F7 past papers by Paula Wallace

Audit and Assurance (International)

Time allowed Reading and planning: 15 minutes Writing: 3 hours ALL FIVE questions are compulsory and MUST be attempted.

Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Pilot Paper â&#x20AC;&#x201C; Skills module

This is a blank page The question paper starts on page 3

ALL FIVE questions are compulsory and MUST be attempted

Westra Co assembles mobile telephones in a large factory. Each telephone contains up to 100 different parts, with each part being obtained from one of 50 authorised suppliers.

Like many companies, Westra’s accounting systems are partly manual and partly computerised. In overview the systems include: (i) Design software (ii) A computerised database of suppliers (bespoke system written in-house at Westra) (iii) A manual system for recording goods inwards and transferring information to the accounts department (iv) A computerised payables ledger maintained in the accounts department (purchased off-the-shelf and used with no program amendments) (v) Online payment to suppliers, also in the accounts department (vi) A computerised general ledger which is updated by the payables ledger

Mobile telephones are assembled in batches of 10,000 to 50,000 telephones. When a batch is scheduled for production, a list of parts is produced by the design software and sent, electronically, to the ordering department. Staff in the ordering department use this list to place orders with authorised suppliers. Orders can only be sent to suppliers on the suppliers’ database. Orders are sent using electronic data interchange (EDI) and confirmed by each supplier using the same system. The list of parts and orders are retained on the computer in an ‘orders placed’ file, which is kept in date sequence.

Parts are delivered to the goods inwards department at Westra. All deliveries are checked against the orders placed file before being accepted. A hand-written pre-numbered goods received note (GRN) is raised in the goods inwards department showing details of the goods received with a cross-reference to the date of the order. The top copy of the GRN is sent to the accounts department and the second copy retained in the goods inwards department. The orders placed file is updated with the GRN number to show that the parts have been received.

Paper invoices are sent by all suppliers following dispatch of goods. Invoices are sent to the accounts department, where they are stamped with a unique ascending number. Invoice details are matched to the GRN, which is then attached to the invoice. Invoice details are then entered into the computerised payables ledger. The invoice is signed by the accounts clerk to confirm entry into the payables ledger. Invoices are then retained in a temporary file in number order while awaiting payment.

After 30 days, the payables ledger automatically generates a computerised list of payments to be made, which is sent electronically to the chief accountant. The chief accountant compares this list to the invoices, signs each invoice to indicate approval for payment, and then forwards the electronic payments list to the accounts assistant. The assistant uses online banking to pay the suppliers. The electronic payments list is filed in month order on the computer.

Required: (a) List the substantive audit procedures you should perform to confirm the assertions of completeness, occurrence and cut-off for purchases in the financial statements of Westra Co. For each procedure, explain the purpose of that procedure. (12 Marks) (b) List the audit procedures you should perform on the trade payables balance in Westra Co’s financial statements. For each procedure, explain the purpose of that procedure. (8 Marks) (c) Describe the control procedures that should be in place over the standing data on the trade payables master file in Westra Co’s computer system. (5 Marks) (d) Discuss the extent to which computer-assisted audit techniques might be used in your audit of purchases and payables at Westra Co. (5 Marks) (30 marks)

(a) ISA 210 Terms of Audit Engagements explains the content and use of engagement letters.

Required:

State SIX items that could be included in an engagement letter.

(b) ISA 500 Audit Evidence explains types of audit evidence that the auditor can obtain.

Required:

State, and briefly explain, four types of audit evidence that can be obtained by the auditor.

(3 marks)

(4 marks)

(c) ISA 700 The Independent Auditor’s Report on a Complete Set of General Purpose Financial Statements explains the form and content of audit reports.

Required:

State three ways in which an auditor’s report may be modified and briefly explain the use of each modification. (3 marks) (10 marks)

You are the audit manager in the audit firm of Dark & Co. One of your audit clients is NorthCee Co, a company specialising in the manufacture and supply of sporting equipment. NorthCee have been an audit client for five years and you have been audit manager for the past three years while the audit partner has remained unchanged.

