it would not be possible to give a report on the accuracy of the cash fl ow forecast. The forecast is an assessment of cash fl ows in the future which is uncertain, particularly in the second year.

The bank should be informed that the kind of report that you could give is a limited assurance or negative assurance report. You would be able to state in your report the kind of work you had carried out, the assumptions that management had made

15

and then to give a negative form of assurance in which you would state, among other things, that nothing had come to your attention that would cause you to believe that the assumptions do not provide a reasonable basis for the cash forecast. You could then go on to say that the forecast has been properly prepared on the basis of the assumptions.

This is assuming that this kind of opinion is appropriate in the light of the work you have performed.

5 (a) As regards accounts payable there are many different assertions that have to be addressed. Some relevant assertions are set out below:

(i) Rights and obligations – Accounts payable represent amounts actually due by the company, that is, there is an obligation, taking into account:

– the actual performance of services for the company; or – transfer of title in goods transferred to the company; and – cash payments or other genuine debit entry. (ii) Valuation and allocation – Accounts payable have been correctly valued taking into account original transaction amounts

and such matters as trade discounts and local sales tax. (iii) Existence – The original transaction amounts are valid and the liability exists. (iv) Completeness – All accounts payable are recorded in the accounting records.

(Tutorial note: The importance of assertions lies in the fact that they provide objectives for the auditor and enable the evidence

search to be carried out in a logical fashion. The auditor will determine the assertions that are made about a particular fi gure

appearing in the fi nancial statements. This provides a series of objectives about that audit area and then the auditor searches

for evidence to prove that each objective is met and that the assertion is valid or invalid.)

(b) Controls that the company has in place to reduce the risk associated with purchases of food and its preparation in the kitchen, together with relevant audit procedures on controls testing, would include the following: (Tutorial note: For a restaurant it

is important that food quality is good and in particular that it does not present any danger to the customer arising from

deterioration or poor practices in its preparation.)

Controls Audit Procedures (i) Overall authority for food purchasing should be in the Review the company’s organisation chart and identify the hands of a designated person to ensure that the food person with overall responsibility for food purchasing. purchased is of the desired quality. This is often in the Discuss with management his or her background and hands of the head chef. expertise.

(ii) There should be a list of approved suppliers to ensure Examine the list of approved suppliers of food and check that the food comes from sources known for their quality. that there are no purchases of food from other parties.

(iii) On receipt of food, whether meat, fi sh, or vegetables Examine a sample of GRNs to ensure that all bear an and fruit, it should be carefully inspected by informed approved signature indicating that food has been people, including those responsible for food preparation. inspected for quality on receipt. This would be to ensure that it was of the desired quality (as well as quantity). A goods received note (GRN) should be signed to provide evidence of receipt and inspection.

(iv) Food purchased should be kept in a clean place and Examine the food storage areas, including refrigerators, refrigerated, if necessary. This would be to ensure that on a surprise basis to ensure they are clean and tidy. it has kept its quality. Ensure that the refrigerators are maintained at the correct temperature. Another test in this area might be to examine reports of local authority and other inspectors to ensure they were happy that the food was being properly stored.

(v) Strict adherence to use-by dates to ensure that no poor Check that there is no food on the premises which is past quality food is prepared. (Tutorial note: Marks would its use-by date. Discuss with management what happens also be available for additional controls such as: to food which is past its use-by date, that is, how it is – Staff training on basic food hygiene. disposed of. – Rotation of inventory.

– Recording temperatures of cooked/reheated food.)

16

(c) Evidence collected by the auditor to enable a conclusion to be formed on the likelihood of the claim being successful (that is, whether a provision would be necessary according to FRS 137 Provisions, Contingent Liabilities and Contingent Assets) includes:

Evidence Explanation (i) Obtain the written claim by the customer. This would tell you the reason why the claim was being made and provide other relevant details, such as whether the customer dined in the restaurant or purchased carry-out food, and the date when the alleged food poisoning took place.

(ii) Review the controls in force over purchases and food This would be to ensure that the company controls preparation (see (b) above). appeared to be effective.

(iii) Obtain written reports concerning any inspections that This would provide evidence about any problems that had been carried out by company staff or third parties had arisen affecting food quality. Discuss with management in the food store and food preparation areas. the actions that were taken to correct any problems that had arisen.

(iv) Discuss the matter with the company’s lawyers to This would provide evidence from a professional third obtain their view on the likelihood of the claim being party as to the likelihood of the claim succeeding and successful. the reasons why the lawyers had reached their conclusion.

(v) Obtain management representations regarding the This is internal evidence and should be approached likelihood of the claim succeeding. (Tutorial note: with professional scepticism, but it would provide the Marks would also be available for additional auditor with the views of an informed group of people. points such as:

– Review of board minutes to assess management’s

view of the likelihood of the claim succeeding

– Discussions with management about any previous

claims and their outcome.)

(d) As you have concluded that the likelihood of the claim being successful is only possible, it would be appropriate for the company to explain the contingent liability by way of note as required by FRS 137, giving a description of the nature of the contingent liability, an estimate of its fi nancial effect, an indication of the uncertainties relating to the amount and timing and the possibility of any reimbursement.

If the company includes a note of this nature, there would be no need to modify your audit opinion, however if the litigation is viewed to be exceptional then an emphasis of matter paragraph might be appropriate. However, if the contingency is not disclosed, the auditor would modify the audit opinion on the grounds of an ‘except for’ disagreement and include in the report the required details of the contingent liability. The auditor should try to persuade management to include the disclosure before issuing the modifi ed opinion. (Tutorial note: An ‘except for’ qualifi cation would be appropriate as the contingent loss is material

only, that is, the uncertainty is not major.)

17

Fundamentals Level – Skills Module, Paper F8 (MYS)

Audit and Assurance (Malaysia) December 2009 Marking Scheme

Marks1 (a) Audit planning

Up to 1 mark for any of the following, but maximum 4.

Important areas of the audit Potential problems Effective and effi cient audit Selection of engagement team members and assignment of work Direction, supervision and review Coordination of work 4

Two matters

Up to 1 mark for relevant matters, but maximum 2.

Risk assessment generally Assessment of control environment Decision to test controls Scope of substantive testing Procedures to comply with ISAs Materiality Timetable of detailed audit work Allocation of work to team members 2 ––– Maximum marks 6 –––

(b) Sales statistics

1 mark each for each relevant procedure and up to 1 for each explanation of how the procedure operates, but maximum 4.

Reconcile to recorded sales Compare trends Discuss with management Customer codes Reports from sales staff ––– Maximum marks 4 –––

(c) Substantive tests on royalties

Up to 11/2 marks for description of test and 1/2 mark for stating objective, but maximum 6.

Compare royalties with sales income Compare budgeted and actual royalties Review sales statistics Check whether royalties due and correctly calculated Agree royalty payments to supporting documentation Check cut-off Compare expected and actual royalties ––– Maximum marks 6 –––

(d) Inventory risks

Up to 1 mark for each identifi ed risk and up to 1 mark for mitigating control, but maximum 4.

Deterioration Unsaleable – lack of demand Unsaleable – defective Theft likely Poor inventory counting Poor cut-off Sale or return ––– Maximum marks 4 –––

18

Marks (e) (i) Defi ne net realisable value

1 mark for each element of defi nition.

Selling price Less estimated costs to completion, marketing, selling and distribution costs ––– Maximum marks 2 –––

(ii) Four procedures

Up to 1 mark for stating procedure and up to 1 further mark for explanation, but maximum 8.

On sales price On costs to completion On selling and distribution cost Discussion with management Inventory provision ––– Maximum marks 8 ––– 30 –––

2 (a) Reliability of audit evidence

Up to 1 mark for identifi cation of factors, but maximum 4.

Independent source Effective controls Evidence obtained directly by auditor Written evidence Original documents Normal course of business Informed management Evidence about the future ––– Maximum marks 4 –––

(b) (i) Responsibilities of those charged with governance

1/2 mark for identifi cation of responsibility and a further 1/2 if adequately described, but maximum 2.

Strategic direction Accountability obligations Financial reporting process Promotion of good corporate governance Risk assessment processes Establishment and monitoring of internal controls Compliance with law and regulations Implementation of controls to prevent and detect fraud and errors ––– Maximum marks 2 –––

(ii) Matters to be communicated

1/2 mark for identifi cation of matter and a further 1/2 mark if explanation is adequate, but maximum 4.

Matters under the following headings – Auditor’s responsibilities – Planned scope and timing – Signifi cant fi ndings from audit – Independence issues – Modifi cations to the audit report – Management representation points – Cases of suspected/actual fraud ––– Maximum marks 4 ––– 10 –––

19

Marks3 (a) Understanding entity and environment

1 mark for each explanation of reason, but maximum 4.

Risks of material misstatement Design and performance of audit procedures Identifi cation of assertions Adequacy of accounting system as a basis for preparing fi nancial statements Assessment of competence to perform the audit Understanding relevant law and regulations Consider the reliability of evidence sources ––– Maximum marks 4 –––

(b) Strengths in control environment

Up to 1 mark for identifi cation of strength and a further 1 mark for impact on control risk, but maximum 12.

Approval of budgets Updating of budget Matching operation adequate Assessment of operation of equipment Independent updating and holding of non-current assets register Independent tests on non-current assets register Internal audit tests on existence Internal audit review of whole system Pre numbered goods received notes update budget Permanent identifi cation on assets Automatic update of register with purchase invoice ––– Maximum marks 12 –––

(c) Test for completeness

Up to 1 mark for what the current test does and a further 1 mark for an adequate explanation. 1 mark for identifi cation of a more appropriate test and a further 1 mark for an explanation why it is more appropriate.

What the test does Why it is inadequate More appropriate test Why more appropriate ––– Maximum marks 4 ––– 20 –––

20

Marks4 (a) Difference between interim audit and fi nal audit

Up to 1 mark for each relevant explanation and maximum of 2 marks for examples of procedures at interim and fi nal audit, but overall maximum 4.

Interim audit and fi nal audit parts of whole audit Interim audit performed during year but fi nal audit at or after the year-end Interim audit performs procedures that cannot be performed at the fi nal audit Interim audit forms interim conclusion, but fi nal audit results in audit opinion Typical work at interim audit Typical work at fi nal audit ––– Maximum marks 4 –––

(b) Work of internal audit

1/2 mark for identifi cation of each factor and up to 1 mark for full explanation, but maximum 6.

Independence – to whom report; links to audit committee Competence – qualifi cations and experience Effective communication – between internal auditors and external auditors Professional care – properly planned and performed Management pressure to present favourable cash fl ow forecast ––– Maximum marks 6 –––

(c) Examination of forecast

Up to 1 mark for identifi cation of a relevant procedure and a further 1 mark if adequately described, but maximum 6.

Opening balance Accuracy of past forecasts Assumptions Sales budgets Non-current assets required Increased working capital required Review post year end period Recalculate and cast the cash fl ow forecast Review board minutes Review the work of the internal audit department ––– Maximum marks 6 –––

(d) Kind of assurance

1 mark for each relevant point, but maximum 4.

Not possible to give a report on accuracy and why Limited assurance or negative assurance What this kind of assurance means Testing assumptions and reporting on validity Forecast properly prepared on basis of assumptions ––– Maximum marks 4 ––– 20 –––

21

Marks5 (a) Accounts payable assertions

1/2 mark for identifi cation of assertion and up to 1 mark for each explanation of assertion, maximum 6.

Rights and obligation Valuation and allocation Existence Completeness ––– Maximum marks 6 –––

(b) Control risk and audit procedures

Up to 1 mark for each control identifi ed, but maximum 2. Up to 1 mark for each audit procedure, but maximum 2.

Overall authority Approved suppliers Inspection on receipt Storage of food Use-by dates Basic food hygiene training Rotation of inventory Recording temperatures of cooked/reheated food ––– Maximum marks 4 –––

(c) Evidence on claim

1 mark for identifi cation of each item of evidence and up to a further 1 mark for explanation.

Written claim Review controls Inspection reports View of lawyer Management representations Review of board minutes Discussions with management about previous claims ––– Maximum marks 6 –––

(d) Reporting in fi nancial statements

Up to 1 mark for assessing meaning of probable and possible and a further mark for showing how the matter should be disclosed, but maximum 2.

Meaning of possibility Therefore contingent liability Note disclosure

Audit reporting

Up to 1 mark for each relevant point, but maximum 2.

If contingent liability correctly included then unqualifi ed opinion Emphasis of matter paragraph if litigation exceptional Material matter if not disclosed Therefore ‘except for’ disagreement Disclosures in audit report ––– Maximum marks 4 ––– 20 –––


The Association of Chartered Certifi ed Accountants

Audit and Assurance(International)


Time allowed

Reading and planning: 15 minutesWriting: 3 hours



During reading and planning time only the question paper may

be annotated. You must NOT write in your answer booklet until

instructed by the supervisor.


Pape

r F8

(IN

T)

2


1 Introduction and client background

You are an audit senior in Staple and Co and you are commencing the planning of the audit of Smoothbrush Paints Co for the year ending 31 August 2010.

Smoothbrush Paints Co is a paint manufacturer and has been trading for over 50 years, it operates from one central site, which includes the production facility, warehouse and administration offi ces.

Smoothbrush sells all of its goods to large home improvement stores, with 60% being to one large chain store Homewares. The company has a one year contract to be the sole supplier of paint to Homewares. It secured the contract through signifi cantly reducing prices and offering a four-month credit period, the company’s normal credit period is one month.

Goods in/purchases

In recent years, Smoothbrush has reduced the level of goods directly manufactured and instead started to import paint from South Asia. Approximately 60% is imported and 40% manufactured. Within the production facility is a large amount of old plant and equipment that is now redundant and has minimal scrap value. Purchase orders for overseas paint are made six months in advance and goods can be in transit for up to two months. Smoothbrush accounts for the inventory when it receives the goods.

To avoid the disruption of a year end inventory count, Smoothbrush has this year introduced a continuous/perpetual inventory counting system. The warehouse has been divided into 12 areas and these are each to be counted once over the year. The counting team includes a member of the internal audit department and a warehouse staff member. The following procedures have been adopted;

1. The team prints the inventory quantities and descriptions from the system and these records are then compared to the inventory physically present.

2. Any discrepancies in relation to quantities are noted on the inventory sheets, including any items not listed on the sheets but present in the warehouse area.

3. Any damaged or old items are noted and they are removed from the inventory sheets. 4. The sheets are then passed to the fi nance department for adjustments to be made to the records when the count

has fi nished. 5. During the counts there will continue to be inventory movements with goods arriving and leaving the warehouse.

At the year end it is proposed that the inventory will be based on the underlying records. Traditionally Smoothbrush has maintained an inventory provision based on 1% of the inventory value, but management feels that as inventory is being reviewed more regularly it no longer needs this provision.

Finance Director

In May 2010 Smoothbrush had a dispute with its fi nance director (FD) and he immediately left the company. The company has temporarily asked the fi nancial controller to take over the role while they recruit a permanent replacement. The old FD has notifi ed Smoothbrush that he intends to sue for unfair dismissal. The company is not proposing to make any provision or disclosures for this, as they are confi dent the claim has no merit.

3 [P.T.O.

Required:

(a) Identify and explain the audit risks identifi ed at the planning stage of the audit of Smoothbrush Paints Co.

(10 marks)

(b) Discuss the importance of assessing risks at the planning stage of an audit. (4 marks)

(c) List and explain suitable controls that should operate over the continuous/perpetual inventory counting system,

to ensure the completeness and accuracy of the existing inventory records at Smoothbrush Paints Co.

(10 marks)

(d) Describe THREE substantive procedures the auditor of Smoothbrush Paints Co should perform at the year end

in confi rming each of the following:

(i) The valuation of inventory; (3 marks)

(ii) The completeness of provisions or contingent liabilities. (3 marks)

(30 marks)

4

2 (a) Auditors are frequently required to provide assurance for a range of non-audit engagements.

Required:

List and explain the elements of an assurance engagement. (5 marks)

(b) ISA 320 Materiality in Planning and Performing an Audit provides guidance on the concept of materiality in planning and performing an audit.

Required:

Defi ne materiality and determine how the level of materiality is assessed. (5 marks)

(10 marks)

3 (a) (i) Defi ne a ‘test of control’ and a ‘substantive procedure’; (2 marks)

(ii) State ONE test of control and ONE substantive procedure in relation to sales invoicing. (2 marks)

(b) Shiny Happy Windows Co (SHW) is a window cleaning company. Customers’ windows are cleaned monthly, the window cleaner then posts a stamped addressed envelope for payment through the customer’s front door.

SHW has a large number of receivable balances and these customers pay by cheque or cash, which is received in the stamped addressed envelopes in the post. The following procedures are applied to the cash received cycle:

1. A junior clerk from the accounts department opens the post and if any cheques or cash have been sent, she records the receipts in the cash received log and then places all the monies into the locked small cash box.

2. The contents of the cash box are counted each day and every few days these sums are banked by which ever member of the fi nance team is available.

3. The cashier records the details of the cash received log into the cash receipts day book and also updates the sales ledger.

4. Usually on a monthly basis the cashier performs a bank reconciliation, which he then fi les, if he misses a month then he catches this up in the following month’s reconciliation.

Required:

For the cash cycle of SHW:

(i) Identify and explain THREE defi ciencies in the system; (3 marks)

(ii) Suggest controls to address each of these defi ciencies; and (3 marks)

(iii) List tests of controls the auditor of SHW would perform to assess if the controls are operating

effectively. (3 marks)

(c) Describe substantive procedures an auditor would perform in verifying a company’s bank balance.

(7 marks)

(20 marks)

5 [P.T.O.

4 (a) State the FIVE threats contained within ACCA’s Code of Ethics and Conduct and for each threat list ONE

example of a circumstance that may create the threat. (5 marks)

(b) You are the audit manager of Jones & Co and you are planning the audit of LV Fones Co, which has been an audit client for four years and specialises in manufacturing luxury mobile phones.

During the planning stage of the audit you have obtained the following information. The employees of LV Fones Co are entitled to purchase mobile phones at a discount of 10%. The audit team has in previous years been offered the same level of staff discount.

During the year the fi nancial controller of LV Fones was ill and hence unable to work. The company had no spare staff able to fulfi l the role and hence a qualifi ed audit senior of Jones & Co was seconded to the client for three months. The audit partner has recommended that the audit senior work on the audit as he has good knowledge of the client. The fee income derived from LV Fones was boosted by this engagement and along with the audit and tax fee, now accounts for 16% of the fi rm’s total fees.

From a review of the correspondence fi les you note that the partner and the fi nance director have known each other socially for many years and in fact went on holiday together last summer with their families. As a result of this friendship the partner has not yet spoken to the client about the fee for last year’s audit, 20% of which is still outstanding.

Required:

(i) Explain the ethical threats which may affect the independence of Jones & Co’s audit of LV Fones Co;

and (5 marks)

(ii) For each threat explain how it might be avoided. (5 marks)

(c) Describe the steps an audit fi rm should perform prior to accepting a new audit engagement. (5 marks)

(20 marks)

6

5 (a) Defi ne the going concern assumption. (2 marks)

Medimade Co is an established pharmaceutical company that has for many years generated 90% of its revenue through the sale of two specifi c cold and fl u remedies. Medimade has lately seen a real growth in the level of competition that it faces in its market and demand for its products has signifi cantly declined. To make matters worse, in the past the company has not invested suffi ciently in new product development and so has been trying to remedy this by recruiting suitably trained scientifi c staff, but this has proved more diffi cult than anticipated.

In addition to recruiting staff the company also needed to invest $2m in plant and machinery. The company wanted to borrow this sum but was unable to agree suitable terms with the bank; therefore it used its overdraft facility, which carried a higher interest rate. Consequently, some of Medimade’s suppliers have been paid much later than usual and hence some of them have withdrawn credit terms meaning the company must pay cash on delivery. As a result of the above the company’s overdraft balance has grown substantially.

The directors have produced a cash fl ow forecast and this shows a signifi cantly worsening position over the coming 12 months.

The directors have informed you that the bank overdraft facility is due for renewal next month, but they are confi dent that it will be renewed. They also strongly believe that the new products which are being developed will be ready to market soon and hence trading levels will improve and therefore that the company is a going concern. Therefore they do not intend to make any disclosures in the accounts regarding going concern.

Required:

(b) Identify any potential indicators that the company is not a going concern and describe why these could impact

upon the ability of the company to continue trading on a going concern basis. (8 marks)

(c) Explain the audit procedures that the auditor of Medimade should perform in assessing whether or not the

company is a going concern. (6 marks)

(d) The auditors have been informed that Medimade’s bankers will not make a decision on the overdraft facility until after the audit report is completed. The directors have now agreed to include going concern disclosures.

Required:

Describe the impact on the audit report of Medimade if the auditor believes the company is a going concern

but a material uncertainty exists. (4 marks)

(20 marks)


Answers

9

Fundamentals Level – Skills Module, Paper F8 (INT)

Audit and Assurance (International) June 2010 Answers

1 (a) Identifi cation of risk Explanation of risk Smoothbrush supplies 60% of its goods Per IAS 2 Inventories, inventory should be to Homewares at a signifi cantly reduced stated at the lower of cost and net realisable selling price, hence inventory may be value (NRV). Therefore, as selling prices are much overvalued. lower for goods sold to Homewares, there is a risk that the NRV of some inventory items may be lower than cost and hence that inventory could be overvalued.

Recoverability of receivable balances as Smoothbrush has extended its credit terms credit period extended. to Homewares from one month to four months. Hence there is an increased risk as balances outstanding become older, that they may become irrecoverable.

Valuation of plant and equipment. The production facility has a large amount of unused plant and equipment. As per IAS 16 Property, Plant and Equipment and IAS 36 Impairment of Assets, this plant and equipment should be stated at the lower of its carrying value and recoverable amount, which may be at scrap value depending on its age and condition.

Cut-off of purchases and inventory may not Smoothbrush imports goods from South Asia and be accurate. the paint can be in transit for up to two months. The company accounts for goods when they receive them. Therefore at the year end only goods that have been received into the warehouse should be included in the inventory balance and a respective payables balance recognised.

New inventory system introduced in the year. Smoothbrush has introduced a continuous/perpetual This could result in inventory balances being inventory counting system in the year. These records misstated. will be used for recording inventory at the year end. If the records and new system have not initially been set up correctly then there is a risk that the year end balances may not be fairly stated.

Inventory may be overstated as Smoothbrush Previously Smoothbrush maintained an inventory no longer has a slow moving provision. provision of 1%, however, this year it has decided to remove this. Unless all slow moving/obsolete items are identifi ed at the year end and their value adjusted, there is a risk that the overall value of inventory may be overstated.

Provisions/contingent liability disclosures may The company’s fi nance director (FD) has left and not be complete. is intending to sue Smoothbrush for unfair dismissal. However, the company does not intend to make any provision/disclosures for sums due to the FD.

Under IAS 37 Provisions, Contingent Liabilities and

Contingent Assets, if there is a present obligation, a probable outfl ow of resources to settle the obligation and a reliable estimate can be made of the obligation then a provision should be recognised.

If the obligation is only possible, or if there is a present obligation but it is not recognised as there is not a probable outfl ow of resources, or the amount of the obligation cannot be measured with suffi cient reliability then a contingent liability should be disclosed, unless the likelihood of payment is remote.

10

Identifi cation of risk Explanation of risk Inherent risk is higher due to the changes The fi nancial controller has been appointed in the fi nance department. as temporary FD and this lack of experience could result in an increased risk of errors arising in the fi nancial statements. In addition the previous FD is not available to help the fi nance or audit team.

Inventory may be over or understated if the The inventory counts are to cover all of the perpetual inventory counts are not complete inventory lines. If any areas of the warehouse and accurate. are not counted then this will need to be done at the year end.

In addition inventory adjustments arising from the counts must be verifi ed and updated by an appropriate member of the fi nance team to ensure that the records are accurate.

(b) ISA 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment, requires auditors ‘to identify and assess the risks of material misstatement, whether due to fraud or error, at the fi nancial statement and assertion levels’.

It is vitally important for auditors to assess engagement risks at the planning stage, this will ensure that attention is focused early on the areas most likely to cause material misstatements.

A thorough risk assessment will also help the auditor to fully understand the entity, which is vital for an effective audit.

Any unusual transactions or balances would also be identifi ed early, so that these could be addressed in a timely manner.

In addition, as most auditors adopt a risks based audit approach then these risks need to be assessed early in order for the audit strategy and detailed work programmes to be developed.

Assessing risks early should also result in an effi cient audit. The team will only focus their time and effort on key areas as opposed to balances or transactions that might be immaterial or unlikely to contain errors.

In addition assessing risk early should ensure that the most appropriate team is selected with more experienced staff allocated to higher risk audits and high risk balances.

A thorough risk analysis should ultimately reduce the risk of an inappropriate audit opinion being given. The audit would have focused on the main risk areas and hence all material misstatements should have been identifi ed, resulting in the correct opinion being given.

It should enable the auditor to have a good understanding of the risks of fraud, money laundering, etc.

Assessing risk should enable the auditor to assess whether the client is a going concern.

(c) Controls over the perpetual/continuous inventory system.

Control Explanation The inventory count team should be Currently the team includes a warehouse staff member and independent of the warehouse team. an internal auditor. There should be segregation of roles between those who have day-to-day responsibility for inventory and those who are checking it. If the same team are responsible for maintaining and checking inventory, then errors and fraud could be hidden.

Timetable of counts should be regularly The warehouse has been divided into 12 areas that are each reviewed to ensure that all areas are counted. due to be counted once over the year. All inventory is required to be counted once a year, hence if the timetable is not monitored then some areas could be missed out.

Movements of inventory should be stopped Goods will continue to move in and out of the warehouse from the designated areas during continuous/ during the counts. Inventory records could be perpetual inventory counts. under/over stated if product lines are missed or double counted due to movements in the warehouse.

Inventory counting sheets should be pre-printed The inventory sheets produced for the count have the with a description or item code of the quantities pre-printed, therefore a risk arises that the goods, but the quantities per the records counting team could just agree with the record quantities, should not be pre-recorded. making under counting more likely, rather than counting the inventory lines correctly.

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Control Explanation A second independent team should check the By counting the lines twice this should help to ensure counts performed by the inventory count team. completeness and accuracy of the counts, and hence that any inventory adjustments are appropriate.

Inventory checks should be performed from Currently the team is comparing the records to the inventory physically present in the warehouse inventory in the warehouse. If the count is performed to the records. from the records to the warehouse then this will only ensure existence or overstatement of the records. To ensure completeness is addressed the inventory in the warehouse must be compared to the records as this will identify any goods physically present but not included in the records.

Any damaged or obsolete goods should be Damaged or obsolete goods should be written down or moved to a designated area, where a provided against to ensure that they are stated at the responsible offi cial then inspects it, it should lower of cost and NRV. This may not involve fully not be removed from the sheets. writing off the inventory item as is currently occurring. This is an assessment that should only be performed by a suitably trained member of the fi nance team, as opposed to the inventory count team.

After the count, the inventory count sheets At the year end the inventory of Smoothbrush will be should be compared to the inventory records, based on the records maintained. Hence the records any adjustments should be investigated and must be complete, accurate and valid. It is important if appropriate the records updated in a prompt that only individuals authorised to do so can amend manner by an authorised person. records.

Senior members of the fi nance team should regularly review the types and levels of adjustments, as recurring inventory adjustments could indicate possible fraud.

(d) Substantive procedures to confi rm valuation of inventory

– Select a representative sample of goods in inventory at the year end, agree the cost per the records to a recent purchase invoice and ensure that the cost is correctly stated.

– Select a sample of year end goods and review post year end sales invoices to ascertain if NRV is above cost or if an adjustment is required.

– For a sample of manufactured items obtain cost sheets and confi rm: – raw material costs to recent purchase invoices – labour costs to time sheets or wage records – overheads allocated are of a production nature. – Review aged inventory reports and identify any slow moving goods, discuss with management why these items have not

been written down. – Compare the level/value of aged product lines to the total inventory value to assess whether the provision for slow moving

goods of 1% should be reinstated. – Review the inventory records to identify the level of adjustments made throughout the year for damaged/obsolete items.

If signifi cant consider whether the year end records require further adjustments and discuss with management whether any further write downs/provision may be required.

– Follow up any damaged/obsolete items noted by the auditor at the inventory counts attended, to ensure that the inventory records have been updated correctly.

– Perform a review of the average inventory days for the current year and compare to prior year inventory days. Discuss any signifi cant variations with management.

– Compare the gross margin for current year with prior year. Fluctuations in gross margin could be due to inventory valuation issues. Discuss signifi cant variations in the margin with management.

Substantive procedures to confi rm completeness of provisions or contingent liability

– Discuss with management the nature of the dispute between Smoothbrush and the former fi nance director (FD), to ensure that a full understanding of the issue is obtained and to assess whether an obligation exists.

– Review any correspondence with the former FD to assess if a reliable estimate of any potential payments can be made. – Write to the company’s lawyers to obtain their views as to the probability of the FD’s claim being successful. – Review board minutes and any company correspondence to assess whether there is any evidence to support the former

FD’s claims of unfair dismissal. – Obtain a written representation from the directors of Smoothbrush confi rming their view that the former FD’s chances of

a successful claim are remote, and hence no provision or contingent liability is required.

Credit will be awarded for any substantive procedures which test for additional provisions or contingent liabilities of Smoothbrush.

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2 (a) An assurance engagement will involve three separate parties;

– The intended user who is the person who requires the assurance report. – The responsible party, which is the organisation responsible for preparing the subject matter to be reviewed. – The practitioner (i.e. an accountant) who is the professional who will review the subject matter and provide the

assurance.

A second element is a suitable subject matter. The subject matter is the data that the responsible party has prepared and which requires verifi cation.

Suitable criteria are required in an assurance engagement. The subject matter is compared to the criteria in order for it to be assessed and an opinion provided.

Appropriate evidence has to be obtained by the practitioner in order to give the required level of assurance.

An assurance report is the opinion that is given by the practitioner to the intended user and the responsible party.

(b) Materiality is defi ned as follows:

‘Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to infl uence the economic decisions of users taken on the basis of the fi nancial statements.’

In assessing the level of materiality there are a number of areas that should be considered. Firstly the auditor must consider both the amount (quantity) and the nature (quality) of any misstatements, or a combination of both. The quantity of the misstatement refers to the relative size of it and the quality refers to an amount that might be low in value but due to its prominence could infl uence the user’s decision, for example, directors’ transactions.

In assessing materiality the auditor must consider that a number of errors each with a low value may when aggregated amount to a material misstatement.

The assessment of what is material is ultimately a matter of the auditors’ professional judgement, and it is affected by the auditor’s perception of the fi nancial information needs of users of the fi nancial statements.

In calculating materiality the auditor should also consider setting the performance materiality level. This is the amount set by the auditor, it is below materiality, and is used for particular transactions, account balances and disclosures.

As per ISA 320 materiality is often calculated using benchmarks such as 5% of profi t before tax or 1% of gross revenue. These values are useful as a starting point for assessing materiality.

3 (a) (i) Tests of control test the operating effectiveness of controls in preventing, detecting or correcting material misstatements.

Substantive procedures are aimed at detecting material misstatements at the assertion level. They include tests of detail of transactions, balances, disclosures and substantive analytical procedures.

(ii) Example tests of control over sales invoicing

– Inspect numerical sequence of sales invoices, if any breaks in the sequence noted, enquire of management as to missing invoices.

– Review a sample of sales invoices for evidence of authorisation by a responsible offi cial of any discounts allowed. – Inspect customer statements for evidence of regular preparation.

Example substantive procedures over sales invoicing

– Select a sample of pre and post year end goods despatch notes and follow through to pre or post year end sales invoices, to ensure the sales cut-off has been correctly applied.

– Perform an analytical review of monthly sales, compare any trends to prior years and discuss signifi cant fl uctuations with management.

– Review post year end credit notes to identify if any pre year end sales should be removed.

(b) Defi ciency Control Test of Control A junior clerk opens the post A second member of the accounts Observe the mail opening process, unsupervised. This could result team or staff independent of the to assess if the control is operating in cash being misappropriated. accounts team should assist with effectively. the mail, one should open the post and the second should record cash received in the cash log.

Cash and cheques are secured in a Cash and cheques should be ideally Enquire of management where the small locked box and only banked banked daily, if not then it should be cash receipts not banked are stored. every few days. A small locked box stored in a fi re proof safe, and access Inspect the location to ensure cash is is not adequate for security of to this safe should be restricted to suitably secure. considerable cash receipts, as it supervised individuals. can easily be stolen.

13

Defi ciency Control Test of Control Cash and cheques are only banked Cash and cheques should be banked Inspect the paying-in-books to see if every few days and any member of every day. cash and cheques have been banked the fi nance team performs this. daily or less frequently.

Review bank statements against the cash received log to confi rm all amounts were banked promptly.

Cash should ideally not be held The cashier should prepare the Enquire of staff as to who performs over-night as it is not secure. Also paying-in-book from the cash the banking process and confi rm if any member of the team banks received log. Then a separate this person is suitably responsible. cash, then this could result in very responsible individual should junior clerks having access to have responsibility for banking signifi cant amounts of money. this cash.

The cashier updates both the cash The cashier should update the cash Observe the process for recording book and the sales ledger. This is book from the cash received log. cash received into the relevant ledgers weak segregation of duties, as the A member of the sales ledger and note if the segregation of duties cashier could incorrectly enter a team should update the sales ledger. is occurring. receipt and this would impact both the cash book and the sales ledger. In addition weak segregation of duties could increase the risk of a ‘teeming and lading’ fraud.

Bank reconciliations are not performed Bank reconciliations should be Review the fi le of reconciliations for every month and they do not appear performed monthly. A responsible evidence of regular performance and to be reviewed by a senior member of individual should then review them. review by senior fi nance team members. the fi nance department. Errors in the cash cycle may not be promptly identifi ed if reconciliations are performed infrequently.

(c) Substantive procedures over bank balance:

– Obtain the company’s bank reconciliation and check the additions to ensure arithmetical accuracy. – Obtain a bank confi rmation letter from the company’s bankers. – Verify the balance per the bank statement to an original year end bank statement and also to the bank confi rmation

letter. – Verify the reconciliation’s balance per the cash book to the year end cash book. – Trace all of the outstanding lodgements to the pre year end cash book, post year end bank statement and also to

paying-in-book pre year end. – Examine any old unpresented cheques to assess if they need to be written back into the purchase ledger as they are no

longer valid to be presented. – Trace all unpresented cheques through to a pre year end cash book and post year end statement. For any unusual

amounts or signifi cant delays obtain explanations from management. – Agree all balances listed on the bank confi rmation letter to the company’s bank reconciliations or the trial balance to

ensure completeness of bank balances. – Review the cash book and bank statements for any unusual items or large transfers around the year end, as this could be

evidence of window dressing. – Examine the bank confi rmation letter for details of any security provided by the company or any legal right of set-off as

this may require disclosure.

4 (a) Compliance with ACCA’s Code of Ethics and Conduct fundamental principles can be threatened by a number of areas. The fi ve categories of threats, which may impact on ethical risk, are:

– Self-interest – Self-review – Advocacy – Familiarity – Intimidation.

Examples for each category (Only one example required per threat):

Self-interest

– Undue dependence on fee income from one client – Close personal or business relationships – Financial interest in a client

14

– Incentive fee arrangements – Concern over employment security – Commercial pressure from outside the employing organisation – Inappropriate personal use of corporate assets.

Self-review

– Member of assurance team being or recently having been employed by the client in a position to infl uence the subject matter being reviewed

– Involvement in implementation of fi nancial system and subsequently reporting on the operation of said system – Same person reviewing decisions or data that prepared them – An analyst, or member of a board, audit committee or audit fi rm being in a position to exert a direct or signifi cant infl uence

over the fi nancial reports – The discovery of a signifi cant error during a re-evaluation of the work undertaken by the member – Performing a service for a client that directly affects the subject matter of an assurance engagement.

Advocacy

– Acting as an advocate on behalf of a client in litigation or disputes – Promoting shares in a listed audit client – Commenting publicly on future events in particular circumstances – Where information is incomplete or advocating an argument which is unlawful.

Familiarity

– Long association with a client – Acceptance of gifts or preferential treatment (signifi cant value) – Over familiarity with management – Former partner of fi rm being employed by client – A person in a position to infl uence fi nancial or non-fi nancial reporting or business decisions having an immediate or close

family member who is in a position to benefi t from that infl uence.

Intimidation

– Threat of litigation – Threat of removal as assurance fi rm – Dominant personality of client director attempting to infl uence decisions – Pressure to reduce inappropriately the extent of work performed in order to reduce fees.

(b) Ethical threat Managing risk The audit team has in previous years been The audit fi rm should ascertain whether the discount is offered a staff discount of 10% on purchasing to be offered to staff this year. luxury mobile phones.

This is a familiarity threat. It would need to If it is then the discount should be reviewed for signifi cance. be confi rmed if this discount is to be offered If it is deemed to be of signifi cant value then the offer of to this year’s team as well, as only goods discount should be declined. of an insignifi cant value are allowed to be accepted. A discount of 10% may not appear to be signifi cant, but as these are luxury mobile phones then this may still be a signifi cant value.

An audit senior of Jones & Co has been on The fi rm should clarify exactly what areas the senior secondment as the fi nancial controller of LV assisted the client on. If he worked on areas not related Fones and is currently part of the audit team. to the fi nancial statements then he may be able to remain in the audit team.

There is a self-review threat if the senior has However, it is likely that he has worked on some related prepared records or schedules that support schedules and therefore he should be removed from the the year end fi nancial statements and he then audit team to ensure that independence is not threatened. audits these same documents.

The total fee income from LV Fones is 16% The fi rm should assess if the recurring fees will exceed 15%. of the total fees for the audit fi rm. If the fees If this is the case then it might need to consider whether for audit and recurring work exceed 15% the appearance of independence will still be met if the tax then there is a self-interest threat. and audit work is retained.

The fees for LV Fones include tax and audit No further work should be accepted in the current year that are assumed to be recurring, however from the client, and it might be advisable to perform the secondment fees would not recur each external quality control reviews. It may also become year. necessary to consider resigning from either the tax or the audit engagement.

15

Ethical threat Managing risk The partner and the fi nance director know The personal relationship should be reviewed in line with each other socially and have holidayed Jones’s ethical policies. together. Personal relationships between the client and members of the audit team can create a familiarity or self-interest threat.

ACCA’s Code of Ethics and Conduct does not Consideration should be given to rotating the partner specifi cally prohibit friendships between the off this engagement and replacing with an alternative audit client and the team. However, due to partner. the senior positions held by both parties then there is a risk that independence may be perceived to have been threatened.

Last year’s audit fee is still outstanding. This Jones & Co should chase the outstanding fees. amounts to 20% of the total fee and is likely to be a signifi cant value.

A self-interest threat can arise if the fees If they remain outstanding, the fi rm should discuss with remain outstanding, as Jones & Co may feel those charged with governance the reasons for the pressure to agree to certain accounting continued non-payment, and ideally agree a payment adjustments in order to have the previous schedule which will result in the fees being settled before year and the current year fee paid. much more work is performed for the current year audit.

In addition outstanding fees could be perceived as a loan to a client, this is strictly prohibited.

(c) Prior to accepting

Prior to accepting an audit engagement the fi rm should consider any issues which might arise which could threaten compliance with ACCA’s Code of Ethics and Conduct or any local legislation. If issues arise then their signifi cance must be considered.

The fi rm should consider whether they are competent to perform the work and whether they would have appropriate resources available, as well as any specialist skills or knowledge.

The prospective fi rm must communicate with the outgoing auditor to assess if there are any ethical or professional reasons why they should not accept appointment.

The prospective fi rm must obtain permission from the client to contact the existing auditor, if this is not given then the engagement should be refused.

The existing auditor must obtain permission from the client to respond, if not given then the prospective auditor should refuse the engagement.

If given permission to respond, then the existing auditor should reply to the prospective auditor, who should then carefully review the response for any issues that could affect acceptance.

In addition the audit fi rm should undertake client screening procedures such as considering management integrity and assessing whether any confl ict of interest with existing clients would arise.

Further client screening procedures would include assessing the level of audit risk of the client and whether the expected engagement fee would be suffi cient for the level of anticipated risk.

5 (a) The going concern assumption means that management believes the company will continue in business for the foreseeable future. Foreseeable future is not defi ned in ISA 570 Going Concern. However under IAS 1 Presentation of Financial Statements, this period is a minimum of 12 months after the year end.

IAS 1 Presentation of Financial Statements requires that management automatically prepare fi nancial statements on a going concern basis unless they believe that the company will soon cease trading.

(b) Indicator Why could impact going concern Medimade has seen a signifi cant decline in If the company is not able to increase demand for its demand for its products. products then it will struggle to generate suffi cient operating cash fl ows leading to going concern diffi culties.

Medimade generates 90% of its revenue As the market is very competitive and Medimade has through sales of just two products, and this only two products then it is very dependent on these market has now become very competitive. and must ensure that it makes suffi cient sales as otherwise it may face diffi culties in meeting all expenses.

Lack of investment in future product development As current products reach the end of their life-cycle they will bring in diminishing cash fl ows. Without new products to generate future income operating cash fl ows will be strained.

16

Indicator Why could impact going concern The company is struggling to recruit suitably The company has decided that it needs to develop new trained scientifi c staff to develop new products, however, this is a highly specialised area products. and therefore it needs suffi ciently trained staff. If it cannot recruit enough staff then it could hold up the product development and stop the company from increasing revenue.

