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F8 AUDIT AND

ASSURANCE

6/14/2012

ABDUL MAJID KHAN

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F8 AUDIT AND ASSURANCE

2 SET # 2 COMPILED BY ABDUL MAJID KHAN

AUDIT PLANNING

All audits start by:

Planning

Understanding

After that the auditor can assess the risk of material misstatements and responded to that risk.

We will see later how the risk of material misstatements can be broken down, but for example if

you are dealing with a relatively new company with an experienced staff with high value, with

portable inventory and many cash transactions. You will probably see that the risk of material

misstatements is relatively high. If the auditors concluded that is the case then you have to

arrange your audit to try and reduce the risk of material misstatements finding its way to the

financial statements.

The audit approach then divides:

Left hand branch. Here, the auditor has reason to expect that there are effective internal

controls operating. If there are effective internal controls then the auditor puts a lot of

reliance on employees of the company checking on one another of reconciliations and

comparisons being performed. So the chances of errors getting through into the financial

statements are relatively remote. Therefore rather than test the high volume of

transactions auditors tend to test the effectiveness of controls.

Right hand branch. If the auditors do not expect there to be effective internal controls

then the only way the auditors will be able to get assurance that the financial statements

are free of material misstatement will be to carry out what are known as substantive testswhich means very high volume testing.

Of course one can start off going down the left hand part of this diagram expecting there to be

internal controls and then once the test being finding those internal controls are not

operating satisfactory which case one will have to change ones approach and go down across

the right hand part of the diagram and carry out full substantial tests almost certainly a

report.

Management will be written to with an outline of why the controls are ineffective or are

operating unsatisfactorily. Hopefully managerial will take action so that in the following year

the problems are less.

After all the detailed testing either of the transactions themselves or of the controls there is an

overall review of the financial statements as a whole, taken as a whole, do we think they show

a true and fair view, and finally the auditors report can be issued.

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AUDIT PLANNING

Audit planning is very important noted in the basis of opinion paragraph in the audit report

where thy auditors state that they planned and performed their audit.

These are the reasons why planning is important:

If u doesnt plan it you wont carry out effectively. You would know something is obvious

is when the year-end is, how many branches or factories a company has, how many staff

members you may need to conduct the audit.

You have to think both of a general strategy in a detailed approach. For Example, in some

very large companies auditors do not visit all the branches every year. They may visit only

a quarter of the branches one year, another quarter the next year and so on. They have to

decide whether not to attend and inventory stock take. They may have to decide whether

not opinions from other experts are required. For Example, on the adequacy of thecompanys pension scheme.

The planning objectives are:

To give appropriate attention to important areas. Is there a high inventory? Is there a high

volume of cash transactions? Are debtors particularly significant?

To identify potential problems. For Example, if the company has recently changed its

computerized accounting system there may well have been problems at the switch-over

time and staff may indeed still be inexperienced.

To carry out the work expeditiously that really means reasonably quickly and efficiently.

To ensure that the right numbers of staff are present with the right skills. We have to

timetable them in so that work for this client and other clients can be accommodated.

To coordinate, if necessary, with other parties. For example, the internal audit department

of the company.

To facilities review. The work performed in an audit is subjected to many reviews. The

audit staff member in-charge of the audit first of all reviews them. All of this has to be

timetabled and time must also be left to clear the review points, for example, if additional

work is required.

UNDERSTANDING THE ENTITY

Pretty much inseparable from the planning process is the process of gaining an understanding

of the entity.

This includes:

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Nature of the entity. We have to understand the nature of the entity. For example, we

simple have to understand what it does, is it in a financial sector, the retail sector, the

manufacturing sector, this may seem trivial and it may help you to think of a new

audit client. You can often tell very little from the name of the client. You have to go

and find out about the entity itself.

Particular regulations. Banks, insurance companies, and may other operations in the

financial sector are subject to regulation and sometimes the auditor has to ensure that

these regulations have been adhered to.

Accounting policies. We need to understand what the entitys accounting policies are;

different entities have different ways of valuing inventories perhaps. If you are a

building company you may have different accounting policies with regard to taking

profits and long-term contracts.

Objectives and strategies. The auditors must gain an understanding of the entitys,

objectives, and strategies. The entitys management defines objectives and strategies

are devised to try and achieve those objectives.