You are now planning the audit for the year ending 31 December 2007. Following an initial meeting with the directors of NorthCee, you have obtained the following information. (i) NorthCee is attempting to obtain a listing on a recognised stock exchange. The directors have established an audit committee, as required by corporate governance regulations, although no further action has been taken in this respect. Information on the listing is not yet public knowledge. (ii) You have been asked to continue to prepare the company’s financial statements as in previous years. (iii) As the company’s auditors, NorthCee would like you and the audit partner to attend an evening reception in a hotel, where NorthCee will present their listing arrangements to banks and existing major shareholders. (iv) NorthCee has indicated that the fee for taxation services rendered in the year to 31 December 2005 will be paid as soon as the taxation authorities have agreed the company’s taxation liability. You have been advising NorthCee regarding the legality of certain items as ‘allowable’ for taxation purposes and the taxation authority is disputing these items.

Finally, you have just inherited about 5% of NorthCee’s share capital as an inheritance on the death of a distant relative. Required: (a) Identify, and explain the relevance of, any factors which may threaten the independence of Dark & Co’s audit of NorthCee Co’s financial statements for the year ending 31 December 2007. Briefly explain how each threat should be managed. (10 Marks) (b) Explain the actions that the board of directors of NorthCee Co must take in order to meet corporate governance requirements for the listing of NorthCee Co. (6 Marks) (c) Explain why your audit firm will need to communicate with NorthCee Co’s audit committee for this and future audits. (4 Marks) (20 Marks)

SouthLea Co is a construction company (building houses, offices and hotels) employing a large number of workers on various construction sites. The internal audit department of SouthLea Co is currently reviewing cash wages systems within the company.

The following information is available concerning the wages systems: (i) Hours worked are recorded using a clocking in/out system. On arriving for work and at the end of each days work, each worker enters their unique employee number on a keypad. (ii) Workers on each site are controlled by a foreman. The foreman has a record of all employee numbers and can issue temporary numbers for new employees. (iii) Any overtime is calculated by the computerised wages system and added to the standard pay. (iv) The two staff in the wages department make amendments to the computerised wages system in respect of employee holidays, illness, as well as setting up and maintaining all employee records. (v) The computerised wages system calculates deductions from gross pay, such as employee taxes, and net pay. Finally a list of net cash payments for each employee is produced. (vi) Cash is delivered to the wages office by secure courier. (vii) The two staff place cash into wages packets for each employee along with a handwritten note of gross pay, deductions and net pay. The packets are given to the foreman for distribution to the individual employees.

Required: (a) (i) Identify and explain weaknesses in SouthLea Coâ&#x20AC;&#x2122;s system of internal control over the wages system that could lead to mis-statements in the financial statements.

(ii) For each weakness, suggest an internal control to overcome that weakness.

(8 Marks)

(b) Compare the responsibilities of the external and internal auditors to detect fraud.

The computer system in the wages department needs to be replaced. The replacement will be carried out under the control of a specialist external consultant.

Required:

(6 Marks)

(c) Explain the factors that should be taken into consideration when appointing an external consultant. (6 Marks) (20 Marks)

EastVale Co manufactures a range of dairy products (for example, milk, yoghurt and cheese) in one factory. Products are stored in a nearby warehouse (which is rented by EastVale) before being sold to 350 supermarkets located within 200 kilometres of EastVale’s factory. The products are perishable with an average shelf life of eight days. EastVale’s financial statements year-end is 31 July.

It is four months since the year-end at your audit client of EastVale and the annual audit of EastVale is almost complete, but the auditor’s report has not been signed.