Medimade was unable to obtain suitable If Medimade was unable to obtain fi nance for its funding for its $2m investment in plant and investment, then this could indicate that the banks machinery. deem the company to be too risky to lend money to. They may be concerned that Medimade is unable to meet its loan payments, suggesting cash fl ow problems.

Some trade payables have been paid much Failing to make payments to suppliers on time could later than their due dates. ultimately lead to some of them refusing to supply Medimade. Therefore the company may need to fi nd alternative suppliers and they could be more expensive which will decrease operating cash fl ows and profi ts.

Some suppliers have withdrawn credit terms As Medimade must now make cash on delivery from Medimade resulting in cash on delivery payments, then it puts additional pressure on the payments. company’s overdraft, which has already grown substantially. This is because the company has to pay for goods in advance but it may not receive cash from its receivables for some time later.

The overdraft facility has increased substantially Medimade’s overdraft has grown signifi cantly and it is and is due for renewal next month. heavily dependent on it to pay its expenses. If the bank does not renew the overdraft and the company is unable to obtain alternative fi nance then it may not be able to continue to trade.

The cash fl ow forecast has shown a signifi cantly The future cash outfl ows are greater than the infl ows and worsening position. this position is worsening rather than improving. If Medimade cannot start to reverse this position, then it may have diffi culties in funding its operating activities.

(c) Obtain the company’s cash fl ow forecast and review the cash in and out fl ows. Assess the assumptions for reasonableness and discuss the fi ndings with management to understand if the company will have suffi cient cash fl ows.

Perform a sensitivity analysis on the cash fl ows to understand the margin of safety the company has in terms of its net cash in/out fl ow.

Review any current agreements with the bank to determine whether any key ratios have been breached.

Review any bank correspondence to assess the likelihood of the bank renewing the overdraft facility.

Discuss with the directors whether they have contacted any alternative banks for fi nance to assess whether they have any other means of repaying the bank overdraft.

Review the company’s post year end sales and order book to assess if the levels of trade are likely to increase and if the revenue fi gures in the cash fl ow forecast are reasonable.

Review post year end correspondence with suppliers to identify if any further restrictions in credit have arisen, and if so ensure that the cash fl ow forecast refl ects an immediate payment for trade payables.

Inquire of the lawyers of Medimade as to the existence of litigation and claims, if any exist then consider their materiality and impact on the going concern basis.

Perform audit tests in relation to subsequent events to identify any items that might indicate or mitigate the risk of going concern not being appropriate.

Review the post year end board minutes to identify any other issues that might indicate fi nancial diffi culties for the company.

Review post year end management accounts to assess if in line with cash fl ow forecast.

Consider whether any additional disclosures as required by IAS 1 Presentation of Financial Statements in relation to material uncertainties over going concern should be made in the fi nancial statements.

Obtain a written representation confi rming the director’s view that Medimade is a going concern.

(d) The directors of Medimade have agreed to make going concern disclosures, however, the impact on the audit report will be dependent on the adequacy of these disclosures. If the disclosures are adequate, then the audit report will be unmodifi ed.However, an emphasis of matter paragraph would be required.

17

This will state that the audit report is not modifi ed, identify that there is a material uncertainty and will cross reference to the disclosure note made by management, this paragraph would be included after the opinion paragraph.

If the disclosures made by management are not adequate the audit report will need to be modifi ed. A material misstatement modifi cation will be required, depending on the materiality of the issue this will be either qualifi ed or an adverse opinion.

A paragraph describing the matter giving rise to the modifi cation will be included just before the opinion paragraph and this will clearly identify the going concern uncertainty. The opinion paragraph will be amended to state ‘except for’ or the accounts are not fairly presented.

19

Fundamentals Level – Skills Module, Paper F8 (INT)

Audit and Assurance (International) June 2010 Marking Scheme

Marks1 (a) 1/2 mark for each identifi cation of risk and up to 1 per description of the risk

– Sole supplier to Homewares, NRV of inventory – Recoverability of receivable as credit period extended – Valuation of plant and equipment – Cut-off – New system – Inventory provision – Provision/contingent liability – Inherent risk increased – Perpetual inventory counts ––– 10 –––

(b) Up to 1 mark per valid point

– ISA 315 requirement (1/2 mark only for ISA ref) – Early identifi cation of material errors – Understand entity – Identifi cation of unusual transactions/balances – Develop strategy – Effi cient audit – Most appropriate team – Reduce risk incorrect opinion – Understanding fraud, money laundering – Assess risk going concern ––– 4 –––

(c) 1/2 mark for each identifi cation of a control and up to 1 mark per well explained description of the control

– Team independent of warehouse – Timetable of counts – Inventory movements stopped – No pre-printed quantities on count sheets – Second independent team – Direction of counting fl oor to records – Damaged/obsolete goods to specifi c area – Records updated by authorised person ––– 10 –––

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Marks (d) Up to 1 mark per substantive procedure

Inventory:

– Cost to purchase invoice – NRV to sales invoice – Manufactured items to invoices/time sheets/production overheads – Review aged inventory reports – Compare aged items to 1% prov – Total level of adjustment over year – Follow up items noted at inventory count – Inventory days – Gross margin Max 3

Provisions:

– Discuss with management – Review correspondence with FD – Write to lawyers – Review board minutes – Obtain written representation

Marks awarded for tests for additional provisions and contingent liabilities of Smoothbrush Max 3 ––– 30 –––

2 (a) Up to 1 mark per description of element:

– Intended user – Responsible party – Practitioner – Suitable criteria – Subject matter – Appropriate evidence – Assurance report ––– 5 –––

(b) Up to 1 mark per valid point:

– ISA 320 (1/2 mark only for ISA ref) – Defi nition – Amount – Nature, or both – Small errors aggregated – Judgement, needs of users – Performance materiality – 5% profi t before tax or 1% revenue ––– 5 ––– ––– 10 –––

21

Marks 3 (a) Up to 1 mark each for defi nition of test of control and substantive procedures and up to 1 mark each for example test given

– Defi nition of test of control (toc) – Defi nition of substantive test ––– 2 –––

– Example toc – Example substantive test ––– 2 –––

(b) Up to 1 mark for each defi ciency identifi ed and explained, up to 1 mark for each suitable control and up to 1 mark per test of control.

– Junior clerk opens post – Small locked box – Cash not banked daily – Cashier updates cash book and sales ledger – Bank reconciliation not performed monthly Max 3 for defi ciencies Max 3 for controls Max 3 for test of controls (c) Up to 1 mark per substantive procedure

– Check additions bank reconciliation – Obtain bank confi rmation letter – Bank balance to statement/bank confi rmation – Cash book balance to cash book – Outstanding lodgements – Unpresented cheques review – Old cheques write back – Agree all balances on bank confi rmation – Unusual items/window dressing – Security/legal right set-off ––– 7 ––– ––– 20 –––

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Marks4 (a) 1/2 mark for each threat and 1/2 per example of a threat

– Self-interest – Self-review – Advocacy – Familiarity – Intimidation ––– 5 –––

(b) Up to 1 mark per ethical threat and up to 1 mark per managing method

– Staff discount – Secondment – Total fee income – Finance director and partner good friends – Outstanding fees Max 5 for threats Max 5 for methods

(c) Up to 1 mark per step

– Compliance with ACCA’s Code of Ethics and Conduct

– Competent – Write outgoing auditor – Permission to contact old auditor – Old auditor permission to respond – Review response – Client screening procedures ––– 5 ––– ––– 20 –––

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Marks5 (a) Up to 1 mark per point

– Continue to trade for foreseeable future – Foreseeable future not defi ned ISA 570, but IAS 1 states minimum 12 months after year end – IAS 1 Accounts automatically on going concern basis ––– 2 –––

(b) 1/2 mark per indicator and up to 1 mark per description of why this could indicate going concern problems for Medimade:

– Decline in demand – Dependent on two products – Lack of investment in future product development – Unable to recruit staff – Inability to obtain funding – Failing to pay payables on time – Withdrawal of credit terms – Overdraft facility due for renewal – Cash fl ow forecast shows worsening position ––– 8 –––

(c) Up to 1 mark per well explained point – If the procedure does not clearly explain how this will help the auditor to consider going concern then a 1/2 mark only should be awarded:

– Review cash fl ow forecasts – Sensitivity analysis – Review bank agreements, breach of key ratios – Review bank correspondence – Discuss if alternative fi nance obtained – Review post year end sales and order book – Review suppliers correspondence – Inquire lawyers any litigation – Subsequent events – Board minutes – Management accounts – Consider additional disclosures under IAS 1 – Written representation ––– 6 –––

(d) Up to 1 mark per point

– Depends on adequacy of disclosures – Adequately disclosed – unmodifi ed – Emphasis of matter para – after opinion – Not adequately disclosed – modifi ed – Material misstatement – Add paragraph before opinion and impact on opinion paragraph ––– 4 ––– ––– 20 –––







Pape

r F8

(M

YS)





1 (a) Auditors have a responsibility under ISA 265 Communicating Deficiencies in Internal Control to those Chargedwith Governance and Management, to communicate deficiencies in internal controls. In particular SIGNIFICANTdeficiencies in internal controls must be communicated in writing to those charged with governance.

Required:

Explain examples of matters the auditor should consider in determining whether a deficiency in internalcontrols is significant. (5 marks)

Greystone Co is a retailer of ladies clothing and accessories. It operates in many countries around the world and hasexpanded steadily from its base in Europe. Its main market is aimed at 15 to 35 year olds and its prices are mid tolow range. The company’s year end was 30 September 2010.

In the past the company has bulk ordered its clothing and accessories twice a year. However, if their goods failed tomeet the key fashion trends then this resulted in significant inventory write downs. As a result of this the companyhas recently introduced a just in time ordering system. The fashion buyers make an assessment nine months inadvance as to what the key trends are likely to be, these goods are sourced from their suppliers but only limitednumbers are initially ordered.

Greystone Co has an internal audit department but at present their only role is to perform regular inventory counts atthe stores.

Ordering process

Each country has a purchasing manager who decides on the initial inventory levels for each store, this is not done inconjunction with store or sales managers. These quantities are communicated to the central buying department at thehead office in Europe. An ordering clerk amalgamates all country orders by specified regions of countries, such asCentral Europe and North America, and passes them to the purchasing director to review and authorise.

As the goods are sold, it is the store manager’s responsibility to re-order the goods through the purchasing manager;they are prompted weekly to review inventory levels as although the goods are just in time, it can still take up to fourweeks for goods to be received in store.

It is not possible to order goods from other branches of stores as all ordering must be undertaken through thepurchasing manager. If a customer requests an item of clothing, which is unavailable in a particular store, then thecustomer is provided with other branch telephone numbers or recommended to try the company website.

Goods received and Invoicing

To speed up the ordering to receipt of goods cycle, the goods are delivered directly from the suppliers to the individualstores. On receipt of goods the quantities received are checked by a sales assistant against the supplier’s delivery note,and then the assistant produces a goods received note (GRN). This is done at quiet times of the day so as to maximisesales. The checked GRNs are sent to head office for matching with purchase invoices.

As purchase invoices are received they are manually matched to GRNs from the stores, this can be a very timeconsuming process as some suppliers may have delivered to over 500 stores. Once the invoice has been agreed thenit is sent to the purchasing director for authorisation. It is at this stage that the invoice is entered onto the purchaseledger.

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Required:

(b) As the external auditors of Greystone Co, write a report to management in respect of the purchasing systemwhich:

(i) Identifies and explains FOUR deficiencies in that system;(ii) Explains the possible implication of each deficiency;(iii) Provides a recommendation to address each deficiency.

A covering letter is required.

Note: Up to two marks will be awarded within this requirement for presentation. (14 marks)

(c) Describe substantive procedures the auditor should perform on the year-end trade payables of Greystone Co. (5 marks)

(d) Describe additional assignments that the internal audit department of Greystone Co could be asked toperform by those charged with governance. (6 marks)

(30 marks)

3 [P.T.O.

2 (a) Explain the concept of TRUE and FAIR presentation. (4 marks)

(b) Explain the status of Malaysian Approved Standards on Auditing. (2 marks)

(c) ISA 230 Audit Documentation deals with the auditor’s responsibility to prepare audit documentation for an auditof financial statements.

Required:

State FOUR benefits of documenting audit work. (4 marks)

(10 marks)

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3 (a) In agreeing the terms of an audit engagement, the auditor is required to agree the basis on which the audit is tobe carried out. This involves establishing whether the preconditions for an audit are present and confirming thatthere is a common understanding between the auditor and management of the terms of the engagement.

Required:

Describe the process the auditor should undertake to assess whether the PRECONDITIONS for an audit arepresent. (3 marks)

(b) List FOUR examples of matters the auditor may consider when obtaining an understanding of the entity.(2 marks)

(c) You are the audit senior of White & Co and are planning the audit of Redsmith Co for the year ended 30 September 2010. The company produces printers and has been a client of your firm for two years; your auditmanager has already had a planning meeting with the finance director. He has provided you with the followingnotes of his meeting and financial statement extracts.

Redsmith’s management were disappointed with the 2009 results and so in 2010 undertook a number ofstrategies to improve the trading results. This included the introduction of a generous sales-related bonus schemefor their salesmen and a high profile advertising campaign. In addition, as market conditions are difficult for theircustomers, they have extended the credit period given to them.

The finance director of Redsmith has reviewed the inventory valuation policy and has included additionaloverheads incurred this year as he considers them to be production related. He is happy with the 2010 resultsand feels that they are a good reflection of the improved trading levels.

Financial statement extracts for year ended 30 September DRAFT ACTUAL2010 2009RMm RMm

Revenue 23·0 18·0Cost of Sales (11·0) (10·0)

––––– –––––Gross profit 12·0 8·0Operating expenses (7·5) (4·0)

––––– –––––Profit before interest and taxation 4·5 4·0

––––– –––––––––– –––––

Inventory 2·1 1·6Receivables 4·5 3·0Cash – 2·3

Trade payables 1·6 1·2Overdraft 0·9 –

Required:

Using the information above:

(i) Calculate FIVE ratios, for BOTH years, which would assist the audit senior in planning the audit; and(5 marks)

(ii) From a review of the above information and the ratios calculated, explain the audit risks that arise anddescribe the appropriate response to these risks. (10 marks)

(20 marks)

5 [P.T.O.

4 (a) Explain the purpose of a value for money audit. (4 marks)

(b) Bluesberry hospital is located in a country where healthcare is free, as the taxpayers fund the hospitals whichare owned by the government. Two years ago management reviewed all aspects of hospital operations andinstigated a number of measures aimed at improving overall ‘value for money’ for the local community.Management have asked that you, an audit manager in the hospital’s internal audit department, perform a reviewover the measures which have been implemented.

Bluesberry has one centralised buying department and all purchase requisition forms for medical supplies mustbe forwarded here. Upon receipt the buying team will research the lowest price from suppliers and a purchaseorder is raised. This is then passed to the purchasing director, who authorises all orders. The small buying teamreceive in excess of 200 forms a day.

The human resources department has had difficulties with recruiting suitably trained staff. Overtime rates havebeen increased to incentivise permanent staff to fill staffing gaps, this has been popular, and reliance onexpensive temporary staff has been reduced. Monitoring of staff hours had been difficult but the hospital hasimplemented time card clocking in and out procedures and these hours are used for overtime payments as well.

The hospital has invested heavily in new surgical equipment, which although very expensive, has meant thatmore operations could be performed and patient recovery rates are faster. However, currently there is a shortageof appropriately trained medical staff. A capital expenditure committee has been established, made up of seniormanagers, and they plan and authorise any significant capital expenditure items.

Required:

(i) Identify and explain FOUR STRENGTHS within Bluesberry’s operating environment; and (6 marks)

(ii) For each strength identified, describe how Bluesberry might make further improvements to provide thebest value for money. (4 marks)

(c) Describe TWO substantive procedures the external auditor of Bluesberry should adopt to verify EACH of thefollowing assertions in relation to an entity’s property, plant and equipment;

(i) Valuation;(ii) Completeness; and(iii) Rights and obligations.

Note: Assume that the hospital adopts Malaysian Financial Reporting Standards. (6 marks)

(20 marks)

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5 Greenfields Co specialises in manufacturing equipment which can help to reduce toxic emissions in the production ofchemicals. The company has grown rapidly over the past eight years and this is due partly to the warranties that thecompany gives to its customers. It guarantees its products for five years and if problems arise in this period itundertakes to fix them, or provide a replacement product.

You are the manager responsible for the audit of Greenfields and you are performing the final review stage of the auditand have come across the following two issues.

Receivable balance owing from Yellowmix Co

Greenfields has a material receivable balance owing from its customer, Yellowmix Co. During the year-end audit, yourteam reviewed the ageing of this balance and found that no payments had been received from Yellowmix for over sixmonths, and Greenfields would not allow this balance to be circularised. Instead management has assured your teamthat they will provide a written representation confirming that the balance is recoverable.

Warranty provision

The warranty provision included within the statement of financial position is material. The audit team has performedtesting over the calculations and assumptions which are consistent with prior years. The team has requested a writtenrepresentation from management confirming the basis and amount of the provision are reasonable. Management hasyet to confirm acceptance of this representation.

Required:

(a) Describe the audit procedures required in respect of accounting estimates. (5 marks)

(b) For each of the two issues above:

(i) Discuss the appropriateness of written representations as a form of audit evidence; and (4 marks)

(ii) Describe additional procedures the auditor should now perform in order to reach a conclusion on thebalance to be included in the financial statements. (6 marks)

Note: The total marks will be split equally between each issue.

(c) The directors of Greenfields have decided not to provide the audit firm with the written representation for thewarranty provision as they feel that it is unnecessary.

Required:

Explain the steps the auditor of Greenfields Co should now take and the impact on the audit report in relationto the refusal to provide the written representation. (5 marks)

(20 marks)


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Answers


1 (a) Examples of matters the external auditor should consider in determining whether a deficiency in internal controls is significantinclude:

– The likelihood of the deficiencies leading to material misstatements in the financial statements in the future. – The susceptibility to loss or fraud of the related asset or liability.– The subjectivity and complexity of determining estimated amounts.– The financial statement amounts exposed to the deficiencies.– The volume of activity that has occurred or could occur in the account balance or class of transactions exposed to the

deficiency or deficiencies.– The importance of the controls to the financial reporting process.– The cause and frequency of the exceptions detected as a result of the deficiencies in the controls.– The interaction of the deficiency with other deficiencies in internal control.

Tutorial note: ISA 265 Communicating Deficiencies in Internal Control to those Charged with Governance and Managementstates that a significant deficiency in internal control is a deficiency or combination of deficiencies in internal control that, inthe auditor’s professional judgement, is of sufficient importance to merit the attention of those charged with governance.

(b) Board of DirectorsGreystone Co30 Any StreetMalaysia

8 December 2010

Dear Sirs,

Audit of Greystone Co for year ended 30 September 2010

Please find enclosed the report to management on significant deficiencies in internal controls identified during the audit forthe year ended 30 September 2010. The report considers deficiencies in the purchases system, implications of thosedeficiencies and provides recommendations to address those deficiencies.

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(i) Deficiency (ii) Implication (iii) RecommendationThe purchasing manager decides onthe inventory levels for each storewithout discussion with store orsales managers. The purchasingmanager may not have theappropriate knowledge of the localmarket for a store.

This could result in stores orderinggoods that are not likely to sell andhence require heavy discounting. Inaddition as a fashion chain, ifcustomers perceive that the goodsare not meeting the key fashiontrends then they may cease to shopat Greystone at all.

The purchasing manager shouldinitially hold a meeting with areamanagers of stores; if meeting allstore managers is not practical, heshould understand the local marketsbefore agreeing jointly goods to bepurchased.

The purchase orders are onlyreviewed and authorised by apurchasing director in a whollyaggregated manner (by specifiedregions of countries).

It will be difficult for the purchasingdirector to assess whether overall thecorrect buying decisions are beingmade as the detail of the orders isnot being presented and he is theonly level of authorisation.

This could result in significant levelsof goods being purchased that arenot right for particular marketsectors.

A purchasing senior manager shouldreview the information prepared foreach country and discuss with localpurchasing managers the specifics oftheir orders. These should then beauthorised and passed to thepurchasing director for final reviewand sign off.

The store managers are responsiblefor re-ordering goods through thepurchasing manager.

If the store managers forget or ordertoo late, then as the ordering processcan take up to four weeks, the storecould experience significant stockouts leading to loss of income.

Automatic re-order levels should beset up in the inventory managementsystems. As the goods sold reach there-order levels the purchasingmanager should receive anautomatic re-order request.

Please note that this report only addresses any significant deficiencies identified during the audit and if further testing hadbeen performed then more deficiencies may have been reported.

This report is solely for the use of management and if you have any further questions then please do not hesitate to contactus.

Yours faithfully

An audit firm

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(i) Deficiency (ii) Implication (iii) Recommendation

It is not possible for a store to ordergoods from other local stores forcustomers who request them.Instead they are told to contact thestores themselves, or use thecompany website.

Customers are less likely to contactindividual stores themselves and thiscould result in the company losingout on valuable sales.

In addition some goods which areslow moving in one store may be outof stock at another, if goods could betransferred between stores thenoverall sales may be maximised.

An inter-branch transfer systemshould be established betweenstores. This should help storeswhose goods are below the re-orderlevel but are awaiting their deliveriesfrom the suppliers.

Deliveries from suppliers areaccepted without being checked first.

In addition they are then checked bysales assistants to the supplier’sdelivery note to agree quantities butnot quality.

Sales assistants are producing thegoods received note (GRN) onreceipt of a supplier’s delivery note.

The stores are receiving goodswithout checking that these arecorrect. Hence if a delivery issubsequently disputed there may belittle recourse for the company.

If the sales assistants are onlychecking quantities then goodswhich are not of a saleable conditionmay be accepted.

The assistants may not beadequately experienced to producethe GRN, and this is an importantdocument used in the invoiceauthorisation process. Errors couldlead to under or overpayments.

Deliveries from suppliers should onlybe accepted between designatedhours such as the first two hours ofthe morning when it is quieter. Thegoods should then be checked onarrival for quantity and quality priorto acceptance from the supplier. Aresponsible official at each storeshould produce the GRN from thesupplier’s delivery information.

Goods are being received withoutany checks being made againstpurchase orders.

This could result in Greystonereceiving and subsequently payingfor goods it did not require.

In addition if no check is madeagainst order then the company mayhave significant purchase orderswhich are outstanding, leading tolost sales.

A copy of the authorised order formshould be sent to the store. Thisshould then be checked to the GRN.Once checked the order should besent to head office and logged ascompleted. On a regular basis thepurchasing clerk should review theorder file for any outstanding items.

Purchase invoices are manuallymatched to a high volume of GRNsfrom the individual stores.

A manual checking processincreases the risk of error, resultingin invoices being accepted orrejected erroneously.

The checked GRNs should be loggedonto the purchasing system,matched against the relevant ordernumber, then as the invoice isreceived this should be automaticallymatched.

The purchasing clerk should thenreview for any unmatched items.

The purchase invoice is only loggedonto the system as it is beingauthorised by the purchasingdirector.

If the invoice is misplaced thenpayables may not be settled on atimely basis. In addition at the year-end the purchase ledger may beunderstated as invoices relating tothe current year have been receivedbut are not in the purchase ledger.

Upon receipt of an invoice thisshould be logged into a file ofunmatched invoices. As it ismatched and authorised it shouldthen be moved into the purchaseledger. At the year-end items in theunmatched invoices file should beaccrued for, to ensure liabilities arenot understated.

(c) Substantive procedures over year-end trade payables

– Obtain a listing of trade payables from the purchase ledger and agree to the general ledger and the financial statements.– Reconcile the total of purchase ledger accounts with the purchase ledger control account, and cast the list of balances

and the purchase ledger control account.– Review the list of trade payables against prior years to identify any significant omissions.– Calculate the trade payable days for Greystone and compare to prior years, investigate any significant differences.– Review after date payments, if they relate to the current year then follow through to the purchase ledger or accrual listing

to ensure completeness.– Review after date invoices and credit notes to ensure no further items need to be accrued.– Obtain supplier statements and reconcile these to the purchase ledger balances, and investigate any reconciling items.– Select a sample of payable balances and perform a trade payables’ circularisation, follow up any non-replies and any

reconciling items between balance confirmed and trade payables’ balance.– Enquire of management their process for identifying goods received but not invoiced or logged in the purchase ledger

and ensure that it is reasonable to ensure completeness of payables.– Select a sample of goods received notes before the year-end and follow through to inclusion in the year-end payables

balance, to ensure correct cut-off.– Review the purchase ledger for any debit balances, for any significant amounts discuss with management and consider

reclassification as current assets.– Ensure payables included in financial statements as current liabilities.

(d) Additional assignments for Greystone’s internal audit department

Testing cash controls at stores

Currently the internal audit department undertake inventory counts at each of the stores. This role could be increased toinclude controls testing over cash receipts and cash counts. As a retailer the stores will have a significant amount of cash ateach premise and will have tight controls over the cash receipts process. These controls should be tested at each location aswell as performance of a cash count to reduce the level of fraud and error reported.

Mystery shopper reviews

In order to improve the customer experience in stores, internal audit department members could undertake ‘mystery shopper’reviews, where they enter the store as a customer, purchase goods and rate the overall shopping experience. This is then fedback to each shop to improve customer service and can provide the basis for further training if necessary.

Overall review of financial/operational controls

The department could undertake reviews of controls at head office, as well as individual stores and make recommendationsto management over such areas as the purchasing process as well as the sales cycle.

Fraud investigations

It is likely that as a retailer, Greystone would have problems with theft of inventory as well as cash. Internal audit could beasked to review the main areas of fraud risk and develop controls to mitigate these risks. If fraud is suspected then internalaudit could be asked to investigate these cases further.

IT system reviews

Greystone is likely to have a relatively complex computer system linking all of the tills in the stores to head office. The internalaudit department could be asked to perform a review over the computer environment and controls.

Value for money review

The internal audit department could be asked to assess whether Greystone are obtaining value for money in areas such asthe just in time ordering system recently introduced.

Regulatory compliance

Greystone operates in countries throughout the world and hence will be subject to varying degrees of law and regulation. Theinternal audit department could help ensure compliance with those regulations.

2 (a) True and Fair presentation

Financial statements are produced by management which give a true and fair view of the entity’s results. The auditor inreviewing these financial statements gives an opinion on the truth and fairness of them.

Although there is no definition in the International Standards on Auditing of true and fair it is generally considered to have thefollowing meaning:

True – Information is factual and conforms with reality in that there are no factual errors. In addition it is assumed that to betrue it must comply with accounting standards and any relevant legislation. Lastly true includes data being correctlytransferred from accounting records to the financial statements.

Fair – Information is clear, impartial and unbiased, and also reflects plainly the commercial substance of the transactions ofthe entity.

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(b) Malaysian Approved Standards on Auditing

The Malaysian Institute of Accountants adopts and issues the International Standards on Auditing (ISAs) as MalaysianApproved Standards on Auditing.

International Standards on Auditing (ISAs) are issued by the International Auditing and Assurance Standards Board (IAASB)and provide guidance on the performance of an audit.

ISAs only apply to the audit of historical financial information. They are written in the context of an audit of financialstatements by an independent auditor.

The ISAs contain basic principles and essential procedures together with related guidance in the form of explanatory materialand appendices. It is necessary to consider and understand the entire text of an ISA to understand and apply the basicprinciples and essential procedures.

The basic principles and essential procedures of an ISA are to be applied in all cases. If in exceptional cases the auditor deemsit necessary to depart from an ISA to achieve the overall aim of the audit, then this departure must be justified.

(c) Documenting audit work

– Provides evidence of the auditor’s basis for a conclusion about the achievement of the overall objective of the audit.– Provides evidence that the audit was planned and performed in accordance with ISAs and applicable legal and regulatory

requirements.– Assists the engagement team to plan and perform the audit.– Assists members of the engagement team responsible for supervision to direct, supervise and review the audit work.– Enables the engagement team to be accountable for its work.– Retains a record of matters of continuing significance to future audits.

3 (a) ISA 210 Agreeing the Terms of Audit Engagements provides guidance to auditors on the steps they should take in acceptinga new audit or continuing on an existing audit engagement. It sets out a number of processes that the auditor should performincluding agreeing whether the preconditions are present, agreement of audit terms in an engagement letter, recurring auditsand changes in engagement terms.

To assess whether the preconditions for an audit are present the auditor must determine whether the financial reportingframework to be applied in the preparation of the financial statements is acceptable. In considering this the auditor shouldassess the nature of the entity, the nature and purpose of the financial statements and whether law or regulations prescribesthe applicable reporting framework.

In addition they must obtain the agreement of management that it acknowledges and understands its responsibility for thefollowing:

– Preparation of the financial statements in accordance with the applicable financial reporting framework, including whererelevant their fair presentation;

– For such internal control as management determines is necessary to enable the preparation of financial statements thatare free from material misstatement, whether due to fraud or error; and

– To provide the auditor with access to all relevant information for the preparation of the financial statements, anyadditional information that the auditor may request from management and unrestricted access to persons within theentity from whom the auditor determines it necessary to obtain audit evidence.

If the preconditions for an audit are not present, the auditor shall discuss the matter with management. Unless required bylaw or regulation to do so, the auditor shall not accept the proposed audit engagement:

– If the auditor has determined that the financial reporting framework to be applied in the preparation of the financialstatements is unacceptable; or

– If management agreement of their responsibilities has not been obtained.

(b) Matters to consider in obtaining an understanding of the entity:

– The market and its competition– Legislation and regulation– Regulatory framework– Ownership of the entity– Nature of products/services and markets– Location of production facilities and factories– Key customers and suppliers– Capital investment activities– Accounting policies and industry specific guidance– Financing structure– Significant changes in the entity on prior years.

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(c) (i) Ratios to assist the audit supervisor in planning the audit:

2010 2009Gross margin 12/23 = 52·2% 8/18 = 44·4%Operating margin 4·5/23 = 19·6% 4/18 = 22·2%Inventory days 2·1/11 * 365 = 70 days 1·6/10 * 365 = 58 daysReceivable days 4·5/23 * 365 = 71 days 3·0/18 * 365 = 61 daysPayable days 1·6/11 * 365 = 53 days 1·2/10 * 365 = 44 daysCurrent ratio 6·6/2·5 = 2·6 6·9/1·2 = 5·8Quick ratio (6·6 – 2·1)/2·5 = 1·8 (6·9 – 1·6)/1·2 = 4·4

(ii)

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Audit risk Response to riskManagement were disappointed with 2009 results andhence undertook strategies to improve the 2010trading results. There is a risk that management mightfeel under pressure to manipulate the results throughthe judgements taken or through the use of provisions.

Throughout the audit the team will need to be alert tothis risk. They will need to carefully review judgementaldecisions and compare treatment against prior years.

A generous sales-related bonus scheme has beenintroduced in the year, this may lead to sales cut-offerrors with employees aiming to maximise their currentyear bonus.

Increased sales cut-off testing will be performed alongwith a review of post year-end sales returns as theymay indicate cut-off errors.

Revenue has grown by 28% in the year however, costof sales has only increased by 10%. This increase insales may be due to the bonus scheme and theadvertising however, this does not explain the increasein gross margin. There is a risk that sales may beoverstated.

During the audit a detailed breakdown of sales will beobtained, discussed with management and tested inorder to understand the sales increase.

Gross margin has increased from 44·4% to 52·2%.Operating margin has decreased from 22·2% to19·6%. This movement in gross margin is significantand there is a risk that costs may have been omitted orincluded in operating expenses rather than cost ofsales. There has been a significant increase inoperating expenses which may be due to the bonusand the advertising campaign but could be related tothe misclassification of costs.

The classification of costs between cost of sales andoperating expenses will be compared with the prioryear to ensure consistency.

The finance director has made a change to theinventory valuation in the year with additionaloverheads being included. In addition inventory dayshave increased from 58 to 70 days. There is a risk thatinventory is overvalued.

The change in the inventory policy will be discussedwith management and a review of the additionaloverheads included performed to ensure that these areof a production nature.

Detailed cost and net realisable value testing to beperformed and the aged inventory report to be reviewedto assess whether inventory requires writing down.

Receivable days have increased from 61 to 71 daysand management have extended the credit period givento customers. This leads to an increased risk ofrecoverability of receivables.

Extended post year-end cash receipts testing and areview of the aged receivables ledger to be performedto assess valuation.

The current and quick ratios have decreased from 5·8to 2·6 and 4·4 to 1·8 respectively. In addition the cashbalances have decreased significantly over the year.Although all ratios are above the minimum levels, thisis still a significant decrease and along with theincrease of sales could be evidence of overtradingwhich could result in going concern difficulties.

Detailed going concern testing to be performed duringthe audit and discussed with management to ensurethat the going concern basis is reasonable.

4 (a) A value for money audit focuses on whether the best combination of services has been obtained for the lowest level ofresources.

In performing a value for money audit there are three areas which an auditor will commonly focus on being economy,efficiency and effectiveness, and these are known as the three Es.

Economy – Keeping the cost of resources used to a minimum.Efficiency – The relationship between the output from goods and services and the resources used to produce them. Effectiveness – How well the organisation’s objectives have been achieved.

(b) Strengths and improvements of Bluesberry’s operating environment to provide best value for money

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Strengths ImprovementsBluesberry has an internal audit department to monitorthe internal control environment. This will help to provideadvice over value for money.

This could be further improved in that the internal auditdepartment could provide advice to departments on initialimplementation of procedures rather than just reviewingthem afterwards.

The centralised buying department purchases all medicalsupplies after researching for the lowest costs. Thisensures that the hospital is being economical as the leastamount of resources is being used.

However, care must be taken to ensure that the quality ofthe goods purchased is considered as well as the cost.

To improve the process the buying department couldconsider establishing an approved supplier listing. In orderto be placed on the list both the cost and quality of goodshas to be of an adequate level, hence improving theefficiency of the goods purchased.

All orders are authorised by a purchasing director. This willensure that only valid expenditure is incurred.

The purchasing director is a senior individual and it is notnecessarily an efficient use of his time for him to authoriseevery purchase order, especially as there is a considerablenumber of them. The buying team receive in excess of200 forms a day.

Instead a purchasing supervisor should be designated toauthorise orders up to a pre-set level with only ordersabove this level going to the director for authorisation. Thisshould free the director to focus on other areas wherecosts can be reduced within the hospital.

Bluesberry has introduced an overtime scheme which hasseen a reduction in the use of temporary staff, which wasexpensive. This has resulted in an overall reduction inlabour costs and possibly improved care levels withpermanent rather than temporary staff working, who maybetter understand the patients’ needs.

Although overall costs may have been reduced, a smallernumber of staff now has to cover all of the requiredstaffing hours. Their efficiency levels must have reducedas they are working normal shifts and then overtime.

To improve this further the human resources departmentshould embark on a recruitment drive to find permanentstaff members to fill gaps and reduce overall overtime andtemporary staff usage.

The hospital has implemented a new procedure of timeclocking in and out cards to record the hours staffmembers have worked. This ensures that staff are onlypaid for the hours they have worked, as opposed to beingpaid with no record of whether they have actually workedfor the required hours.

This system is also used to determine overtime payments;however, there does not appear to be any authorisation ofthis overtime and employees could be being paid simplyfor staying longer hours as opposed to filling a staffinggap.

This could be further improved in that a report of overtimehours per staff member should be sent on a weekly basisto the department head for authorisation. This shouldensure that the hospital keeps its labour costs to aminimum.

Bluesberry has heavily invested in new surgicalequipment, which has improved patient recovery rates andwill lead to more operations being performed. Withimproving recovery rates and utilisation of equipment theoverall effectiveness of the hospital will improve.

This equipment is not being utilised efficiently as there isa shortage of trained medical staff. In order to maximisethe efficiency and effectiveness of this equipment it wouldbe advisable to look at ways to address these staffshortages.

For example, there may be medical staff at other hospitalswho wish to be seconded to Bluesberry to gain experienceon this new type of surgical equipment.

(c) (i) Valuation of property, plant and equipment (PPE):

– Review depreciation policies for reasonableness by comparison to prior year, industry practices, the entity’sreplacement policy and the profits/losses arising on disposal of assets.

– For a sample of assets recalculate the depreciation charge for the year and agree to the entity asset register.– Perform a proof in total calculation of depreciation, considering the timing of additions and disposals and compare

this expectation to the actual charge, and investigate any significant differences.– If any assets have been revalued during the year then assess the reasonableness of the valuer. In particular consider

their experience, independence, scope of work and assumptions used.– Agree the revalued amounts to a valuation report, for a sample recalculate the revaluation surplus and agree to the

revaluation reserve.– For a sample of the new surgical equipment additions vouch the cost to a recent purchase invoice.

(ii) Completeness of PPE:

– Reconcile the schedule of PPE with the general ledger.– Select a sample of assets physically present at the entity’s premises and inspect the asset register to ensure that

these are included.– Reperform the reconciliation of the non-current asset register to the general ledger, investigate any differences.– Review the repairs and maintenance expense account in the income statement for items of a capital nature.

(iii) Rights and obligations of PPE:

– Verify ownership of property via inspection of title deeds and land registration documents.– For a sample of additions agree to purchase invoices to verify invoice relates to the entity. – Review any new lease agreements to ensure assets are correctly treated as finance or operating leases. – Inspect vehicle registration documents to confirm ownership of motor vehicles.

5 (a) Procedures the auditor should adopt in respect of auditing accounting estimates include:

– Enquire of management how the accounting estimate is made and the data on which it is based.– Determine whether events occurring up to the date of the auditor’s report (after the reporting period) provide audit

evidence regarding the accounting estimate. – Review the method of measurement used and assess the reasonableness of assumptions made. – Test the operating effectiveness of the controls over how management made the accounting estimate. – Develop an expectation of the possible estimate (point estimate) or a range of amounts to evaluate management’s

estimate.– Review the judgements and decisions made by management in the making of accounting estimates to identify whether

there are indicators of possible management bias.– Evaluate overall whether the accounting estimates in the financial statements are either reasonable or misstated.– Obtain sufficient appropriate audit evidence about whether the disclosures in the financial statements related to

accounting estimates and estimation uncertainty are reasonable.– Obtain written representations from management and, where appropriate, those charged with governance whether they

believe significant assumptions used in making accounting estimates are reasonable.

(b) Receivables balance owing from Yellowmix Co

(i) The written representation proposed by management is intended to verify valuation, existence and rights and obligationsof a material receivables balance. As management has refused to allow the auditor to circularise the balance and therehas been little activity on the account for the past six months then there is very little evidence that has been obtainedby the auditor.

This representation would constitute entity generated evidence and this is less reliable than auditor generated evidenceor evidence from an external source. If related control systems operate effectively then this evidence becomes morereliable. In addition if the representation is written as opposed to oral then this will increase the reliability as an evidencesource.

Overall this representation is a weak form of evidence, as there were more reliable evidence options available, such asthe circularisation but this was not undertaken.

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Strengths ImprovementsA capital expenditure committee has been established toplan and authorise the purchase of significant capitalitems.

This should ensure that significant cash flow expenditureis budgeted for, and that the expenditure will be for validitems only.

The committee is made up of senior managers, however,due to some capital expenditure being very significant invalue, it would be improved further if board approval wasrequired for any orders above a designated level. Theboard would have an overriding requirement to considerwhether this expenditure would deliver value for money forthe hospital.

(ii) In order to reach a conclusion on the balance the following procedures should be performed:

– Discuss with management the reasons as to why a circularisation request was refused.– Review the post year-end period to identify whether any cash has now been received from Yellowmix Co.– Review correspondence with Yellowmix Co to assess reasons for the continued non-payment.– Review board minutes and legal correspondence to assess whether any legal action is being taken to recover the

amounts due.– Discuss with management whether a provision or write down is now required.– Consider impact on audit opinion if balance is considered to be materially misstated.

Warranty provision

(i) In this case the auditor has performed some testing of the provision in order to obtain auditor generated evidence. Theteam has tested the calculations and assumptions. None of this is evidence from an external source.

The very nature of this provision means that it is difficult for the auditor to obtain a significant amount of reliable evidenceas to the level of future warranty claims. Hence the written representation, whilst being an entity generated source ofevidence, would still be useful as there are few other alternatives.

(ii) In order to reach a conclusion on the balance the following procedures should be performed:

– Review the post year-end period to compare the level of claims actually made against the amounts provided.– Review the level of prior year provisions with the amounts claimed to assess the reasonableness of management’s

forecasting.– Review board minutes to assess whether any changes are required to the level of the provision as a result of an

increased or decreased level of claims by customers.

(c) Steps to take if written representation on warranty provision is not provided

ISA 580 Written Representations provides guidance to the auditor in the case where written representations are requestedfrom management but they refuse to provide.

If management does not provide the requested written representation on the warranty provision the auditor of Greenfieldsshould discuss the matter with management to understand why they are refusing.

In addition the auditor should re-evaluate the integrity of Greenfields’ management and consider the effect that this may haveon the reliability of other representations (oral or written) and audit evidence in general.

The auditor should then take appropriate actions, including determining the possible effect on the audit opinion.

Impact on audit report

As the auditor is unable to obtain sufficient appropriate evidence to conclude that the warranty provision is free from materialmisstatement then a modified audit opinion will be required.

The warranty provision is material but not pervasive and therefore a qualified opinion would be appropriate.