Nature of business risks. Business risk can arise from circumstances which mean that

the objectives and strategies may not be achieved. Business risk is broader than the

risk of material misstatement of the financial statements. Most business risks will

eventually have financial consequences and therefore an effect on the financial

statements is important for the auditors. Therefore to understand what the businesses

objectives and strategies are.

Internal controls. The auditor has to gain an understanding of the entities internal

controls operate. The management of some companies has a very high regard for

careful control, for careful recording, and for attention to detail. Other management

teams may have less regard for this. For example, it may be for more interesting inmaking a sale which is of course important, but are not so interested in perhaps

recording that sale correctly. They will see some aspects of internal control as been in

nuisance.

How does management identify business risks? It is important for management to

identify business risks. Management has a real expertise of the business sector and if

they cant identify business risks it can be relatively difficult for the auditor to ensure

that all business risks have been covered.

Financial performance. Finally, the auditors should obtain an understanding of the

measurement and review of the entitys financial performance. Performance measures

and the review indicate to the auditor aspects of the entitys performance thatmanagement and others considered be important. Obtaining an understanding of the

entitys performance measures assist the auditor in considering whether such

pressures result in management actions that may have increased the risks of material

misstatements.

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SUMMARY

WHY PLAN (ISA-300)

Enables the audit to be carried out in an effective and timely manner.

To reduce audit risk.

To determine the audit approach.

To decide how much audit work.

To facilitate review.

Matters to consider when planning an audit

ISA 300 suggests

Knowledge of the business.

Understanding accounting and internal control systems.

Risk and materiality.

Nature, extent and timing of procedures.

Coordination, direction, supervision and review.

Other matters.

In the exam you might use the mnemonic MARE

Materiality Accounting treatment problems more likely where there is

ComplexityEstimationJudgment

Risk Evidence practical problems

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Contents of the audit strategy memorandum Q29 Tempest 20 marks Characteristics of the business what does the business do Nature of assignment - what work is to be done is it and Audit?? Key dates interim and final audit dates, deadlines for the AGM Budget

Overall audit approach test of control and substantive assess the systems to decidereliance Overall materiality Risk areas and important figures Specific areas of audit work (because of issues) Client assistance IA, documentation etc

INTERIM AND FINAL AUDIT

INTERIM AUDIT FINAL AUDIT

MEANING It is voluntary.Conducted in betweentwo final audits (duringan accounting period)

Done after the end ofthe accounting period

ADVANTAGES Errors and frauds arediscovered at an earlystage.

Books and records ofclients are always up todate.

Reduces workload for

final audit.

Allocation of work tostaff becomes easier.

Costs are lower. No duplication of work

DISADVANTAGES Audited figures may bealtered.

Not relevant for smallentities.

High cost.

Delay in presentationof final accounts andcompletion of work

May overlook somedetailed aspects

Contents of the audit planning memorandum

Risk assessment. Audit approach (see below).

Sampling. Planned audit procedures. Key audit risks.

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JUNE 2009 QUESTION 1

Background information

B-Star is a theme park based on a popular series of childrens books. Customers pay a fixed fee toenter the park, where they can participate in a variety of activities such as riding roller-coasters,playing on slides and purchasing themed souvenirs from gift shops.The park is open all year and has been in operation for the last seven years. It is located in acountry which has very little rainfall the park is open-air so poor weather such as rain results ina significant fall in the number of customers for that day (normally by 50%). During the last seven

years there have been on average 30 days each year with rain.B-Star is now very successful; customer numbers are increasing at approximately 15% each year.

Ticket sales

Customers purchase tickets to enter the theme park from ticket offices located outside the park.

Tickets are only valid on the day of purchase. Adults and children are charged the same price foradmission to the park. Tickets are preprinted and stored in each ticket office.Tickets are purchased using either cash or credit cards.Each ticket has a number comprising of two elements two digits relating to the ticket officefollowed by six digits to identify the ticket. The last six digits are in ascending sequential order.

Cash sales

1. All ticket sales are recorded on a computer showing the amount of each sale and thenumber of tickets issued.

2. This information is transferred electronically to the accounts office.

3. Cash is collected regularly from each ticket office by two security guards. The cash is thencounted by two accounts clerks and banked on a daily basis.4. The total cash from each ticket office is agreed to the sales information that has been

transferred from each office.5. Total cash received is then recorded in the cash book, and then the general ledger.