The audit report will require an additional paragraph before the opinion which will describe the reason for the modification;namely that management refused to provide a written representation in relation to the warranty provision and hence we areunable to form an opinion on this balance. The opinion paragraph will be amended to state ‘except for’.

18


MARKS1 (a) Up to 1 mark per valid point

Likelihood of deficiencies leading to errorsRisk of fraudSubjectivity and complexityFinancial statement amountsVolume of activityImportance of the controlsCause and frequency of exceptionsInteraction with other deficiencies 5

–––

(b) Up to 1 mark per well explained deficiency, up to 1 mark per implication and up to 1 mark per recommendation. If not well explained then just give ½ mark for each.

2 marks for presentation; 1 for address and intro and 1 for conclusion

Purchasing manager orders goods without consulting storesPurchase order reviewed in aggregate by purchasing directorStore managers re-order goodsNo inter-branch transfer systemDeliveries accepted without proper checksSales assistants produce the goods received noteGoods received but not checked to purchase ordersManual matching of goods received notes to invoicePurchase invoice logged late 14

–––

(c) Up to 1 mark per well explained substantive procedure

Agree purchase ledger to general and financial statementsReview payable to prior yearCalculate trade payablesAfter date payments reviewAfter date invoices/credit notes reviewSupplier statement reviewsPayables’ circularisation Goods received not invoicedCut-off testingDebit balances reviewDisclosure within current liabilities 5

–––

(d) Up to 1 mark per well explained point

Cash controls testingMystery shopperFinancial/operational controlsFraud investigationsIT system reviewValue for money reviewRegulatory compliance 6

–––30––––––

19


Accounts produced and auditors give opinion on true and fair viewTrue – factual, conforms with realityTrue – conforms with standards and legislationTrue – correctly transferred from accounting recordsFair – clear, plain and unbiasedFair – reflects commercial substance 4

–––


Issued by MIA as Malaysian Approved Standards on Auditing and ISAs are issued by IAASBApply to audit of historical financial informationContain basic principles/essential procedures/explanatory material and appendicesIf depart from ISA – justify 2

–––

(c) Up to 1 mark per valid point

Evidence of conclusionsEvidence of compliance with ISAsHelps team to plan and perform auditHelps supervisionTeam is accountableRecord of matters of continuing significance 4

–––10––––––

3 (a) Up to 1 mark per valid point

– ISA 210 provides guidance– Determination of acceptable framework– Agreement of management responsibilities– Preparation of financial statements with applicable framework– Internal controls– Provide auditor with relevant information and access– If preconditions are not present discuss with management– Decline if framework unacceptable– Decline if agreement of responsibilities not obtained 3

–––

(b) ½ mark per example of matter to consider in obtaining an understanding of the nature of an entity. 2–––

(c) (i) ½ mark per ratio calculation per year

– Gross margin– Operating margin– Inventory days– Receivable days– Payable days– Current ratio– Quick ratio 5

–––

(ii) Up to 1 mark per well explained audit risk and up to 1 mark per audit response

– Management manipulation of results– Sales cut-off– Revenue growth– Misclassification of costs between cost of sales and operating– Inventory valuation– Receivables valuation– Going concern risk 10

–––20––––––

20


Explanation of value for money auditEconomy – descriptionEfficiency – descriptionEffectiveness – description 4

–––

(b) ½ mark for identification of and up to 1 mark for explanation of each well explained strength andup to 1 mark per improvement, if not well explained then only give ½ mark, but overall maximum of four points.

Internal audit departmentCentralised buying department buys from lowest cost supplierAuthorisation of all purchase order by purchasing directorReduction in use of temporary staffEmployee clocking in cards to monitor hours workedNew surgical equipment leading to better recovery ratesCapital expenditure committee 10

–––

(c) Up to 1 mark per substantive procedure

Valuation:– Review depreciation policies for reasonableness.– Recalculate the depreciation charge.– Proof in total calculation of depreciation.– Reasonableness of valuer.– Agree the revalued amounts to a valuation report.– Surgical equipment additions vouch the cost to invoice. 2

–––

Completeness:– Reconcile PPE schedule to general ledger.– Physical inspection of assets.– Reconciliation of non-current asset register to the general ledger.– Review the repairs and maintenance expense account. 2

–––

Rights and obligations:– Verify ownership of property via inspection of title deeds.– Additions agree to purchase invoices to verify invoice relates to the entity.– Review any new lease agreements. – Inspect vehicle registration documents. 2

–––6

–––20––––––

21

MARKS5 (a) Up to 1 mark per well explained procedure

Enquire of management how estimate made Review after the reporting periodReview method and assumptionsTest effectiveness of controlsDevelop expectation of estimateConsider management biasOverall assessment whether estimates reasonable or misstatedDisclosures adequateWritten representation 5

–––

(b) (i) Up to 2 marks for each discussion of reliability of representations

Receivable balanceWarranty provision 4

–––

(ii) Up to 1 mark per procedure, max of 3 marks per issue

Receivable balanceDiscuss with management why circularisation not allowedReview post year-end receiptsReview customer correspondenceBoard minutes and legal correspondenceDiscuss with management need for provision or write downConsider impact on audit opinion 3

–––

Warranty provisionReview post year-end claimsCompare prior year provisions to claims madeReview board minutes 3

–––

(c) Up to 1 mark per point

ISA 580 provides guidanceDiscuss with managementRe-evaluate management integrityConsider impact on audit opinionModified opinionQualified opinion as not pervasiveAdditional paragraph describing modification‘Except for’ opinion 5

–––20––––––

22







Pape

r F8

(M

YS)





1 Introduction

Tinkerbell Toys Co (Tinkerbell) is a manufacturer of children’s building block toys; they have been trading for over 35 years and they sell to a wide variety of customers including large and small toy retailers across the country. Thecompany’s year end is 31 May 2011.

The company has a large manufacturing plant, four large warehouses and a head office. Upon manufacture, the toysare stored in one of the warehouses until they are despatched to customers. The company does not have an internalaudit department.

Sales ordering, goods despatched and invoicing

Each customer has a unique customer account number and this is used to enter sales orders when they are receivedin writing from customers. The orders are entered by an order clerk and the system automatically checks that thegoods are available and that the order will not take the customer over their credit limit. For new customers, a salesmanager completes a credit application; this is checked through a credit agency and a credit limit entered into thesystem by the credit controller. The company has a price list, which is updated twice a year. Larger customers areentitled to a discount; this is agreed by the sales director and set up within the customer master file.

Once the order is entered an acceptance is automatically sent to the customer by mail/email confirming the goodsordered and a likely despatch date. The order is then sorted by address of customer. The warehouse closest to thecustomer receives the order electronically and a despatch list and sequentially numbered goods despatch notes(GDNs) are automatically generated. The warehouse team pack the goods from the despatch list and, before they aresent out, a second member of the team double checks the despatch list to the GDN, which accompanies the goods.

Once despatched, a copy of the GDN is sent to the accounts team at head office and a sequentially numbered salesinvoice is raised and checked to the GDN. Periodically a computer sequence check is performed for any missing salesinvoice numbers.

Fraud

During the year a material fraud was uncovered. It involved cash/cheque receipts from customers being diverted intoemployees’ personal accounts. In order to cover up the fraud, receipts from subsequent unrelated customers wouldthen be recorded against the earlier outstanding receivable balances and this cycle of fraud would continue.

The fraud occurred because two members of staff ‘who were related’ colluded. One processed cash receipts andprepared the weekly bank reconciliation; the other employee recorded customer receipts in the sales ledger. Anunrelated sales ledger clerk was supposed to send out monthly customer statements but this was not performed. Thebank reconciliations each had a small unreconciled amount but no-one reviewed the reconciliations after they wereprepared. The fraud was only uncovered when the two employees went on holiday at the same time and it wasdiscovered that cash receipts from different customers were being applied to older receivable balances to hide theearlier sums stolen.

Required:

(a) Recommend SIX tests of controls the auditor would normally carry out on the sales system of Tinkerbell, andexplain the objective for each test. (12 marks)

(b) Describe substantive procedures the auditor should perform to confirm Tinkerbell’s year-end receivablesbalance. (8 marks)

(c) Identify and explain controls Tinkerbell should implement to reduce the risk of fraud occurring again and, foreach control, describe how it would mitigate the risk. (6 marks)

(d) Describe substantive procedures the auditor should perform to confirm Tinkerbell’s revenue. (4 marks)

(30 marks)

2

2 (a) Auditors are required to document their understanding of the client’s internal controls. There are various optionsavailable for recording the internal control system. Two of these options are narrative notes and internal controlquestionnaires.

Required:

Describe the advantages and disadvantages to the auditor of narrative notes and internal controlquestionnaires as methods for documenting the system. (6 marks)

(b) ISA 210 Agreeing the Terms of Audit Engagements provides guidance on the content of engagement letters anddeals with the auditor’s responsibilities in agreeing the terms of the audit engagement with management.

Required:

(i) State the purpose of an engagement letter. (1 mark)

(ii) List SIX matters that should be included within an audit engagement letter. (3 marks)

(10 marks)

3 [P.T.O.

3 (a) The auditor has a responsibility to design audit procedures to obtain sufficient and appropriate evidence. Thereare various audit procedures for obtaining evidence, such as external confirmation.

Required:

Apart from external confirmation:

(i) State and explain FIVE procedures for obtaining evidence and;(ii) For each procedure, describe an example relevant to the audit of purchases and other expenses.

(10 marks)

(b) Donald Co operates an airline business. The company’s year end is 31 July 2011.

You are the audit senior and you have started planning the audit. Your manager has asked you to have a meetingwith the client and to identify any relevant audit risks so that the audit plan can be completed. From your meetingyou ascertain the following:

In order to expand their flight network, Donald Co will need to acquire more airplanes; they have placed ordersfor another six planes at an estimated total cost of RM20m and the company is not sure whether these planeswill be received by the year end. In addition, the company has spent an estimated RM15m on refurbishing theirexisting planes. In order to fund the expansion Donald Co has applied for a loan of RM25m. It has yet to hearfrom the bank as to whether it will lend them the money.

The company receives bookings from travel agents as well as directly via their website. The travel agents are givena 90-day credit period to pay Donald Co, however, due to difficult trading conditions a number of the receivablesare struggling to pay. The website was launched in 2010 and has consistently encountered difficulties withcustomer complaints that tickets have been booked and paid for online but Donald Co has no record of them andhence has sold the seat to another customer.

Donald Co used to sell tickets via a large call centre located near to their head office. However, in May they closedit down and made the large workforce redundant.

Required:

Using the information provided, describe FIVE audit risks and explain the auditor’s response to each risk inplanning the audit of Donald Co. (10 marks)

(20 marks)

4

4 You are an audit manager in NAB & Co, a large audit firm which specialises in the audit of retailers. The firm currentlyaudits Goofy Co, a food retailer, but Goofy Co’s main competitor, Mickey Co, has approached the audit firm to act asauditors. Both companies are highly competitive and Goofy Co is concerned that if NAB & Co audits both companiesthen confidential information could pass across to Mickey Co.

Required:

(a) Explain the safeguards that your firm should implement to ensure that this conflict of interest is properlymanaged. (4 marks)

Goofy Co’s year end is 31 December, which is traditionally a busy time for NAB & Co. Goofy Co currently has aninternal audit department of five employees but they have struggled to undertake the variety and extent of workrequired by the company, hence Goofy Co is considering whether to recruit to expand the department or to outsourcethe internal audit department. If outsourced, Goofy Co would require a team to undertake monthly visits to testcontrols at the various shops across the country, and to perform ad hoc operational reviews at shops and head office.

Goofy Co is considering using NAB & Co to provide the internal audit services as well as remain as external auditors.

Required:

(b) Discuss the advantages and disadvantages to both Goofy Co and NAB & Co of outsourcing their internal auditdepartment. (10 marks)

(c) The audit engagement partner for Goofy Co has been in place for approximately six years and her son has justaccepted a job offer from Goofy Co as a sales manager; this role would entitle him to shares in Goofy Co as partof his remuneration package. If NAB & Co is appointed as internal as well as external auditors, then Goofy Cohas suggested that the external audit fee should be renegotiated with at least 20% of the fee being based on theprofit after tax of the company as they feel that this will align the interests of NAB & Co and Goofy Co.

Required:

From the information in (c) explain the ethical threats which may affect the independence of NAB & Co inrespect of the audit of Goofy Co, and for each threat explain how it may be reduced. (6 marks)

(20 marks)

5 [P.T.O.

5 You are the audit manager of Daffy & Co and you are briefing your team on the approach to adopt in undertaking thereview and finalisation stage of the audit. In particular, your audit senior is unsure about the steps to take in relationto uncorrected misstatements.

During the audit of Minnie Co the following uncorrected misstatement has been noted.

The property balance was revalued during the year by an independent expert valuer and an error was made in relationto the assumptions provided to the valuer.

Required:

(a) Explain the term ‘misstatement’ and describe the auditor’s responsibility in relation to misstatements.(4 marks)

(b) Describe the factors Daffy & Co should consider when placing reliance on the work of the independent valuer.(4 marks)

(c) The following additional issues have arisen during the course of the audit of Minnie Co. Profit before tax isRM10m.

(i) Depreciation has been calculated on the total of land and buildings. In previous years it has only beencharged on buildings. Total depreciation is RM2·5m and the element charged to land only is RM0·7m.

(4 marks)

(ii) Minnie Co’s computerised wages program is backed up daily, however for a period of two months the wagesrecords and the back-ups have been corrupted, and therefore cannot be accessed. Wages and salaries forthese two months are RM1·1m. (4 marks)

(iii) Minnie Co’s main competitor has filed a lawsuit for RM5m against them alleging a breach of copyright; thiscase is ongoing and will not be resolved prior to the audit report being signed. The matter is correctlydisclosed as a contingent liability. (4 marks)

Required:

Discuss each of these issues and describe the impact on the audit report if the above issues remainunresolved.

Note: The mark allocation is shown against each of the three issues above. Audit report extracts are NOTrequired.

(20 marks)


6

Answers

Fundamentals Level – Skills Module, Paper F8 (MYS)Audit and Assurance (Malaysia) June 2011 Answers

1 (a) Tests of control and objective of each test for the sales cycle of Tinkerbell Toys Co (Tinkerbell)

(b) Substantive procedures to confirm receivables balance for Tinkerbell

– Perform a positive trade receivables circularisation of a representative sample of Tinkerbell’s year-end balances, for anynon-replies, with Tinkerbell’s permission, send a reminder letter to follow up.

– Review the after date cash receipts and follow through to pre-year-end receivable balances.– Calculate average receivable days and compare this to prior year, investigate any significant differences.– Review the reconciliation of sales ledger control account to the sales ledger list of balances.– Select a sample of goods despatched notes (GDN) before and just after the year end and follow through to the sales

invoice to ensure they are recorded in the correct accounting period.– Inspect the aged receivables report to identify any slow moving balances, discuss these with the credit control manager

to assess whether an allowance or write down is necessary.– For any slow moving/aged balances review customer correspondence to assess whether there are any invoices in

dispute. – Review board minutes of Tinkerbell to assess whether there are any material disputed receivables.– Review a sample of post year-end credit notes to identify any that relate to pre-year-end transactions to verify that they

have not been included in receivables.– Review the sales ledger for any credit balances and discuss with management whether these should be reclassified as

payables.– Select a sample of year-end receivable balances and agree back to valid supporting documentation of GDN and sales

order to ensure existence.

9

Test of control Objective of test

The auditor should attempt to enter an order for a fictitiouscustomer account number. The system should not acceptthis order.

To ensure that orders are only accepted and processed forvalid customers.

With the client’s permission, attempt to enter a sales orderwhich will take a customer over the agreed credit limit, thesystem should reject the order.

To ensure that goods are not supplied to poor credit risks.

Inspect a sample of processed credit applications from thecredit agency and follow through the credit limit agreed tothe sales system.

To ensure that goods are only supplied to customers withgood credit ratings.

Obtain a copy of the current price list and agree for asample of invoices that relevant/current prices have beenused.

To ensure that goods are only sold at authorised prices.

Confirm discounts applied to invoices agree to the customermaster file.

Attempt to process an order with a sales discount for acustomer not normally entitled to discounts to assess theapplication controls.

To ensure that sales discounts are only provided to validcustomers.

Inspect a sample of orders to confirm that an orderacceptance email/letter has been generated.

Observe the sales order clerk processing orders and assesswhether the order acceptance is automatically generated.

To ensure that all orders are recorded completely andaccurately.

Visit a warehouse and observe the goods despatch processto assess whether all goods are double checked against thegoods despatch note (GDN) and the despatch list prior tosending out.

To ensure that goods are despatched correctly to customersand that they are of an adequate quality.

Inspect a sample of GDNs and agree that a valid salesinvoice has been correctly raised.

To ensure that all goods despatched are correctly invoiced.

Review the last system generated sequence check of salesinvoices to identify any omissions.

To ensure completeness of income for goods despatched.

(c) Controls to reduce the risk of fraud occurring again

Tutorial note: This type of fraud is known as a teeming and lading fraud.

Tutorial note: Marks will be awarded for any additional general fraud points made.

(d) Substantive procedures to confirm Tinkerbell’s revenue:

– Compare the overall level of revenue against prior years and budget, and investigate any significant fluctuations.– Obtain a schedule of sales for the year broken down into the major categories of toys manufactured and compare this

to the prior year breakdown, and for any unusual movements and discuss with management.– Calculate the gross margin for Tinkerbell and compare this to the prior year, and investigate any significant fluctuations.– Select a sample of sales invoices for larger customers and recalculate the discounts allowed to ensure that these are

accurate.– Recalculate for a sample of invoices that the sales tax has been correctly applied to the sales invoice.– Select a sample of customer orders and agree these to the despatch notes and sales invoices through to inclusion in the

sales ledger to ensure completeness of revenue.– Select a sample of despatch notes both pre and post the year end, follow these through to sales invoices in the correct

accounting period to ensure that cut-off has been correctly applied.– Select a sample of credit notes issued after the year end and follow through to sales invoice to ensure the returns were

recorded in the proper period.

2 (a) Advantages and Disadvantages of methods of recording the system

Narrative Notes

Advantages

The main advantage of narrative notes is that they are simple to record, after discussion with the company these discussionsare easily written up as notes.

Additionally, as the notes are simple to record, this can facilitate understanding by all members of the team, especially morejunior members who might find alternative methods too complex.

10

Control Mitigate risk

Members of staff who are related should not be permitted towork in the same department whereby they can breachsegregation of duty controls.

This should reduce the risk of staff collusion and being ableto commit a fraud without easily being discovered.

Cash receipts should be processed by two members of staff. This should reduce the risk of one person being able to stealcash receipts. In order to commit the fraud these twomembers of staff would need to collude and to avoiddetection, also collude with other members of the financeteam.

Monthly customer statements should be sent out promptlyto all customers. The sales ledger supervisor should reviewto ensure that all customers have been sent statements.

If customers receive regular statements then they would bein a position to flag to Tinkerbell that there was a delay intheir payments being credited to their accounts. This shouldthen flag a possible ‘teeming and lading’ fraud.

Bank reconciliations should be reviewed by a responsibleofficial (different to the preparer of the reconciliation) on aregular basis. Any unreconciled amounts should be promptlyinvestigated and resolved.

A small unreconciled amount can actually represent twolarge balances which almost cancel each other out andhence could indicate significant problems with cash andbank.

Where fraud arises it can often be quickly spotted byperforming and reviewing a bank reconciliation.

On a regular basis staff within the finance departmentshould rotate duties.

If staff members know that they will need to rotate theirroles then they will be less inclined to commit fraudulentactivities, as the chances of them being caught increasesignificantly.

The sales ledger should be reconciled to the sales ledgercontrol account on a monthly basis, and this reconciliationshould be reviewed by a responsible official.

This will increase the likelihood of spotting errors in thereceivable balances and help to create an environment ofcontrols, which will decrease the likelihood of fraudsoccurring.

Management should consider establishing an internal auditdepartment which could assess the effectiveness of controlsand identify areas of weaknesses, as well as performspecific fraud investigations.

As there has been a significant breakdown in the internalcontrols then the mere presence of an internal auditdepartment would help to deter employees committingfraud. In addition, fraudulent activities would be more likelyto be identified quicker as internal controls would be tested.

Disadvantages

Narrative notes may prove to be too cumbersome especially if the system is complex.

This method can make it more difficult to identify missing internal controls as the notes record the detail but do not identifycontrol exceptions clearly.

Questionnaires

Internal control questionnaires are used to assess whether controls exist which meet specific objectives or prevent or detecterrors and omissions.

Advantages

Questionnaires are quick to prepare, which means they are a cost effective method for recording the system.

They ensure that all controls present within the system are considered and recorded; hence missing controls or deficienciesare clearly highlighted.

Questionnaires are simple to complete and therefore any members of the team can complete them and they are easy to useand understand.

Disadvantages

It can be easy for the company to overstate the level of the controls present as they are asked a series of questions relatingto potential controls.

Without careful tailoring of the questionnaire to make it company specific, there is a risk that controls may be misunderstoodand unusual controls missed.

(b) (i) Purpose of an engagement letter

An engagement letter provides a written agreement of the terms of the audit engagement between the auditor andmanagement or those charged with governance.

Confirming that there is a common understanding between the auditor and management, or those charged withgovernance, of the terms of the audit engagement helps to avoid misunderstandings with respect to the audit.

(ii) Matters to be included in an audit engagement letter:

– The objective and scope of the audit;– The responsibilities of the auditor;– The responsibilities of management;– Identification of the financial reporting framework for the preparation of the financial statements; – Expected form and content of any reports to be issued;– Elaboration of the scope of the audit with reference to legislation;– The form of any other communication of results of the audit engagement;– The fact that some material misstatements may not be detected;– Arrangements regarding the planning and performance of the audit, including the composition of the audit team;– The expectation that management will provide written representations;– The basis on which fees are computed and any billing arrangements;– A request for management to acknowledge receipt of the audit engagement letter and to agree to the terms of the

engagement; – Arrangements concerning the involvement of internal auditors and other staff of the entity;– Any obligations to provide audit working papers to other parties;– Any restriction on the auditor’s liability;– Arrangements to make available draft financial statements and any other information;– Arrangements to inform the auditor of facts that might affect the financial statements, of which management may

become aware during the period from the date of the auditor’s report to the date the financial statements are issued.

3 (a) Procedures to obtain evidence and an audit test relevant to purchases and other expenses:

Inspection

Inspection involves examining records or documents, whether internal or external, in paper form, electronic form, or othermedia, or a physical examination of an asset.

– Inspect a sample of purchase invoices and agree the amount is included correctly within the purchase ledger.– Inspect purchase orders for evidence of authorisation by a responsible official.

Observation

Observation consists of looking at a process or procedure being performed by others.

– Observe the process for logging purchase invoices into the system to ensure that all invoices are entered completely andaccurately.

11

– Observe the goods received department to assess whether goods received are checked against purchase orders andreviewed for adequate quality.

Analytical procedures

Analytical procedures consist of evaluations of financial information through analysis of plausible relationships among bothfinancial and non-financial data. Analytical procedures also encompass such investigation as is necessary of identifiedfluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by asignificant amount.

– Calculate the operating profit margin/overhead ratio and compare it to last year and budget and investigate anysignificant differences.

– Review monthly other expenses to identify any significant fluctuations and discuss with management.

Inquiry

Inquiry consists of seeking information of knowledgeable persons, both financial and non-financial, within the entity or outsidethe entity.

– Discuss with management whether there have been any changes in the key suppliers used and compare this to thepurchase ledger to assess completeness and accuracy of purchases.

– Inquire of department heads the process they follow in authorising orders to ensure that it follows the specified companyauthorisation process.

Recalculation

Recalculation consists of checking the mathematical accuracy of documents or records. Recalculation may be performedmanually or electronically.

– Recalculate the accuracy of a sample of purchase invoices.– Recalculate the prepayments and accruals charged at the year end to ensure the accuracy of the other expenses.

Reperformance

Reperformance involves the auditor’s independent execution of procedures or controls that were originally performed as partof the entity’s internal control.

– Reperform the purchase ledger control account reconciliation to ensure accuracy.– Select a sample of purchase orders and match them to the goods received notes and purchase invoices to ensure

completeness of the purchase cycle.

Tutorial note: Marks will be awarded for any other relevant purchases and expenses tests.

(b) Audit risks and responses:

12

Audit risk Audit response

Donald Co has ordered six planes which may not have beenreceived by the year end. Only assets which physically existat the year end should be included in property, plant andequipment.

Discuss with management as to whether the planes havearrived, if so then physically verify a sample of these planesto ensure existence.

The existing planes have been refurbished at a cost ofRM15m. This expenditure needs to be reviewed to assesswhether it is of a capital nature and should be includedwithin assets or expensed as repairs.

Review a breakdown of the costs and agree to invoices toassess the nature of the expenditure and if capital agree toinclusion within the asset register and if repairs agree to theincome statement.

Donald Co has applied for a loan of RM25m. It has notreceived this loan yet, but it has already ordered the planesand if it does not receive the money in time then it maystruggle to pay for the planes ordered and this could resultin going concern difficulties.

Discuss with management the status of the loan applicationand if still outstanding whether any other banks have beenapproached for the loan.

Perform a detailed going concern review.

The travel agents who sell tickets on behalf of the airline arestruggling to pay their outstanding balances to Donald Co.This could result in an increase in irrecoverable debts andreceivables being overvalued.

Extended post year-end cash receipts testing and a review ofthe aged receivables ledger to be performed to assessvaluation.

An allowance for receivables to be discussed withmanagement.

Donald Co’s website has encountered difficulties withrecording sales, this could lead to errors in relation tocompleteness of income.

Extended controls testing to be performed over the salescycle to assess the extent of the errors. Detailed testing to beperformed over completeness of income.

Due to the website errors tickets have been sold twice,therefore some customers will require refunds. At the yearend there is a risk that the tickets to be refunded have notbeen removed from sales.

Review the cut-off of customer refunds around the year endto ensure that sales are complete and accurate.

4 (a) Safeguards to be adopted to address the conflict of interest of auditing both Goofy Co and Mickey Co:

– Both Goofy Co and Mickey Co should be notified that NAB & Co would be acting as auditors for each company and, ifnecessary, consent obtained.

– Advising one or both clients to seek additional independent advice.– The use of separate engagement teams, with different engagement partners and team members. Once an employee has

worked on one audit such as Goofy Co then they would be prevented from being on the audit of Mickey Co for a periodof time. This separation of teams is known as building a ‘Chinese wall’.

– Procedures to prevent access to information, for example, strict physical separation of both teams, confidential andsecure data filing.

– Clear guidelines for members of each engagement team on issues of security and confidentiality. These guidelines couldbe included within the audit engagement letters.

– Potentially the use of confidentiality agreements signed by employees and partners of the firm.– Regular monitoring of the application of the above safeguards by a senior individual in NAB & Co not involved in either

audit.

(b) Advantages of outsourcing Goofy Co’s internal audit department

StaffingGoofy Co needs to expand its internal audit department from five employees as it is too small. However, if they outsourcethen there will be no need to recruit as NAB & Co will provide the staff members and this will be an instant solution.

Skills and experienceNAB & Co is a large firm and so will have a large pool of staff available to provide the internal audit service. In addition, Goofy Co has requested that reviews are performed and depending on the nature of these, it may find that the firm hasspecialist skills that Goofy Co may not be able to afford if the internal audit department continues to be run internally.

CostsAny associated costs such as training will be eliminated as NAB & Co will train its own employees. In addition, the costs forthe internal audit service will be agreed in advance. This will ensure that Goofy Co can budget accordingly.

As NAB & Co will be performing both the external and internal audit there is a possibility that the fees may be reduced.

FlexibilityWith the department being outsourced Goofy Co will have total flexibility in its internal audit service. Staff can be requestedfrom NAB & Co to suit Goofy Co’s workloads and requirements. This will ensure that, when required, extra staff can be usedto visit a large number of shops and in quieter times there may be no internal audit presence.

Additional feesNAB & Co will benefit from the internal audit service being outsourced as this will generate additional fee income. However,the firm will need to monitor the fees to ensure that they do not represent too high a percentage of their total fee income.

Disadvantages of outsourcing Goofy Co’s internal audit department

Knowledge of systemsNAB & Co will allocate available staff members to work on the internal audit assignment. This may mean that each monththe staff members are different and hence they may not understand the systems of Goofy Co. This will decrease the qualityof the services provided and increase the time spent by Goofy Co employees explaining the system to the auditors.

IndependenceIf NAB & Co continues as external auditor as well as providing the internal audit service, there may be a self-review threat,where the internal audit work is relied upon by the external auditors. NAB & Co would need to take steps to ensure thatseparate teams were put in place as well as additional safeguards.

Existing internal audit departmentGoofy Co has an existing internal audit department of five employees. If they cannot be redeployed elsewhere in the companythen they may need to be made redundant and this could be costly for the company. Staff may oppose the outsourcing if itresults in redundancies.

CostAs well as the cost of potential redundancies, the internal audit fee charged by NAB & Co may, over a period of time, proveto be very expensive.

13


Donald Co is closing its call centre and making theworkforce redundant. As it has announced this to the staffthen under FRS 137 Provisions, Contingent Liabilities andContingent Assets a redundancy provision will be requiredfor any staff not yet paid at the year end.

Discuss with management the status of the redundancyprogramme and review and recalculate the redundancyprovision.

Loss of in-house skillsIf the current internal audit team is not deployed elsewhere in the company valuable internal audit knowledge and experiencemay be lost. If Goofy Co then decided at a future date to bring the service back in-house, this might prove to be too difficult.

TimingNAB & Co may find that Goofy Co requires internal audit staff at the busy periods for the audit firm, and hence it might provedifficult to actually provide the required level of resources.

ConfidentialityKnowledge of company systems and confidential data will be available to NAB & Co. Although the engagement letter wouldprovide confidentiality clauses, this may not stop breaches of confidentiality.

ControlGoofy Co will currently have more control over the activities of its internal audit department. However, once outsourced it willneed to discuss areas of work and timings well in advance with NAB & Co.

(c) Ethical threats and managing these risks

5 (a) Misstatements

ISA 450 Evaluation of Misstatements Identified During the Audit considers what a misstatement is and deals with theauditor’s responsibility in relation to misstatements.

It identifies a misstatement as being: A difference between the amount, classification, presentation, or disclosure of a reportedfinancial statement item and the amount, classification, presentation, or disclosure that is required for the item to be inaccordance with the applicable financial reporting framework. Misstatements can arise from error or fraud.

It also then defines uncorrected misstatements as: Misstatements that the auditor has accumulated during the audit and thathave not been corrected.

There are three categories of misstatements:

(i) Factual misstatements are misstatements about which there is no doubt.

(ii) Judgemental misstatements are differences arising from the judgements of management concerning accountingestimates that the auditor considers unreasonable, or the selection or application of accounting policies that the auditorconsiders inappropriate.

(iii) Projected misstatements are the auditor’s best estimate of misstatements in populations, involving the projection ofmisstatements identified in audit samples to the entire populations from which the samples were drawn.

The auditor has a responsibility to accumulate misstatements which arise over the course of the audit unless they are verysmall amounts.

Identified misstatements should be considered during the course of the audit to assess whether the audit strategy and planshould be revised.

14

Ethical threat Managing risk

A familiarity threat arises where an engagement partner isassociated with a client for a long period of time. NAB &Co’s partner has been involved in the audit of Goofy Co forsix years and hence may not maintain her professionalscepticism and objectivity.

NAB & Co should monitor the relationship betweenengagement and client staff, and should consider rotatingengagement partners when a long association has occurred.In addition, ACCA’s Code of Ethics and Conductrecommends that engagement partners rotate off an auditafter five years for listed and public interest entities.

Therefore consideration should be given to appointing analternative audit partner.

The engagement partner’s son has accepted a job as a salesmanager at Goofy Co. This could represent a self-interest/familiarity threat if the son was involved in thefinancial statement process.

It is unlikely that as a sales manager the son would be in aposition to influence the financial statements and henceadditional safeguards would not be necessary.

A self-interest threat can arise when an audit firm has afinancial interest in the company. In this case the partner’sson will receive shares as part of his remuneration. As theson is an immediate family member of the partner then if heholds the shares it will be as if the partner holds theseshares, and this is prohibited.

In this case as holding shares is prohibited by ACCA’s Codeof Ethics and Conduct then either the son should refuse theshares or more likely the engagement partner will need tobe removed from the audit.

Fees based on the outcome or results of work performed areknown as contingent fees and are prohibited by ACCA’sCode of Ethics and Conduct. Hence Goofy Co’s request that20% of the external audit fee is based on profit after taxwould represent a contingent fee.

NAB & Co will not be able to accept contingent fees andshould communicate to Goofy Co that the external audit feeneeds to be based on the time and level of work performed.

The auditor should determine whether uncorrected misstatements are material in aggregate or individually.

All misstatements should be communicated to those charged with governance on a timely basis and request that they makenecessary amendments. If this request is refused then the auditor should consider the potential impact on their audit report.

A written representation should be requested from management to confirm that unadjusted misstatements are immaterial.

Tutorial note: The model answer is more comprehensive than would be expected for 4 marks. This is because ISA 450 is arelatively new auditing standard and the above has been presented as a teaching resource.

(b) Reliance on the work of an independent valuer

ISA 500 Considering the Relevance and Reliability of Audit Evidence requires auditors to evaluate the competence,capabilities including expertise and objectivity of a management expert.

This would include consideration of the qualifications of the valuer and assessment of whether they were members of anyprofessional body or industry association.

In addition, the auditor should meet with the expert and discuss with them their relevant expertise; in particular whether theyhave valued similar properties to Minnie Co in the past. Also consider whether they understand the accounting requirementsof FRS 116 Property, Plant and Equipment in relation to valuations.

The expert’s independence should be ascertained, with potential threats such as undue reliance on Minnie Co or a self-interestthreat such as share ownership considered.

The valuation should then be evaluated, and the assumptions used should be carefully reviewed and compared to previousrevaluations at Minnie Co. These assumptions should be discussed with both management and the valuer to understandwhere the misstatement has arisen.

In order to correct the misstatement, it might be necessary for the valuer to undertake further work and this should be agreed.

Daffy & Co would not be able to state in their audit report that they had relied on an expert for the property valuation.

(c) (i) Depreciation on land and buildings

Depreciation has been provided on the land element of property, plant and equipment and this is contrary to FRS 116Property, Plant and Equipment, as depreciation should only be charged on buildings.

The error is material as it represents 7% of profit before tax (0·7m/10m) and hence management should remove thisfrom the financial statements.

If management refuse to amend this error then the audit report will need to be modified. As management has notcomplied with FRS 116 and the error is material but not pervasive then a qualified opinion would be necessary.

A basis for qualified opinion paragraph would need to be included explaining the material misstatement in relation tothe provision of depreciation on land and the effect on the financial statements. The opinion paragraph would bequalified ‘except for’ – due to material misstatement.

(ii) Wages program

Minnie Co’s wages program has been corrupted leading to a loss of payroll data for a period of two months. The auditorsshould attempt to verify payroll in an alternative manner. If they are unable to do this then payroll for the whole yearwould not have been verified.

Wages and salaries for the two month period represents 11% of profit before tax (1·1m/10m) and therefore is a materialbalance for which audit evidence has not been available.

The auditors will need to modify the audit report as they are unable to obtain sufficient appropriate evidence in relationto a material, but not pervasive, element of wages and salaries and therefore a qualified opinion will be required.

A basis for qualified opinion paragraph will be required to explain the limitation in relation to the lack of evidence overtwo months of payroll records. The opinion paragraph will be qualified ‘except for’ – due to insufficient appropriate auditevidence.

(iii) Lawsuit

The company is being sued by a competitor for breach of copyright. This matter has been correctly disclosed inaccordance with FRS 137 Provisions, Contingent Liabilities and Contingent Assets.

The lawsuit is for RM5m which represents 50% of profit before tax (5·0m/10m) and hence is a material matter. This isan important matter which needs to be brought to the attention of the users.

An emphasis of matter paragraph would need to be included in the audit report, in that the matter is appropriatelydisclosed but is fundamental to the users’ understanding of the financial statements; this will not affect the audit opinionwhich will be unmodified in relation to this matter.

An emphasis of matter paragraph should be inserted after the opinion paragraph, the paragraph would explain clearlyabout the lawsuit and cross references to where in the financial statements the disclosure of this contingent liability canbe found.

15

Fundamentals Level – Skills Module, Paper F8 (MYS)Audit and Assurance (Malaysia) June 2011 Marking Scheme

MARKS1 (a) Up to 1 mark per well explained control and up to 1 mark for each objective

Process order for fictitious orderSales order over credit limitInspect credit applicationsAgree prices used to relevant price listConfirm discounts used on invoices agree to customer master fileAttempt to process a discount for a small customerInspect orders to confirm order acceptance generatedObserve sales order clerk processing orders to see if acceptance generatedObserve goods despatch processAgree goods despatch notes (GDN) to invoicesSequence checks over invoices 12

–––

(b) Up to 1 mark per well explained procedure

– Trade receivables circularisation, follow up any non-replies– Review the after date cash receipts– Calculate average receivable days– Reconciliation of sales ledger control account– Cut-off testing of GDN– Aged receivables report to identify any slow moving balances– Review customer correspondence to assess whether there are any invoices in dispute – Review board minutes– Review post year-end credit notes– Review for any credit balances– Agree to GDN and sales order to ensure existence 8

–––

(c) Up to 1 mark per well explained control and up to 1 mark for how it mitigates risk

Relatives not permitted to work in the same departmentCash receipts processed by two members of staffMonthly customer statements sentBank reconciliations reviewed by responsible officialRotation of duties within finance departmentSales ledger control account reconciliation regularly performedConsider establishing an internal audit department 6

–––

(d) Up to 1 mark per well explained procedure

Analytical review over revenue compared to budget and prior yearAnalytical review of major categories of toy sales compared to prior yearGross margin reviewRecalculate discounts allowed for larger customersRecalculate sales taxFollow order to goods despatched note to sales invoice to sales ledgerSales cut-offReview post year-end credit notes 4

–––30––––––

17


Notes:Simple to understandFacilitate understanding by all teamCumbersome especially if complex systemDifficult to identify missing controlsQuestionnaires:Quick to prepare and hence cost effectiveAll internal controls considered and missing controls identifiedEasy to complete and useEasy to overstate controlsEasy to misunderstand controls and miss unusual controls 6

–––

(b) (i) Up to 1 mark per valid point

Written agreement of terms of engagementAvoid misunderstandings 1

–––

(ii) ½ mark per valid point

– Objective/scope– Responsibilities of auditor– Responsibilities of management– Identification of framework for financial statements– Form/content reports– Elaboration of scope– Form of communications– Some misstatements may be missed– Arrangement for audit– Written representations required– Fees/billing– Management acknowledge letter– Internal auditor arrangements– Obligations to provide working papers to others– Restriction on auditor’s liability– Arrangements to make draft financial statements available– Arrangements to inform auditors of subsequent events 3

–––10––––––

3 (a) Up to 1 mark per well explained procedure and up to 1 mark for a valid audit test, overall maximum of 2 marks per type of procedure and test.

InspectionObservationAnalytical proceduresInquiryRecalculationReperformance 10

–––

(b) Up to 1 mark per well explained risk and up to 1 mark per response, overall maximum of 10.

Planes ordered may not exist at year endRefurbishment of planes – capital or repairsLoan of RM25m not received yetRecoverability of receivablesCompleteness of incomeCustomer refundsRedundancy provision 10

–––20––––––

18

MARKS4 (a) Up to 1 mark per well explained safeguard

– Notify Goofy Co and Mickey Co– Advise seek independent advice– Separate engagement teams– Procedures prevent access to information– Clear guidelines on security and confidentiality– Confidentiality agreements– Monitoring of safeguards 4

–––

(b) Up to 1 mark per well explained advantage/disadvantage

Staffing gaps addressed immediatelySkills and experience increasedCosts of training eliminatedPossibly reduced feesFlexibility of serviceAdditional fees for NAB & CoKnowledge of systems reduced Independence issues NAB & CoExisting internal audit department staff, cost of potential redundanciesFees by NAB & Co may increase over timeLoss of in-house skillsTiming of work may not suit NAB & CoConfidentiality issuesControl of department reduced 10

–––

(c) Up to 1 mark per well explained threat and up to 1 mark for method of managing risk, overall maximum 6 marks.

Familiarity threat – long association of partnerSelf-interest threat – son gained employment at client companySelf-interest threat – financial interest (shares) in client companyContingent fees 6

–––20––––––

19

MARKS5 (a) Up to 1 mark per well explained point

Definition of misstatementsDefinition of uncorrected misstatementsFactual misstatementsJudgemental misstatementsProjected misstatementsAuditor should accumulate misstatementsConsider if audit strategy/plan should be revisedAssess if uncorrected misstatements materialCommunicate to those charged with governance, request changesIf refused then assess impact on audit reportRequest written representation 4

–––


ISA 500 provides guidanceConsider if member of professional body or industry associationAssess whether relevant expertiseAssess independenceEvaluate assumptionsAgree any further work requiredNo reference in audit report of Daffy & Co 4

–––

(c) Up to 1 mark per valid point, overall maximum of 4 marks PER ISSUE

Discussion of issueCalculation of materialityType of audit report modification requiredImpact on audit report 12

–––20––––––

20







Pape

r F8

(IN

T)


Thursday 8 December 2011



1 Introduction and client background

You are the audit senior of Blair & Co and your team has just completed the interim audit of Chuck Industries Co,whose year end is 31 January 2012. You are in the process of reviewing the systems testing completed on the payrollcycle, as well as preparing the audit programmes for the final audit.