Credit card sales

1. Payments by credit cards are authorized 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 thetotal sales values to the amounts received from the credit card companies, less thecommission payable to those companies. The receivables ledger is updated with thepayments received.

You are now commencing the planning of the annual audit of B-Star. The date is 3 June 2009 andB-Stars year end is 30 June 2009.

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Required:

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

SOLUTION

SECTION OF DOCUMENT PURPOSE EXAMPLE FROM B-STAR

Characteristics ofengagement

This section of audit strategyidentifies the keycharacteristics of the client

which helps the auditor todevelop basic knowledge aboutthe client (number of locations,financial reporting framework,

etc)

Use of IT (ticket sales arerecorded on computer)

Reporting objectives This section of audit strategyidentifies the types ofcommunication the auditorneeds to have with the clientmanagement, componentauditor and team members

N/A

Significant factors This section of audit strategyidentifies the significant areasof client which includessignificant changes in business,

high risky areas, quality ofinternal controls, etc.

1. Cash sales2. Reasonable control

procedures in place

Nature, timing and extent ofresources

This section of audit strategyidentifies the time and workallocation among teammembers normally in highrisky areas.

Senior audit staff will beallocated to the audit of cashsale (risky areas identifiedabove)

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RISK

The sources of risk

International standard on auditing 315, states that the auditor should:

Obtain an understanding of the entity and its environment sufficient to identify and

assess the risk of a material misstatement in the financial statements.

The total risk of material misstatement can be split into two:

Business risks.

Audit risks.

Business risks result from significant conditions, events, circumstance, actions or inactions that

could adversely affect the entities ability to achieve its objectives and execute its strategies. Thebusiness risks can itself be split into:

Financial risk

Operational risk, and

Compliance risk.

Financial risks, for example, could arise because of high borrowings and a rise in interest rates.This will put to business under severe pressure and could increase the risk of material

misstatement, perhaps with regards to going concern problems. Operational risks could arise

from operational errors. The products are made incorrectly, that there might be warranty claims,

that there is a loss of reputations or indeed the products simply become old-fashioned and an

insufficient investing has been made historical in research and development to have new products

coming online. Compliance risks arises from a failure to comply with regulations, this can mean

that the business has got large penalties or fines to pay or it may result in the business been

prevented from continuing to trade.

The auditor does not have a responsibility to identify or assess all business risks, but anunderstanding of business risks increases a likelihood of identifying risks of material

misstatement. Other than potential implications for going concern assumptions, business risk is

not something to worry about at the F8 stage.

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AUDIT RISK

The second component of total risk is the audit risk, and that is a risk that the auditor gives an

inappropriate opinion on the financial statements. For example, the audit report states thefinancial statement show a true and fair view when in fact they contain a material misstatement.

Audit risk comprises two elements:

The risk that the financial statements actually contained the material misstatement.

The risk that the auditors have failed to detect it. This is detection risk.

In turn, we can ask why the financial statements might contain a material misstatement

and that depends on two other risks:

The risk that the error occurs in the first place, that is inherent risk

The risk that the clients own procedures dont pick up and correct that error that is

known as control risk.

Therefore, for an inappropriate opinion to have been expressed:

The audit risk equation

The risks found of an audit can be expressed as an equation. This equation is saying that the audit

risk depends on inherent risks, the control risks, and the detections risk.

AR = IR x CR x DR

Dont look upon it too mathematically. What it is saying is auditors will want the audit risk to be

low: they dont want to make an error in their audit opinion. If you want the audit risk being low

then the terms on the right hand side of the equation, or at least some of them, have to be low.

The errorhas to

occured

The client'sprocedures andstaff must not

have picked that

up and correctedit

Theauditors

musthave

failed todetect it

The materialerror reachesthe published

financialstatements

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If both inherent risk and control risks are high then the only way you will get the audit risk low is

to be very sure that your detections risk is low. This means you would have to do an enormous

amount of work.

If, however, the inherent risk and control risks are low themselves, in other words that there is

only a small chance the error occurs in the first place and the client systems and staff are verygood, then you can achieve a relatively low audit risk even with a relatively high detections risk.

In other words the auditor doesnt have to do quite so much work.

In the short-term the auditors cannot control the inherent risk and the control risks; those are

givens in an audit. The auditor must respond by varying the amount of work which is actually

performed.