Chuck Industries Co manufactures lights and the manufacturing process is predominantly automated; however thereis a workforce of 85 employees, who monitor the machines, as well as approximately 50 employees who work insales and administration. The company manufactures 24 hours a day seven days a week.

Below is a description of the payroll system along with deficiencies identified by the audit team:

Factory workforce

The company operates three shifts every day with employees working eight hours each. They are required to clock inand out using an employee swipe card, which identifies the employee number and links into the hours worked reportproduced by the computerised payroll system. Employees are paid on an hourly basis for each hour worked. There isno monitoring/supervision of the clocking in/out process and an employee was witnessed clocking in severalemployees using their employee swipe cards.

The payroll department calculates on a weekly basis the cash wages to be paid to the workforce, based on the hoursworked report multiplied by the hourly wage rate, with appropriate tax deductions. These calculations are not checkedby anyone as they are generated by the payroll system. During the year the hourly wage was increased by the HumanResources (HR) department and this was notified to the payroll department verbally.

Each Friday, the payroll department prepares the pay packets and physically hands these out to the workforce, whooperate the morning and late afternoon shifts, upon production of identification. However, for the night shift workers,the pay packets are given to the factory supervisor to distribute. If any night shift employees are absent on pay daythen the factory supervisor keeps these wages and returns them to the payroll department on Monday.

Sales and administration staff

The sales and administration staff are paid monthly by bank transfer. Employee numbers do fluctuate and during Julytwo administration staff joined; however, due to staff holidays in the HR department, they delayed informing thepayroll department, resulting in incorrect salaries being paid out.

Required:

(a) For the deficiencies already identified in the payroll system of Chuck Industries Co:

(i) explain the possible implications of these; and (ii) suggest a recommendation to address each deficiency. (12 marks)

(b) Describe substantive procedures you should now perform to confirm the accuracy and completeness ofChuck Industries’ payroll charge. (6 marks)

(c) Last week the company had a visit from the tax authorities who reviewed the wages calculations and discoveredthat incorrect levels of tax had been deducted by the payroll system, as the tax rates from the previous year hadnot been updated. The finance director has queried with the audit team why they did not identify this non-compliance with tax legislation during last year’s audit.

Required:

Explain the responsibilities of management and auditors of Chuck Industries Co in relation to compliancewith law and regulations under ISA 250 Consideration of Laws and Regulations in an Audit of FinancialStatements. (4 marks)

2

(d) Chuck Industries has decided to outsource its sales ledger department and as a result it is making 14 employeesredundant. A redundancy provision, which is material, will be included in the draft accounts.

Required:

Describe substantive procedures you should perform to confirm the redundancy provision at the year end.(4 marks)

(e) Chuck Industries is considering establishing an internal audit (IA) department next year. The finance director hasasked whether the work performed by the IA department can be relied upon by Blair & Co.

Required:

Explain the factors that should be considered by an external auditor before reliance can be placed on thework performed by a company’s internal audit department. (4 marks)

(30 marks)

3 [P.T.O.

2 (a) ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and ItsEnvironment requires auditors to understand the entity’s internal control. An entity’s internal control is made upof several components.

Required:

State the FIVE components of an entity’s internal control and give a brief explanation of each component.(5 marks)

(b) ISA 700 Forming an Opinion and Reporting on Financial Statements provides guidance on the form and contentof the auditor’s report and should contain a number of elements.

Required:

Describe FIVE elements of an unmodified auditor’s report. (5 marks)

(10 marks)

4

3 (a) Explain the components of audit risk and, for each component, state an example of a factor which can resultin increased audit risk. (6 marks)

Abrahams Co develops, manufactures and sells a range of pharmaceuticals and has a wide customer base acrossEurope and Asia. You are the audit manager of Nate & Co and you are planning the audit of Abrahams Co whosefinancial year end is 31 January. You attended a planning meeting with the finance director and engagement partnerand are now reviewing the meeting notes in order to produce the audit strategy and plan. Revenue for the year isforecast at $25 million.

During the year the company has spent $2·2 million on developing several new products. Some of these are in theearly stages of development whilst others are nearing completion. The finance director has confirmed that all projectsare likely to be successful and so he is intending to capitalise the full $2·2 million.

Once products have completed the development stage, Abrahams begins manufacturing them. At the year end it isanticipated that there will be significant levels of work in progress. In addition the company uses a standard costingmethod to value inventory; the standard costs are set when a product is first manufactured and are not usuallyupdated. In order to fulfil customer orders promptly, Abrahams Co has warehouses for finished goods located acrossEurope and Asia; approximately one third of these are third party warehouses where Abrahams just rents space.

In September a new accounting package was introduced. This is a bespoke system developed by the informationtechnology (IT) manager. The old and new packages were not run in parallel as it was felt that this would be tooonerous for the accounting team. Two months after the system changeover the IT manager left the company; a newmanager has been recruited but is not due to start work until January.

In order to fund the development of new products, Abrahams has restructured its finance and raised $1 millionthrough issuing shares at a premium and $2·5 million through a long-term loan. There are bank covenants attachedto the loan, the main one relating to a minimum level of total assets. If these covenants are breached then the loanbecomes immediately repayable. The company has a policy of revaluing land and buildings, and the finance directorhas announced that all land and buildings will be revalued as at the year end.

The reporting timetable for audit completion of Abrahams Co is quite short, and the finance director would like toreport results even earlier this year.

Required:

(b) Using the information provided, identify and describe FIVE audit risks and explain the auditor’s response toeach risk in planning the audit of Abrahams Co. (10 marks)

(c) Describe substantive procedures you should perform to obtain sufficient appropriate evidence in relation to:

(i) Inventory held at the third party warehouses; and(ii) Use of standard costs for inventory valuation. (4 marks)

(20 marks)

5 [P.T.O.

4 (a) Explain what is meant by ‘corporate governance’ and why it is important. (3 marks)

(b) Serena VDW Co has been trading for over 20 years and obtained a listing on a stock exchange five years ago. Itprovides specialist training in accounting and finance.

The listing rules of the stock exchange require compliance with corporate governance principles, and the directorsare fairly confident that they are following best practice in relation to this. However, they have recently receivedan email from a significant shareholder, who is concerned that Serena VDW Co does not comply with corporategovernance principles.

Serena VDW Co’s board is comprised of six directors; there are four executives who originally set up the companyand two non-executive directors who joined Serena VDW Co just prior to the listing. Each director has a specificarea of responsibility and only the finance director reviews the financial statements and budgets.

The chief executive officer, Daniel Brown, set up the audit committee and he sits on this sub-committee alongwith the finance director and the non-executive directors. As the board is relatively small, and to save costs,Daniel Brown has recently taken on the role of chairman of the board. It is the finance director and the chairmanwho make decisions on the appointment and remuneration of the external auditors. Again, to save costs, nointernal audit function has been set up to monitor internal controls.

The executive directors’ remuneration is proposed by the finance director and approved by the chairman. Theyare paid an annual salary as well as a generous annual revenue related bonus.

Since the company listed, the directors have remained unchanged and none have been subject to re-election byshareholders.

Required:

Describe SIX corporate governance weaknesses faced by Serena VDW Co and provide recommendations toaddress each weakness, to ensure compliance with corporate governance principles. (12 marks)

(c) Explain the auditor’s ethical responsibilities with regard to client confidentiality and when they have an:

(i) obligatory responsibility; and(ii) voluntary responsibility to disclose client information. (5 marks)

(20 marks)

6

5 (a) Describe the auditor’s responsibility for subsequent events occurring between:

(i) The year-end date and the date the auditor’s report is signed; and(ii) The date the auditor’s report is signed and the date the financial statements are issued. (5 marks)

(b) Humphries Co operates a chain of food wholesalers across the country and its year end was 30 September 2011.The final audit is nearly complete and it is proposed that the financial statements and audit report will be signedon 13 December. Revenue for the year is $78 million and profit before taxation is $7·5 million. The followingevents have occurred subsequent to the year end.

Receivable

A customer of Humphries Co has been experiencing cash flow problems and its year-end balance is $0·3 million.The company has just become aware that its customer is experiencing significant going concern difficulties.Humphries believe that as the company has been trading for many years, they will receive some, if not full,payment from the customer; hence they have not adjusted the receivable balance.

Lawsuit

A key supplier of Humphries Co is suing them for breach of contract. The lawsuit was filed prior to the year end,and the sum claimed by them is $1 million. This has been disclosed as a contingent liability in the notes to thefinancial statements; however correspondence has just arrived from the supplier indicating that they are willingto settle the case for a payment by Humphries Co of $0·6 million. It is likely that the company will agree to this.

Warehouse

Humphries Co has three warehouses; following extensive rain on 20 November significant rain and river waterflooded the warehouse located in Bass. All of the inventory was damaged and has been disposed of. Theinsurance company has already been contacted. No amendments or disclosures have been made in the financialstatements.

Required:

For each of the three events above:

(i) discuss whether the financial statements require amendment;

(ii) describe audit procedures that should be performed in order to form a conclusion on the amendment;and

(iii) explain the impact on the audit report should the issue remain unresolved. (15 marks)

Note: The total marks will be split equally between each event.

(20 marks)


7

Answers

Fundamentals Level – Skills Module, Paper F8 (INT)Audit and Assurance (International) December 2011 Answers

1 (a) Payroll system implications and recommendations

11

Implication Recommendation

Clocking in process

As there is no supervision of the clocking in process then,as witnessed, employees can clock in multiple employeessimply by using their employee swipe cards. This will resultin a substantially increased payroll cost for Chuck Industries.

The clocking in and out procedures should be supervised bya responsible official to prevent one individual clocking inmultiple employees. In addition, Chuck Industries couldconsider linking the access to the factory floor with theemployee swipe card system. Hence employees can onlyaccess the factory one at a time upon presentation of theiremployee swipe card.

In addition, this could create a weaker control environmentwhereby employees consider it acceptable not to followcontrols.

Employees should be reminded about the importance offollowing Chuck Industries’ policies and procedures,especially in relation to the clocking in/out process.

Without supervision/monitoring of the clocking in or outprocess, employees could try to boost their hours worked byclocking out several hours after their shift has finished, thiswill lead to invalid and unauthorised overtime payments.

Overtime hours should be reviewed by the productionsupervisor prior to payment, to ensure that only previouslyauthorised overtime is paid for.

Wages calculations

The wages calculations are generated by the payroll systemand there are no checks performed. Therefore, if systemerrors occur during the payroll processing then this wouldnot be identified. This could result in wages being over orunder calculated, leading to an additional payroll cost orloss of employee goodwill.

A senior member of the payroll team should recalculate thegross to net pay workings for a sample of employees andcompare their results to the output from the payroll system.These calculations should be signed as approved beforewages payments are made.

Hourly wage increase

The hourly wage has been increased by the HumanResources (HR) department and notified to the payrolldepartment verbally. As payroll can be a significant expensefor a business, any decision to increase this should be madeby the board as a whole and not just by HR.

All increases of pay should be proposed by the HRdepartment and then formally agreed by the board ofdirectors.

The payroll department should not accept verbalnotifications of pay increases as it could be an unauthorisedincrease, or an effort by an employee in HR to increase thepay of certain members of staff, such as their friends.

Written notification of the increase should be sent to payrolland HR and only then should the pay rise be incorporatedinto the payroll package.

Wage payout

The factory supervisor should not be given the pay packetsof the night shift staff as this is a significant amount ofcash, being approximately one-third of the workforce. Thiscash will not be in a secure location and so is open to therisk of theft.

Consideration should be given to operating a shift system forthe payroll department on Fridays. This will ensure thatthere are sufficient payroll employees to perform the wagespayout to the night shift employees. Therefore the samecontrols applied to the morning and late afternoon shifts canbe put in place for the night shift.

In addition, the supervisor is not sufficiently independent topay wages out. He could adjust pay packets to increasethose of his close friends whilst reducing others.

Employees who miss the payout by the payroll departmentwill need to wait until Monday for their pay. No factorysupervisor should be allowed to hand out wages.

For employees absent on pay day, the supervisor retains thewages and only returns them on Monday. This cash istherefore not secure and is susceptible to loss or theft.

Pay packets of absent employees should be safely securedin the safe overnight and then banked on Monday.

Joiners/leavers

Notification of joiners and leavers should be made on atimely basis to the payroll department, even if some staff areon holiday. Otherwise Chuck Industries could continuemaking payments to employees who have left, or pay newemployees late, resulting in a loss of employee goodwill.

During periods of illness or holidays, key roles of theaffected employees should be reallocated to other membersof the team to ensure that controls are maintained.

Forms for new joiners should be completed when they areappointed with appropriate start dates filled in, these shouldthen be distributed to all relevant departments. This shouldreduce the risk of new joiners being missed out by thepayroll department.

(b) Payroll substantive procedures

– Agree the total wages and salaries expense per the payroll system to the detailed trial balance, investigate anydifferences.

– Cast a sample of payroll records to confirm completeness and accuracy of the payroll expense.

– For a sample of employees, recalculate the gross and net pay and agree to the payroll records to verify accuracy.

– Re-perform calculation of statutory deductions to confirm whether correct deductions for this year have been includedwithin the payroll expense.

– Compare the total payroll expense to the prior year and investigate any significant differences.

– Review monthly payroll charges, compare this to the prior year and budgets and discuss with management anysignificant variances.

– Perform a proof in total of total wages and salaries, incorporating joiners and leavers and the pay increase. Compare thisto the actual wages and salaries in the financial statements and investigate any significant differences.

– Select a sample of joiners and leavers, agree their start/leaving date to supporting documentation, recalculate that theirfirst/last pay packet was accurately calculated and recorded.

– For salaries, agree the total net pay per the payroll records to the bank transfer listing of payments and to the cashbook.

– For wages, agree the total cash withdrawn for wage payments equates to the weekly wages paid plus any surplus cashsubsequently banked to confirm completeness and accuracy.

– Agree the year-end tax liabilities to the payroll records, and subsequent payment to the post year-end cash book toconfirm completeness.

– Agree the individual wages and salaries per the payroll to the personnel records and records of hours worked per clockingin cards.

(c) Laws and regulations

Under ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements, management have aresponsibility to ensure that the operations of Chuck Enterprises are conducted in accordance with the provisions of laws andregulations. This includes compliance with laws and regulations that determine amounts and disclosures in financialstatements, including tax liabilities and charges.

Auditors are not responsible for preventing non-compliance with laws and regulations, and cannot be expected to detect non-compliance with all laws and regulations. They have a responsibility to obtain reasonable assurance that the financialstatements are free from material misstatement, whether caused by fraud or error.

Blair & Co’s responsibility differs in relation to the two different categories of laws and regulations identified below:

– Laws and regulations which have a DIRECT effect on the determination of material amounts and disclosures in financialstatements. Here the auditor is responsible for obtaining sufficient appropriate audit evidence regarding compliance.

– Laws and regulations which DO NOT HAVE A DIRECT EFFECT on the determination of material amounts and disclosuresin financial statements, but may impact the entity’s ability to continue to trade. Here the auditor’s responsibility is limitedto specified audit procedures to help identify non-compliance with those laws and regulations that may have a materialeffect on the financial statements. This includes inquiring with management whether the entity is in compliance withsuch laws and regulations, and inspecting correspondence with relevant licensing or regulatory authorities.

Blair & Co also has a responsibility to remain alert, by maintaining professional scepticism, to the possibility that other auditprocedures may bring instances of identified or suspected non-compliance with laws and regulations.

(d) Substantive procedures to verify redundancy provision

– Discuss with the directors of Chuck Industries as to whether they have formally announced their intention to make thesales ledger department redundant, to confirm that a present obligation exists at the year end.

– If announced before the year end, review supporting documentation to verify that the decision has been formallyannounced.

– Review the board minutes to ascertain whether it is probable that the redundancy payments will be paid.

– Obtain a breakdown of the redundancy calculations by employee and cast it to ensure completeness.

– Recalculate the redundancy provision to confirm completeness and agree components of the calculation to supportingdocumentation.

– Review the post year-end period to identify whether any redundancy payments have been made, compare actualpayments to the amounts provided to assess whether the provision is reasonable.

– Obtain a written representation from management to confirm the completeness of the provision.

– Review the disclosure of the redundancy provision to ensure compliance with IAS 37 Provisions, Contingent Liabilitiesand Contingent Assets.

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(e) Reliance on internal audit

ISA 610 Using the Work of Internal Auditors details the factors the external auditors should consider in order to place relianceon the work of the internal audit (IA) department as follows:

Objectivity

They should consider the status of IA within the company and if they are independent of other departments, in particular thefinance department. In addition, consideration should be given as to who IA reports to, whether this is directly to thosecharged with governance or to a finance director.

Technical competence

The technical competence of IA staff should be considered. Consideration should be given to whether they are members of aprofessional body and have relevant qualifications and experience.

Due professional care

The external auditors should consider if the IA department have exercised due professional care, the work would need to havebeen properly planned including detailed work programmes, supervised, documented and reviewed.

Communication

In order to place reliance there needs to be effective communication between the internal auditors and the external auditor.This is most likely to occur when the IA department is free to communicate openly and regular meetings are held throughoutthe year.

2 (a) Internal control components

ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environmentconsiders the components of an entity’s internal control. It identifies the following components:

(i) Control environment

The control environment includes the governance and management functions and the attitudes, awareness, and actionsof those charged with governance and management concerning the entity’s internal control and its importance in theentity. The control environment sets the tone of an organisation, influencing the control consciousness of its people.

The control environment has many elements such as communication and enforcement of integrity and ethical values,commitment to competence, participation of those charged with governance, management’s philosophy and operatingstyle, organisational structure, assignment of authority and responsibility and human resource policies and practices.

(ii) Entity’s risk assessment process

For financial reporting purposes, the entity’s risk assessment process includes how management identifies business risksrelevant to the preparation of financial statements in accordance with the entity’s applicable financial reportingframework. It estimates their significance, assesses the likelihood of their occurrence, and decides upon actions torespond to and manage them and the results thereof.

(iii) Information system, including the related business processes, relevant to financial reporting, and communication

The information system relevant to financial reporting objectives, which includes the accounting system, consists of theprocedures and records designed and established to initiate, record, process, and report entity transactions (as well asevents and conditions) and to maintain accountability for the related assets, liabilities, and equity.

(iv) Control activities relevant to the audit

Control activities are the policies and procedures that help ensure that management directives are carried out. Controlactivities, whether within information technology or manual systems, have various objectives and are applied at variousorganisational and functional levels.

(v) Monitoring of controls

Monitoring of controls is a process to assess the effectiveness of internal control performance over time. It involvesassessing the effectiveness of controls on a timely basis and taking necessary remedial actions. Managementaccomplishes the monitoring of controls through ongoing activities, separate evaluations, or a combination of the two.Ongoing monitoring activities are often built into the normal recurring activities of an entity and include regularmanagement and supervisory activities.

(b) Audit report elements

The following elements should be included within an auditor’s report:

Title – The auditor’s report shall have a title that clearly indicates that it is the report of an independent auditor, thisdistinguishes this report from any other.

Addressee – The auditor’s report shall be addressed as required by the circumstances of the engagement, it is determined bylaw or regulation but is usually to the shareholders.

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Introductory paragraph – The introductory paragraph in the auditor’s report shall identify the entity whose financial statementshave been audited, state that the financial statements have been audited, identify the title of each statement that comprisesthe financial statements, refer to the summary of significant accounting policies and other explanatory information, andspecify the date or period covered by each financial statement.

Management’s responsibility for the financial statements – This section of the auditor’s report describes the responsibilities ofthose in the organisation who are responsible for the preparation of the financial statements. The description shall include anexplanation that management is responsible for the preparation of the financial statements in accordance with the applicablefinancial reporting framework, and for such internal control it determines is necessary to enable the preparation of thefinancial statements that are free from material misstatement, whether due to fraud or error.

Auditor’s responsibility – The auditor’s report shall state that the responsibility of the auditor is to express an opinion on thefinancial statements based on the audit and that the audit was conducted in accordance with International Standards onAuditing and ethical requirements and that the auditor plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free from material misstatement.

Opinion paragraph – When expressing an unmodified opinion the auditor’s opinion shall either state that the financialstatements ‘present fairly’ or ‘give a true and fair view’ in accordance with the applicable financial reporting framework.

Other reporting responsibilities – If the auditor addresses other reporting responsibilities in the auditor’s report, these shall beaddressed in a separate section in the auditor’s report titled ‘Report on Other Legal and Regulatory Requirements’.

Signature of the auditor – The auditor’s report must be signed, this is normally the personal name of the auditor or, if a partneris signing on behalf of the audit firm, then the signature is of the name of the firm.

Date of the auditor’s report – The auditor’s report shall be dated no earlier than the date on which the auditor has obtainedsufficient appropriate audit evidence on which to base the auditor’s opinion on the financial statements.

Auditor’s address – The auditor’s report shall name the location where the auditor practises.

3 (a) Components of audit risk

Inherent riskThe susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that could bematerial, either individually or when aggregated with other misstatements, before consideration of any related controls.

Inherent risk is affected by the nature of an entity and factors which can result in an increase include:

– Changes in the industry it operates in.– Operations that are subject to a high degree of regulation.– Going concern and liquidity issues including loss of significant customers.– Developing or offering new products or services, or moving into new lines of business.– Expanding into new locations.– Application of new accounting standards.– Accounting measurements that involve complex processes.– Events or transactions that involve significant accounting estimates.– Pending litigation and contingent liabilities.

Control riskThe risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure andthat could be material, either individually or when aggregated with other misstatements, will not be prevented, or detectedand corrected, on a timely basis by the entity’s internal control.

The following factors can result in an increase in control risk:

– Lack of personnel with appropriate accounting and financial reporting skills.– Changes in key personnel including departure of key management.– Deficiencies in internal control, especially those not addressed by management.– Changes in the information technology (IT) environment.– Installation of significant new IT systems related to financial reporting.

Detection riskThe risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect amisstatement that exists and that could be material, either individually or when aggregated with other misstatements.

Detection risk is affected by sampling and non-sampling risk and factors which can result in an increase include:

– Inadequate planning.– Inappropriate assignment of personnel to the engagement team.– Failing to apply professional scepticism.– Inadequate supervision and review of the audit work performed.– Incorrect sampling techniques performed.– Incorrect sample sizes.

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(b) Audit risks and responses

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The finance director of Abrahams is planning to capitalisethe full $2·2 million of development expenditure incurred.However in order to be capitalised it must meet all of thecriteria under IAS 38 Intangible Assets.

There is a risk that some projects may not reach finaldevelopment stage and hence should be expensed ratherthan capitalised. Intangible assets could be overstated andthis risk is increased due to the loan covenant requirementsto maintain a minimum level of assets.

A breakdown of the development expenditure should bereviewed and tested in detail to ensure that only projectswhich meet the capitalisation criteria are included as anintangible asset, with the balance being expensed.

The inventory valuation method used by Abrahams isstandard costing. This method is acceptable under IAS 2Inventories; however, only if standard cost is a closeapproximation to actual cost.

Abrahams has not updated their standard costs from whenthe product was first developed and hence there is a riskthat the standard costs could be out of date, resulting inover or undervalued inventory.

The standard costs used for the inventory valuation shouldbe tested in detail and compared to actual cost. If there aresignificant variations this should be discussed withmanagement, to ensure that the valuation is appropriate.

The work in progress balance at the year end is likely to bematerial; however there is a risk that due to the nature ofthe production process the audit team may not besufficiently qualified to assess the quantity and value ofwork in progress leading to misstated work in progress.

Consideration should be given as to whether an independentexpert is required to value the work in progress. If so thiswill need to be arranged with consent from managementand in time for the year-end count.

Over one-third of the warehouses of Abrahams belong tothird parties. Sufficient and appropriate evidence will needto be obtained to confirm the quantities of inventory held inthese locations in order to verify completeness andexistence.

Additional procedures will be required to ensure thatinventory quantities have been confirmed for both thirdparty and company owned locations.

In September Abrahams Co introduced a new accountingsystem. This is a critical system for the accounts preparationand if there were any errors that occurred during thechangeover process, these could impact on the finalamounts in the trial balance.

The new system will need to be documented in full andtesting should be performed over the transfer of data fromthe old to the new system.

The new accounting system is bespoke and the IT managerwho developed it has left the company already and hisreplacement is not due to start until just before the yearend. The accounting personnel who are using the systemmay have encountered problems and without the ITmanager’s support, errors could be occurring in the systemdue to a lack of knowledge and experience. This could resultin significant errors arising in the financial statements.

This issue should be discussed with the finance director tounderstand how he is addressing this risk of misstatement.In addition, the team should remain alert throughout theaudit for evidence of such errors.

Significant finance has been obtained in the year, $1 millionof equity finance and $2·5 million of long-term loans. Thisfinance needs to be accounted for correctly, with adequatedisclosure made. The equity finance needs to be allocatedcorrectly between share capital and share premium, and theloan should be presented as a non-current liability.

Check that the split of the equity finance is correct and thattotal financing proceeds of $3·5 million were received. Inaddition, the disclosures for this finance should be reviewedin detail to ensure compliance with relevant accountingstandards.

The loan has a number of covenants attached to it. If theseare breached then the loan would be instantly repayableand would be classified as a current liability. This couldresult in the company being in a net current liabilityposition. If the company did not have sufficient cash flow tomeet this loan repayment then there could be going concernimplications.

Review the covenant calculations prepared by Abrahams Coand identify whether any defaults have occurred; if so thendetermine the effect on the company.

The team should maintain their professional scepticism andbe alert to the risk that assets have been overstated toensure compliance with covenants.

(c) (i) Procedures to confirm inventory held at third party locations

– Send a letter requesting direct confirmation of inventory balances held at year end from the third party warehouseproviders used by Abrahams Co regarding quantities and condition.

– Attend the inventory count (if one is to be performed) at the third party warehouses to review the controls inoperation to ensure the completeness and existence of inventory.

– Inspect any reports produced by the auditors of the warehouses in relation to the adequacy of controls overinventory.

– Inspect any documentation in respect of third party inventory.

(ii) Procedures to confirm use of standard costs for inventory valuation

– Discuss with management of Abrahams Co the basis of the standard costs applied to the inventory valuation, andhow often these are reviewed and updated.

– Review the level of variances between standard and actual costs and discuss with management how these aretreated.

– Obtain a breakdown of the standard costs and agree a sample of these costs to actual invoices or wage records toassess their reasonableness.

4 (a) Corporate governance

Corporate governance is the system by which companies are directed and controlled. According to the UK CorporateGovernance Code the ‘purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management thatcan deliver the long-term success of the company’.

Corporate governance considers the responsibilities of directors, how the board of directors should be run and structured, theneed for good internal controls and the relationship with external auditors.

It is important for companies to consider good corporate governance principles as often it is management or those chargedwith governance who run the company, but the owners are the shareholders and they are not involved in the running of thebusiness.

For these shareholders their only opportunity to raise concerns is at the annual general meeting, which only occurs once ayear and often attendance is low.

Shareholders need to ensure that their needs are taken into account by management, and that there is a process in place forthem to be informed as to how the business is operating.

(b) Corporate governance weaknesses and recommendations

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The land and buildings are to be revalued at the year end, itis likely that the revaluation surplus/deficit will be material.The revaluation needs to be carried out and recorded inaccordance with IAS 16 Property, Plant and Equipment;otherwise non-current assets may be incorrectly valued.

Review the reasonableness of the valuation and recalculatethe revaluation surplus/deficit to ensure that land andbuildings are correctly valued.

The reporting timetable for Abrahams Co is likely to bereduced. The previous timetable was already quite short andany further reductions will increase detection risk and placeadditional pressure on the team in obtaining sufficient andappropriate evidence.

The timetable should be confirmed with the finance director.If it is to be reduced then consideration should be given toperforming an interim audit in late December or earlyJanuary, this would then reduce the pressure on the finalaudit.

Weakness Recommendation

The chairman of Serena VDW Co, Daniel Brown, is both thechairman and chief executive. There should be a cleardivision of responsibility at the head of the company and noone individual should have such unrestricted levels ofdecision-making, as this can lead to an abuse of power.

The roles of chairman and chief executive should be splitand not performed by the same individual. Daniel Brownshould remain as chief executive, but one of the non-executives should be appointed as chairman. CorporateGovernance principles would recommend that the chairmanshould be an independent non-executive director.

The board is comprised of four executives and two non-executive directors. There should be an appropriatebalance of executives and non-executives, to ensure that theboard makes the correct objective decisions, which are inthe best interest of the stakeholders of the company, and noindividual or group of individuals dominates the board’sdecision-making.

At least half of the board should be comprised of non-executive directors. Hence Serena VDW Co shouldconsider recruiting and appointing an additional one to twonon-executive directors.

(c) Client confidentiality

ACCA’s Code of Ethics and Conduct addresses the area of auditor confidentiality and states that auditors acquiring informationin the course of their professional work should not disclose any such information to third parties without first obtainingpermission from their clients.

Confidentiality is an implied term of auditors’ contracts with their clients. For this reason auditors should not discloseconfidential information to other persons, against their client’s wishes. The obligation of confidentiality continues even thougha professional relationship has ended.

There are, however, circumstances where auditors may disclose information to third parties without first obtaining permission.These can be categorised as obligatory and voluntary disclosures.

Obligatory

Auditors are obliged to make disclosure where, for example, there is a statutory right or duty to disclose, such as if the auditorsuspects the client is involved in money laundering, terrorism or drug trafficking in which case they must immediately notifythe relevant authorities.

In addition, auditors must make disclosure if compelled by the process of law, for example under a court order or summons,under which they are obliged to disclose information.

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Weakness Recommendation

The finance director is the only member of the board whoreviews the financial statements and budgets. However, theboard as a whole should be presented with anunderstandable assessment of Serena VDW Co’s financialposition and prospects. They should be aware of thefinancial implications of any business decisions made.

The finance director should produce financial informationand budgets and present this to either the audit committeeor the full board. This will allow all directors to understandthe financial position of the company and to make informedbusiness decisions.

The audit committee is comprised of two non-executives,the chairman and the finance director. The audit committeeis supposed to be made up of independent non-executivesas opposed to having executive directors as well. Thechairman can, for smaller companies, sit on the committeeprovided that he is an independent non-executive, which isnot the case for Serena VDW Co.

The audit committee must be comprised of non-executivesonly; the chairman and finance director should resign fromthe committee. If Serena VDW Co does appoint additionalnon-executives, then they should be invited to sit on theaudit committee as well.

The task of appointing and remunerating the externalauditors is undertaken by the chairman and the financedirector. This should be performed by the audit committeeso as to strengthen the independence of the externalauditors. If executive directors are responsible, the auditorsmay feel that if they do not provide an unmodified auditopinion then they could be removed.

The audit committee should have primary responsibility inappointing the auditors and in setting their remuneration.

In order to reduce costs, Serena VDW Co has notestablished an internal audit function. The audit committeeshould consider the effectiveness of internal controls andinternal audit could perform this role. Where there is nointernal audit function, the audit committee is required toannually consider the need for one.

Further consideration should be given to establishing aninternal audit function. Both costs and benefits should beconsidered, as it is not sufficient to solely consider costsavings.

The remuneration for the directors is set by the financedirector and chairman. However, no director should beinvolved in setting their own remuneration as this may resultin excessive levels of pay being set.

There should be a fair and transparent policy in place forsetting remuneration levels. The non-executive directorsshould decide on the remuneration of the executives. Thefinance director or chairman should decide on the pay of thenon-executives.

Executive remuneration is comprised of a salary and annualbonus. However, the pay should motivate the directors tofocus on the long-term growth of the business. Annualtargets can encourage short-term strategies rather thanmaximising shareholder wealth.

The remuneration of executives should be restructured toinclude a significant proportion aimed at long-term companyperformance. Perhaps they could be granted share options,as this would help to move the focus to the longer term.

No member of the board of directors has been subject to re-election by shareholders for over five years. Theshareholders should review on a regular basis that thecomposition of the board of directors is appropriate, andthey do this by re-electing directors.

The directors should be subject to re-election by theshareholders at regular intervals not exceeding three years.At the current year’s AGM it should be proposed that anumber of the directors are subject to re-election. Theremaining directors could then be subject to re-election nextyear.

Voluntary

In certain circumstances auditors are free, as opposed to obliged, to disclose information without obtaining the client’spermission first. These circumstances can be categorised into the four areas below:

Public interest – An auditor may disclose information which would otherwise be confidential if disclosure can be justified inthe ‘public interest’. This would be perhaps if those charged with governance are involved in fraudulent activities;

Protect a member’s interest – Members/auditors may disclose information to defend themselves against a negligence action,disciplinary proceedings or if suing for unpaid fees;

Authorised by statute/laws – There are cases of express statutory provision where disclosure of information to a properauthority overrides the duty of confidentiality;

Non-governmental bodies – Auditors may be approached by non-governmental bodies seeking information concerningsuspected acts of misconduct not amounting to a crime or civil wrong. Disclosure should only be made to those bodies withstatutory powers to compel disclosure.

5 (a) ISA 560 Subsequent Events responsibilities

Period between the year-end date and the date the auditor’s report is signed

The auditor shall perform audit procedures designed to obtain sufficient appropriate audit evidence that all events occurringbetween the date of the financial statements and the date of the auditor’s report that require adjustment of, or disclosure in,the financial statements have been identified.

The auditor is not, however, expected to perform additional audit procedures on matters to which previously applied auditprocedures have provided satisfactory conclusions.

Period between the date the auditor’s report is signed and the date the financial statements are issued

The auditor has no obligation to perform any audit procedures regarding the financial statements after the date of the auditor’sreport.

However, if a fact becomes known to the auditor that, had it been known to the auditor at the date of the auditor’s report,may have caused him to amend the auditor’s report, the auditor shall: discuss the matter with management, determinewhether the financial statements need amendment and, if so, inquire how management intends to address the matter in thefinancial statements.

If management amends the financial statements, the auditor shall carry out the necessary audit procedures, extend thesubsequent events testing to the date of the new auditor’s report, and provide a new auditor’s report on the amended financialstatements.

(b) Humphries Co

Receivable

A customer, owing $0·3 million at the year end, is experiencing significant going concern difficulties. This information wasreceived after the year end but provides further evidence of the recoverability of the receivable balance at the year end. UnderIAS 10 Events after the Reporting Period, if the customer is experiencing cash flow difficulties just a few months after theyear end, then it is highly unlikely that the $0·3m was recoverable as at 30 September.

The receivables balance is overstated and consideration should be given to adjusting this balance, if material, through theuse of an allowance for receivables or by being written off.

The following audit procedures should be applied to form a conclusion as to the level of the adjustment:

– The correspondence with the customer should be reviewed to assess whether there is any likelihood of payment.– Discuss with management as to why they feel an adjustment is not required.– Review the post year-end period to see if any payments have been received from the customer.

The receivable of $0·3 million is not material as it represents 4% of profit (0·3/7·5) and 0·4% of revenue (0·3/78) andtherefore, although overstated, it does not require adjustment. However, the $0·3m should be noted in the summary ofunadjusted errors.

As the error is immaterial then no amendment is required to the audit opinion.

Lawsuit

A key supplier is suing Humphries Co for $1 million; the company has made contingent liability disclosures. However,subsequent to the year end the supplier agreed to settle at $0·6 million and it is likely the company will agree. Although thesettlement was agreed after the year end, it provides further evidence that the company had a present obligation as at 30 September.

The financial statements should be adjusted with the contingent liability disclosures being removed and instead a provisionof $0·6 million being recorded.

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The following audit procedures should be applied to form a conclusion as to the level of the adjustment:

– The auditor should contact the company’s lawyers to ask their view as to whether the settlement is probable and whether$0·6 million is the likely amount.

– Review the correspondence with the supplier to confirm that the amount they are willing to accept is in fact $0·6 million.

– Discuss with management as to whether it is probable that they will pay this sum and obtain a written representationconfirming this.

The sum being claimed is $1 million but the probable payment is $0·6 million, this is material as it represents 8% of profit(0·6/7·5) and hence management should provide for this amount.

If management refuse to provide then the audit report will need to be modified. As management has not complied with IAS 37 Provisions, Contingent Liabilities and Contingent Assets and the error is material but not pervasive then a qualifiedopinion would be necessary.

A basis for qualified opinion paragraph would be required and would need to include a paragraph explaining the materialmisstatement in relation to the lack of a provision and the effect on the financial statements. The opinion paragraph wouldbe qualified ‘except for’.

Warehouse

The warehouse in Bass has been subject to a flood in late November, the entire inventory has been disposed of and thecompany has insurance in place. This event occurred after the year end and the flood would not have been in existence at30 September, and hence this event indicates a non-adjusting event.

The financial statements should not be adjusted; however, if the impact of any uninsured losses are material, then a disclosureof the nature of the event and any estimates of the financial impact may be required. If the amount is not material then itmay not be necessary to include any disclosures.

The following audit procedures should be applied to form a conclusion as to the extent of any disclosures:

– Discuss the matter with the directors, checking whether the company has sufficient inventory to continue trading in theshort term.

– Obtain a written representation confirming that the company’s going concern status is not impacted.– Obtain a schedule showing the inventory destroyed and compare this to the average inventory in the other two

warehouses to see if the amount claimed to be damaged is reasonable.– Review any correspondence from the insurers, confirming the amount of the insurance claim to assess the extent of any

uninsured amounts.

The amount of damaged inventory is likely to be material; however, the company has insurance and so it is only the uninsuredlevel of inventory which should possibly be disclosed.

If disclosures are not required, because the uninsured loss is immaterial, then there will be no reporting implications for theaudit report.

If disclosure of this subsequent event is required and management refuse to make these disclosures, then the audit reportwill need to be modified with a qualified ‘except for’ opinion.

If the impact of the uninsured level of inventory is such that the company’s going concern status is impacted, considerationshould be given to modifying the audit report opinion. This would involve including an emphasis of matter paragraph drawingattention to the possible risk in relation to going concern.

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Fundamentals Level – Skills Module, Paper F8 (INT)Audit and Assurance (International) December 2011 Marking Scheme

Marks1 (a) Up to 1 mark per well explained implication and up to 1 mark for each well explained recommendation

Multiple employees can be clocked inWeaker control environmentUnauthorised overtime hoursPayroll system errors not identifiedPayroll increases to be agreed by the board Written notification of pay increases to payroll departmentNight shift wages susceptible to risk of theftFactory supervisor not independent Absent night shift employees’ pay not secure over weekendJoiners/leavers notified on timely basis 12

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(b) Up to 1 mark per substantive procedure

Agree wages and salaries per payroll to trial balanceCast payroll recordsRecalculate gross and net payRecalculate statutory deductions, agree relevant to current year ratesCompare total payroll to prior yearReview monthly payroll to prior year and budgetProof in total of payrollVerify joiners/leavers and recalculate first/last payAgree salaries paid per payroll to bank transfer list and cashbookAgree total cash withdrawn from bank equates to wages paid and surplus cash bankedAgree tax liabilities to payroll and post year-end cashbookAgree the individual wages and salaries as per the payroll to the personnel records and records of hours worked per clocking in cards 6

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Management responsibility to comply with law and regulationsAuditors not responsible for preventing non-complianceAuditors – reasonable assurance financial statements free from material errorLaw and regulations – Direct effect responsibilityLaw and regulations – Indirect effect responsibilityRemain alert/Professional scepticism 4

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(d) Up to 1 mark per substantive procedure

Discuss with directors whether formal announcement made of redundanciesReview supporting documentation to confirm present obligationReview board minutes to confirm payment probableCast breakdown of redundancy provisionRecalculate provision and agree components of calculation to supporting documentationReview post year-end period to compare actual payments to amounts providedWritten representation to confirm completenessReview disclosures for compliance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets 4

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(e) Up to 1 mark per well explained point

Objectivity – independence, status and to whom reportTechnical Competence – qualifications and experienceDue professional care – properly planned and performedCommunication – between internal and external auditors 4

–––30––––––

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Marks2 (a) Up to 1 mark per well explained component, being 0·5 for stating the component and 0·5 for an

explanation

Control environment – governance and management function, attitudes awareness and actions of managementControl environment – made up of a number of elements (need to list at least 2 of these to score 1 mark)Entity’s risk assessment – process for identifying riskInformation system relevant to financial reporting – procedures and records to record an entity’s transactions, assets and liabilities and to maintain accountabilityControl activities – policies and procedures to help ensure management directives are carried outMonitoring controls – assess effectiveness of internal controls 5

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Note to markers: Please award credit for reasonable explanations of internal control components, even if not listed above

(b) Up to 1 mark per well described element

Title Addressee Introductory paragraph Management responsibilityAuditor’s responsibilityOpinion paragraph Other reporting responsibilitiesSignature of the auditorDate of the auditor’s report Auditor’s address 5

–––10––––––

3 (a) Up to 1 mark for each component of audit risk (if just a component is given without an explanation then just give 0·5) and up to 1 mark for each example of factor which increases risk.

Inherent riskControl riskDetection risk 6

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(b) Up to 1 mark per well explained risk and up to 1 mark for each well explained response. Overall max of 5 for risks and 5 for responses.