The detections risk itself depends on two components:

Sampling risk

Non-sampling risk.

Sampling risk arises because, in most audits, auditors only look at a very small proportional of

transactions and documents. There is always a risk that they happen to look at all the documents

and transactions which are correct and dont find any which are incorrect. That can just be bad

luck in sampling and could lead the auditor to do too little work. Sampling risk can be reduced by

examining larger samples.

Non-sampling risk arises from reasons other than sampling. For example, if the staff and the audit

were inappropriately qualified then there is a high risk because they wouldnt properly

understand what was going on or detect the regularities in the financial statements. Non-

sampling risk can be reduced by batter planning of the audit, and ensuring that audit staff are

better trained, have appropriate skills and that their work is well-supervised and reviewed.

Examples of three types of risk

Lets look at the three types of risks in a little bit more detail.

Inherent risk is the risk that there is a misstatement that could be material, if there were norelated internal controls which could identify and trap that misstatement. Inherent risks can be

increased by complex transactions which are difficult to understand, inexperience staff, a cash-

based business (because cash is usually more difficult to record that bank transfers) a pressure to

perform which may mean that some staff members who have optimistic view of sales and costs,

and short reporting deadlines.

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Control riskis the risk that material misstatement, having occurred, will not be prevented,detected, or corrected by internal control system. The three elements which effects which affect

control risk are the control environment (that is really the status that the internal control system

has in the organization), the design of the internal control system itself, and finally how well and

consistently the internal control system operates.

Detections risk is the failure of the auditor to detect the material misstatement in thefinancial statements. This will be increased if the auditor was relatively inexperienced, if it was a

new client, if there was a lot of time and fee pressure, if planning was poor so the entity was

poorly understood, and if the auditor was straying into an industry where they had little previous

experience or expertise.

WHERE THE AUDIT RISK CAN BE FOUND

Audit risk has to be reduced to an acceptable amount of both the

Financial statement level

Assertion levels.

Dealing first with the assertion level, essentially any single figure which appears in the financial

statements is making an assertion is saying something about its size, its accuracy, its valuation.

There are some figures, for example, directors emoluments which in the overall scheme of thing

may not be terribly material, but which by law are required to be disclosed accurately andrelatively a material misstatement would mean that the accounts are not showing a true and fair

view.

Dealing with the financial statement level, all the figures appearing in the financial statements

could be true, but overall the financial statements could still not how a true and fair view. For

example, liquidity issues could be concealed or in some way the overall effect of the accounts is to

be misleading.

To get a higher assurance at the assertion levels audit procedures must be designed and

performed in line with the assessed risks of material misstatement. For example, if you are

worried about debtors valuations you have to do a lot more work verifying the debtors arerecoverable. Perhaps you could try to wait for several months after year end to see which

customers actually pay.

At a financial statement level just to doing more work as such is probably insufficient. You need

more experienced and batter staff. Misstatements at the financial statement level are potentially

more subtle and require a higher level of skill to detect.

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SUMMARYBUSINESS RISK

Risk inherent to the business

Of interest to the auditor as business risk may cause material misstatements in the financial

statements Broken down into

a) Financial riskb) Operational riskc) Compliance risk

AUDIT RISK

AR = IR x CR x DR

Definitions are in the open book glossary of terms.

Audit risk

Inherent risk Control risk

Detection risk

Risk is determined at the planning stage as it affects the nature, extent and timing of work to bedone.

Materiality ISA 320

Information is material if its misstatement or omission would influence the decision ofusers of the financial statements.

This can result from size or nature.

Qualitative considerations

Effect on use e.g. descriptions of accounting policies should not be misleading. Some items are capable of precise determination e.g. cash, share capital. Directors transactions must be accurate.

Quantitative considerations

Auditor must use their judgment Some rules of thumb:

- 1% revenue1 2% gross assets5 10% profit before tax

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JUNE 2010 QUESTION 2 (B)

ISA 320Materiality in Planning and Performing an Auditprovides guidance on the concept ofmateriality in planning and performing an audit.

Required:

Define materiality and determine how the level of materiality is assessed. (5 marks)

SOLUTION

Materiality is defined as follows:

Misstatements, including omissions, are considered to be material if they, individually or in theaggregate, could reasonably be expected to influence the economic decisions of users taken on thebasis of the financial statements.