Development expenditure treatmentStandard costing for valuation of inventoryExpert possibly required in verifying work in progressThird party inventory locationsNew accounting system introduced in the yearLack of support by IT staff on new system may result in errors in accounting system New finance obtained; loans and equity finance treatmentLoan covenants and risk of going concern problemsRevaluation of land and buildingsReduced reporting timetable 10

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(c) 1 mark per well explained procedure, maximum of 2 marks for each of (i) and (ii)

(i) Third party locationsLetter requesting direct confirmationAttend inventory countReview other auditor reports and documentation 2

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(ii) Standard costingDiscuss with management basis of standard costsReview variancesBreakdown of standard costs and agree to actual costs 2

–––20––––––

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Marks4 (a) Up to 1 mark per valid point

System by which companies are directed and controlledConsiders directors’ responsibilities, board structure, importance of good internal controls and relationship with external auditors Management run the business but shareholders own the companyShareholders only have annual general meeting to raise concernsShareholders need process in place to ensure their needs met and kept informed 3

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(b) Up to 1 mark per well explained weakness and up to 1 mark per recommendation. Overall max of 6 for weaknesses and 6 for recommendations.

Chairman is chief executiveTwo of six directors are non-executive, should be at least halfFinance director alone reviews financial information and budgetsAudit committee comprised of non-executives, chairman and finance directorFinance director and chairman appoint and remunerate external auditorsNo internal audit function to save costsFinance director and chairman decide on the remuneration for the executive directorsRemuneration all in form of salary and yearly bonusNo director subject to re-election for the last five years 12

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ACCA’s Code of Ethics and Conduct – auditors should not disclose information without client consentConfidentiality implied term of engagement contractObligatory disclosure in certain circumstancesStatutory right or duty to discloseCompelled by process of lawVoluntary disclosure in certain circumstancesPublic interestProtect member’s interestAuthorised by statute/lawsNon-governmental bodies 5

–––20––––––

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Marks5 (a) Up to 1 mark per valid point

Auditor shall perform audit procedures to identify subsequent events requiring adjustment or disclosureNo need to perform additional procedures for areas already tested No obligation to perform audit procedures on financial statements after auditor’s report signed Discuss with management if fact known which may have changed audit reportDetermine if adjustments required, if so discuss with managementIf amended then audit adjustment, extend subsequent events testing, provide new auditor’s report 5

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(b) Up to 1 mark per valid point, overall maximum of 5 marks per event.

ReceivableProvides evidence of conditions at the year endReceivable to be adjusted via write down or allowanceReview correspondence with customerDiscuss with managementReview post year-end period for cash receiptsCalculation of materialityNo audit report modification required 5

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LawsuitProvides evidence of present obligation at the year endProvision required and not contingent liability disclosuresDiscuss with company lawyerReview correspondence with supplierDiscuss with management and obtain written representationCalculation of materialityType of audit report modification requiredImpact on audit report 5

–––

WarehouseProvides evidence of conditions that arose subsequent to the year endNo adjustment required, possible disclosure of any uninsured sumsDiscuss with management whether sufficient levels of inventory to continue operatingObtain written representation that going concern status appropriateObtain schedule of damaged inventory and review reasonablenessReview correspondence with insurance firm to assess levels of uninsured goodsCalculation of materialityType of audit report modification requiredImpact on audit report 5

–––20––––––

24







Pape

r F8

(IN

T)


Thursday 14 June 2012



1 Pear International Co (Pear) is a manufacturer of electrical equipment. It has factories across the country and itscustomer base includes retailers as well as individuals, to whom direct sales are made through their website. Thecompany’s year end is 30 September 2012. You are an audit supervisor of Apple & Co and are currently reviewingdocumentation of Pear’s internal control in preparation for the interim audit.

Pear’s website allows individuals to order goods directly, and full payment is taken in advance. Currently the websiteis not integrated into the inventory system and inventory levels are not checked at the time when orders are placed.

Goods are despatched via local couriers; however, they do not always record customer signatures as proof that thecustomer has received the goods. Over the past 12 months there have been customer complaints about the delaybetween sales orders and receipt of goods. Pear has investigated these and found that, in each case, the sales orderhad been entered into the sales system correctly but was not forwarded to the despatch department for fulfilling.

Pear’s retail customers undergo credit checks prior to being accepted and credit limits are set accordingly by salesledger clerks. These customers place their orders through one of the sales team, who decides on sales discount levels.

Raw materials used in the manufacturing process are purchased from a wide range of suppliers. As a result of staffchanges in the purchase ledger department, supplier statement reconciliations are no longer performed. Additionally,changes to supplier details in the purchase ledger master file can be undertaken by purchase ledger clerks as well assupervisors.

In the past six months Pear has changed part of its manufacturing process and as a result some new equipment hasbeen purchased, however, there are considerable levels of plant and equipment which are now surplus torequirement. Purchase requisitions for all new equipment have been authorised by production supervisors and littlehas been done to reduce the surplus of old equipment.

Required:

(a) In respect of the internal control of Pear International Co:

(i) Identify and explain FIVE deficiencies;(ii) Recommend a control to address each of these deficiencies; and (iii) Describe a test of control Apple & Co would perform to assess if each of these controls is operating

effectively. (15 marks)

(b) Describe substantive procedures you should perform at the year end to confirm each of the following for plantand equipment:

(i) Additions; and(ii) Disposals. (4 marks)

(c) Pear’s finance director has expressed an interest in Apple & Co performing other review engagements in additionto the external audit; however, he is unsure how much assurance would be gained via these engagements andhow this differs to the assurance provided by an external audit.

Required:

Identify and explain the level of assurance provided by an external audit and other review engagements.(3 marks)

2

Pear’s directors are considering establishing an internal audit department next year, and the finance director has askedabout the differences between internal audit and external audit and what impact, if any, establishing an internal auditdepartment would have on future external audits performed by Apple & Co.

Required:

(d) Distinguish between internal audit and external audit. (4 marks)

(e) Explain the potential impact on the work performed by Apple & Co during the interim and final audits, if PearInternational Co was to establish an internal audit department. (4 marks)

(30 marks)

3 [P.T.O.

2 (a) ISA 300 Planning an Audit of Financial Statements provides guidance to assist auditors in planning an audit.

Required:

Explain the benefits of audit planning. (4 marks)

(b) ISA 530 Audit Sampling provides guidance on methods for selecting a sample of items for testing.

Required:

Identify and explain THREE methods of selecting a sample. (3 marks)

(c) Describe the three types of modified audit opinions. (3 marks)

(10 marks)

3 (a) Explain the external auditors’ responsibilities in relation to the prevention and detection of fraud and error.(4 marks)

You are the audit manager of Currant & Co and you are planning the audit of Orange Financials Co (Orange), whospecialise in the provision of loans and financial advice to individuals and companies. Currant & Co has auditedOrange for many years.

The directors are planning to list Orange on a stock exchange within the next few months and have asked if theengagement partner can attend the meetings with potential investors. In addition, as the finance director of Orange islikely to be quite busy with the listing, he has asked if Currant & Co can produce the financial statements for thecurrent year.

During the year, the assistant finance director of Orange left and joined Currant & Co as a partner. It has beensuggested that due to his familiarity with Orange, he should be appointed to provide an independent partner reviewfor the audit.

Once Orange obtains its stock exchange listing it will require several assignments to be undertaken, for example,obtaining advice about corporate governance best practice. Currant & Co is very keen to be appointed to theseengagements, however, Orange has implied that in order to gain this work Currant & Co needs to complete the externalaudit quickly and with minimal questions/issues.

The finance director has informed you that once the stock exchange listing has been completed, he would like theengagement team to attend a weekend away at a luxury hotel with his team, as a thank you for all their hard work.In addition, he has offered a senior member of the engagement team a short-term loan at a significantly reducedinterest rate.

Required:

(b) (i) Explain SIX ethical threats which may affect the independence of Currant & Co’s audit of OrangeFinancials Co; and

(ii) For each threat explain how it might be reduced to an acceptable level. (12 marks)

(c) Orange is aware that subsequent to the stock exchange listing it will need to establish an audit committee andhas asked for some advice in relation to this.

Required:

Explain the benefits to Orange of establishing an audit committee. (4 marks)

(20 marks)

4

4 (a) (i) Identify and explain FOUR financial statement assertions relevant to account balances at the year end;and

(ii) For each identified assertion, describe a substantive procedure relevant to the audit of year-endinventory. (8 marks)

(b) Pineapple Beach Hotel Co (Pineapple) operates a hotel providing accommodation, leisure facilities andrestaurants. Its year end was 30 April 2012. You are the audit senior of Berry & Co and are currently preparingthe audit programmes for the year end audit of Pineapple. You are reviewing the notes of last week’s meetingbetween the audit manager and finance director where two material issues were discussed.

Depreciation

Pineapple incurred significant capital expenditure during the year on updating the leisure facilities for the hotel.The finance director has proposed that the new leisure equipment should be depreciated over 10 years using thestraight-line method.

Food poisoning

Pineapple’s directors received correspondence in March from a group of customers who attended a wedding atthe hotel. They have alleged that they suffered severe food poisoning from food eaten at the hotel and areclaiming substantial damages. Pineapple’s lawyers have received the claim and believe that the lawsuit againstthe company is unlikely to be successful.

Required:

Describe substantive procedures to obtain sufficient and appropriate audit evidence in relation to the abovetwo issues.

Note: The total marks will be split equally between each issue. (8 marks)

(c) List and explain the purpose of FOUR items that should be included on every working paper prepared by theaudit team. (4 marks)

(20 marks)

5 [P.T.O.

5 (a) Explain the three stages of an audit when analytical procedures can be used by the auditor. (3 marks)

You are the audit manager of Kiwi & Co and you have been provided with financial statements extracts and thefollowing information about your client, Strawberry Kitchen Designs Co (Strawberry), who is a kitchen manufacturer.The company’s year end is 30 April 2012.

Strawberry has recently been experiencing trading difficulties, as its major customer who owes $0·6m to Strawberryhas ceased trading, and it is unlikely any of this will be received. However the balance is included within the financialstatements extracts below. The sales director has recently left Strawberry and has yet to be replaced.

The monthly cash flow has shown a net cash outflow for the last two months of the financial year and is forecast asnegative for the forthcoming financial year. As a result of this, the company has been slow in paying its suppliers andsome are threatening legal action to recover the sums owing.

Due to its financial difficulties, Strawberry missed a loan repayment and, as a result of this breach in the loancovenants, the bank has asked that the loan of $4·8m be repaid in full within six months. The directors have decidedthat in order to conserve cash, no final dividend will be paid in 2012.

Financial statements extracts for year ended 30 April:

DRAFT ACTUAL2012 2011$m $m

Current AssetsInventory 3·4 1·6Receivables 1·4 2·2Cash – 1·2

Current LiabilitiesTrade payables 1·9 0·9Overdraft 0·8 –Loans 4·8 0·2

Required:

(b) Explain the potential indicators that Strawberry Kitchen Designs Co is not a going concern. (6 marks)

(c) Describe the audit procedures that you should perform in assessing whether or not the company is a goingconcern. (6 marks)

(d) Having performed the going concern audit procedures, you have serious concerns in relation to the going concernstatus of Strawberry. The finance director has informed you that as the cash flow issues are short term he doesnot propose to make any amendments to the financial statements.

Required:

(i) State Kiwi & Co’s responsibility for reporting on going concern to the directors of Strawberry KitchenDesigns Co; and (2 marks)

(ii) If the directors refuse to amend the financial statements, describe the impact on the audit report.(3 marks)

(20 marks)


6

Answers

Fundamentals Level – Skills Module, Paper F8 (INT)Audit and Assurance (International) June 2012 Answers

1 (a) Pear International’s (Pear) internal control

9

Deficiency Control Test of control

Currently the website is not integratedinto inventory system.

This can result in Pear acceptingcustomer orders when they do not havethe goods in inventory. This can causethem to lose sales and customergoodwill.

The website should be updated toinclude an interface into the inventorysystem; this should check inventorylevels and only process orders ifadequate inventory is held. If inventoryis out of stock, this should appear onthe website with an approximate waitingtime.

Test data could be used to attempt toprocess orders via the website for itemswhich are not currently held ininventory. The orders should be flaggedas being out of stock and indicate anapproximate waiting time.

For goods despatched by local couriers,customer signatures are not alwaysobtained.

This can lead to customers falselyclaiming that they have not receivedtheir goods. Pear would not be able toprove that they had in fact despatchedthe goods and may result in goodsbeing despatched twice.

Pear should remind all local couriersthat customer signatures must beobtained as proof of despatch andpayment will not be made for anydespatches with missing signatures.

Select a sample of despatches bycouriers and ask Pear for proof ofdespatch by viewing customersignatures.

There have been a number of situationswhere the sales orders have not beenfulfilled in a timely manner.

This can lead to a loss of customergoodwill and if it persists will damagethe reputation of Pear as a reliablesupplier.

Once goods are despatched they shouldbe matched to sales orders and flaggedas fulfilled.

The system should automatically flagany outstanding sales orders past a predetermined period, such as five days.This report should be reviewed by aresponsible official.

Review the report of outstanding salesorders. If significant, discuss with aresponsible official to understand whythere is still a significant time periodbetween sales order and despatch date.

Select a sample of sales orders andcompare the date of order to the goodsdespatch date to ascertain whether thisis within the acceptable predeterminedperiod.

Customer credit limits are set by salesledger clerks.

Sales ledger clerks are not sufficientlysenior and so may set limits too high,leading to irrecoverable debts, or toolow, leading to a loss of sales.

Credit limits should be set by a seniormember of the sales ledger departmentand not by sales ledger clerks. Theselimits should be regularly reviewed by aresponsible official.

For a sample of new customersaccepted in the year, review theauthorisation of the credit limit, andensure that this was performed by aresponsible official.

Enquire of sales ledger clerks as to whocan set credit limits.

Sales discounts are set by Pear’s salesteam.

In order to boost their sales, members ofthe sales team may set the discountstoo high, leading to a loss of revenue.

All members of the sales team shouldbe given authority to grant salesdiscounts up to a set limit. Any salesdiscounts above these limits should beauthorised by sales area managers orthe sales director.

Regular review of sales discount levelsshould be undertaken by the salesdirector, and this review should beevidenced.

Discuss with members of the sales team the process for setting sales discounts.

Review the sales discount report forevidence of review by the sales director.

Supplier statement reconciliations areno longer performed.

This may result in errors in therecording of purchases and payables notbeing identified in a timely manner.

Supplier statement reconciliationsshould be performed on a monthly basisfor all suppliers and these should bereviewed by a responsible official.

Review the file of reconciliations toensure that they are being performed ona regular basis and that they have beenreviewed by a responsible official.

(b) Substantive procedures – Additions and disposals

Additions– Obtain a breakdown of additions, cast the list and agree to the non-current asset register to confirm completeness of

plant & equipment (P&E).– Select a sample of additions and agree cost to supplier invoice to confirm valuation.– Verify rights and obligations by agreeing the addition of plant and equipment to a supplier invoice in the name of Pear.– Review the list of additions and confirm that they relate to capital expenditure items rather than repairs and maintenance.– Review board minutes to ensure that significant capital expenditure purchases have been authorised by the board.– For a sample of additions recorded in P&E physically verify them on the factory floor to confirm existence.

Disposals– Obtain a breakdown of disposals, cast the list and agree all assets removed from the non-current asset register to confirm

existence.– Select a sample of disposals and agree sale proceeds to supporting documentation such as sundry sales invoices.– Recalculate the profit/loss on disposal and agree to the income statement.

(c) Levels of assurance

The level of assurance provided by audit and other review engagements is as follows:

AuditExternal Audit – A high but not absolute level of assurance is provided, this is known as reasonable assurance. This providescomfort that the financial statements are true and fair and are free of material misstatements.

Other review engagementsOther review engagements where an opinion is being provided, the practitioner gathers sufficient evidence to be satisfied thatthe subject matter is plausible; in this case negative assurance is given whereby the practitioner confirms that nothing hascome to his attention which indicates that the subject matter contains material misstatements.

(d) Differences between internal and external audit

10

Deficiency Control Test of control

Changes to supplier details in thepurchase ledger master file can beundertaken by purchase ledger clerks.

This could lead to key supplier databeing accidently amended or fictioussuppliers being set up, which canincrease the risk of fraud.

Only purchase ledger supervisors shouldhave the authority to make changes tomaster file data. This should becontrolled via passwords.

Regular review of any changes tomaster file data by a responsible officialand this review should be evidenced.

Request a purchase ledger clerk toattempt to access the master file and tomake an amendment, the systemshould not allow this.

Review a report of master data changesand review the authority of thosemaking amendments.

Pear has considerable levels of surplusplant and equipment.

Surplus unused plant is at risk of theft.In addition, if the surplus plant is notdisposed of then the company couldlose sundry income.

Regular review of the plant andequipment on the factory floor by seniorfactory personnel to identify any old orsurplus equipment.

As part of the capital expenditureprocess there should be a requirementto confirm the treatment of theequipment being replaced.

Observe the review process by seniorfactory personnel, identifying thetreatment of any old equipment.

Review processed capital expenditureforms to ascertain if the treatment ofreplaced equipment is stated.

Purchase requisitions are authorised byproduction supervisors.

Production supervisors are notsufficiently independent or senior toauthorise capital expenditure.

Capital expenditure authorisation levelsto be established. Productionsupervisors should only be able toauthorise low value items, any highvalue items should be authorised by theboard.

Review a sample of authorised capitalexpenditure forms and identify if thecorrect signatory has authorised them.

External Audit Internal Audit

Objective

The main objective of the external auditor is to express anopinion on the truth and fairness of the financial statements.

The main objective of internal audit is to improve acompany’s operations, by reviewing the efficiency andeffectiveness of the company’s internal controls.

Reporting

External auditors report to the shareholders or members ofthe company. External audit reports are contained within thefinancial statements and hence are publicly available.

Internal auditors normally report to management or thosecharged with governance. Internal audit reports not publiclyavailable and are only intended to be seen by the addresseeof the report. The reports are normally provided to the boardof directors and those charged with governance such as theaudit committee.

(e) Impact on interim and final audit

Interim auditApple & Co could look to rely on any internal control documentation produced by internal audit (IA) as they would need toassess whether the control environment has changed during the year.

If the IA department has performed testing during the year on internal control systems, such as the payroll, sales and purchasesystems, then Apple & Co could review and possibly place reliance on this work. This may result in the workload reducingand possibly a decrease in the external audit fee.

During the interim audit, Apple & Co would need to perform a risk assessment to assist in the planning process. It is possiblethat the IA department may have conducted a risk assessment and so Apple could use this as part of their initial planningprocess.

Apple & Co would need to consider the risk of fraud and error and non-compliance with law and regulations resulting inmisstatements in the financial statements. This is also an area for IA to consider, hence there is scope for Apple & Co to reviewthe work and testing performed by IA to assist in this risk assessment.

Final auditIt is possible that the IA department may assist with year-end inventory counting and controls and so Apple & Co can placesome reliance on the work performed by them, however, they would still need to attend the count and perform their ownreduced testing.

2 (a) Benefits of audit planning

Audit planning is addressed by ISA 300 Planning an Audit of Financial Statements. It states that adequate planning benefitsthe audit of financial statements in several ways:

– Helping the auditor to devote appropriate attention to important areas of the audit.– Helping the auditor to identify and resolve potential problems on a timely basis.– Helping the auditor to properly organise and manage the audit engagement so that it is performed in an effective and

efficient manner.– Assisting in the selection of engagement team members with appropriate levels of capabilities and competence to

respond to anticipated risks and the proper assignment of work to them.– Facilitating the direction and supervision of engagement team members and the review of their work.– Assisting, where applicable, in coordination of work done by experts.

(b) Sampling methods

Methods of sampling in accordance with ISA 530 Audit Sampling:

Random selection – Ensures each item in a population has an equal chance of selection, for example, by using randomnumber generators or tables.

Systematic selection – This involves having a constant sampling interval, such as every 40th item being selected, the startingpoint for testing is determined randomly.

Monetary Unit Sampling – This is a type of value-weighted selection in which sample size, selection and evaluation resultsin a conclusion in monetary amounts.

Haphazard selection – Here the auditor selects the sample without following a structured technique. The auditor must ensurethat no conscious bias or predictability arises and this method is not appropriate when using statistical sampling.

Block selection – This involves selection of a block(s) of contiguous items from within the population. Block selection cannotordinarily be used in audit sampling because most populations are structured such that items in a sequence can be expectedto have similar characteristics to each other, but different characteristics from items elsewhere in the population.

11

External Audit Internal Audit

Scope of work

The external auditor’s work is limited to verifying the truthand fairness of the financial statements of the company.

The internal auditor can have a wide scope of work and it isdetermined by the requirements of management or thosecharged with governance. Commonly internal audit focus onthe company’s internal control environment, but any otherarea of a company’s operations can be reviewed.

Relationship with company

External auditors are appointed by the company’sshareholders. They are independent of the company.

Internal auditors are appointed by management. As internalauditors are normally employees of the company they lackindependence. However, the internal audit department canbe outsourced and this can increase their independence.

(c) Audit report modifications

As per ISA 705 Modifications to the Opinion in the Independent Auditor’s Report identifies three types of modifications whichresult in the opinion being modified:

Qualified opinion – Arises where the auditor concludes, having obtained sufficient evidence, that material BUT NOT pervasivemisstatements are present in the financial statements.

A qualified opinion also arises where the auditor is unable to obtain sufficient evidence on which to base an opinion and thepossible effect on the financial statements is material BUT NOT pervasive.

Adverse opinion – Where the auditor, having obtained sufficient appropriate audit evidence, concludes that misstatements areBOTH material and pervasive to the financial statements.

Disclaimer of opinion – When the auditor is unable to obtain sufficient appropriate audit evidence on which to base theopinion, and the auditor concludes that the possible effects on the financial statements of undetected misstatements couldbe BOTH material and pervasive.

3 (a) Responsibilities of auditor in relation to fraud and error

An auditor conducting an audit in accordance with ISA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit ofFinancial Statements is responsible for obtaining reasonable assurance that the financial statements taken as a whole are freefrom material misstatement, whether caused by fraud or error.

In order to fulfil this responsibility auditors are required to identify and assess the risks of material misstatement of the financialstatements due to fraud.

The auditor will need to obtain sufficient appropriate audit evidence regarding the assessed risks of material misstatementdue to fraud, through designing and implementing appropriate responses.

In addition, the auditor must respond appropriately to fraud or suspected fraud identified during the audit.

When obtaining reasonable assurance, the auditor is responsible for maintaining professional scepticism throughout the audit,considering the potential for management override of controls and recognising the fact that audit procedures that are effectivein detecting error may not be effective in detecting fraud.

To ensure that the whole engagement team is aware of the risks and responsibilities for fraud and error, ISAs require that adiscussion is held within the team. For members not present at the meeting the engagement partner should determine whichmatters are to be communicated to them.

(b) Ethical threats and managing these risks

12

Ethical Threat Managing Risk

Orange Financials Co (Orange) has asked the engagementpartner of Currant & Co to attend meetings with potentialinvestors. This represents an advocacy threat as the auditfirm may be perceived as promoting investment in Orangeand this threatens objectivity.

The engagement partner should politely decline this requestfrom Orange, as it represents too great a threat toindependence.

Due to the stock exchange listing, Orange has requestedthat Currant & Co produce the financial statements. Thisrepresents a self-review threat. As Orange is currently not alisted company then Currant & Co are permitted to producethe financial statements and also audit them.

However, Orange is seeking a listing and therefore thesefinancial statements will be critical to the potential investorsand this increases audit risk.

Ideally, Currant & Co should not undertake the preparationof the financial statements. Due to the imminent listing, thiswould probably represent too high a risk.

If Currant & Co choose to produce the financial statementsthen separate teams should undertake each assignment andthe audit team should not be part of the accountspreparation process.

The assistant finance director of Orange has joined Currant& Co as a partner and has been proposed as the reviewpartner.

This represents a self-review threat, as he was in a positionto influence the financial statements whilst working atOrange; if he is the review partner there could be a risk ofhim reviewing his own work.

This partner must not be involved in the audit of Orange fora period of at least two years. An alternative review partnershould be appointed.

(c) Benefits of audit committee for Orange Financials Co

Appointing an audit committee will benefit Orange in the following ways:

– It will help to improve the quality of the financial reporting of Orange; whilst the company already has a finance director,the audit committee will assist by reviewing the financial statements.

– The establishment of an audit committee can help to improve the internal control environment of the company. The auditcommittee is able to devote more time and attention to areas such as internal controls.

– Orange does not currently have any non-executive directors, hence once appointed, they will bring considerable outsideexperience to the executive directors as well as challenging their decisions and contributing to an independentjudgement.

– The finance director will benefit in that he will be able to raise concerns and discuss accounting issues with the auditcommittee.

– The audit committee will be responsible for appointing the external auditors and this will strengthen the auditors’independence and contribute to a channel of communication and forum of issues.

– If Orange has an internal audit (IA) department, then establishing an audit committee will also improve theindependence of IA.

– The audit committee can also provide advice on risk management to the executive directors. They can create a climateof discipline and control and reduce the opportunity for fraud, and increase the public confidence in the credibility andobjectivity of the financial statements.

4 (a) Financial statement assertions and inventory substantive procedures for balances at the year end.

(i) ExistenceAssets, liabilities and equity interests exist.

Substantive proceduresDuring the inventory count select a sample of assets recorded in the inventory records and agree to the warehouse toconfirm the assets exist.

Obtain a sample of pre year-end goods despatch notes and agree that these finished goods are excluded from theinventory records.

(ii) Rights and obligationsThe entity holds or controls the rights to assets, and liabilities are the obligations of the entity.

13

Ethical Threat Managing Risk

Orange has several potential assurance assignmentsavailable and Currant & Co wish to be appointed to these.There is a potential self-interest threat as these assurancefees along with the external audit fee could represent asignificant proportion of Currant & Co’s fee income.

The firm should assess whether these assignments alongwith the audit fee would represent more than 15% of grosspractice income for two consecutive years. These assuranceassignments will only arise if the company obtains its listingand hence will be a public interest company.

If the recurring fees are likely to exceed 15% of annualpractice income then additional consideration should begiven as to whether these assignments should be sought bythe firm.

Orange has implied to Currant & Co that they must completethe audit quickly and with minimal questions/issues if theywish to obtain the assurance assignments.

This creates an intimidation threat on the team as they mayfeel pressure to cut corners and not raise issues, and thiscould compromise the objectivity of the audit team.

The engagement partner should politely inform the financedirector that the team will undertake the audit in accordancewith all relevant ISAs and their own quality controlprocedures. This means that the audit will take as long as isnecessary to obtain sufficient, appropriate evidence to forman opinion. If any residual concerns remain or theintimidation threat continues then Currant & Co may need toconsidering resigning from the engagement.

The finance director has offered the team a free weekendaway at a luxury hotel. This represents a self-interest threatas the acceptance of goods and services, unless insignificantin value, is not permitted.

As it is unlikely that a weekend at a luxury hotel for thewhole team has an insignificant value, then this offer shouldbe politely declined.

The finance director has offered a senior team member aloan at discounted interest rates.

Orange does provide loans and hence the provision of aloan is within the normal course of business. However, if theloan is on preferential rates, as this is, then it wouldrepresent a self-interest threat.

This loan must not be accepted by the audit senior due tothe preferential terms.

However, if the terms of the loan are amended so that theinterest rate charged is in line with Orange’s normal levels,then the provision of the loan is acceptable.

Substantive proceduresConfirm during the inventory count that any goods belonging to third parties are excluded from the inventory recordsand count.

For year-end raw materials and finished goods confirm title belongs to the company by agreeing goods to a recentpurchase invoice in the company name.

(iii) CompletenessAll assets, liabilities and equity interests that should have been recorded have been recorded.

Substantive proceduresObtain a copy of the inventory listing and agree the total to the general ledger and the financial statements.

During the inventory count select a sample of goods physically present in the warehouse and confirm recorded in theinventory records.

(iv) Valuation and allocationAssets, liabilities and equity interests are included in the financial statements at appropriate amounts and any resultingvaluation or allocation adjustments are appropriately recorded.

Substantive proceduresSelect a sample of goods in inventory at the year end, agree the cost per the records to a recent purchase invoice andensure that the cost is correctly stated.

Select a sample of year-end goods and review post year-end sales invoices to ascertain if net realisable value is abovecost or if an adjustment is required.

(b) Substantive procedures

Depreciation

– Review the reasonableness of the depreciation rates applied to the new leisure facilities and compare to industryaverages.

– Review the capital expenditure budgets for the next few years to assess whether there are any plans to replace any ofthe new leisure equipment, as this would indicate that the useful life is less than 10 years.

– Review profits and losses on disposal of assets disposed of in the year, to assess the reasonableness of the depreciationpolicies.

– Select a sample of leisure equipment and recalculate the depreciation charge to ensure that the non-current asset registeris correct.

– Perform a proof in total calculation for the depreciation charged on the equipment, discuss with management ifsignificant fluctuations arise.

– Review the disclosure of the depreciation charges and policies in the draft financial statements.

Food poisoning

– Review the correspondence from the customers claiming food poisoning to assess whether Pineapple has a presentobligation as a result of a past event.

– Send an enquiry letter to the lawyers of Pineapple to obtain their view as to the probability of the claim being successful.– Review board minutes to understand whether the directors believe that the claim will be successful or not.– Review the post year-end period to assess whether any payments have been made to any of the claimants.– Discuss with management as to whether they propose to include a contingent liability disclosure or not, consider the

reasonableness of this.– Obtain a written management representation confirming management’s view that the lawsuit is unlikely to be successful

and hence no provision is required.– Review the adequacy of any disclosures made in the financial statements.

(c) Working papers

– Name of client – identifies the client being audited. – Year-end date – identifies the year end to which the audit working papers relate. – Subject – identifies the area of the financial statements that is being audited, the topic area of the working paper, such

as receivables circularisation. – Working paper reference – provides a clear reference to identify the number of the working paper, for example, R12

being the 12th working paper in the audit of receivables.– Preparer – identifies the name of the audit team member who prepared the working paper, so any queries can be

directed to the relevant person. – Date prepared – the date that the audit work was performed by the team member; this helps to identify what was known

at the time and what issues may have occurred subsequently.– Reviewer – the name of the audit team member who reviewed the working paper; this provides evidence that the audit

work was reviewed by an appropriate member of the team.– Date of review – the date the audit work was reviewed by the senior member of the team; this should be prior to the

date that the audit report was signed.

14

– Objective of work/test – the aim of the work being performed, could be the related financial statement assertion; thisprovides the context for why the audit procedure is being performed.

– Details of work performed – the audit tests performed along with sufficient detail of items selected for testing.– Results of work performed – whether any exceptions arose in the audit work and if any further work is required.– Conclusion – the overall conclusion on the audit work performed, whether the area is true and fair.

5 (a) Analytical procedures

Analytical procedures can be used at all stages of an audit; however, ISA 315 Identifying and Assessing the Risks of MaterialMisstatement through Understanding the Entity and Its Environment and ISA 520 Analytical Procedures identify threeparticular stages.

During the planning stage analytical procedures must be used as risk assessment procedures in order to help the auditor toobtain an understanding of the entity and assess the risk of material misstatement.

During the final audit analytical procedures can be used to obtain sufficient appropriate evidence. Substantive procedures caneither be tests of detail or substantive analytical procedures.

At the final review stage the auditor must design and perform analytical procedures that assist him when forming an overallconclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity.

(b) Going concern indicators

(i) A major customer of Strawberry Kitchen Designs Co (Strawberry) has ceased trading owing them $0·6m. This will resultin a significant loss of future revenues and profit, and unless this customer can be replaced then there will be a reductionof future cash flows.

(ii) The sales director has recently left the company and has yet to be replaced. Loss of a key director will impact on thecompany’s sales, as Strawberry has already lost a major customer, then without an experienced sales director to generatenew sales the company will face significantly reduced sales and cash flows.

(iii) Strawberry is experiencing negative monthly cash flows and this is expected to continue. If the company continues tohave cash outflows then it will increase its overdraft further and will start to run out of available cash.

(iv) The company has been late paying some of its suppliers. If suppliers are being paid late then they may refuse to supplyStrawberry with goods or impose ‘cash on delivery’ terms which will disrupt service or sales to customers.

(v) A number of the suppliers are threatening legal action. If this occurs then Strawberry will have legal costs on top of theamounts owed already and this will further increase the pressure on cash flows. In addition, other suppliers may hearabout the legal action and, as a result, stop supplying goods to Strawberry.

(vi) Strawberry has missed a loan repayment which is a breach in the loan covenant and hence the loan of $4·8m is nowall repayable. The company only has six months to raise $4·8m; as it currently stands they do not have this level ofcash available and unless they are able to raise alternative finance or sell non-current assets, it is difficult to see howthey will be able to raise this amount.

(vii) In order to conserve cash Strawberry has decided not to pay a final dividend for 2012. This may result in shareholderslosing faith in the company and they may attempt to sell their shares; in addition, they are highly unlikely to invest furtherequity, and Strawberry urgently needs to raise finance to repay their loans.

(viii) The current ratio has significantly declined from 4·55 (1·6 + 2·2 + 1·2/0·9 + 0·2) in 2011 to 0·64 (3·4 + 1·4/1·9+ 0·8 + 4·8) in 2012. The current ratio is showing that the current assets are not sufficient to pay the current liabilities.This is another indication of the worsening liquidity position of the company, which has mainly occurred due to the loanbecoming repayable.

(c) Going concern procedures

– Obtain the company’s cash flow forecast and review the cash in and out flows. Assess the assumptions forreasonableness and discuss the findings with management to understand if the company will have sufficient cash flows.

– Perform a sensitivity analysis on the cash flows to understand the margin of safety the company has in terms of its netcash in/out flow.

– Discuss with the finance director whether the sales director has yet been replaced and whether any new customers havebeen obtained to replace the one lost.

– Review the company’s post year-end sales and order book to assess if the levels of trade are likely to increase and if therevenue figures in the cash flow forecast are reasonable.

– Review the loan agreement and recalculate the covenant which has been breached. Confirm the timing and amount ofthe loan repayment.

– Review any agreements with the bank to determine whether any other covenants have been breached, especially inrelation to the overdraft.

– Discuss with the directors whether they have contacted any alternative banks for finance to assess whether they haveany other means of repaying the loan of $4·8m.

15

– Review any correspondence with shareholders to assess whether any of these are likely to increase their equityinvestment in the company.

– Review post year-end correspondence with suppliers to identify if any others have threatened legal action or refused tosupply goods.

– Enquire of the lawyers of Strawberry as to the existence of any additional litigation and request their assessment of thelikely amounts payable to the suppliers.

– Perform audit tests in relation to subsequent events to identify any items that might indicate or mitigate the risk of goingconcern not being appropriate.

– Review the post year-end board minutes to identify any other issues that might indicate further financial difficulties forthe company.

– Review post year-end management accounts to assess if in line with cash flow forecast.– Consider whether the going concern basis is appropriate for the preparation of the financial statements.– Obtain a written representation confirming the director’s view that Strawberry is a going concern.

(d) (i) Reporting in relation to going concern to the directors of Strawberry Kitchen Designs Co

Kiwi & Co has a responsibility to report to the directors in relation to any events or conditions which may cast doubt onStrawberry’s ability to continue as a going concern. These include:

– Whether the events or conditions constitute a material uncertainty;– Whether the use of the going concern assumption is appropriate in the preparation of the financial statements; and– The adequacy of related disclosures in the financial statements.

(ii) Audit report

The directors do not wish to make any amendments to the financial statements. However, if we believe that Strawberryis not a going concern then the audit report will need to be modified. An adverse opinion will be required regardless ofwhether or not the financial statements include disclosure of the inappropriateness of management’s use of the goingconcern assumption as the financial statements are materially misstated, and the misstatements are material andpervasive to the financial statements.

The basis for adverse opinion paragraph will require an explanation that the use of the going concern basis isinappropriate. The opinion paragraph will state that the financial statements do not present fairly or are not true and fair.

16

Fundamentals Level – Skills Module, Paper F8 (INT)Audit and Assurance (International) June 2012 Marking Scheme

Marks1 (a) Up to 1 mark per deficiency, up to 1 mark per well explained control and up to 1 mark for each

well explained test of control, max of 5 for deficiencies, max of 5 for controls and max of 5 for tests of control.

Website not integrated into inventory systemCustomer signaturesUnfulfilled sales ordersCustomer credit limitsSales discountsSupplier statement reconciliationsPurchase ledger master fileSurplus plant and equipmentAuthorisation of capital expenditure 15

–––

(b) Up to 1 mark per substantive procedure, max of 2 for additions and max of 2 for disposals.

AdditionsCast list of additions and agree to non-current asset registerVouch cost to recent supplier invoiceAgree addition to a supplier invoice in the name of Pear to confirm rights and obligationsReview additions and confirm capital expenditure items rather than repairs and maintenanceReview board minutes to ensure authorised by the boardPhysically verify them on the factory floor to confirm existence

DisposalsCast list of disposals and agree removed from non-current asset registerVouch sale proceeds to supporting documentation such as sundry sales invoicesRecalculate the profit/loss on disposal 4

–––

(c) Up to 1½ marks per well explained point

External audit – Reasonable assuranceOther review engagements – Negative assurance 3

–––

(d) Up to 1 mark per well explained point

ObjectiveWhom they report toReports – publicly available or notScope of workAppointed byIndependence of company 4

–––

(e) Up to 1 mark per well explained point

Interim auditSystems documentationTesting of systems such as payroll, sales, purchases Risk assessmentFraud and error, non-compliance with law and regulations

Final auditInventory count procedures 4

–––30––––––

17

Marks2 (a) Up to 1 mark per well explained point

Important areas of the auditPotential problemsEffective and efficient auditSelection of engagement team members and assignment of workDirection, supervision and reviewCoordination of work 4

–––

(b) Up to 1 mark per well explained point, if the method is identified but not explained then maximum of ½ mark.

Random selectionSystematic selectionMonetary unit samplingHaphazard selectionBlock selection 3

–––

(c) Up to 1 mark per well explained point

Qualified opinion – misstatements which are material but not pervasiveQualified opinion – cannot obtain sufficient evidence, possible misstatements which are material but not pervasiveAdverse opinionDisclaimer of opinion 3

–––10––––––

3 (a) Up to 1 mark per well explained point

Per ISA 240 – obtain reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or errorIdentify and assess the risks of material misstatement due to fraudObtain sufficient appropriate audit evidenceRespond appropriately to fraud or suspected fraud identified during the auditMaintain professional scepticism throughout the auditDiscussion within the engagement team 4

–––

(b) Up to 1 mark per ethical threat and up to 1 mark per managing method, max of 6 for threats and max 6 for methods

Engagement partner attending listing meetingPreparation of financial statementsAssistant finance director as review partner on auditTotal fee incomePressure to complete audit quickly and with minimal issuesWeekend away at luxury hotelProvision of loan at preferential rates 12

–––


Improve the quality of the financial reportingImprove the internal control environment of the companyNon-executives will bring outside experience to the executive directorsThe finance director will be able to raise concerns with the audit committeeThe audit committee will be responsible for appointing the external auditorsEstablishing an audit committee will improve the independence of IAProvide advice on risk management to the executive directors 4

–––20––––––

18

Marks4 (a) Up to 1 mark per assertion, ½ mark for stating assertion and ½ mark for explanation, max of 4 marks;

up to 1 mark per relevant inventory substantive procedure, max of 4 marks.

Existence – explanation and relevant substantive procedureRights and obligations – explanation and relevant substantive procedure Completeness – explanation and relevant substantive procedure Valuation and allocation – explanation and relevant substantive procedure 8

–––

(b) Up to 1 mark per relevant substantive procedure, max of 4 marks for each issue.

DepreciationReview the reasonableness of the depreciation rates and compare to industry averagesReview the capital expenditure budgetsReview profits and losses on disposal for assets disposed of in yearRecalculate the depreciation charge for a sample of assetsPerform a proof in total calculation for the depreciation charged on the equipmentReview the disclosure of depreciation in the draft financial statements

Food poisoningReview the correspondence from the customersSend an enquiry to the lawyers as to the probability of the claim being successfulReview board minutesReview the post year-end period to assess whether any payments have been madeDiscuss with management as to whether they propose to include a contingent liability disclosure Obtain a written management representation Review any disclosures made in the financial statements 8

–––

(c) Up to 1 mark per well explained point, ½ mark only if just identifies item to be included, max of 4 points.

Name of client Year-end dateSubjectWorking paper referencePreparerDate preparedReviewerDate of reviewObjective of work/testDetails of work performedResults of work performedConclusion 4

–––20––––––

19


Planning stage – risk assessment proceduresDuring the final audit – substantive proceduresReview stage – form overall conclusion 3

–––

(b) Up to 1 mark per explanation of why this could indicate going concern problems, if just identify indicator then max of ½ mark.

Loss of major customerLoss of sales directorNegative monthly cash flowsSlow payment to suppliersPotential legal actionBreach of covenants and loan now repayableNo final dividendLow current ratio 6

–––


Review cash flow forecastsSensitivity analysisDiscuss if sales director replaced and new customers obtainedReview post year-end sales and order bookReview the loan agreement and recalculate the covenant breached to confirm timing and amount of the loan repayment Review bank agreements, breach of covenantsReview bank correspondenceDiscuss if alternative finance obtainedReview shareholders’ correspondenceReview suppliers’ correspondenceEnquire of lawyers any further litigation by suppliersSubsequent eventsBoard minutesManagement accountsConsider going concern basis appropriateWritten representation 6

–––

(d) (i) Up to 1 mark per well explained point

Events or conditions constitute a material uncertaintyUse of the going concern assumption is appropriateAdequacy of disclosures in the financial statements 2

–––

(ii) Up to 1 mark per well explained point

Not going concern therefore modified opinionAdverse opinionBasis for adverse opinion paragraph, going concern basis not appropriateOpinion paragraph, financial statements not true and fair 3

–––20––––––

20







Pape

r F8

(IN

T)





1 Lily Window Glass Co (Lily) is a glass manufacturer, which operates from a large production facility, where itundertakes continuous production 24 hours a day, seven days a week. Also on this site are two warehouses, wherethe company’s raw materials and finished goods are stored. Lily’s year end is 31 December.

Lily is finalising the arrangements for the year-end inventory count, which is to be undertaken on 31 December 2012.The finished windows are stored within 20 aisles of the first warehouse. The second warehouse is for large piles ofraw materials, such as sand, used in the manufacture of glass. The following arrangements have been made for theinventory count:

The warehouse manager will supervise the count as he is most familiar with the inventory. There will be ten teamsof counters and each team will contain two members of staff, one from the finance and one from the manufacturingdepartment. None of the warehouse staff, other than the manager, will be involved in the count.

Each team will count an aisle of finished goods by counting up and then down each aisle. As this process issystematic, it is not felt that the team will need to flag areas once counted. Once the team has finished counting anaisle, they will hand in their sheets and be given a set for another aisle of the warehouse. In addition to the above,to assist with the inventory counting, there will be two teams of counters from the internal audit department and theywill perform inventory counts.

The count sheets are sequentially numbered, and the product codes and descriptions are printed on them but noquantities. If the counters identify any inventory which is not on their sheets, then they are to enter the item on aseparate sheet, which is not numbered. Once all counting is complete, the sequence of the sheets is checked andany additional sheets are also handed in at this stage. All sheets are completed in ink.

Any damaged goods identified by the counters will be too heavy to move to a central location, hence they are to beleft where they are but the counter is to make a note on the inventory sheets detailing the level of damage.

As Lily undertakes continuous production, there will continue to be movements of raw materials and finished goodsin and out of the warehouse during the count. These will be kept to a minimum where possible.

The level of work-in-progress in the manufacturing plant is to be assessed by the warehouse manager. It is likely thatthis will be an immaterial balance. In addition, the raw materials quantities are to be approximated by measuring theheight and width of the raw material piles. In the past this task has been undertaken by a specialist; however, thewarehouse manager feels confident that he can perform this task.

Required:

(a) For the inventory count arrangements of Lily Window Glass Co:

(i) Identify and explain SIX deficiencies; and(ii) Provide a recommendation to address each deficiency.

The total marks will be split equally between each part (12 marks)

2

You are the audit senior of Daffodil & Co and are responsible for the audit of inventory for Lily. You will be attendingthe year-end inventory count on 31 December 2012.

In addition, your manager wishes to utilise computer-assisted audit techniques for the first time for controls andsubstantive testing in auditing Lily Window Glass Co’s inventory.

Required:

(b) Describe the procedures to be undertaken by the auditor DURING the inventory count of Lily Window GlassCo in order to gain sufficient appropriate audit evidence. (6 marks)

(c) For the audit of the inventory cycle and year-end inventory balance of Lily Window Glass Co:

(i) Describe FOUR audit procedures that could be carried out using computer-assisted audit techniques(CAATS);

(ii) Explain the potential advantages of using CAATs; and (iii) Explain the potential disadvantages of using CAATs.

The total marks will be split equally between each part (12 marks)

(30 marks)

3 [P.T.O.

2 (a) In order for auditors to operate effectively and to provide an opinion on an entity’s financial statements, they aregiven certain rights.

Required:

State THREE rights of an auditor, excluding those related to resignation and removal. (3 marks)

(b) ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and ItsEnvironment requires auditors to obtain an understanding of control activities relevant to the audit.

Control activities are the policies and procedures that help ensure that management directives are carried out;and which are designed to prevent and detect fraud and error occurring. An example of a control activity is themaintenance of a control account.

Required:

Apart from maintenance of a control account, explain FOUR control activities a company may undertake toprevent and detect fraud and error. (4 marks)

(c) Describe THREE limitations of external audits. (3 marks)

(10 marks)

4

3 Sunflower Stores Co (Sunflower) operates 25 food supermarkets. The company’s year end is 31 December 2012.The audit manager and partner recently attended a planning meeting with the finance director and have provided youwith the planning notes below.

You are the audit senior, and this is your first year on this audit. In order to familiarise yourself with Sunflower, theaudit manager has asked you to undertake some research in order to gain an understanding of Sunflower, so that youare able to assist in the planning process. He has then asked that you identify relevant audit risks from the notesbelow and also consider how the team should respond to these risks.

Sunflower has spent $1·6 million in refurbishing all of its supermarkets; as part of this refurbishment programme theircentral warehouse has been extended and a smaller warehouse, which was only occasionally used, has beendisposed of at a profit. In order to finance this refurbishment, a sum of $1·5 million was borrowed from the bank.This is due to be repaid over five years.

The company will be performing a year-end inventory count at the central warehouse as well as at all 25 supermarketson 31 December. Inventory is valued at selling price less an average profit margin as the finance director believes thatthis is a close approximation to cost.

Prior to 2012, each of the supermarkets maintained their own financial records and submitted returns monthly tohead office. During 2012 all accounting records have been centralised within head office. Therefore at the beginningof the year, each supermarket’s opening balances were transferred into head office’s accounting records. The increasedworkload at head office has led to some changes in the finance department and in November 2012 the financialcontroller left. His replacement will start in late December.

Required:

(a) List FIVE sources of information that would be of use in gaining an understanding of Sunflower Stores Co,and for each source describe what you would expect to obtain. (5 marks)

(b) Using the information provided, describe FIVE audit risks and explain the auditor’s response to each risk inplanning the audit of Sunflower Stores Co. (10 marks)

(c) The finance director of Sunflower Stores Co is considering establishing an internal audit department.

Required:

Describe the factors the finance director should consider before establishing an internal audit department.(5 marks)

(20 marks)

5 [P.T.O.

4 (a) Identify and explain each of the FIVE fundamental principles contained within ACCA’s Code of Ethics andConduct. (5 marks)

(b) Rose Leisure Club Co (Rose) operates a chain of health and fitness clubs. Its year end was 31 October 2012.You are the audit manager and the year-end audit is due to commence shortly. The following three matters havebeen brought to your attention.

(i) Trade payables and accruals

Rose’s finance director has notified you that an error occurred in the closing of the purchase ledger at theyear end. Rather than it closing on 1 November, it accidentally closed one week earlier on 25 October. Allpurchase invoices received between 25 October and the year end have been posted to the 2013 year-endpurchase ledger. (6 marks)

(ii) Receivables

Rose’s trade receivables have historically been low as most members pay monthly in advance. However,during the year a number of companies have taken up group memberships at Rose and hence thereceivables balance is now material. The audit senior has undertaken a receivables circularisation for thebalances at the year end; however, there are a number who have not responded and a number of responseswith differences. (5 marks)

(iii) Reorganisation

The company recently announced its plans to reorganise its health and fitness clubs. This will involve closingsome clubs for refurbishment, retraining some existing staff and disposing of some surplus assets. Theseplans were agreed at a board meeting in October and announced to their shareholders on 29 October. Roseis proposing to make a reorganisation provision in the financial statements. (4 marks)

Required:

Describe substantive procedures you would perform to obtain sufficient and appropriate audit evidence inrelation to the above three matters.

Note: The mark allocation is shown against each of the three matters above.

(20 marks)

6

5 (a) Explain the purpose of, and procedures for, obtaining written representations. (5 marks)

(b) The directors of a company have provided the external audit firm with an oral representation confirming that thebank overdraft balances included within current liabilities are complete.

Required:

Describe the relevance and reliability of this oral representation as a source of evidence to confirm thecompleteness of the bank overdraft balances. (3 marks)

(c) You are the audit manager of Violet & Co and you are currently reviewing the audit files for several of your clientsfor which the audit fieldwork is complete. The audit seniors have raised the following issues:

Daisy Designs Co (Daisy)

Daisy’s year end is 30 September, however, subsequent to the year end the company’s sales ledger has beencorrupted by a computer virus. Daisy’s finance director was able to produce the financial statements prior to thisoccurring; however, the audit team has been unable to access the sales ledger to undertake detailed testing ofrevenue or year-end receivables. All other accounting records are unaffected and there are no backups availablefor the sales ledger. Daisy’s revenue is $15·6m, its receivables are $3·4m and profit before tax is $2m.

Fuchsia Enterprises Co (Fuchsia)

Fuchsia has experienced difficult trading conditions and as a result it has lost significant market share. The cashflow forecast has been reviewed during the audit fieldwork and it shows a significant net cash outflow.Management are confident that further funding can be obtained and so have prepared the financial statementson a going concern basis with no additional disclosures; the audit senior is highly sceptical about this. The prioryear financial statements showed a profit before tax of $1·2m; however, the current year loss before tax is $4·4mand the forecast net cash outflow for the next 12 months is $3·2m.

Required:

For each of the two issues:

(i) Discuss the issue, including an assessment of whether it is material;(ii) Recommend procedures the audit team should undertake at the completion stage to try to resolve the

issue; and (iii) Describe the impact on the audit report if the issue remains unresolved.

Notes: 1 The total marks will be split equally between each issue. 2 Audit report extracts are NOT required. (12 marks)

(20 marks)


7

Answers

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International) December 2012 Answers

1 (a) Inventory count arrangements

11

Deficiencies Recommendations

The warehouse manager is planning to supervise theinventory count. Whilst he is familiar with the inventory, hehas overall responsibility for the inventory and so is notindependent. He may want to hide inefficiencies and anyissues that arise so that his department is not criticised.

An alternative supervisor who is not normally involved withthe inventory, such as an internal audit manager, shouldsupervise the inventory count. The warehouse manager andhis team should not be involved in the count at all.

There are ten teams of counters, each team having twomembers of staff. However, there is no clear division ofresponsibilities within the team. Therefore, both members ofstaff could count together rather than checking each other’scount; and errors in their count may not be identified.

Each team should be informed that both members arerequired to count their assigned inventory separately.Therefore, one counts and the second member checks thatthe inventory has been counted correctly.

The internal audit teams are undertaking inventory countsrather than reviewing the controls and performing sampletest counts. Their role should be focused on confirming theaccuracy of the inventory counting procedures.

The internal audit counters should sample check thecounting undertaken by the ten teams to provide an extracontrol over the completeness and accuracy of the count.

Once areas are counted, the teams are not flagging theaisles as completed. Therefore there is the risk that someareas of the warehouse could be double counted or missedout.

All aisles should be flagged as completed, once the inventoryhas been counted. In addition, internal audit or the countsupervisor should check at the end of the count that all 20aisles have been flagged as completed.

Inventory not listed on the sheets is to be entered ontoseparate sheets, which are not sequentially numbered.Therefore the supervisor will be unable to ensure thecompleteness of all inventory sheets.

Each team should be given a blank sheet for entering anyinventory count which is not on their sheets. This blanksheet should be sequentially numbered, any unused sheetsshould be returned at the end of the count, and thesupervisor should check the sequence of all sheets at theend of the count.

The sheets are completed in ink and are sequentiallynumbered, however, there is no indication that they aresigned by the counting team. Therefore if any issues arisewith the counting in an aisle, it will be difficult to follow upas the identity of the counting team will not be known.

All inventory sheets should be signed by the relevant teamupon completion of an aisle. When the sheets are returned,the supervisor should check that they have been signed.

Damaged goods are not being stored in a central area, andinstead the counter is just noting on the inventory sheets thelevel of damage. However, it will be difficult for the financeteam to decide on an appropriate level of write down if theyare not able to see the damaged goods. In addition, if thesegoods are left in the aisles, they could be inadvertently soldto customers or moved to another aisle.

Damaged goods should be clearly flagged by the countingteams and at the end of the count appropriate machineryshould be used to move all damaged windows to a centrallocation. This will avoid the risk of selling these goods.

A senior member of the finance team should then inspectthese goods to assess the level of any write down orallowance.

Lily Window Glass Co (Lily) undertakes continuousproduction and so there will be movements of goods duringthe count. Inventory records could be under/overstated ifgoods are missed or double counted due to movements inthe warehouse.

It is not practical to stop all inventory movements as theproduction needs to continue. However, any raw materialsrequired for 31 December should be estimated and put toone side. These will not be included as raw materials andinstead will be work-in-progress.

The goods which are manufactured on 31 December shouldbe stored to one side, and at the end of the count should becounted once and included within finished goods.

Any goods received from suppliers should be stored in onelocation and counted once at the end and included as partof raw materials. Goods to be despatched to customersshould be kept to a minimum for the day of the count.

(b) Procedures during the inventory count

– Observe the counting teams of Lily to confirm whether the inventory count instructions are being followed correctly. – Select a sample and perform test counts from inventory sheets to warehouse aisle and from warehouse aisle to inventory

sheets.– Confirm the procedures for identifying and segregating damaged goods are operating correctly. – Select a sample of damaged items as noted on the inventory sheets and inspect these windows to confirm whether the

level of damage is correctly noted.– Observe the procedures for movements of inventory during the count, to confirm that no raw materials or finished goods

have been omitted or counted twice.– Obtain a photocopy of the completed sequentially numbered inventory sheets for follow up testing on the final audit.– Identify and make a note of the last goods received notes (GRNs) and goods despatched notes (GDNs) for 31 December

in order to perform cut-off procedures. – Observe the procedures carried out by the warehouse manager in assessing the level of work-in-progress and consider

the reasonableness of any assumptions used.– Discuss with the warehouse manager how he has estimated the raw materials quantities. To the extent that it is possible,

re-perform the procedures adopted by the warehouse manager. – Identify and record any inventory held for third parties (if any) and confirm that it is excluded from the count.

(c) Computer-assisted audit techniques (CAATS)

(i) Audit procedures using CAATS

The audit team can use audit software to calculate inventory days for the year-to-date to compare against the prior yearto identify whether inventory is turning over slower, as this may be an indication that it is overvalued.

Audit software can be utilised to produce an aged inventory analysis to identify any slow moving goods, which mayrequire write down or an allowance.

Cast the inventory listing to confirm the completeness and accuracy of inventory.

Audit software can be used to select a representative sample of items for testing to confirm net realisable value and/orcost.

Audit software can be utilised to recalculate cost and net realisable value for a sample of inventory.

CAATs can be used to verify cut-off by testing whether the dates of the last GRNs and GDNs recorded relate to pre yearend; and that any with a date of 1 January 2013 onwards have been excluded from the inventory records.

CAATs can be used to confirm whether any inventory adjustments noted during the count have been correctly updatedinto final inventory records.

(ii) Advantages of using CAATS

– CAATs enable the audit team to test a large volume of inventory data accurately and quickly. – If CAATs are utilised on the audit of Lily, then as long as they do not change their inventory systems, they can be

cost effective after setup.– CAATs can test program controls within the inventory system as well as general IT controls, such as passwords.– Allows the team to test the actual inventory system and records rather than printouts from the system which could

be incorrect.– CAATs reduce the level of human error in testing and hence provide a better quality of audit evidence.– CAATs results can be compared with traditional audit testing; if these two sources agree, then overall audit

confidence will increase. – The use of CAATs frees up audit team members to focus on judgemental and high risk areas, rather than number

crunching.

(iii) Disadvantages of using CAATS

– The cost of using CAATs in this first year will be high as there will be significant set up costs, it will also be a time-consuming process which increases costs.

12

Deficiencies Recommendations

The warehouse manager is to assess the level of work-in-progress and raw materials. In the past, a specialisthas undertaken this role. It is unlikely that the warehousemanager has the experience to assess the level of work-in-progress as this is something that the factorymanager would be more familiar with.

A specialist should be utilised to assess both work-in-progress and the quantities of raw materials.

In addition, whilst the warehouse manager is familiar withthe raw materials, if he makes a mistake in assessing thequantities then inventory could be materially misstated.

With regards to the warehouse manager, he could estimatethe raw materials and the specialist could check it. Thiswould give an indication as to whether he is able toaccurately assess the quantities for subsequent inventorycounts.

– As this is the first time that CAATs will be used on Lily’s audit, then the team may require training on the specificCAATs to be utilised.

– If Lily’s inventory system is likely to change in the foreseeable future, then costly revisions may be required to thedesigned CAATs.

– The inventory system may not be compatible with the audit firm’s CAATs, in which case bespoke CAATs may berequired, which will increase the audit costs.

– If testing is performed over the live inventory system, then there is a risk that the data could be corrupted or lost.– If testing is performed using copy files rather than live data, then there is the risk that these files are not genuine

copies of the actual files.– In order to perform CAATs, there must be adequate systems documentation available. If this is not the case for Lily,

then it will be more difficult to devise appropriate CAATs due to a lack of understanding of the inventory system.

2 (a) Auditors’ rights

– Right of access at all times to the company’s books, accounts and vouchers.– Right to require from an officer of the company such information or explanations as they think necessary for the

performance of their duties as auditors.– Right to receive all communications relating to written resolutions.– Right to receive all notices of, and other communications relating to, any general meeting which a member of the

company is entitled to receive.– Right to attend any general meeting of the company.– Right to be heard at any general meeting which an auditor attends on any part of the business of the meeting which

concerns them as auditor.

(b) Control activities

Segregation of duties – assignment of roles/responsibilities to different people, thereby reducing the risk of fraud and erroroccurring.

Information processing – computer controls including general IT controls, which cover a range of applications and supportthe overall IT environment and application controls which are manual or automated controls which operate on acycle/business process level.

Authorisation – approval of transactions by a suitably responsible official to ensure transactions are genuine.

Physical controls – restricting access to physical assets such as cash, inventory and plant and equipment, thereby reducingthe risk of theft.

Performance reviews – comparison or review of the performance of the business by looking at areas such as budget v actualresults.

Arithmetical controls – controls which check the arithmetical accuracy of accounting records.

Account reconciliations – comparison of an account balance with another source; often this source is from a third party, suchas the bank, with differences being investigated.

(c) Limitations of external audits

An external audit has a number of limitations which reduce its usefulness:

Sampling – it is not practical for an auditor to test 100% of transactions and so they have to apply sampling methodologiesin selecting balances/transactions to test. Therefore, there could be an error in an item not selected for testing by the auditor.

Subjectivity – financial statements include judgemental and subjective areas and therefore the auditor is required to use theirjudgement in assessing whether the financial statements are true and fair.

Inherent limitations of internal control systems – an internal control system is operated by people and hence is liable to humanerror. In addition, there is the possibility of controls override by management and of collusion and fraud. It is impossible toremove all of these inherent limitations and as the auditor relies on the internal control systems, this can reduce the usefulnessof the audit.

Evidence is persuasive not conclusive – the opinion is based on audit evidence gathered; however, while this evidence canindicate possible issues affecting the audit opinion, evidence involves estimates and judgements and hence does not give adefinite conclusion.

Audit report format – the format of the opinion is determined by International Standards on Auditing. However, the terminologyused is not usually understood by non-accountants. This means that users may not actually understand the audit opiniongiven.

Historic information – the audit report is often issued some time after the year end, and so the financial information can bequite different to the current position. In the current marketplace where companies’ financial positions can change quitequickly, the audit opinion may no longer be relevant as it is out of date.

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3 (a) Understanding an entity

Source of information Information expect to obtainPrior year audit file Identification of issues that arose in the prior year audit and how

these were resolved. Also whether any points brought forward werenoted for consideration for this year’s audit.

Prior year financial statements Provides information in relation to the size of the entity as well as thekey accounting policies and disclosure notes.

Accounting systems notes Provides information on how each of the key accounting systemsoperates.

Discussions with management Provides information in relation to any important issues which havearisen or changes to the company during the year.

Current year budgets and management Provides relevant financial information for the year to date. Will help accounts of Sunflower Stores Co (Sunflower) the auditor to identify whether Sunflower has changed materially since

last year. In addition, this will be useful for preliminary analyticalreview and risk identification.

Permanent audit file Provides information in relation to matters of continuing importancefor the company and the audit team, such as statutory booksinformation or important agreements.

Sunflower’s website Recent press releases from the company may provide background onchanges to the business during the year as this could lead toadditional audit risks.

Prior year report to management Provides information on the internal control deficiencies noted in theprior year; if these have not been rectified by management then theycould arise in the current year audit as well.

Financial statements of competitors This will provide information about Sunflower’s competitors, inrelation to their financial results and their accounting policies. Thiswill be important in assessing Sunflower’s performance in the yearand also when undertaking the going concern review.

(b) Audit risks and auditor responses

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Audit risk Auditor response

Sunflower has spent $1·6m on refurbishing its 25 foodsupermarkets. This expenditure needs to be reviewed toassess whether it is of a capital nature and should beincluded within non-current assets or expensed as repairs.

Review a breakdown of the costs and agree to invoices toassess the nature of the expenditure and, if capital, agree toinclusion within the asset register and, if repairs, agree tothe income statement.

During the year a small warehouse has been disposed of ata profit. The asset needs to have been correctly removedfrom property plant and equipment to ensure the non-currentasset register is not overstated, and the profit on disposalshould be included within the income statement.

Review the non-current asset register to ensure that theasset has been removed. Also confirm the disposal proceedsas well as recalculating the profit on disposal.

Consideration should be given as to whether the profit ondisposal is significant enough to warrant separate disclosurewithin the income statement.

Sunflower has borrowed $1·5m from the bank via a five year loan. This loan needs to be correctly split betweencurrent and non-current liabilities.

In addition, Sunflower may have given the bank a chargeover its assets as security for the loan. There is a risk thatthe disclosure of any security given is not complete.

During the audit the team would need to confirm that the$1·5m loan finance was received. In addition, the splitbetween current and non-current liabilities and thedisclosures for this loan should be reviewed in detail toensure compliance with relevant accounting standards.

The loan agreement should be reviewed to ascertain whetherany security has been given, and this bank should becircularised as part of the bank confirmation process.

Sunflower will be undertaking a number of simultaneousinventory counts on 31 December including the warehouseand all 25 supermarkets. It is not practical for the auditor toattend all of these counts; hence it may not be possible togain sufficient appropriate audit evidence over inventorycounts.

The team should select a sample of sites to visit. It is likelythat the warehouse contains most goods and thereforeshould be selected. In relation to the 25 supermarkets, theteam should visit those with material inventory balancesand/or those with a history of inventory count issues.

(c) Internal audit department

Prior to establishing an internal audit (IA) department, the finance director of Sunflower should consider the following:

(i) The costs of establishing an IA department will be significant, therefore prior to committing to these costs andmanagement time, a cost benefit analysis should be performed.

(ii) The size and complexity of Sunflower should be considered. The larger, more complex and diverse a company is, thenthe greater the need for an IA department. At Sunflower there are 25 supermarkets and a head office and therefore itwould seem that the company is diverse enough to gain benefit from an IA department.

(iii) The role of any IA department should be considered. The finance director should consider what tasks he would envisageIA performing. He should consider whether he wishes them to undertake inventory counts at the stores, or whether hewould want them to undertake such roles as internal controls reviews.

(iv) Having identified the role of any IA department, the finance director should consider whether there are existing managersor employees who could perform these tasks, therefore reducing the need to establish a separate IA department.

(v) The finance director should assess the current control environment and determine whether there are departments orstores with a history of control deficiencies. If this is the case, then it increases the need for an IA department.

(vi) If the possibility of fraud is high, then the greater the need for an IA department to act as both a deterrent and also topossibly undertake fraud investigations. As Sunflower operates 25 food supermarkets, it will have a significant risk offraud of both inventory and cash.

4 (a) Fundamental principles

Integrity – to be straightforward and honest in all professional and business relationships.

Objectivity – to not allow bias, conflict of interest or undue influence of others to override professional or business judgements.

Professional Competence and Due Care – to maintain professional knowledge and skill at the level required to ensure that aclient receives competent professional services, and to act diligently and in accordance with applicable technical andprofessional standards.

Confidentiality – to respect the confidentiality of information acquired as a result of professional and business relationshipsand, therefore, not to disclose any such information to third parties without proper authority, nor use the information forpersonal advantage.

Professional Behaviour – to comply with relevant laws and regulations and avoid any action that discredits the profession.

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Audit risk Auditor response

Sunflower’s inventory valuation policy is selling price lessaverage profit margin. Inventory should be valued at thelower of cost and net realisable value (NRV) and if this is notthe case, then inventory could be under or overvalued.

IAS 2 Inventories allows this as an inventory valuationmethod as long as it is a close approximation to cost. If thisis not the case, then inventory could be under or overvalued.

Testing should be undertaken to confirm cost and NRV ofinventory and that on a line-by-line basis the goods arevalued correctly.

In addition, valuation testing should focus on comparing thecost of inventory to the selling price less margin to confirmwhether this method is actually a close approximation tocost.

The opening balances for each supermarket have beentransferred into the head office’s accounting records at thebeginning of the year. There is a risk that if this transfer hasnot been performed completely and accurately, the openingbalances may not be correct.

Discuss with management the process undertaken totransfer the data and the testing performed to confirm thetransfer was complete and accurate.

Computer-assisted audit techniques could be utilised by theteam to sample test the transfer of data from eachsupermarket to head office to identify any errors.

There has been an increased workload for the financedepartment, the financial controller has left and hisreplacement will only start in late December.

This increases the inherent risk within Sunflower as errorsmay have been made within the accounting records by theoverworked finance team members. The new financialcontroller may not be sufficiently experienced to produce thefinancial statements and resolve any audit issues.

The team should remain alert throughout the audit foradditional errors within the finance department.

In addition, discuss with the finance director whether he willbe able to provide the team with assistance for any auditissues the new financial controller is unable to resolve.

(b) Substantive procedures

(i) Trade payables and accruals

– Calculate the trade payable days for Rose Leisure Clubs Co (Rose) and compare to prior years, investigate anysignificant difference, in particular any decrease for this year.

– Compare the total trade payables and list of accruals against prior year and investigate any significant differences.– Discuss with management the process they have undertaken to quantify the understatement of trade payables due

to the cut-off error and consider the materiality of the error.– Discuss with management whether any correcting journal entry has been included for the understatement.– Select a sample of purchase invoices received between the period of 25 October and the year end and follow them

through to inclusion within accruals or as part of the trade payables journal adjustment.– Review after date payments; if they relate to the current year, then follow through to the purchase ledger or accrual

listing to ensure they are recorded in the correct period.– Obtain supplier statements and reconcile these to the purchase ledger balances, and investigate any reconciling

items.– Select a sample of payable balances and perform a trade payables’ circularisation, follow up any non-replies and

any reconciling items between the balance confirmed and the trade payables’ balance.– Select a sample of goods received notes before the year end and after the year end and follow through to inclusion

in the correct period’s payables balance, to ensure correct cut-off.

(ii) Receivables

– For non-responses, with the client’s permission, the team should arrange to send a follow up circularisation.– If the receivable does not respond to the follow up, then with the client’s permission, the senior should telephone

the customer and ask whether they are able to respond in writing to the circularisation request.– If there are still non-responses, then the senior should undertake alternative procedures to confirm receivables.– For responses with differences, the senior should identify any disputed amounts, and identify whether these relate

to timing differences or whether there are possible errors in the records of Rose.– Any differences due to timing, such as cash in transit, should be agreed to post year-end cash receipts in the cash

book.– The receivables ledger should be reviewed to identify any possible mispostings as this could be a reason for a

response with a difference.– If any balances have been flagged as disputed by the receivable, then these should be discussed with management

to identify whether a write down is necessary.

(iii) Reorganisation

– Review the board minutes where the decision to reorganise the business was taken, ascertain if this decision wasmade pre year end.

– Review the announcement to shareholders in late October, to confirm that this was announced before the year end. – Obtain a breakdown of the reorganisation provision and confirm that only direct expenditure from restructuring is

included.– Review the expenditure to confirm that there are no retraining costs included. – Cast the breakdown of the reorganisation provision to ensure correctly calculated.– For the costs included within the provision, agree to supporting documentation to confirm validity of items included.– Obtain a written representation confirming management discussions in relation to the announcement of the

reorganisation.– Review the adequacy of the disclosures of the reorganisation in the financial statements to ensure they are in

accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

5 (a) Written representations

Written representations are necessary information that the auditor requires in connection with the audit of the entity’s financialstatements. Accordingly, similar to responses to inquiries, written representations are audit evidence.

The auditor needs to obtain written representations from management and, where appropriate, those charged with governancethat they believe they have fulfilled their responsibility for the preparation of the financial statements and for the completenessof the information provided to the auditor.

Written representations are needed to support other audit evidence relevant to the financial statements or specific assertionsin the financial statements, if determined necessary by the auditor or required by other International Standards on Auditing.This may be necessary for judgemental areas where the auditor has to rely on management explanations.

Written representations can be used to confirm that management have communicated to the auditor all deficiencies in internalcontrols of which management are aware.

Written representations are normally in the form of a letter, written by the company’s management and addressed to theauditor. The letter is usually requested from management but can also be requested from the chief operating officer or chieffinancial officer. Throughout the fieldwork, the audit team will note any areas where representations may be required.

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During the final review stage, the auditors will produce a draft representation letter. The directors will review this and thenproduce it on their letterhead.

It will be signed by the directors and dated as at the date the audit report is signed, but not after.

(b) Oral representation

A representation from management confirming that overdrafts are complete would be relevant evidence. Overdrafts areliabilities and therefore the main focus for the auditor is completeness.

With regards to reliability, the evidence is oral rather than written and so this reduces its reliability. The directors could in thefuture deny having given this representation, and the auditors would have no documentary evidence to prove what thedirectors had said.

This evidence is obtained from management rather than being auditor generated, and is therefore less reliable. Managementmay wish to provide biased evidence in order to reduce the amount of liabilities in the financial statements. The auditors areunbiased and so evidence generated directly by them will be better.

External evidence obtained from the company’s banks could be used to confirm the bank overdraft balances and this wouldbe more independent than relying on management’s internal confirmations.

(c) Daisy Designs Co (Daisy)

(i) Daisy’s sales ledger has been corrupted by a computer virus; hence no detailed testing has been performed on revenueand receivables. The audit team will need to see if they can confirm revenue and receivables in an alternative manner.If they are unable to do this, then two significant balances in the financial statements will not have been confirmed.Revenue and receivables are both higher than the total profit before tax (PBT) of $2m; receivables are 170% of PBTand revenue is nearly eight times the PBT; hence this is a very material issue.

(ii) Procedures to be adopted include:

– Discuss with management whether they have any alternative records which detail revenue and receivables for theyear.

– Attempt to perform analytical procedures, such as proof in total or monthly comparison to last year, to gain comfortin total for revenue and for receivables.

(iii) The auditors will need to modify the audit report as they are unable to obtain sufficient appropriate evidence in relationto two material and pervasive areas, being receivables and revenue. Therefore a disclaimer of opinion will be required.

A basis for disclaimer of opinion paragraph will be required to explain the limitation in relation to the lack of evidenceover revenue and receivables. The opinion paragraph will be a disclaimer of opinion and will state that we are unableto form an opinion on the financial statements.

Fuchsia Enterprises Co (Fuchsia)

(i) Fuchsia is facing going concern problems as it has experienced difficult trading conditions and it has a negative cashoutflow. However, the financial statements have been prepared on a going concern basis, even though it is possible thatthe company is not a going concern. The prior year financial statements showed a profit of $1·2m and the currentfinancial statements show a loss before tax of $4·4m, the net cash outflow of $3·2m represents 73% of this loss(3·2/4·4m) and hence is a material issue.

(ii) Management are confident that further funding can be obtained; however, the team is sceptical and so the followingprocedures should be adopted:

– Discuss with management whether any finance has now been secured. – Review the correspondence with the finance provider to confirm the level of funding that is to be provided and this

should be compared to the net cash outflow of $3·2m.– Review the most recent board minutes to understand whether management’s view on Fuchsia’s going concern has

altered.– Review the cash flow forecasts for the year and assess the reasonableness of the assumptions adopted.

(iii) If management refuse to amend the going concern basis of the financial statements or at the very least make adequategoing concern disclosures, then the audit report will need to be modified. As the going concern basis is probably incorrectand the error is material and pervasive, then an adverse opinion would be necessary.

A basis for adverse opinion paragraph will be required to explain the inappropriate use of the going concern assumption.The opinion paragraph will be an adverse opinion and will state that the financial statements do not give a true and fairview.

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Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International) December 2012 Marking Scheme

Marks1 (a) Up to 1 mark per well explained deficiency and up to 1 mark per recommendation. If not well explained

then just give ½ mark for each.

Warehouse manager supervising the countNo division of responsibilities within each counting teamInternal audit teams should be checking controls and performing sample counts No flagging of aisles once counting completeAdditional inventory listed on sheets which are not sequentially numberedInventory sheets not signed by countersDamaged goods not moved to central locationMovements of inventory during the count Warehouse manager not qualified to assess the level of work-in-progressWarehouse manager not experienced enough to assess the quantities of raw materials 12

–––

(b) Up to 1 mark per well described procedure

Observe the counters to confirm if inventory count instructions are being followedPerform test counts inventory to sheets and sheets to inventoryConfirm procedures for damaged goods are operating correctlyInspect damaged goods to confirm whether the level of damage is correctly notedObserve procedures for movements of inventory during the countObtain a photocopy of the completed inventory sheetsIdentify and make a note of the last oods received notes and goods despatched notesObserve the procedures carried out by warehouse manager in assessing the level of work-in-progressDiscuss with the warehouse manager how he has estimated the raw materials quantitiesIdentify inventory held for third parties and ensure excluded from count 6

–––

(c) (i) Up to 1 mark per well described procedure, max of 4 procedures

Calculate inventory daysProduce an aged inventory analysis to identify any slow moving goodsCast the inventory listingSelect a sample of items for testing to confirm net realisable value (NRV) and/or costRecalculate cost and NRV for sample of inventoryComputer-assisted audit techniques (CAATs) can be used to confirm cut-offCAATs can be used to confirm whether inventory adjustments noted during the count have been updated to inventory records. 4

–––

(ii) Up to 1 mark per well explained advantage

Test a large volume of inventory data accurately and quickly Cost effective after setupCAATs can test program controls as well as general IT controlsTest the actual inventory system and records rather than printouts from the systemCAATs reduce the level of human error in testingCAATs results can be compared with traditional audit testingFree up audit team members to focus on judgemental and high risk areas 4

–––

(iii) Up to 1 mark per well explained disadvantage

Costs of using CAATs in this first year will be highTeam may require training on the specific CAATs to be utilisedChanges in the inventory system may require costly revisions to the CAATsThe inventory system may not be compatible with the audit firm’s CAATsIf testing the live system, there is a risk the data could be corrupted or lostIf using copy files rather than live data, there is the risk that these files are not genuine copiesAdequate systems documentation must be available 4

–––30––––––

g

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Marks2 (a) Up to 1 mark per well stated right, max of 3 rights

– Right of access to books and records– Right to require information or explanations– Right to receive all written resolutions– Right to receive all notices of any general meeting– Right to attend any general meeting of the company– Right to be heard at the annual general meeting 3

–––

(b) Up to 1 mark per well explained control activity

Segregation of duties Information processingAuthorisation Physical controls Performance reviews Arithmetical controls Account reconciliations 4

–––

(c) Up to 1 mark per well explained limitation

Sampling Subjectivity Inherent limitations of internal control systems Evidence is persuasive not conclusive Audit report formatHistoric information 3

–––10––––––

3 (a) ½ mark for source of documentation and ½ mark for information expect to obtain, max of 2½ marks forsources and 2½ marks for information expect

– Prior year audit file– Prior year financial statements– Accounting systems notes– Discussions with management– Permanent audit file– Current year budgets and management accounts– Sunflower’s website– Prior year report to management– Financial statements of competitors 5

–––

(b) Up to 1 mark per well described risk and up to 1 mark for each well explained response. Overall max of 5 marks for risks and 5 marks for responses.

Treatment of $1·6m refurbishment expenditureDisposal of warehouseBank loan of $1·5mAttendance at year-end inventory countsInventory valuation Transfer of opening balances from supermarkets to head officeIncreased inherent risk of errors in finance department and new financial controller 10

–––

(c) Up to 1 mark per well described point

Costs versus benefits of establishing an internal audit (IA) departmentSize and complexity of Sunflower should be consideredThe role of any IA department should be consideredWhether existing managers/employees can undertake the roles requiredWhether the control environment has a history of control deficienciesWhether the possibility of fraud is high 5

–––20––––––

20

Marks4 (a) Up to 1 mark per well explained point, being ½ mark for the principle and ½ mark for the explanation.

IntegrityObjectivityProfessional competence and due careConfidentialityProfessional behaviour 5

–––

(b) Up to 1 mark per well described procedure

(i) Trade payables and accruals– Calculate trade payable days– Compare total trade payables and list of accruals against prior year– Discuss with management process to quantify understatement of payables– Discuss with management whether any correcting journal adjustment posted– Sample invoices received between 25 October and year end and follow to inclusion in year-end

accruals or trade payables correcting journal– Review after date payments– Review supplier statements reconciliations– Perform a trade payables’ circularisation– Cut-off testing pre and post year-end GRN 6

–––

(ii) Receivables– For non-responses arrange to send a follow up circularisation– With the client’s permission, telephone the customer and ask for a response– For remaining non-responses, undertake alternative procedures to confirm receivables– For responses with differences, identify any disputed amounts, identify whether these relate to

timing differences or whether there are possible errors in the records– Cash in transit should be vouched to post year-end cash receipts in the cash book– Review receivables ledger to identify any possible mispostings– Disputed balances, discuss with management whether a write down is necessary 5

–––

(iii) Reorganisation– Review the board minutes where decision taken– Review the announcement to shareholders in late October – Obtain a breakdown and confirm that only direct expenditure from restructuring is included– Review expenditure to ensure retraining costs excluded– Cast the breakdown of the reorganisation provision– Agree costs included to supporting documentation– Obtain a written representation– Review the adequacy of the disclosures 4

–––20––––––

21


– Written representations are necessary information the auditor needs in connection with the audit ofthe entity’s financial statements

– Required to confirm directors’ responsibilities– Required to support other evidence or required by other ISAs– Required to confirm management have communicated all deficiencies in internal controls– Normally in the form of a letter, written by the company’s directors and addressed to the auditor– Throughout the fieldwork, note any areas where representations may be required– Auditors produce a draft representation letter, directors review and then produce it on their letterhead– Signed by the directors and dated just before the date the audit report is signed 5

–––

(b) Up to 1 mark per well described point

RelevanceReliability – oral v writtenReliability – client v auditor generatedReliability – better external evidence could be obtained 3

–––

(c) Up to 1 mark per valid point, overall maximum of 6 marks PER ISSUE

Discussion of issueCalculation of materialityProcedures at completion stageType of audit report modification requiredImpact on audit report 12

–––20––––––

22







Pape

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(IN

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Thursday 6 June 2013



1 (a) ISA 260 Communication with Those Charged with Governance provides guidance to auditors in relation tocommunicating with those charged with governance on matters arising from the audit of an entity’s financialstatements.

Required:

(i) Explain why it is important that auditors communicate throughout the audit with those charged withgovernance; and (2 marks)

(ii) Describe THREE examples of matters that the auditors may communicate to those charged withgovernance. (3 marks)

IntroductionFox Industries Co (Fox) manufactures engineering parts. It has one operating site and a customer base spread acrossEurope. The company’s year end was 30 April 2013. Below is a description of the purchasing and payments system.

Purchasing systemWhenever production materials are required, the relevant department sends a requisition form to the orderingdepartment. An order clerk raises a purchase order and contacts a number of suppliers to see which can despatchthe goods first. This supplier is then chosen. The order clerk sends out the purchase order. This is not sequentiallynumbered and only orders above $5,000 require authorisation.

Purchase invoices are input daily by the purchase ledger clerk, who has been in the role for many years and, as anexperienced team member, he does not apply any application controls over the input process. Every week thepurchase day book automatically updates the purchase ledger, the purchase ledger is then posted manually to thegeneral ledger by the purchase ledger clerk.

Payments systemFox maintains a current account and a number of saving (deposit) accounts. The current account is reconciled weeklybut the saving (deposit) accounts are only reconciled every two months.

In order to maximise their cash and bank balance, Fox has a policy of delaying payments to all suppliers for as longas possible. Suppliers are paid by a bank transfer. The finance director is given the total amount of the payments list,which he authorises and then processes the bank payments.

Required:

(b) As the external auditors of Fox Industries Co, write a report to management in respect of the purchasing andpayments system described above which:

(i) Identifies and explains FOUR deficiencies in the system; and(ii) Explains the possible implication of each deficiency; and(iii) Provides a recommendation to address each deficiency.

A covering letter IS required.

Note: Up to two marks will be awarded within this requirement for presentation and the remaining marks willbe split equally between each part. (14 marks)

(c) Identify and explain FOUR application controls that should be adopted by Fox Industries Co to ensure thecompleteness and accuracy of the input of purchase invoices. (4 marks)

(d) Describe substantive procedures the auditor should perform to confirm the bank and cash balance of FoxIndustries Co at the year end. (7 marks)

(30 marks)

2

2 (a) Compliance with the fundamental principles in ACCA’s Code of Ethics and Conduct can be threatened in anumber of ways.

Required:

List the FIVE ethical threats to independence and objectivity and for EACH threat identify ONE example ofa circumstance that may create the threat. (5 marks)

(b) In accordance with ISA 570 Going Concern, explain the responsibilities of auditors and managementregarding going concern. (3 marks)

(c) Describe the content of an emphasis of matter paragraph. (2 marks)

(10 marks)

3 [P.T.O.