In assessing the level of materiality there are a number of areas that should be considered. Firstlythe auditor must consider both the amount (quantity) and the nature (quality) of anymisstatements, or a combination of both. The quantity of the misstatement refers to the relativesize of it and the quality refers to an amount that might be low in value but due to its prominencecould influence the users decision, for example, directors transactions.

In assessing materiality the auditor must consider that a number of errors each with a low valuemay when aggregated amount to a material misstatement.

The assessment of what is material is ultimately a matter of the auditors professional judgment,

and it is affected by the auditors perception of the financial information needs of users of thefinancial statements.

In calculating materiality the auditor should also consider setting the performance materialitylevel. This is the amount set by the auditor, it is below materiality, and is used for particulartransactions, account balances and disclosures.

As per ISA 320 materiality is often calculated using benchmarks such as 5% of profit before tax or1% of gross revenue. These values are useful as a starting point for assessing materiality.

DECEMBER 2009 QUESTION 1 (a)

Explain the importance of audit planning and state TWO matters that would be includedin an audit plan. (6 marks)

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SOLUTION

Audit planning is addressed by ISA 300 (Redrafted) Planning an Audit of Financial Statements.The standard notes that an audit plan will be developed after the overall audit strategy has beenestablished and then states that adequate planning benefits the audit of financial 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 organize and manage the audit engagement so that it isperformed in an effective and efficient manner.

Assisting in the selection of engagement team members with appropriate levels ofcapabilities 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 oftheir 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:

(1) A description of the nature, timing and extent of planned risk assessment procedures sufficientto assess the risks of material misstatement.

(2) This would include assessment of inherent risk and control risk at both the entity andassertion level. An important element of the plan would be the understanding and assessment ofthe control environment of the organization.

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

(4)This would include an explanation of the decision

Whether to test the operating effectiveness of controls (an important decision is whetherreliance is to be placed on controls).

On the nature, timing and extent of planned substantive procedures (this would depend onthe decision as to the level of control risk).

(5) Audit procedures required to be carried out for the engagement in order to comply with ISAs,for example, the use of external confirmations to obtain sufficient appropriate evidence at theassertion level.

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Introduction and client backgroundYou are an audit senior in Staple and Co and you are commencing the planning of the audit ofSmoothbrush 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 operatesfrom one central site, which includes the production facility, warehouse and administrationoffices.Smoothbrush sells all of its goods to large home improvement stores, with 60% being to one largechain store Homewares. The company has a one year contract to be the sole supplier of paint toHomewares. It secured the contract through significantly reducing prices and offering a four-month credit period, the companys normal credit period is one month.

Goods in/purchasesIn recent years, Smoothbrush has reduced the level of goods directly manufactured and insteadstarted 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 monthsin advance and goods can be in transit for up to two months. Smoothbrush accounts for theinventory when it receives the goods.To avoid the disruption of a year-end inventory count, Smoothbrush has this year introduced acontinuous/perpetual inventory counting system. The warehouse has been divided into 12 areasand these are each to be counted once over the year. The counting team includes a member of theinternal audit department and a warehouse staff member. The following procedures have beenadopted;1. The team prints the inventory quantities and descriptions from the system and these recordsare 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 finance department for adjustments to be made to therecords when the count has finished.5. During the counts there will continue to be inventory movements with goods arriving andleaving 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 needsthis provision.

Finance DirectorIn May 2010 Smoothbrush had a dispute with its finance director (FD) and he immediately left thecompany. The company has temporarily asked the financial controller to take over the role whilethey recruit a permanent replacement.The old FD has notified Smoothbrush that he intends to sue for unfair dismissal. The company isnot proposing to make any provision or disclosures for this, as they are confident the claim has nomerit.

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Required:

(a) Identify and explain the audit risks identified at the planning stage of the audit ofSmoothbrush Paints Co. (10 marks)

IDENTIFICATION OF RISK EXPLANATION OF RISKSmoothbrush supplies 60% of its goods toHomewares at a significantly reduced sellingprice, hence inventory may be overvalued.

Per IAS 2 Inventories, inventory should bestated at the lower of cost and net realizable

value (NRV). Therefore, as selling prices aremuch lower for goods sold to Homewares,there is a risk that the NRV of some inventoryitems may be lower than cost and hence thatinventory could be overvalued.