3 (a) Explain the concepts of materiality and performance materiality in accordance with ISA 320 Materiality inPlanning and Performing an Audit. (5 marks)

(b) You are the audit senior of Rhino & Co and you are planning the audit of Kangaroo Construction Co (Kangaroo)for the year ended 31 March 2013. Kangaroo specialises in building houses and provides a five-year buildingwarranty to its customers. Your audit manager has held a planning meeting with the finance director. He hasprovided you with the following notes of his meeting and financial statement extracts:

Kangaroo has had a difficult year; house prices have fallen and, as a result, revenue has dropped. In order toaddress this, management has offered significantly extended credit terms to their customers. However, demandhas fallen such that there are still some completed houses in inventory where the selling price may be belowcost. During the year, whilst calculating depreciation, the directors extended the useful lives of plant andmachinery from three years to five years. This reduced the annual depreciation charge.

The directors need to meet a target profit before interest and taxation of $0·5 million in order to be paid theirannual bonus. In addition, to try and improve profits, Kangaroo changed their main material supplier to a cheaperalternative. This has resulted in some customers claiming on their building warranties for extensive repairs. Tohelp with operating cash flow, the directors borrowed $1 million from the bank during the year. This is due forrepayment at the end of 2013.

Financial statement extracts for year ended 31 March

DRAFT ACTUAL2013 2012$m $m

Revenue 12·5 15·0Cost of sales (7·0) (8·0

–––– ––––Gross profit 5·5 7·0Operating expenses (5·0) (5·1)

–––– ––––Profit before interest and taxation 0·5 1·9

–––– ––––Inventory 1·9 1·4Receivables 3·1 2·0Cash 0.8 1·9Trade payables 1·6 1·2Loan 1·0 –

Required:

Using the information above:

(i) Calculate FIVE ratios, for BOTH years, which would assist the audit senior in planning the audit; and(5 marks)

(ii) Using the information provided and the ratios calculated, identify and describe FIVE audit risks andexplain the auditor’s response to each risk in planning the audit of Kangaroo Construction Co.

(10 marks)

(20 marks)

4

4 (a) (i) Describe FIVE types of procedures for obtaining audit evidence; and(ii) For each procedure, describe an example relevant to the audit of property, plant and equipment.

Note: The total marks will be split equally between each part. (10 marks)

Bush-Baby Hotels Co operates a chain of 18 hotels located across the country. Each hotel has bedrooms, a restaurantand leisure club facilities. Most visitors to the restaurant and leisure club are hotel guests; however, these facilities areopen to the public as well. Hotel guests generally charge any costs to their room but other visitors must make paymentdirectly to the hotel staff.

During the year, senior management noticed an increased level of cash discrepancies and inventory discrepancies,and they suspect that some employees have been stealing cash and goods from the hotels. They are keen to preventthis from reoccurring and are considering establishing an internal audit department to undertake a fraud investigation.

Required:

(b) Explain how the new internal audit department of Bush-Baby Hotels Co could assist the directors inpreventing and detecting fraud and error. (3 marks)

(c) Describe the limitations of Bush-Baby Hotels Co establishing and maintaining an internal audit department.(2 marks)

The directors would like the internal audit department to have as broad a role as possible, as this will make thedecision to recruit an internal audit department more cost effective.

Required:

(d) Describe additional functions, other than fraud investigations, the directors of Bush-Baby Hotels Co couldask the internal audit department to undertake. (5 marks)

(20 marks)

5 [P.T.O.

5 (a) Explain the five elements of an assurance engagement. (5 marks)

(b) Panda Co manufactures chemicals and has a factory and four offsite storage locations for finished goods. Panda Co’s year end was 30 April 2013. The final audit is almost complete and the financial statements andaudit report are due to be signed next week. Revenue for the year is $55 million and profit before taxation is $5·6 million.

The following two events have occurred subsequent to the year end. No amendments or disclosures have beenmade in the financial statements.

Event 1 – Defective chemicals

Panda Co undertakes extensive quality control checks prior to despatch of any chemicals. Testing on 3 May 2013found that a batch of chemicals produced in April was defective. The cost of this batch was $0·85 million. In itscurrent condition it can be sold at a scrap value of $0·1 million. The costs of correcting the defect are toosignificant for Panda Co’s management to consider this an alternative option.

Event 2 – Explosion

An explosion occurred at the smallest of the four offsite storage locations on 20 May 2013. This resulted in somedamage to inventory and property, plant and equipment. Panda Co’s management have investigated the causeof the explosion and believe that they are unlikely to be able to claim on their insurance. Management of Panda Co has estimated that the value of damaged inventory and property, plant and equipment was $0·9 million and it now has no scrap value.

Required:

For each of the two events above:

(i) Explain whether the financial statements require amendment; and(ii) Describe audit procedures that should be performed in order to form a conclusion on any required

amendment.

Note: The total marks will be split equally between each event. (12 marks)

(c) The directors do not wish to make any amendments or disclosures to the financial statements for the explosion(event 2).

Required:

Explain the impact on the audit report should this issue remain unresolved. (3 marks)

(20 marks)


6

Answers

Fundamentals Level – Skills Module, Paper F8 (INT)Audit and Assurance (International) June 2013 Answers

1 (a) (i) Importance of reporting to those charged with governance

In accordance with ISA 260 Communication with Those Charged with Governance, it is important for the auditors toreport to those charged with governance as it helps in the following ways:

(1) It assists the auditor and those charged with governance in understanding matters related to the audit, and indeveloping a constructive working relationship. This relationship is developed while maintaining the auditor’sindependence and objectivity.

(2) It helps the auditor in obtaining, from those charged with governance, information relevant to the audit. Forexample, those charged with governance may assist the auditor in understanding the entity and its environment,in identifying appropriate sources of audit evidence and in providing information about specific transactions orevents.

(3) It helps those charged with governance in fulfilling their responsibility to oversee the financial reporting process,thereby reducing the risks of material misstatement of the financial statements.

(ii) Matters to be communicated to those charged with governance

– The auditor’s responsibilities with regards to providing an opinion on the financial statements and that they havecarried out their work in accordance with International Standards on Auditing.

– The auditor should explain the planned approach to the audit as well as the audit timetable.– Any key audit risks identified during the planning stage should be communicated.– In addition, any significant difficulties encountered during the audit should be communicated.– Also significant matters arising during the audit, as well as significant accounting adjustments.– During the audit any significant deficiencies in the internal control system identified should be communicated in

writing or verbally.– Those charged with governance should be notified of any written representations required by the auditor.– Other matters arising from the audit that are significant to the oversight of the financial reporting process.– If any suspected frauds are identified during the audit, these must be communicated.– If the auditors are intending to make any modifications to the audit opinion, these should be communicated to

those charged with governance.– For listed entities, a confirmation that the auditors have complied with ethical standards and appropriate safeguards

have been put in place for any ethical threats identified.

(b) Report to management

Board of directorsFox Industries Co

15 Dog StreetCat TownX Country

6 June 2013

Dear Sirs,

Audit of Fox Industries Co (Fox) for the year ended 30 April 2013

Please find enclosed the report to management on deficiencies in internal controls identified during the audit for the yearended 30 April 2013. The appendix to this report considers deficiencies in the purchasing and payments system, theimplications of those deficiencies and recommendations to address those deficiencies.

Please note that this report only addresses the deficiencies identified during the audit and if further testing had beenperformed, then more deficiencies may have been reported.

This report is solely for the use of management and if you have any further questions, then please do not hesitate to contactus.

Yours faithfully

An audit firm

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APPENDIX

Deficiency Implication Recommendation

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When raising purchase orders, theclerks choose whichever supplier candespatch the goods the fastest.

This could result in Fox ordering goodsat a much higher price or a lowerquality than they would like, as the onlyfactor considered was speed of delivery.

It is important that goods aredespatched promptly, but this is justone of many criteria that should beused in deciding which supplier to use.

An approved supplier list should becompiled; this should take into accountthe price of goods, their quality and alsothe speed of delivery.

Once the list has been produced, allorders should only be placed withsuppliers on the approved list.

Purchase orders are not sequentiallynumbered.

Failing to sequentially number theorders means that Fox’s ordering teamare unable to monitor if all orders arebeing fulfilled in a timely manner; thiscould result in stock outs.

If the orders are numbered, then asequence check can be performed forany unfulfilled orders.

All purchase orders should besequentially numbered and on a regularbasis a sequence check of unfulfilledorders should be performed.

Purchase orders below $5,000 are notauthorised and are processed solely byan order clerk.

This can result in goods beingpurchased which are not required byFox. In addition, there is an increasedfraud risk as an order clerk could placeorders for personal goods up to thevalue of $5,000, which is significant.

All purchase orders should beauthorised by a responsible official.Authorised signatories should beestablished with varying levels ofpurchase order authorisation.

Purchase invoices are input daily bythe purchase ledger clerk and due tohis experience, he does not utilise anyapplication controls.

Without application controls there is arisk that invoices could be input into thesystem with inaccuracies or they maybe missed out entirely.

This could result in suppliers being paidincorrectly or not all, leading to a loss ofsupplier goodwill.

The purchase ledger clerk should inputthe invoices in batches and applyapplication controls, such as controltotals, to ensure completeness andaccuracy over the input of purchaseinvoices.

The purchase day book automaticallyupdates with the purchase ledger butthis ledger is manually posted to thegeneral ledger.

Manually posting the amounts to thegeneral ledger increases the risk oferrors occurring. This could result in thepayables balance in the financialstatements being under or overstated.

The process should be updated so thaton a regular basis the purchase ledgerautomatically updates the generalledger.

A responsible official should thenconfirm through purchase ledger controlaccount reconciliations that the updatehas occurred correctly.

Fox’s saving (deposit) bank accountsare only reconciled every two months.

If these accounts are only reconciledperiodically, there is the risk that errorswill not be spotted promptly.

Also, this increases the risk ofemployees committing fraud. If they areaware that these accounts are notregularly reviewed, then they could usethese cash sums fraudulently.

All bank accounts should be reconciledon a regular basis, and at least monthly,to identify any unusual or missingitems.

The reconciliations should be reviewedby a responsible official and they shouldevidence their review.

Fox has a policy of delaying paymentsto their suppliers for as long aspossible.

Whilst this maximises Fox’s bankbalance, there is the risk that Fox ismissing out on early settlementdiscounts. Also, this can lead to a lossof supplier goodwill as well as the riskthat suppliers may refuse to supplygoods to Fox.

Fox should undertake cash flowforecasting/budgeting to maximise bankbalances. The policy of delayingpayment should be reviewed, andsuppliers should be paid in a systematicway, such that supplier goodwill is notlost.

(c) Application controls

Document counts – the number of invoices to be input are counted, the invoices are then entered one by one, at the end thenumber of invoices input is checked against the document count. This helps to ensure completeness of input.

Control totals – here the total of all the invoices, such as the gross value, is manually calculated. The invoices are input, thesystem aggregates the total of the input invoices’ gross value and this is compared to the control total. This helps to ensurecompleteness and accuracy of input.

One for one checking – the invoices entered into the system are manually agreed back one by one to the original purchaseinvoices. This helps to ensure completeness and accuracy of input.

Review of output to expected value – an independent assessment is made of the value of purchase invoices to be input, thisis the expected value. The invoices are input and the total value of invoices is compared to the expected value. This helps toensure completeness of input.

Check digits – this control helps to reduce the risk of transposition errors. Mathematical calculations are performed by thesystem on a particular data field, such as supplier number, a mathematical formula is run by the system, this checks that thedata entered into the system is accurate. This helps to ensure accuracy of input.

Range checks – a pre-determined maximum is input into the system for gross invoice value, for example, $10,000; wheninvoices are input if the amount keyed in is incorrectly entered as being above $10,000, the system will reject the invoice.This helps to ensure accuracy of input.

Existence checks – the system is set up so that certain key data must be entered, such as supplier name, otherwise the invoiceis rejected. This helps to ensure accuracy of input.

Tutorial note: Marks will be awarded for any other relevant application controls.

(d) Substantive procedures over bank and cash balance of Fox Industries Co (Fox)

– Obtain Fox’s current bank account reconciliation and check the additions to ensure arithmetical accuracy.– Obtain a bank confirmation letter from Fox’s bankers for all of its accounts.– For the current account, agree the balance per the bank statement to an original year-end bank statement and also to

the bank confirmation letter.– Agree the reconciliation’s balance per the cash book to the year-end cash book.– Trace all of the outstanding lodgements to the pre year-end cash book, post year-end bank statement and also to

paying-in-book pre year end.– Trace all unpresented cheques through to a pre year-end cash book and post year-end statement. For any unusual

amounts or significant delays obtain explanations from management.– Examine any old unpresented cheques to assess if they need to be written back into the purchase ledger as they are no

longer valid to be presented.– Agree all balances listed on the bank confirmation letter to Fox’s bank reconciliations or the trial balance to ensure

completeness of bank balances.– Review the cash book and bank statements for any unusual items or large transfers around the year end, as this could

be evidence of window dressing.– Examine the bank confirmation letter for details of any security provided by Fox or any legal right of set-off as this may

require disclosure.– For the saving (deposit) bank accounts, review any reconciling items on the year-end bank reconciliations and agree to

supporting documentation.– In respect of material cash balances, count cash balances at the year end and agree to petty cash records, such as the

petty cash book.– Review the financial statements to ensure that the disclosure of cash and bank balances are complete and accurate.

Tutorial note: Marks will be awarded for any other relevant bank and cash tests.

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The finance director authorises thebank transfer payment list forsuppliers; however, he only views thetotal amount of payments to be made.

Without looking at the detail of thepayments list, as well as supportingdocumentation, there is a risk thatsuppliers could be being paid anincorrect amount, or that sums arebeing paid to fictitious suppliers.

The finance director should review thewhole payments list prior to authorising.As part of this, he should agree theamounts to be paid to supportingdocumentation, as well as reviewing thesupplier names to identify anyduplicates or any unfamiliar names. Heshould evidence his review by signingthe bank transfer list.

2 (a) Ethical threats

The five categories of threats as per the ACCA Code of Ethics and Conduct along with an example of each threat are:

(i) Self-interest

– Undue dependence on fee income from one client.– Close personal or business relationships.– Direct financial interest in a client.– Concern over loss of significant client.– Contingent fee arrangements.– Member of audit team entering into employment negotiations with client.– The discovery of a significant error during a re-evaluation of the work undertaken by the member.

(ii) Self-review

– Member of assurance team being or recently having been employed by the client in a position to influence thesubject matter being reviewed.

– Involvement in implementation of financial system and subsequently reporting on the operation of said system.– Firm having prepared the original data used to generate records that are the subject matter of the assurance

engagement, for example, preparing clients’ financial statements.– Performing a service for a client that directly affects the subject matter of an assurance engagement.

(iii) Advocacy

– Acting as an advocate on behalf of a client in litigation or disputes.– Promoting shares in a listed audit client.

(iv) Familiarity

– Long association with a client.– Acceptance of gifts or preferential treatment (significant value).– Former partner of firm being employed by client.– A person in a position to influence financial or non-financial reporting or business decisions having an immediate

or close family member who is in a position to benefit from that influence.

(v) Intimidation

– Threat of litigation.– Threat of removal as assurance firm.– Threat of not being awarded non-audit engagements if disagree with directors’ accounting treatment.– Accountant threatened by audit partner of not being promoted within the firm if disagree with client.– Dominant personality of client director attempting to influence decisions.– Pressure to reduce inappropriately the extent of work performed in order to reduce fees.

Tutorial note: Only one example per threat is required, credit will be awarded for other relevant examples of threats.

(b) Going concern

Management have a responsibility under IAS 1 Presentation of Financial Statements to undertake an assessment of thecompany’s ability to continue as a going concern and to make appropriate disclosures with regards to going concern.

In accordance with ISA 570 Going Concern, the auditor’s responsibility is to obtain sufficient appropriate audit evidence aboutthe appropriateness of management’s use of the going concern assumption in the preparation of the financial statements byundertaking appropriate substantive procedures.

The auditor should consider whether the period of management’s going concern assessment is adequate. The assessmentneeds to cover a period of no less than 12 months from the date of the financial statements.

In addition, the auditor should conclude whether there is a material uncertainty about the entity’s ability to continue as agoing concern and consider the reporting implications.

(c) Emphasis of matter paragraph

ISA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report identifiessituations where the audit report is modified, by the inclusion of additional paragraphs, but result in an unmodified opinion.An emphasis of matter paragraph is one such example. These are commonly used in raising awareness of issues such asgoing concern.

Emphasis of matter paragraph – A paragraph included in the auditor’s report that refers to a matter appropriately presentedor disclosed in the financial statements that, in the auditor’s judgement, is of such importance that it is fundamental to users’understanding of the financial statements. The paragraph must state that the auditor’s opinion is not modified in respect ofthe matter emphasised.

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3 (a) Materiality and performance materiality

Materiality and performance materiality are dealt with under ISA 320 Materiality in Planning and Performing an Audit.Auditors need to establish the materiality level for the financial statements as a whole, as well as assess performancemateriality levels, which are lower than the overall materiality.

Materiality is defined in ISA 320 as follows:

‘Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonablybe expected to influence the economic decisions of users taken on the basis of the financial statements.’

In assessing the level of materiality, there are a number of areas that should be considered. First the auditor must considerboth the amount (quantity) and the nature (quality) of any misstatements, or a combination of both. The quantity of themisstatement refers to the relative size of it and the quality refers to an amount that might be low in value but due to itsprominence could influence the user’s decision, for example, directors’ transactions.

As per ISA 320, materiality is often calculated using benchmarks such as 5% of profit before tax or 1% of total revenue ortotal expenses. These values are useful as a starting point for assessing materiality.

The assessment of what is material is ultimately a matter of the auditor’s professional judgement, and it is affected by theauditor’s perception of the financial information needs of users of the financial statements and the perceived level of risk; thehigher the risk, the lower the level of overall materiality.

In assessing materiality, the auditor must consider that a number of errors each with a low value may, when aggregated,amount to a material misstatement.

In calculating materiality, the auditor should also set the performance materiality level. Performance materiality is normallyset at a level lower than overall materiality. It is used for testing individual transactions, account balances and disclosures.The aim of performance materiality is to reduce the risk that the total of errors in balances, transactions and disclosures doesnot in total exceed overall materiality.

Tutorial note: Award marks for ISA 320 definition of performance materiality below:

‘Performance materiality means the amount or amounts set by the auditor at less than materiality for the financialstatements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected andundetected misstatements exceeds materiality for the financial statements as a whole. If applicable, performance materialityalso refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes oftransactions, account balances or disclosures.’

(b) (i) Ratios

Ratios to assist the audit supervisor in planning the audit:

2013 2012Gross margin 5·5/12·5 = 44% 7/15 = 46·7%Operating margin 0·5/12·5 = 4% 1·9/15 = 12·7%Inventory days 1·9/7 * 365 = 99 days 1·4/8 * 365 = 64 daysInventory turnover 7/1·9 = 3·7 8/1·4 = 5·7Receivable days 3·1/12·5 * 365 = 91 days 2·0/15 * 365 = 49 daysPayable days 1·6/7 * 365 = 83 days 1·2/8 * 365 = 55 daysCurrent ratio 5·8/2·6 = 2·2 5·3/1·2 = 4·4Quick ratio (5·8 – 1·9)/2·6 = 1·5 (5·3 – 1·4)/1·2 = 3·3

(ii) Audit risks and responses

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Receivable days have increased from 49 to 91 days andmanagement has significantly extended the credit termsgiven to customers. This leads to an increased risk ofrecoverability of receivables as they may be overvalued.

Extended post year-end cash receipts testing and a reviewof the aged receivables ledger to be performed to assessvaluation.

Due to the fall in demand for Kangaroo Construction Co’s(Kangaroo) houses, there are some houses where theselling price may be below cost. IAS 2 Inventoriesrequires that inventory should be stated at the lower ofcost and NRV.

In addition, inventory days have increased from 64 to 99days and inventory turnover has fallen from 5·7 in 2012to 3·7 in the current year. There is a risk that inventory isovervalued.

Detailed cost and net realisable value (NVR) testing to beperformed and the aged inventory report to be reviewedto assess whether inventory requires writing down.

Tutorial note: It has been assumed that customers do not pay in advance for houses and hence the company hasreceivable balances.

4 (a) Procedures to obtain evidence and an audit test relevant to property, plant and equipment:

(i) InspectionInspection involves examining records or documents, whether internal or external, in paper form, electronic form, orother media, or a physical examination of an asset.

(ii) – Inspect a sample of capital items at the client site to ensure they exist, are in use and in good condition, and agreeincluded in the non-current assets register to confirm completeness of assets.

– Inspect capital expenditure forms for evidence of authorisation by a responsible official.

(i) ObservationObservation consists of looking at a process or procedure being performed by others.

(ii) – Observe the process for logging property, plant and equipment invoices into the system to ensure that all invoicesare entered completely and accurately.

– Observe the process of physical confirmation of non-current assets undertaken by internal audit/financedepartment.

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The directors have extended the useful lives of plant andmachinery from three to five years, resulting in thedepreciation charge reducing. Under IAS 16 Property,Plant and Equipment, useful lives are to be reviewedannually, and if asset lives have genuinely increased, thenthis change is reasonable.

However, there is a risk that this reduction has occurredin order to achieve profit targets. If this is the case, thenplant and machinery is overvalued and profit overstated.

Discuss with the directors the rationale for extending theuseful lives. Also, the five year life should be compared tohow often these assets are replaced, as this providesevidence of the useful life of assets.

The directors need to reach a profit level of $0·5 millionin order to receive their annual bonus. There is a risk thatthey might feel under pressure to manipulate the resultsthrough the judgements taken or through the use ofprovisions.

Throughout the audit, the team will need to be alert tothis risk and maintain professional scepticism. They willneed to carefully review judgemental decisions andcompare treatment against prior years. In addition, awritten representation should be obtained frommanagement confirming the basis of any significantjudgements.

Due to a change in material supplier, the quality ofproducts used has deteriorated and this has led tocustomers claiming on their five-year building warranty. Ifthe overall number of people claiming on the warranty islikely to increase, then the warranty provision shouldpossibly be higher. If the directors have not increased thelevel of the provision, then there is a risk the provision isunderstated.

Review the level of the warranty provision in light of theincreased level of claims to confirm completeness of theprovision.

Kangaroo has borrowed $1·0m from the bank via a short-term loan. This loan needs to be repaid in 2013and so should be disclosed as a current liability.

In addition, Kangaroo may have given the bank a chargeover its assets as security for the loan. There is a risk thatthe disclosure of any security given is not complete.

During the audit, the team would need to check that the$1·0m loan finance was received. In addition, thedisclosures for this loan should be reviewed in detail toensure compliance with relevant accounting standardsand legislation.

The loan correspondence should be reviewed to ascertainwhether any security has been given, and this bankshould be circularised as part of the bank confirmationprocess.

The current and quick ratios have decreased from 4·4 to2·2 and 3·3 to 1·5 respectively. In addition, the cashbalances have decreased over the year, there is a fall indemand and Kangaroo have taken out a short-term loanof $1 million, which needs to be repaid in 2013.

Although all ratios are above the minimum levels, this isstill a significant decrease and along with the fall in bothoperating and gross profit margins, as well as thesignificant increase in payable days could be evidence ofgoing concern difficulties.

Detailed going concern testing to be performed during theaudit and discussed with the directors to ensure that thegoing concern basis is reasonable.

The team should discuss with the directors how theshort-term loan of $1·0 million will be repaid later in2013.

(i) Analytical proceduresAnalytical procedures consist of evaluations of financial information through analysis of plausible relationships amongboth financial and non-financial data. Analytical procedures also encompass such investigation as is necessary ofidentified fluctuations or relationships that are inconsistent with other relevant information or that differ from expectedvalues by a significant amount.

(ii) – Undertake a proof in total calculation for depreciation, taking into account additions and disposals, compare it tothe actual charge and investigate any significant differences.

– Review monthly depreciation charges to identify any significant fluctuations and discuss with management.

(i) InquiryInquiry consists of seeking information from knowledgeable persons, both financial and non-financial, within the entityor outside the entity.

(ii) – Discuss with management whether there have been any changes in useful lives or residual values of assets as thiswill impact the depreciation calculation.

– Inquire of department heads the process they follow in authorising capital expenditure orders to ensure that itfollows the specified company authorisation process.

(i) RecalculationRecalculation consists of checking the mathematical accuracy of documents or records. Recalculation may be performedmanually or electronically.

(ii) – Recalculate the depreciation charge for a sample of assets and agree the charge to the non-current assets register.– Recalculate the profit or loss on disposal for a sample of assets disposed of in the year to ensure accuracy.

(i) External confirmationAn external confirmation represents audit evidence obtained by the auditor as a direct written response to the auditorfrom a third party, in paper form, electronic form or by other medium.

(ii) – Obtain a confirmation from the company’s bank or lawyers of any non-current assets held as security for loans, asthis will require disclosure in the financial statements.

– Write to the firm who have undertaken the valuation of property, plant and equipment for the year and obtain acopy of their report in order to undertake testing of the assumptions and calculations.

(i) ReperformanceReperformance involves the auditor’s independent execution of procedures or controls that were originally performed aspart of the entity’s internal control.

(ii) – Reperform the non-current asset register reconciliation to the general ledger to ensure accuracy.– Select a sample of authorised capital expenditure orders; match to the invoice and to inclusion in the non-current

assets register to ensure completeness of the capital expenditure cycle.

Tutorial note: Marks will be awarded for any other relevant property, plant and equipment tests.

(b) Preventing and detecting fraud and error

The directors of Bush-Baby Hotels Co (Bush-Baby) are responsible for the prevention and detection of fraud and error.However, the new internal audit department can help the directors by assessing the main areas of fraud risk, assessing theadequacy and effectiveness of control systems and helping to develop controls to mitigate key risks.

Having developed the controls, they can undertake regular reviews of compliance by each hotel of these controls. Where non-compliance is identified, they can instigate further training if necessary or report suspected frauds to senior management.

Where fraud is suspected, the internal audit department can undertake a detailed fraud investigation to identify who isinvolved, likely sums stolen and gather evidence for any subsequent police investigation.

In addition, the presence of an internal audit department can itself act as a fraud deterrent, as the risk of being discoveredmeans individuals are less likely to undertake fraudulent activities.

(c) Limitations of establishing and maintaining an internal audit department

The internal auditors of Bush-Baby will be employees of the company and so this can impair their independence, as theymay not report issues to those charged with governance for fear of losing their job.

Although some internal auditors are professionally qualified, there is no requirement to be qualified, as there is for externalauditors. Hence, there may be gaps in the experience and technical knowledge of the internal audit department.

The cost of establishing an internal audit department can be significant; hence prior to recruiting a team, the management ofBush-Baby should consider carefully the roles the team can perform and whether this will generate sufficient value for money.

As Bush-Baby has not previously had any form of internal audit, there may be some resistance from employees of thecompany. They may be uncomfortable with the idea of their work being reviewed, especially if the first role of the departmentis to undertake fraud investigations.

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(d) Additional functions for Bush-Baby’s internal audit department

Monitoring asset levelsThe internal audit department could undertake inventory counts at the restaurants of the 18 hotels. There is likely to be asignificant level of goods held at each hotel. Internal audit could count actual levels of goods held and compare them to thehotels’ records. If consistent negative differences occur for a hotel, then this may be an early indicator of fraud. If positivedifferences are highlighted, then it could be because employees have not been adequately trained on how to record inventory.

Cash controls at hotelsBush-Baby’s internal auditors could undertake controls testing over cash receipts and cash counts. It is likely that cash ateach hotel will be significant as there would be cash at the reception, restaurant and leisure club. Each hotel should havetight controls over the cash receipts process. These controls should be tested at each location as well as performance of acash count to reduce the level of errors.

Customer satisfaction levelsIn order to improve the overall guest experience in the hotel, members of the internal audit department could undertake‘mystery guest’ reviews, where they enter the hotel as a guest, stay the night, eat and drink in the restaurant and visit theleisure club. They then rate the overall hotel experience. This is fed back to each hotel to improve customer service and canprovide the basis for further training, if necessary.

Overall review of financial/operational controlsThe department could undertake reviews of controls at head office, as well as individual hotels and make recommendationsto management over such areas as the purchasing process as well as the payroll cycle.

IT system reviewsBush-Baby is likely to have a relatively complex computer system linking all of the tills in the hotels to head office. The internalaudit department could be asked to perform a review over the computer environment and controls.

Value for money reviewThe internal audit department could be asked to assess whether Bush-Baby is obtaining value for money in areas such ascapital expenditure.

Regulatory complianceBush-Baby’s operations include leisure clubs, restaurants and hotel rooms. There will be various laws and regulations suchas health and safety, food hygiene and fire prevention that impact Bush-Baby. The internal audit department could help tomonitor compliance with these regulations.

5 (a) Elements of an assurance engagement

In accordance with ISAE 3000 Assurance Engagements other than Audits or Reviews of Historical Financial Information, anassurance engagement will involve three separate parties:

– The intended user who is the person who requires the assurance report.– The responsible party, which is the organisation responsible for preparing the subject matter to be reviewed.– The practitioner (i.e. an accountant) who is the professional who will review the subject matter and provide the

assurance.

A second element is a suitable subject matter. The subject matter is the data that the responsible party has prepared andwhich requires verification.

Suitable criteria are required in an assurance engagement. The subject matter is compared to the criteria in order for it to beassessed and an opinion provided.

Sufficient appropriate evidence has to be obtained by the practitioner in order to give the required level of assurance.

An assurance report is the opinion that is given by the practitioner to the intended user and the responsible party.

(b) Subsequent events

Event 1 – Defective chemicals

Panda Co’s (Panda) quality control procedures have identified that inventory with a cost of $0·85 million is defective; thescrap value of this inventory is $0·1 million. This information was obtained after the year end but provides further evidenceof the net realisable value of inventory at the year end and hence is an adjusting event.

IAS 2 Inventories requires that inventory is valued at the lower of cost and net realisable value. The inventory of $0·85 millionmust be written down to its net realisable value of $0·1 million. The write down of $0·75 million (0·85 – 0·1) is material asit represents 13·4% (0·75/5·6) of profit before tax and 1·4% (0·75/55) of revenue. Hence, the directors should amend thefinancial statements by writing down the inventory to $0·1 million.

The following audit procedures should be applied to form a conclusion on the adjustment:

– Review the board minutes/quality control reports to assess whether this event was the only case of defective inventoryas there could potentially be other inventory which requires writing down.

– Discuss the matter with the directors, checking whether the company has sufficient inventory to continue trading in theshort term.

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– Obtain a written representation confirming that the company’s going concern status is not impacted.– Obtain a schedule showing the defective inventory and agree to supporting production documentation that it was

produced prior to 30 April, as otherwise it would not require a write down at the year end.– Discuss with management how they have assessed the scrap value of $0·1 million and agree this amount to any

supporting documentation to confirm the value.

Event 2 – Explosion

An explosion has occurred in one of the offsite storage locations and property, plant and equipment and inventory valued at$0·9 million have been damaged and now have no scrap value. The directors do not believe they are likely to be able toclaim insurance for the damaged assets. This event occurred after the year end and the explosion would not have been inexistence at 30 April, and hence this event indicates a non-adjusting event.

The damaged assets of $0·9 million are material as they represent 16·1% (0·9/5·6) of profit before tax and 1·6% (0·9/55)of revenue. As a material non-adjusting event, the assets should not be written down to zero; however, the directors shouldconsider including a disclosure note detailing the explosion and the value of assets impacted.

The following audit procedures should be applied to form a conclusion on any amendment:

– Obtain a schedule showing the damaged property, plant and equipment and agree the net book value to the non-currentassets register to confirm what the value of damaged assets was.

– Obtain the latest inventory records for this storage location to ascertain the likely level of inventory at the time of theexplosion.

– Discuss with the directors whether they will disclose the effect of the explosion in the financial statements.– Discuss with the directors why they do not believe that they are able to claim on their insurance; if a claim was to be

made, then only uninsured losses would require disclosure, and this may be an immaterial amount.

(c) Audit report

The explosion is a non-adjusting post year-end event and the level of damaged assets are material. Hence a disclosure noteshould be included in the 2013 financial statements and the write down of assets would be included in the 2014 financialstatements.

If the directors refuse to make the subsequent event disclosures, then the financial statements are materially misstated andas the lack of disclosure is material but not pervasive, the audit report will be modified and a qualified opinion will benecessary.

A basis for qualified opinion paragraph would need to be included before the opinion paragraph. This would explain themisstatement in relation to the lack of subsequent events disclosure and the effect on the financial statements. The opinionparagraph would be qualified ‘except for’.

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Fundamentals Level – Skills Module, Paper F8 (INT)Audit and Assurance (International) June 2013 Marking Scheme

Marks1 (a) (i) Up to 1 mark per well explained point

– Assists the auditor and those charged with governance in understanding matters related to theaudit

– Obtains information relevant to the audit– Helps those charged with governance in fulfilling their responsibility to oversee the financial

reporting process 2–––

(ii) Up to 1 mark for each example matter to be communicated to those charged with governance 3–––

(b) Up to 1 mark per well explained deficiency, implication and recommendation. If not well explained thenjust give ½ mark for each. Overall maximum of 4 marks each for deficiencies, implications andrecommendations.

2 marks for presentation: 1 for address and intro and 1 for conclusion.

– No approved suppliers list– Purchase orders not sequentially numbered– Orders below $5,000 are not authorised by a responsible official– No application controls over input of purchase invoices– Purchase ledger manually posted to general ledger– Saving (deposit) bank accounts only reconciled every two months– Payments to suppliers delayed– Finance director only reviews the total of the payment list prior to payment authorising 14

–––

(c) Up to 1 mark per well explained application control

– Document counts– Control totals– One for one checking– Review of output to expected value– Check digits– Range checks– Existence checks 4

–––

(d) Up to 1 mark per substantive procedure

– Check additions of bank reconciliation– Obtain bank confirmation letter– Bank balance to statement/bank confirmation– Cash book balance to cash book– Outstanding lodgements– Unpresented cheques review– Old cheques write back– Agree all balances on bank confirmation– Unusual items/window dressing– Security/legal right set-off– Review reconciliations for saving (deposit) accounts– Cash counts for significant cash balances– Review disclosure of bank and cash in financial statements 7

–––30–––

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Marks2 (a) ½ mark for each threat and ½ mark per example of a threat:

– Self-interest– Self-review– Advocacy– Familiarity– Intimidation 5

–––

(b) Up to 1 mark per well explained responsibility

– Management assessment of the company’s ability to continue as a going concern and to makeappropriate disclosures

– Auditor’s responsibility to obtain evidence about the appropriateness of management’s going concernassumption

– Auditor consider whether the period of management’s going concern assessment is adequate; no lessthan 12 months from the date of the financial statements

– Auditor should conclude whether there is a material uncertainty about going concern and consider the reporting implications 3

–––

(c) Up to 1 mark per well described point

– Emphasis of matter 2–––10–––

3 (a) Up to 1 mark per well explained point:

– Materiality for financial statements as a whole and also performance materiality levels – Definition of materiality– Amount or nature of misstatements, or both– 5% profit before tax or 1% revenue or total expenses– Judgement, needs of users and level of risk– Small errors aggregated– Performance materiality 5

–––

(b) (i) ½ mark per ratio calculation per year.

– Gross margin– Operating margin– Inventory days– Inventory turnover– Receivable days– Payable days– Current ratio– Quick ratio 5

–––

(ii) Up to 1 mark per well described audit risk and up to 1 mark per well explained audit response

– Receivables valuation – Inventory valuation– Depreciation of plant and machinery– Management manipulation of profit to reach bonus targets– Completeness of warranty provision– Disclosure of bank loan of $1 million– Going concern risk 10

–––20–––

20

Marks4 (a) Up to 1 mark per well described procedure and up to 1 mark for a valid audit test, overall maximum of

2 marks per type of procedure and test, maximum of 5 marks for procedures and maximum of 5 marks fortests.

– Inspection– Observation– Analytical procedures– Inquiry– Recalculation– External confirmation– Reperformance 10

–––

(b) Up to 1 mark per well explained point

– Internal audit (IA) can assess fraud risk and develop controls to mitigate fraud– Regular reviews of compliance with these controls– Where fraud suspected, IA can undertake detailed fraud investigation– Existence of IA department acts as a fraud deterrent 3

–––

(c) Up to 1 mark per well described limitation

– Lack of independence as employees of the company– No requirement to be professionally qualified– Cost of establishing department– Possible resistance from existing employees to idea of being audited 2

–––

(d) Up to 1 mark per well described point

– Monitoring asset levels– Cash controls testing– Customer satisfaction levels– Financial/operational controls– IT system review– Value for money review– Regulatory compliance 5

–––20–––

21

Marks5 (a) Up to 1 mark per well explained element

– Intended user, responsible party, practitioner– Subject matter– Suitable criteria– Appropriate evidence– Assurance report 5

–––

(b) Up to 1 mark per valid point, overall maximum of 6 marks per event

Event 1 – Defective chemicals– Provides evidence of conditions at the year end– Inventory to be adjusted to lower of cost and net realisable value– Calculation of materiality– Review board minutes/quality control reports– Discuss with the directors, adequate inventory to continue to trade– Obtain written representation re going concern– Obtain schedule of defective inventory, agree to supporting documentation– Discuss with directors basis of the scrap value 6

–––

Event 2 – Explosion– Provides evidence of conditions that arose subsequent to the year end– Non-adjusting event, requires disclosure if material– Calculation of materiality– Obtain schedule of damaged property, plant and equipment and agree values to asset register– Obtain latest inventory records to confirm damaged inventory levels– Discuss with the directors if they will make disclosures– Discuss with directors why no insurance claim will be made 6

–––

(c) Up to 1 mark per well explained valid point

– Disclosure required in 2013 financial statements and adjustment to the assets in 2014 financialstatements

– Material but not pervasive misstatement, modified audit report, qualified opinion – Basis for qualified opinion paragraph required– Opinion paragraph – except for 3

–––20–––

22







Pape

r F8

(IN

T)





1 Minty Cola Co (Minty) manufactures fizzy drinks such as cola and lemonade as well as other soft drinks and its yearend is 31 December 2013. You are the audit manager of Parsley & Co and are currently planning the audit of Minty.You attended the planning meeting with the engagement partner and finance director last week and recorded theminutes from the meeting shown below. You are reviewing these as part of the process of preparing the audit strategy.

Minutes of planning meeting for Minty

Minty’s trading results have been strong this year and the company is forecasting revenue of $85 million, which isan increase from the previous year. The company has invested significantly in the cola and fizzy drinks productionprocess at the factory. This resulted in expenditure of $5 million on updating, repairing and replacing a significantamount of the machinery used in the production process.

As the level of production has increased, the company has expanded the number of warehouses it uses to storeinventory. It now utilises 15 warehouses; some are owned by Minty and some are rented from third parties. Therewill be inventory counts taking place at all 15 of these sites at the year end.

A new accounting general ledger has been introduced at the beginning of the year, with the old and new systemsbeing run in parallel for a period of two months.

As a result of the increase in revenue, Minty has recently recruited a new credit controller to chase outstandingreceivables. The finance director thinks it is not necessary to continue to maintain an allowance for receivables andso has released the opening allowance of $1·5 million.

In addition, Minty has incurred expenditure of $4·5 million on developing a new brand of fizzy soft drinks. Thecompany started this process in January 2013 and is close to launching their new product into the market place.

The finance director stated that there was a problem in November in the mixing of raw materials within the productionprocess which resulted in a large batch of cola products tasting different. A number of these products were sold;however, due to complaints by customers about the flavour, no further sales of these goods have been made. Noadjustment has been made to the valuation of the damaged inventory, which will still be held at cost of $1 million at the year end.

As in previous years, the management of Minty is due to be paid a significant annual bonus based on the value ofyear-end total assets.

Required:

(a) Explain audit risk and the components of audit risk. (5 marks)

(b) Using the minutes provided, identify and describe SIX audit risks, and explain the auditor’s response to eachrisk, in planning the audit of Minty Cola Co. (12 marks)

(c) Identify the main areas, other than audit risks, that should be included within the audit strategy documentfor Minty Cola Co; and for each area provide an example relevant to the audit. (4 marks)

(d) Describe substantive procedures the audit team should perform to obtain sufficient and appropriate auditevidence in relation to the following three matters:

(i) The treatment of the $5 million expenditure incurred on improving the factory production process;(ii) The release of the $1·5 million allowance for receivables; and(iii) The damaged inventory.


(30 marks)

2

2 (a) (i) Define a ‘test of control’ and provide an example of a test of control in relation to the audit of wages andsalaries; and

(ii) Define a ‘substantive procedure’ and provide an example of a substantive procedure in relation to theaudit of wages and salaries.


(b) ISA 500 Audit Evidence requires auditors to obtain sufficient and appropriate audit evidence. Appropriateness isa measure of the quality of audit evidence; that is, its relevance and its reliability.

Required:

Identify and explain THREE factors which influence the reliability of audit evidence. (3 marks)

(c) Auditors are required to perform an overall review of the financial statements before they provide their auditopinion.

Required:

Explain THREE procedures an auditor should perform in conducting their overall review of the financialstatements. (3 marks)

(10 marks)

3 [P.T.O.

3 You are a member of the recently formed internal audit department of Oregano Co (Oregano). The companymanufactures tinned fruit and vegetables which are supplied to large and small food retailers. Management and thosecharged with governance of Oregano have concerns about the effectiveness of their sales and despatch system andhave asked internal audit to document and review the system.

Sales and despatch system

Sales orders are mainly placed through Oregano’s website but some are made via telephone. Online orders areautomatically checked against inventory records for availability; telephone orders, however, are checked manually byorder clerks after the call. A follow-up call is usually made to customers if there is insufficient inventory. When takingtelephone orders, clerks note down the details on plain paper and afterwards they complete a three part pre-printedorder form. These order forms are not sequentially numbered and are sent manually to both despatch and theaccounts department.

As the company is expanding, customers are able to place online orders which will exceed their agreed credit limit by10%. Online orders are automatically forwarded to the despatch and accounts department.

A daily pick list is printed by the despatch department and this is used by the warehouse team to despatch goods.The goods are accompanied by a despatch note and all customers are required to sign a copy of this. On return, thesigned despatch notes are given to the warehouse team to file.

The sales quantities are entered from the despatch notes and the authorised sales prices are generated by theinvoicing system. If a discount has been given, this has to be manually entered by the sales clerk onto the invoice.Due to the expansion of the company, and as there is a large number of sale invoices, extra accounts staff have beenasked to help out temporarily with producing the sales invoices. Normally it is only two sales clerks who produce thesales invoices.

Required:

(a) Describe TWO methods for documenting the sales and despatch system; and for each explain an advantageand a disadvantage of using this method. (6 marks)

(b) List TWO control objectives of Oregano Co’s sales and despatch system. (2 marks)

(c) Identify and explain SIX deficiencies in Oregano Co’s sales and despatch system and provide arecommendation to address each of these deficiencies. (12 marks)

(20 marks)

4

4 Salt & Pepper & Co (Salt & Pepper) is a firm of Chartered Certified Accountants which has seen its revenue declinesteadily over the past few years. The firm is looking to increase its revenue and client base and so has developed anew advertising strategy where it has guaranteed that its audits will minimise disruption to companies as they willnot last longer than two weeks. In addition, Salt & Pepper has offered all new audit clients a free accounts preparationservice for the first year of the engagement, as it is believed that time spent on the audit will be reduced if the firmhas produced the financial statements.

The firm is seeking to reduce audit costs and has therefore decided not to update the engagement letters of existingclients, on the basis that these letters do not tend to change much on a yearly basis. One of Salt & Pepper’s existingclients has proposed that this year’s audit fee should be based on a percentage of their final pre-tax profit. The partnersare excited about this option as they believe it will increase the overall audit fee.

Salt & Pepper has recently obtained a new audit client, Cinnamon Brothers Co (Cinnamon), whose year end is 31 December. Cinnamon requires their audit to be completed by the end of February; however, this is a very busytime for Salt & Pepper and so it is intended to use more junior staff as they are available. Additionally, in order to savetime and cost, Salt & Pepper have not contacted Cinnamon’s previous auditors.

Required:

(a) Describe the steps that Salt & Pepper should take in relation to Cinnamon:

(i) Prior to accepting the audit; and (5 marks)

(ii) To confirm whether the preconditions for the audit are in place. (3 marks)

(b) State FOUR matters that should be included within an audit engagement letter. (2 marks)

(c) (i) Identify and explain FIVE ethical risks which arise from the above actions of Salt & Pepper & Co; and(ii) For each ethical risk explain the steps which Salt & Pepper & Co should adopt to reduce the risks arising.


(20 marks)

5 [P.T.O.

5 (a) ISA 510 Initial Audit Engagements – Opening Balances requires auditors to undertake additional auditprocedures for confirming opening balances for new audit engagements. In addition, the ISA gives guidance onaudit report implications if auditors are unable to confirm opening balances or if they contain misstatements.

Required:

(i) Describe procedures the auditor should undertake to confirm opening balances for a new auditengagement; and

(ii) Explain the impact on the audit report if the auditor is unable to confirm the opening balances, or if theopening balances contain misstatements.


You are an audit manager in Brown & Co and you are nearing completion of the audit of Paprika & Co (Paprika). Theaudit senior has produced extracts below from the draft audit report for Paprika.

Auditor’s responsibility

(1) Our responsibility is to express an opinion on all pages of the financial statements based on our audit. Weconducted our audit in accordance with most of the International Standards on Auditing.

(2) Those standards require that we comply with ethical requirements and plan and perform the audit to obtainmaximum assurance as to whether the financial statements are free from all misstatements whether caused byfraud or error.

(3) We have a responsibility to prevent and detect fraud and error and to prepare the financial statements inaccordance with International Financial Reporting Standards.

(4) An audit involves performing procedures to obtain evidence about the amounts and disclosures in the financialstatements. The procedures selected depend on the availability and experience of audit team members. Weconsidered internal controls relevant to the entity; and express an opinion on the effectiveness of these internalcontrols.

(5) We did not evaluate the overall presentation of the financial statements, as this is management’s responsibility.We considered the reasonableness of any new accounting estimates made by management. We did not reviewthe appropriateness of accounting policies as these are the same as last year. In order to confirm raw materialinventory quantities, we relied on the work undertaken by an independent expert.

The extracts are numbered to help you refer to them in your answer.

Required:

(b) Describe the factors to consider and steps Brown & Co should take, prior to placing reliance on the work ofthe independent expert, in order to confirm raw material quantities. (4 marks)

(c) For the above audit report extracts, identify and explain SIX elements of this report which requireamendment.

Note: Redrafted audit report extracts are not required. (12 marks)

(20 marks)


6

Answers

Fundamentals Level – Skills Module, Paper F8 (INT)Audit and Assurance (International) December 2013 Answers

1 (a) Audit risk and its components

Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materiallymisstated. Audit risk is a function of two main components being the risks of material misstatement and detection risk. Riskof material misstatement is made up of two components, inherent risk and control risk.

Inherent risk is the susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatementthat could be material, either individually or when aggregated with other misstatements, before consideration of any relatedcontrols.

Control risk is the risk that a misstatement which could occur in an assertion about a class of transaction, account balanceor disclosure and which could be material, either individually or when aggregated with other misstatements, will not beprevented, or detected and corrected, on a timely basis by the entity’s internal control.

Detection risk is the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will notdetect a misstatement which exists and which could be material, either individually or when aggregated with othermisstatements. Detection risk is affected by sampling and non-sampling risk.

(b) Audit risks and responses

9

Audit risk Auditor responseMinty has incurred $5m on updating, repairing andreplacing a significant amount of the production processmachinery.

If this expenditure is of a capital nature, it should becapitalised as part of property, plant and equipment (PPE)in line with IAS 16 Property, Plant and Equipment.However, if it relates more to repairs, then it should beexpensed to the statement of profit or loss (incomestatement). If the expenditure is not correctly classified,profit and PPE could be under or overstated.

The auditor should review a breakdown of these costs toascertain the split of capital and revenue expenditure, andfurther testing should be undertaken to ensure that theclassification in the financial statements is correct.

At the year end there will be inventory counts undertaken inall 15 warehouses.

It is unlikely that the auditor will be able to attend all 15inventory counts and therefore they need to ensure that theyobtain sufficient evidence over the inventory countingcontrols, and completeness and existence of inventory forany warehouses not visited.

The auditor should assess which of the inventory sites theywill attend the counts for. This will be any with materialinventory or which have a history of significant errors.

For those not visited, the auditor will need to review thelevel of exceptions noted during the count and discuss withmanagement any issues which arose during the count.

Inventory is stored within 15 warehouses; some are ownedby Minty and some rented from third parties. Onlywarehouses owned by Minty should be included withinPPE. There is a risk of overstatement of PPE andunderstatement of rental expenses if Minty has capitalisedall 15 warehouses.

The auditor should review supporting documentation for allwarehouses included within PPE to confirm ownership byMinty and to ensure non-current assets are not overstated.

A new accounting general ledger system has beenintroduced at the beginning of the year and the old systemwas run in parallel for two months.

There is a risk of opening balances being misstated and lossof data if they have not been transferred from the oldsystem correctly. In addition, the new general ledger systemwill require documenting and the controls over this willneed to be tested.

The auditor should undertake detailed testing to confirmthat all opening balances have been correctly recorded inthe new general ledger system.

They should document and test the new system. Theyshould review any management reports run comparing theold and new system during the parallel run to identify anyissues with the processing of accounting information.

The finance director of Minty has decided to release theopening provision of $1·5 million for allowance forreceivables as he feels it is unnecessary.

There is a risk that receivables will be overvalued, asdespite having a credit controller, some balances will beirrecoverable and so will be overstated if not providedagainst. In addition, due to the damaged inventory there isan increased risk of customers refusing to make paymentsin full.

Extended post year-end cash receipts testing and a review ofthe aged receivables ledger to be performed to assessvaluation and the need for an allowance for receivables.

(c) Audit strategy document

The audit strategy sets out the scope, timing and direction of the audit and helps the development of the audit plan. It shouldconsider the following main areas.

It should identify the main characteristics of the engagement which define its scope. For Minty it should consider thefollowing:

– Whether the financial information to be audited has been prepared in accordance with IFRS.– To what extent audit evidence obtained in previous audits for Minty will be utilised.– Whether computer-assisted audit techniques will be used and the effect of IT on audit procedures.– The availability of key personnel at Minty.

It should ascertain the reporting objectives of the engagement to plan the timing of the audit and the nature of thecommunications required, such as:

– The audit timetable for reporting and whether there will be an interim as well as final audit.– Organisation of meetings with Minty’s management to discuss any audit issues arising.– Location of the 15 inventory counts.– Any discussions with management regarding the reports to be issued.– The timings of the audit team meetings and review of work performed.– If there are any expected communications with third parties.

The strategy should consider the factors that, in the auditor’s professional judgement, are significant in directing Minty’s auditteam’s efforts, such as:

– The determination of materiality for the audit.– The need to maintain a questioning mind and to exercise professional skepticism in gathering and evaluating audit

evidence.

It should consider the results of preliminary audit planning activities and, where applicable, whether knowledge gained onother engagements for Minty is relevant, such as:

– Results of previous audits and the results of any tests over the effectiveness of internal controls.– Evidence of management’s commitment to the design, implementation and maintenance of sound internal control.– Volume of transactions, which may determine whether it is more efficient for the audit team to rely on internal control.– Significant business developments affecting Minty, such as the change in the accounting system and the significant

expenditure on an overhaul of the factory.

The audit strategy should ascertain the nature, timing and extent of resources necessary to perform the audit, such as:

– The selection of the audit team with experience of this type of industry. – Assignment of audit work to the team members.– Setting the audit budget.

Tutorial note: The answer is longer than required for four marks but represents a teaching aid.

10

Audit risk Auditor responseMinty has incurred expenditure of $4·5 million ondeveloping a new brand of fizzy drink. This expenditure isresearch and development under IAS 38 Intangible Assets.The standard requires research costs to be expensed anddevelopment costs to be capitalised as an intangible asset.

If Minty has incorrectly classified research costs asdevelopment expenditure, there is a risk the intangible assetcould be overstated and expenses understated.

Obtain a breakdown of the expenditure and undertaketesting to determine whether the costs relate to the researchor development stage. Discuss the accounting treatmentwith the finance director and ensure it is in accordance withIAS 38.

A large batch of cola products has been damaged in theproduction process and will be in inventory at the year end.No adjustment has been made by management.

The valuation of inventory as per IAS 2 Inventories shouldbe at the lower of cost and net realisable value. Hence it islikely that this inventory is overvalued.

Detailed cost and net realisable value testing to beperformed to assess how much the inventory requireswriting down by.

Due to the damaged cola products, a number of customershave complained. It is likely that for any of the damagedgoods sold, Minty will need to refund these customers.

Revenue is possibly overstated if the sales returns are notcompletely and accurately recorded.

Review the breakdown of sales of damaged goods, andensure that they have been accurately removed fromrevenue.

The management of Minty receives a significant annualbonus based on the value of year end total assets. There isa risk that management might feel under pressure tooverstate the value of assets through the judgements takenor through the use of releasing provisions.

Throughout the audit the team will need to be alert to thisrisk. They will need to maintain professional skepticism andcarefully review judgemental decisions and comparetreatment against prior years.

(d) Substantive procedures

(i) $5 million expenditure incurred on improving the factory production process

– Obtain a schedule of the $5 million expenditure and cast to ensure accuracy.– For those items treated as capital and included with property, plant and equipment, agree to purchase invoices and

ascertain whether they are in fact of a capital nature.– For capital items, agree to the non-current assets register to ensure that they are correctly included.– For capital items, recalculate the depreciation charged to ensure it has been appropriately time apportioned.– For items treated as repairs, agree to invoices to ensure they are not of a capital nature and that they have been

correctly expensed to the statement of profit or loss (income statement).

(ii) Release of $1·5 million allowance for receivables

– Discuss with the finance director his rationale for not providing against any receivables.– Review the aged receivable ledger to identify any slow moving or old receivable balances, discuss the status of

these balances with the credit controller to assess whether they are likely to pay.– Review whether there are any after date cash receipts for slow moving/old receivable balances.– Review customer correspondence to identify any balances which are in dispute or unlikely to be paid.– Review board minutes to identify whether there are any significant concerns in relation to payments by customers.– Calculate the potential level of receivables which are not recoverable and assess whether this is material or not and

discuss with management.

(iii) Damaged inventory

– Obtain a schedule of the $1 million damaged cola products and cast to ensure accuracy.– During the inventory count identify the quantity of the damaged goods and agree to the schedule.– Discuss with management their plans for disposing of these goods, whether they believe these goods have a net

realisable value (NRV) at all or if they will need to be scrapped.– If any of the goods have been sold post year end, agree to the sales invoice to assess NRV. – Agree the cost of the inventory to supporting documentation to confirm the raw material cost, labour cost and any

overheads attributed to the cost. – Quantify the level of adjustment required to value inventory at the lower of cost and NRV and discuss with

management.

2 (a) Test of control and substantive procedures

(i) Tests of control evaluate the operating effectiveness of controls in preventing, or detecting and correcting, materialmisstatements at the assertion level.

Example tests of control over wages and salaries

– Inspect numerical sequence of clock cards/timesheets; if any breaks in the sequence are noted, enquire ofmanagement as to missing payroll records.

– Review a sample of timesheets/clock cards for evidence of authorisation of overtime by a responsible official.– Observe whether there is adequate segregation of duties between human resources and payroll departments.

(ii) Substantive procedures are aimed at detecting material misstatements at the assertion level. They include tests of detailsof transactions, balances, disclosures and substantive analytical procedures.

Example substantive procedures over wages and salaries

– Perform a proof in total of total payroll taking into account joiners and leavers and any annual pay rise, compareany trends to prior years and discuss significant fluctuations with management.

– For a sample of employees, recalculate the gross and net pay and agree to the payroll records to verify accuracy.– Re-perform calculation of statutory deductions to confirm whether correct deductions for this year have been

included within the payroll expense.

Tutorial note: Marks will be awarded for any other relevant wages and salaries tests/procedures.

(b) Reliability of audit evidence

The following factors or generalisations can be made when assessing the reliability of audit evidence:

– The reliability of audit evidence is increased when it is obtained from independent sources outside the entity.– The reliability of audit evidence which is generated internally is increased when the related controls, including those over

its preparation and maintenance, imposed by the entity are effective.– Audit evidence obtained directly by the auditor is more reliable than audit evidence obtained indirectly or by inference.– Audit evidence in documentary form, whether paper, electronic or other medium, is more reliable than evidence obtained

orally.– Audit evidence provided by original documents is more reliable than audit evidence provided by photocopies or

facsimiles, the reliability of which may depend on the controls over their preparation and maintenance.

11

(c) Overall review of financial statements

Procedures an auditor should perform include:

– Reviewing the financial statements to ensure compliance with accounting standards and local legislation disclosure. Thisis sometimes done via the use of a disclosure checklist.

– Reviewing the disclosure of the accounting policies to ensure that they are in accordance with the accounting treatmentadopted in the financial statements, and that they are sufficiently disclosed.

– Reviewing the financial statements to ensure they are consistent with the auditor’s knowledge of the business and theresults of their audit work.

– Reviewing the financial statements to assess whether they adequately reflect the information and explanations previouslyobtained and conclusions reached during the course of the audit.

– Performing analytical procedures of the financial statements, under ISA 520 Analytical Procedures; this helps the auditorto form an overall conclusion on the financial statements.

– Reviewing the aggregate of uncorrected misstatements to assess whether in aggregate a material misstatement arises; ifso discuss with management with regards to a potential adjustment.

– As part of the overall review, the auditor should assess whether the audit evidence gathered by the team is sufficientand appropriate to support the audit opinion.

3 (a) Documenting the sales and despatch system

There are several methods which can be used by the internal audit department of Oregano Co (Oregano) to document theirsystem.

Narrative notes

Narrative notes consist of a written description of the system; they would detail what occurs in the system at each stage andwould include any controls which operate at each stage.

Advantages of this method include:

– They are simple to record; after discussion with staff members of Oregano, these discussions are easily written up asnotes.

– They can facilitate understanding by all members of the internal audit team, especially more junior members who mightfind alternative methods too complex.

Disadvantages of this method include:

– Narrative notes may prove to be too cumbersome, especially if the sales and distribution system is complex.– This method can make it more difficult to identify missing internal controls as the notes record the detail but do not

identify control exceptions clearly.

Questionnaires

Internal control questionnaires (ICQ) or internal control evaluation questionnaires (ICEQ) contain a list of questions; ICQs areused to assess whether controls exist whereas ICEQs test the effectiveness of the controls.


– Questionnaires are quick to prepare, which means they are a timely method for recording the system.– They ensure that all controls present within the system are considered and recorded; hence missing controls or

deficiencies are clearly highlighted by the internal audit team.


– It can be easy for the staff members of Oregano to overstate the level of the controls present as they are asked a seriesof questions relating to potential controls.

– A standard list of questions may miss out unusual controls of Oregano.

Flowcharts

Flowcharts are a graphic illustration of the internal control system for the sales and despatch system. Lines usuallydemonstrate the sequence of events and standard symbols are used to signify controls or documents.


– It is easy to view the sales system in its entirety as it is all presented together in one diagram.– Due to the use of standard symbols for controls, they are easy to spot as are any missing controls.


– They can sometimes be difficult to amend, as any amendments may require the whole flowchart to be redrawn.– There is still the need for narrative notes to accompany the flowchart and hence it can be a time consuming method.

Note: Full marks will be awarded for describing TWO methods for documenting the sales and despatch system andexplaining ONE advantage and ONE disadvantage for each method.

12

(b) Control objectives for sales and despatch system

– To ensure that orders are only accepted if goods are available to be processed for customers.– To ensure that all orders are recorded completely and accurately.– To ensure that goods are not supplied to poor credit risks.– To ensure that goods are despatched for all orders on a timely basis.– To ensure that goods are despatched correctly to customers and that they are of an adequate quality.– To ensure that all goods despatched are correctly invoiced.– To ensure completeness of income for goods despatched.– To ensure that sales discounts are only provided to valid customers.

(c) Deficiencies and controls for Oregano Co’s sales and despatch system

13

Deficiency Control

Inventory availability for telephone orders is not checked atthe time the order is placed. The order clerks manuallycheck the availability later and only then inform customers ifthere is insufficient inventory available.

There is the risk that where goods are not available, orderclerks could forget to contact the customers, leading tounfulfilled orders. This could lead to customerdissatisfaction, and would impact Oregano’s reputation.

When telephone orders are placed, the order clerk shouldcheck the inventory system whilst the customer is on thephone; they can then give an accurate assessment of theavailability of goods and there is no risk of forgetting toinform customers.

Telephone orders are not recorded immediately on the threepart pre-printed order forms; these are completed after thetelephone call.

There is a risk that incorrect or insufficient details may berecorded by the clerk and this could result in incorrectorders being despatched or orders failing to be despatchedat all, resulting in a loss of customer goodwill.

All telephone orders should be recorded immediately on thethree part pre-printed order forms. The clerk should alsodouble check all the details taken with the customer overthe telephone to ensure the accuracy of the order recorded.

Telephone orders are not sequentially numbered. Thereforeif orders are misplaced whilst in transit to the despatchdepartment, these orders will not be fulfilled, resulting indissatisfied customers.

The three part pre-printed orders forms should besequentially numbered and on a regular basis the despatchdepartment should run a sequence check of ordersreceived. Where there are gaps in the sequence, theyshould be investigated to identify any missing orders.

Customers are able to place online orders which will exceedtheir agreed credit limit by 10%. This increases the risk ofaccepting orders from bad credit risks.

Customer credit limits should be reviewed more regularly bya responsible official and should reflect the current spendingpattern of customers. If some customers have increased thelevel of their purchases and are making payments on time,then these customers’ credit limits could be increased.

The online ordering system should be amended to not allowany orders to be processed which will exceed thecustomer’s credit limit.

A daily pick list is used by the despatch department whensending out customer orders. However, it does not appearthat the goods are checked back to the original order; thiscould result in incorrect goods being sent out.

In addition to the pick list, copies of all the related ordersshould be printed on a daily basis. When the goods havebeen picked ready to be despatched, they should be crosschecked back to the original order. They should checkcorrect quantities and product descriptions, as well aschecking the quality of goods being despatched to ensurethey are not damaged.

Additional staff have been drafted in to help the two salesclerks produce the sales invoices. As the extra staff will notbe as experienced as the sales clerks, there is an increasedrisk of mistakes being made in the sales invoices. Thiscould result in customers being under or overcharged.

Only the sales clerks should be able to raise sales invoices.As Oregano is expanding, consideration should be given torecruiting and training more permanent sales clerks whocan produce sales invoices.

Discounts given to customers are manually entered onto thesales invoices by sales clerks. This could result inunauthorised sales discounts being given as there does notseem to be any authorisation required.

In addition, a clerk could forget to manually enter thediscount or enter an incorrect level of discount for acustomer, leading to the sales invoice being overstated anda loss of customer goodwill.

For customers who are due to receive a discount, theauthorised discount levels should be updated to thecustomer master file. When the sales invoices for thesecustomers are raised, their discounts should automaticallyappear on the invoice.

The invoicing system should be amended to prevent salesclerks from being able to manually enter sales discountsonto invoices.

4 (a) (i) Steps prior to accepting the audit of Cinnamon Brothers Co (Cinnamon)

ISA 210 Agreeing the Terms of Audit Engagements provides guidance to Salt & Pepper & Co (Salt & Pepper) on thesteps they should take in accepting the new audit client, Cinnamon. It sets out a number of processes that the auditorshould perform prior to accepting a new engagement, in addition to considering whether preconditions for the audit arein place.

Salt & Pepper should consider any issues which might arise which could threaten compliance with ACCA’s Code ofEthics and Conduct or any local legislation, including conflict of interest with existing clients. If issues arise, then theirsignificance must be considered.

In addition, they should consider whether they are competent to perform the work and whether they would haveappropriate resources available, as well as any specialist skills or knowledge required for the audit of Cinnamon.

Salt & Pepper should consider what they already know about the directors of Cinnamon; they need to consider thereputation and integrity of the directors. If necessary, the firm may want to obtain references if they do not formally knowthe directors.

Additionally, Salt & Pepper should consider the level of risk attached to the audit of Cinnamon and whether this isacceptable to the firm. As part of this, they should consider whether the expected audit fee is adequate in relation to therisk of auditing Cinnamon.

Salt & Pepper should communicate with the outgoing auditor of Cinnamon to assess if there are any ethical orprofessional reasons why they should not accept appointment. They should obtain permission from Cinnamon’smanagement to contact the existing auditor; if this is not given, then the engagement should be refused.

If given permission to respond, the auditors should reply to Salt & Pepper, who should carefully review the response forany issues that could affect acceptance.

(ii) Preconditions for the audit

ISA 210 Agreeing the Terms of Audit Engagements requires auditors to only accept a new audit engagement when ithas been confirmed that the preconditions for an audit are present.

To assess whether the preconditions for an audit are present, Salt & Pepper must determine whether the financialreporting framework to be applied in the preparation of Cinnamon’s financial statements is acceptable. In consideringthis, the auditor should assess the nature of the entity, the nature and purpose of the financial statements and whetherlaw or regulations prescribes the applicable reporting framework.

In addition, they must obtain the agreement of Cinnamon’s management that it acknowledges and understands itsresponsibility for the following:

– Preparation of the financial statements in accordance with the applicable financial reporting framework, includingwhere relevant their fair presentation;

– For such internal control as management determines is necessary to enable the preparation of financial statementswhich are free from material misstatement, whether due to fraud or error; and

– To provide Salt & Pepper with access to all relevant information for the preparation of the financial statements, anyadditional information that the auditor may request from management and unrestricted access to persons withinCinnamon from whom the auditor determines it necessary to obtain audit evidence.

If the preconditions for an audit are not present, Salt & Pepper shall discuss the matter with Cinnamon’s management.Unless required by law or regulation to do so, the auditor shall not accept the proposed audit engagement:

– If the auditor has determined that the financial reporting framework to be applied in the preparation of the financialstatements is unacceptable; or

– If management agreement of their responsibilities has not been obtained.

(b) Engagement letters

Matters to be included in an audit engagement letter:

– The objective and scope of the audit;– The responsibilities of the auditor;– The responsibilities of management;– Identification of the financial reporting framework for the preparation of the financial statements;– Expected form and content of any reports to be issued;– Elaboration of the scope of the audit with reference to legislation;– The form of any other communication of results of the audit engagement;– The fact that some material misstatements may not be detected;– Arrangements regarding the planning and performance of the audit, including the composition of the audit team;– The expectation that management will provide written representations;– The basis on which fees are computed and any billing arrangements;– A request for management to acknowledge receipt of the audit engagement letter and to agree to the terms of the

engagement;– Arrangements concerning the involvement of internal auditors and other staff of the entity;

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– Any obligations to provide audit working papers to other parties;– Any restriction on the auditor’s liability; and– Arrangements to make available draft financial statements and any other information.

(c) Ethical risks and steps to reduce the risks

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Ethical risk Steps to reduce the risks

Salt & Pepper has guaranteed that their audit will not lastlonger than two weeks and will minimise disruption tocompanies.

Every audit engagement is different and hence will require adiffering amount of time. Complex audits cannot possibly becompleted within two weeks as the team would not be ableto gather sufficient and appropriate audit evidence in thistime, leading to an incorrect opinion.

Salt & Pepper should cease this advertising campaignimmediately as it is not in compliance with ACCA’s Code ofEthics and Conduct.

For any potential clients who have approached Salt &Pepper as a result of this advert, the firm should informthem that the audit duration will be based on the level ofaudit risk present, and this could be considerably longerthan two weeks.

Salt & Pepper has offered all new audit clients a freeaccounts preparation service for the first year of theengagement.

Whilst Salt & Pepper is able to prepare accounts for unlistedclients, this does increase the risk of self-review as the auditteam could be auditing their own work.

Additionally, if this service is offered for free, then in order tomake a profit on the total engagement, Salt & Pepper couldbe inclined to substantially reduce the proceduresundertaken on the audit engagement.

For engagements where Salt & Pepper is to prepare theaccounts, they must ensure that this work is undertaken bya team separate to the audit team.

In addition, the firm should ensure that all auditengagements are conducted in accordance withInternational Standards on Auditing.

The firm is not updating engagement letters for existingclients on the basis that they do not change much on ayearly basis.

This is not in accordance with ISA 210 Agreeing the Termsof Audit Engagements as even if engagement letters are notchanged, they should still be reviewed to ensure that theyare still relevant and up to date.

Salt & Pepper should comply fully with ISA 210 andannually review the need for revising the engagementletters.

An existing client of Salt & Pepper has proposed an auditfee based on a percentage of the client’s final pre-tax profit.

This is a contingent fee arrangement and is prohibited as itcreates a self-interest threat which cannot be reduced to anadequate level.

Salt & Pepper should politely decline the proposedcontingent fee arrangement as it would be a breach ofACCA’s Code of Ethics and Conduct. Instead they shouldinform the client that the fees will be based on the level ofwork required to obtain sufficient and appropriate auditevidence.

Salt & Pepper intends to use junior staff for the audit of theirnew client Cinnamon as the timing of the audit is when thefirm is very busy.

As a new engagement, Salt & Pepper has little knowledge ofthe risks associated with this audit. If they use too juniorstaff, they will not be competent enough to assess whetherthey have performed adequate work, and the risk of givingan incorrect audit opinion is increased.

Salt & Pepper should review the staffing of Cinnamon andmake changes to increase the amount of experienced teammembers. If this is not possible, they should discuss withthe directors of Cinnamon to see whether the timing of theaudit could be moved to a point where the firm hasadequate staff resources.

Salt & Pepper has not contacted Cinnamon’s previousauditors.

Contacting the previous auditors is important as the firmneeds to understand why Cinnamon has changed theirauditors. They may have been acting unethically and theirprevious auditors therefore refused to continue.

In addition, it is professional courtesy to contact theprevious auditors.

Salt & Pepper should contact the previous auditors toidentify if there are any ethical issues which would preventthem from acting as auditors of Cinnamon.

5 (a) Opening balances

An auditor is required to obtain sufficient appropriate evidence as to whether the opening balances contain misstatementswhich may materially impact the current year financial statements and whether accounting policies are consistently applied.

(i) The auditor should perform the following procedures:

– Review the most recent financial statements, if any, and the prior year auditor’s report, if any, for informationrelevant to opening balances, including disclosures.

– The auditor shall agree the opening balances to the prior year’s financial statement closing balances to confirmwhether they have been correctly brought forward to the current year.

– They should determine whether the opening balances reflect the application of appropriate accounting policies.– They should consider reviewing the prior auditor’s working papers to obtain evidence regarding opening balances.– If this is not possible, then they should consider whether procedures performed in the current period provide

evidence over the opening balances.– In exceptional cases the auditor may need to perform specific audit procedures to obtain evidence regarding the

opening balances.

(ii) Impact on the audit report

If the auditor is unable to confirm the opening balances, they will be required to express a qualified or disclaimer opinionas they are unable to obtain sufficient evidence.

If the opening balances contain misstatements and they may materially impact the current financial statements, theauditor should express a qualified or adverse opinion.

(b) Reliance on the work of an expert

ISA 620 Using the Work of an Auditor’s Expert provides guidance to the auditor on factors to consider and steps to take inorder to place reliance on the work of an expert.

Brown & Co is required to consider whether the expert has the necessary competence, capabilities including expertise.

They should consider the nature, scope and objective of the inventory expert’s work, such as whether they have relevanttechnical knowledge

The expert’s independence should be ascertained, with potential threats such as undue reliance on Paprika Co or a self-interest threat such as share ownership considered.

In addition, the auditor should meet with the expert and discuss with them their relevant expertise in order to understandtheir field of expertise; in particular whether they have assessed similar inventory to Paprika Co in the past.

The expert’s inventory quantities should be evaluated. Any assumptions used should be carefully reviewed and compared toprevious inventory counts. Also the relevance, completeness and accuracy of any source data used should be verified.

(c) Audit report elements

Extract 1

‘Our responsibility is to express an opinion on all pages of the financial statements.’ This is incomplete as the auditor isrequired to list the components of the financial statements which have been audited, being: statement of financial position,statement of profit or loss (income statement), statement of cash flows, summary of significant accounting policies and otherexplanatory information detailed in the notes to the financial statements.

‘We conducted our audit in accordance with most of the International Standards on Auditing (ISAs).’ An auditor is requiredto perform their audit in accordance with all ISAs and cannot just choose to apply some. They must state that they follow allISAs.

Extract 2

‘Obtain maximum assurance as to whether the financial statements are free from all misstatements.’ The auditor is not ableto obtain maximum assurance and they cannot confirm that the financial statements contain no errors. This is because theydo not test every transaction or balance as it is not practical. They only test a sample of transactions and may only considermaterial balances. Hence auditors give reasonable assurance that financial statements are free from material misstatements.

Extract 3

‘We have a responsibility to prevent fraud and error.’ This is not correct as it is in fact management’s and not the auditor’sresponsibility to prevent and detect fraud and error. The auditor only has a responsibility to detect material misstatementswhether caused by fraud or error.

‘We prepare the financial statements.’ Again this is a responsibility of management, as they prepare the financial statements.The auditor provides an opinion on the truth and fairness of the financial statements.

Extract 4

‘The procedures selected depend on the availability and experience of audit team members.’ The auditor is required to obtainsufficient and appropriate evidence and therefore should carry out any necessary procedures. Availability and experience ofteam members should not dictate the level of testing performed.

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‘We express an opinion on the effectiveness of these internal controls.’ The audit report is produced for the shareholders ofPaprika Co and the auditor provides an opinion on the truth and fairness of the financial statements. Brown & Co will reviewthe effectiveness of the internal controls and they will report on any key deficiencies identified during the course of the auditto management.

Extract 5

‘We did not evaluate the overall presentation of the financial statements as this is management’s responsibility.’ Managementis responsible for producing the financial statements and so will consider the overall presentation as part of this. However,the auditors also have a responsibility to review the overall presentation to ensure that it is in accordance with relevantaccounting standards and in line with their audit findings.

‘We considered the reasonableness of any new accounting estimates.’ The auditor is required to consider all materialaccounting estimates made by management, whether these are brought forward from prior years or are new. Estimates fromprior years, such as provisions, need to be considered annually as they may require amendment or may no longer be required.

‘We did not review the appropriateness of accounting policies as these are the same as last year.’ Accounting policies mustbe reviewed annually as there could be a change in Paprika’s circumstances which means a change in accounting policy maybe required. In addition, new accounting standards may have been issued which require accounting policies to change.

‘We relied on the work undertaken by an independent expert.’ Auditors are not expected to have knowledge of all elementsof a company and hence it is acceptable to rely on the work of an independent expert. However, it is not acceptable for Brown& Co to refer to this in their audit report, as this implies that they are passing responsibility for this account balance to a thirdparty. The auditor is ultimately responsible for the true and fair opinion and so cannot refer in their report to reliance on anythird parties.

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Fundamentals Level – Skills Module, Paper F8 (INT)Audit and Assurance (International) December 2013 Marking Scheme

Marks1 (a) Up to 1 mark for each explanation of audit risk and its components (if just a component is given without

an explanation then just give ½ mark).

– Audit risk (max of 2 marks)– Inherent risk– Control risk– Detection risk 5

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(b) Up to 1 mark per well described risk and up to 1 mark for each well explained response. Overall max of 6 marks for risks and 6 marks for responses.

– $5 million expenditure on production process– Inventory counts at 15 warehouses at year end– Treatment of owned v third party warehouses– New general ledger system introduced at the beginning of the year– Release of opening provision for allowance for receivables– Research and development expenditure– Damaged inventory– Sales returns– Management bonus based on asset values 12

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(c) ½ mark for identifying an area of the audit strategy document and ½ mark for an example for each arearelevant to Minty.

– Main characteristics of the audit – Reporting objectives of the audit and nature of communications required– Factors that are significant in directing the audit team’s efforts– Results of preliminary engagement activities and whether knowledge gained on other engagements is

relevant– Nature, timing and extent of resources necessary to perform the audit 4

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(d) Up to 1 mark per well described substantive procedure, overall maximum of 3 marks per issue.

(i) $5 million expenditure incurred on improving the factory production process– Obtain a schedule of the $5 million expenditure and cast – For capital items, agree to purchase invoices and ascertain if they are in fact of a capital nature– For capital items, agree to the non-current assets register to ensure that they are correctly

included– For capital items, recalculate the depreciation charged to ensure it has been appropriately time

apportioned– For items treated as repairs, vouch to invoices and that correctly expensed to profit or loss

(ii) Release of $1·5 million allowance for receivables– Discuss with the finance director rationale for not providing against any receivables – Review aged receivable ledger to identify any slow moving or old receivable balances, discuss

with the credit controller– Review after date cash receipts for slow moving/old receivable balances– Review customer correspondence to identify any balances in dispute or unlikely to be paid– Review board minutes to identify any significant concerns in relation to payments by customers– Calculate the potential level of receivables which are not recoverable and assess if material or not

(iii) Damaged inventory– Obtain a schedule of the $1 million damaged cola products and cast– During the inventory count identify the damaged goods and agree to the schedule– Discuss with management whether these goods have a net realisable value (NRV)– If any goods sold post year end, agree to sales invoice to assess NRV – Agree the cost of the inventory to supporting documentation to verify the raw material cost,

labour cost and any overheads attributed to the cost – Quantify the level of adjustment required to value inventory at the lower of cost and NRV and

discuss with management 9–––30

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Marks2 (a) Up to 1 mark each for definitions of test of control (TOC) and substantive procedure and up to 1 mark each

for example test of controls and substantive procedures.

– Definition of TOC– Example TOC– Definition of substantive test– Example substantive test 4

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(b) Up to 1 mark per well explained point, maximum of 3 points.

– Reliability increased when it is obtained from independent sources– Internally generated evidence more reliable when the controls are effective– Evidence obtained directly by the auditor is more reliable than evidence obtained indirectly or by

inference– Evidence in documentary form is more reliable than evidence obtained orally– Evidence provided by original documents is more reliable than evidence provided by copies 3

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(c) Up to 1 mark per well explained point, maximum of 3 points.

– Review compliance with accounting standards and local legislation disclosure– Review the disclosure of the accounting policies– Review to ensure consistency with the auditor’s knowledge of the business and the results of their

audit work– Review the financial statements to assess whether adequately reflect the information and explanations

previously obtained and conclusions reached during the course of the audit– Performing analytical procedures of the financial statements to form an overall conclusion– Review aggregate of uncorrected misstatements to assess whether material in aggregate– Assess whether the audit evidence gathered is sufficient and appropriate 3

–––10

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3 (a) Up to 1 mark each for a description of a method, up to 1 mark each for an advantage, up to 1 mark eachfor a disadvantage. Overall max of 2 marks each for methods, advantages and disadvantages.

– Narrative notes– Questionnaires– Flowcharts 6

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(b) 1 mark for each control objective, overall maximum of 2 points.

– To ensure orders are only accepted if goods are available to be processed for customers– To ensure all orders are recorded completely and accurately– To ensure goods are not supplied to poor credit risks– To ensure goods are despatched for all orders on a timely basis– To ensure goods are despatched correctly to customers and are of an adequate quality– To ensure all goods despatched are correctly invoiced– To ensure completeness of income for goods despatched– To ensure sales discounts are only provided to valid customers 2

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(c) Up to 1 mark per well explained deficiency and up to 1 mark for each control. Overall max of 6 marks fordeficiencies and 6 marks for controls.

– Inventory not checked when order taken– Orders not completed on pre-printed order forms– Order forms not sequentially numbered– Credit limits being exceeded– Goods despatched not agreed to order to check quantity and quality– Sales invoices being raised by inexperienced staff– Sales discounts manually entered by sales clerks 12

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Marks4 (a) (i) Up to 1 mark per well described point.

– Compliance with ACCA’s Code of Ethics and Conduct– Competent– Reputation and integrity of directors– Level of risk of Cinnamon audit– Fee adequate to compensate for risk– Write to outgoing auditor after obtaining permission to contact– Review response for any issues 5

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(ii) Up to 1 mark per valid point.

– Determination of acceptable framework– Agreement of management responsibilities– Preparation of financial statements with applicable framework– Internal controls– Provide auditor with relevant information and access– If preconditions are not present discuss with management– Decline if framework unacceptable– Decline if agreement of responsibilities not obtained 3

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(b) ½ mark per valid point.

– Objective/scope– Responsibilities of auditor– Responsibilities of management– Identification of framework for financial statements– Form/content reports– Elaboration of scope– Form of communications– Some misstatements may be missed– Arrangement for audit– Written representations required– Fees/billing– Management acknowledge letter– Internal auditor arrangements– Obligations to provide working papers to others– Restriction on auditor’s liability– Arrangements to make draft financial statements available 2

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(c) Up to 1 mark per well explained ethical risk and up to 1 mark per well explained step to reduce risk, maxof 5 marks for risks and max 5 marks for steps to reduce.

– Duration of audit no more than two weeks– Free accounts preparation service– Engagement letters not updated– Contingent fees– Timing of audit– Contact previous auditor of Cinnamon Brothers Co 10

–––20

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Marks5 (a) (i) Up to 1 mark per well described procedure, overall maximum of 2 marks.

– Review the most recent financial statements– Agree the opening balances to the prior year’s closing balances– Determine whether the opening balances reflect the application of appropriate accounting

policies– Consider reviewing the prior auditor’s working papers to obtain evidence regarding opening

balances– Consider if procedures performed in the current period provide evidence over the opening

balances– Perform specific audit procedures to obtain evidence regarding the opening balances

(ii) Up to 1 mark per well described point, overall maximum of 2 marks.

– Unable to obtain evidence, qualified or disclaimer opinion– Misstatements which impact current accounts, qualified or adverse opinion 4

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(b) Up to 1 mark per valid point.

– Consider if expert has necessary competence, capabilities– Consider nature, scope and objective of their work– Assess independence– Assess whether relevant expertise– Evaluate inventory assessment including assumptions and source data used 4

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(c) Up to 1 mark for each element identified and up to 1 mark per explanation, overall maximum of 6 marksfor identification and 6 marks for explanation of elements.

– Opinion on all pages– Audit in accordance with most International Standards on Auditing– Maximum assurance, free from all misstatements– Responsibility to prevent and detect fraud and error– We prepare financial statements– Procedures depend on availability and experience of team members– We express opinion on effectiveness of internal controls– Did not evaluate overall presentation of financial statements– Considered reasonableness of new accounting estimates– Did not review accounting policies– Relied on work of independent expert 12

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