Recoverability of receivable balances as creditperiod extended

Smoothbrush has extended its credit terms toHomewares from one month to four months.Hence there is an increased risk as balancesoutstanding become older, that they maybecome irrecoverable.

Valuation of plant and equipment. The production facility has a large amount ofunused plant and equipment. As per IAS 16Property, Plant and Equipment and IAS 36Impairment of Assets, this plant and equipmentshould be stated at the lower of its carrying

value and recoverable amount, which may be atscrap value depending on its age and condition.

60% paints are imported from South Asia This situation might result in an inappropriaterecognition of exchange gain/loss.

Smoothbrush will need to identify appropriateamount of exchange gain/loss resulting fromfluctuation in exchange rates. However, themanagement might be interested in showing apicture of exchange gains to supportprofitability of Smoothbrush.

Redundant plant and equipment The situation might result in an inappropriatevalue at which the redundant plant needs to berecorded if the financial statements ofSmoothbrush Co. Redundant plants need to berecorded at a lower of recoverable amount or

value in use. There is a risk that management isnot applying the policy accurately thusaffecting the value of plant in financialstatements

Inherent risk is higher due to the changes inthe finance department

The financial controller has been appointed astemporary FD and this lack of experience couldresult in an increased risk of errors arising inthe financial statements. In addition the

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previous FD is not available to help the financeor audit team.

Provisions/contingent liability disclosures maynot be complete

The companys finance director (FD) has leftand is intending to sue Smoothbrush for unfairdismissal. However, the company does not

intend to make any provision/disclosures forsums due to the FD.Under IAS 37 Provisions, Contingent LiabilitiesandContingent Assets, if there is a presentobligation, a probable outflow of resources tosettle the obligation and a reliable estimate canbe made of the obligation then a provisionshould be recognized. If the obligation is onlypossible, or if there is a present obligation but itis not recognized as there is not a probableoutflow of resources, or the amount of the

obligation cannot be measured with sufficientreliability then a contingent liability should bedisclosed, unless the likelihood of payment isremote


Zak Co sells garden sheds and furniture from 15 retail outlets. Sales are made to individuals, withincome being in the form of cash and debit cards. All items purchased are delivered to thecustomer using Zaks own delivery vans; most sheds are too big for individuals to transport intheir own motor vehicles. The directors of Zak indicate that the company has had a difficult year,

but are pleased to present some acceptable results to the members.The income statements for the last two financial years are shown below:

Income statement

31ST MARCH 2008 31ST MARCH 2007

REVENUE 7482 6364

COST OF SALES (3520) (4253)

GROSS PROFIT 3962 2111

OPERATINGEXPENSES

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ADMINISTRATION (1235) (1320)

SELLING ANDDISTRIBUTION

(981) (689)

INTEREST PAYABLE (101) (105)

INVESTMENTINCOME

145 -

PROFIT/(LOSS)BEFORE TAX

1790 (3)

Financial statementextract

Cash and bank 253 (950)

Required:

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

SOLUTION

Net profit

Overall, Zaks result has changed from a net loss to a net profit. Given that sales have onlyincreased by 17% and those expenses, at least administration expenses, appear low, then there isthe 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 incomemust be ascertained as the change does not conform to the directors comments. It is possiblethat the industry as a whole, has been growing allowing Zak to produce this good result.

Cost of sales fall 17%

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A fall in cost of sales is unusual given that sales have increased significantly. This may have beencaused by an incorrect inventory valuation and the use of different (cheaper) suppliers which maycause 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 change will need to focus initially on the change in sales and cost ofsales.

Administration fall 6%

A fall is unusual given that sales are increasing and so an increase in administration to supportthose sales would be expected.Expenditure may be understated, or there has been a decrease in the number of administrationstaff.

Selling and distribution increase 42%

This increase does not appear to be in line with the increase in sales selling and distributionwould be expected to increase in line with sales. There may be a misallocation of expenses fromadministration or the age of Zaks delivery vans is increasing resulting in additional service costs.

Interest payable small fall

Given that Zak has a considerable cash surplus this year, continuing to pay interest is surprising.The amount may be overstated reasons for lack of fall in interest payment e.g. loans that cannotbe 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 indicatingpossible errors in the amount or other income generating assets not disclosed on the balancesheet extract.

DECEMBER 2008 QUESTION 4

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

The EuKaRe charity was established in 1960. The charitys aim is to provide support to childrenfrom disadvantaged backgrounds who wish to take part in sports such as tennis, badminton andfootball.EuKaRe has a detailed constitution which explains how the charitys income can be spent. Theconstitution also notes that administration expenditure cannot exceed 10% of income in any year.The charitys income is derived wholly from voluntary donations. Sources of donations include:(1) Cash collected by volunteers asking the public for donations in shopping areas,

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(2) Cheques sent to the charitys head office,(3) Donations from generous individuals. Some of these donations have specific clauses attachedto them indicating that the initial amount donated (capital) cannot be spent and that the income(interest) from the donation must be spent on specific activities, for example, provision of sportsequipment.

The rules regarding the taxation of charities in the country EuKaRe is based are complicated, withonly certain expenditure being allowable for taxation purposes and donations of capital beingtreated as income in some situations.

Required:

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

SOLUTION

(a) Audit risk

Audit riskis the risk that an auditor gives an inappropriate opinion on the financial statementsbeing audited.Inherent riskis the susceptibility of an assertion to a misstatement that could be materialindividually or when aggregated with misstatements, assuming that there are no related controls.The risk of such misstatement is greater for some assertions and related classes of transactions,account balances, and disclosures than for others.Control riskis the risk that a material error could occur in an assertion that could be material,individually or when aggregated with other misstatements, will not be prevented or detected on a

timely basis by the companys internal control systems.Detection riskis the risk that the auditors procedures will not detect a misstatement that exists inan assertion that could be material, individually or when aggregated with other misstatements.

(b)

AREA OF INHERENT RISK EFFECT ON AUDIT APPROACHIncome is from voluntary donations only. Thereis a risk that donations will fall, especially

where donors own income is limited by thecredit crunch etc.

It is difficult to estimate that income in thefuture will be sufficient to meet the expenditureof the charity.

Audit of the going concern concept (as inensuring that the charity can still operate) willtherefore be quite difficult

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

Careful review of expenditure will be necessaryto ensure that expenditure is not ultra viresthe objectives of the charity.The auditor will need to review the constitutionof the EuKaRe charity carefully in this respect.

Taxation rules relevant to charities. There is a The auditor will need to ensure that staff,

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risk that the rules will be broken due to lack ofcorrect analysis of income/expenditure.

familiar with the taxation rules affecting thecharity, is on the audit team.

Requirement to report expenditure inaccordance with the constitution administration expenditure can be no more

than 10% of total income. Risks here includeincome being overstated to allow expenditureto be overstated.

The trustees may attempt to hide excessiveexpenditure on administration under otherexpense headings.

As the auditor has to report on the accuracy ofincome and expenditure then audit proceduresmust focus on the accuracy of recording ofexpenditure.

Completeness of income where there are nocontrols to ensure income is complete forexample sales invoices are not raised to obtaindonations and donations could be stolen bystaff.

Audit tests are unlikely to be effective to meetthe assertion of completeness. The audit reportmay need to be modified and qualified toexplain the lack of evidence stating thatcompleteness of income cannot be confirmed.

Donations to charity for specific activities forexample provision of sports equipment. Thereis a risk that donations are not spent inaccordance with donors instructions

Documentation for any donation will need tobe obtained and then expenditure agreed to theterms of the documentation. Any discrepancies

will have to be reported to management.

DECMBER 2010 QUESTION 3

(c)You are the audit senior of White & Co and are planning the audit of Redsmith Co for the yearended 30 September 2010. The company produces printers and has been a client of your firm fortwo years; your audit manager has already had a planning meeting with the finance director. Hehas provided you with the following notes of his meeting and financial statement extracts.Redsmiths management was disappointed with the 2009 results and so in 2010 undertook anumber of strategies to improve the trading results. This included the introduction of a generoussales-related bonus scheme for their salesmen and a high profile advertising campaign. In

addition, as market conditions are difficult for their customers, they have extended the creditperiod given to them.The finance director of Redsmith has reviewed the inventory valuation policy and has includedadditional overheads incurred this year as he considers them to be production related. He ishappy with the 2010 results and feels that they are a good reflection of the improved tradinglevels.

Financial statement extracts for year ended 30 September

DRAFT 2010 ACTUAL 2009

Revenue 23.0 18.0Cost of sales (11) (10)

Gross profit 12 8

Operating expenses (7.5) (4.0)

PBIT 4.5 4

Inventory 2.1 1.6

Receivables 4.5 3.0

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Cash - 2.3

Trade payables 1.6 1.2

Overdraft 0.9 -

Required:

Using the information above:

(1) Calculate FIVE ratios, for BOTH years, which would assist the audit senior in planningthe audit; and(5 marks)

(2) From a review of the above information and the ratios calculated, explain the auditrisks that arise and describe the appropriate response to these risks. (10 marks)

SOLUTION

(c) (1) 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 = 5.8

Quick ratio (6.6-2.1)/2.5 = 1.8 (6.9-1.6)/ 1.2 = 4.4

(c) (2)

Audit risk Response to riskManagement was disappointed with 2009results and hence undertook strategies toimprove the 2010 trading results. There is a riskthat management might feel under pressure tomanipulate the results through the judgmentstaken or through the use of provisions.

Throughout the audit the team will need to bealert to this risk. They will need to carefullyreview judgmental decisions and comparetreatment against prior years.

A generous sales-related bonus scheme hasbeen introduced in the year; this may lead tosales cut-off errors with employees aiming tomaximize their current year bonus.

Increased sales cut-off testing will be performedalong with a review of post year-end salesreturns as they may indicate cut-off errors.

Revenue has grown by 28% in the yearhowever; cost of sales has only increased by10%. This increase in sales may be due to thebonus scheme and the advertising however,

During the audit a detailed breakdown of saleswill be obtained, discussed with managementand tested in order to understand the salesincrease.

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this does not explain the increase in grossmargin. There is a risk that sales may beoverstated.Gross margin has increased from 444% to522%.

Operating margin has decreased from 222% to196%. This movement in gross margin issignificant and there is a risk that costs mayhave been omitted or included in operatingexpenses rather than cost of sales. There hasbeen a significant increase in operatingexpenses which may be due to the bonus andthe advertising campaign but could be relatedto the misclassification of costs.

The classification of costs between cost of salesand operating expenses will be compared with

the prior year to ensure consistency.

The finance director has made a change to theinventory valuation in the year with additionaloverheads being included. In additioninventory days have increased from 58 to 70days. There is a risk that inventory isovervalued

The change in the inventory policy will bediscussed with management and a review of theadditional overheads included performed toensure that these are of a production nature.Detailed cost and net realizable value testing tobe performed and the aged inventory report tobe reviewed to assess whether inventoryrequires writing down.

Receivable days have increased from 61 to 71days and management have extended the creditperiod given to customers. This leads to anincreased risk of recoverability of receivables.

Extended post year-end cash receipts testingand a review of the aged receivables ledger tobe performed to assess valuation

The current and quick ratios have decreasedfrom 58 to 26 and 44 to 18 respectively. In

addition the cash balances have decreasedsignificantly over the year. Although all ratiosare above the minimum levels, this is still asignificant decrease and along with the increaseof sales could be evidence of overtrading whichcould result in going concern difficulties

Detailed going concern testing to be performedduring the audit and discussed with

management to ensure that the going concernbasis is reasonable.


(b) Donald Co operates an airline business. The companys year-end is 31 July 2011.

You are the audit senior and you have started planning the audit. Your manager has asked you tohave a meeting with the client and to identify any relevant audit risks so that the audit plan canbe completed. From your meeting you ascertain the following:In order to expand their flight network, Donald Co will need to acquire more airplanes; they haveplaced orders for another six planes at an estimated total cost of $20m and the company is notsure whether these planes will be received by the year end. In addition the company has spent anestimated $15m on refurbishing their existing planes. In order to fund the expansion Donald Co

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has applied for a loan of $25m. It has yet to hear from the bank as to whether it will lend them themoney.The company receives bookings from travel agents as well as directly via their website. The travelagents are given a 90-day credit period to pay Donald Co, however, due to difficult tradingconditions a number of the receivables are struggling to pay. The website was launched in 2010

and has consistently encountered difficulties with customer complaints that tickets have beenbooked and paid for online but Donald Co has no record of them and hence has sold the seat toanother customer.Donald Co used to sell tickets via a large call centre located near to their head office. However, inMay they closed it down and made the large workforce redundant.

Required:

Using the information provided, describe FIVE audit risks and explain the auditorsresponse to each risk in planning the audit of Donald Co. (10 marks)

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