The following events have just come to your attention. Both events occurred in late November. (a) A fire in the warehouse rented by the company has destroyed 60% of the inventory held for resale. (b) A batch of cheese produced by EastVale was found to contain some chemical impurities. Over 300 consumers have complained about food poisoning after eating the cheese. 115 supermarkets have stopped purchasing EastVale’s products and another 85 are considering whether to stop purchasing from EastVale. Lawyers acting on behalf of the consumers are now presenting a substantial claim for damages against EastVale. Required: In respect of EACH of the events at EastVale Co mentioned above: (i) Describe the additional audit procedures you will carry out;

(8 Marks)

(ii) State, with reasons, whether or not the financial statements for the year-end require amendment; and (6 Marks) (iii) Discuss whether or not the audit report should be modified.

(6 Marks)

Note: The total marks will be split equally between each event. (20 Marks)

End of question paper

Answers

Pilot Paper F8 (INT) Audit and Assurance (International)

Answers

Tutorial note: Some answers are longer than could be expected from candidates sitting this examination. The answers may also include more points than would be necessary to obtain full marks in the examination. This is to provide examples of valid points that could be made.

(a) Audit procedures â&#x20AC;&#x201C; purchases

Audit procedure Obtain a sample of list of parts documents from the computer. Trace individual parts to the goods received note (GRN). For entries in the list of parts where no GRN number has been entered, enquire with goods inwards staff why there is no GRN. Document reasons obtained. Obtain a sample of GRNs. Agree details to the list of parts document on the computer. For a sample of GRNs from the goods inwards department, trace to the invoice held in the accounts department. Review file of unmatched GRNs, investigate reasons for any old (more than one week) items. Obtain a sample of paid invoices. Ensure that the GRN is attached. For the sample of invoices, check details into the computerised payables ledger, ensuring the correct account has been updated and the invoice amount is accurate. Obtain the unmatched invoices file. Investigate old items obtaining reason for GRN not being received / invoice not being processed. For a sample of entries from the payables ledger, agree details back to the purchase invoice. For the sample of entries on the payables ledger, agree to the electronic payments list confirming that the supplier name and amount is correct. For a sample of entries on each electronic payments list, agree details to the purchase invoice. For the sample of entries in the electronic payments list, agree details to the bank statement. Obtain the bank statements. Trace a sample of payments to the electronic payments list. For a sample of GRNs in the week pre- and post- year-end, trace to the supporting invoice and entry in the payables ledger, ensuring recorded in the correct accounting year.

Reason for procedure Checks the completeness of recording of liabilities.

Checks that goods have not been received but details not recorded. Possible cut-off error where goods have been received but GRN not raised. Ensures that the parts received had been ordered by Westra, giving evidence for the occurrence assertion. Ensures the completeness of recording of liabilities. GRNs with no matching invoice indicate a liability has been incurred. Unmatched GRNs should be included in the payables accrual. Note this test will be difficult because there is no cross reference maintained of the GRN to the invoice. Ensures the completeness of recording of liabilities. Unmatched items prior to the year end should be included in the payables accrual. Confirms that the invoice should be included in the payables ledger, meeting the completeness assertion. Confirms the completeness of recording of payables invoices in the ledger.

Unmatched items at the year end could indicate unrecorded liabilities. Ensure included in the payables accrual if the goods had been received pre-year end. Ensures that the liability does belong to Westra, meeting the occurrence assertion. Ensures that the liability has been properly discharged by Westra and that the payments list is therefore complete. Ensures that the payment has been made for a liability incurred by Westra, meeting the occurrence assertion. Shows that the payment was actually made to that supplier. Confirms that the payment made does relate to Westra, confirming the occurrence assertion. Confirms the accuracy of cut-off in the financial statements.

Tutorial note. This answer follows the structure of the scenario provided in the question. An alternative and valid format would be to use the assertions as main headings and to make points under each heading.

(b) Audit procedures – payables

Audit procedure Obtain a list of payables balances from the computerised payables ledger as at Westra’s year end. Cast the list. Agree the total of payables to the general ledger and financial statements. Perform analytical procedures on the list of payables. Determine reasons for any unusual changes in the total balance or individual payables in the list. For a sample of payables on the list, agree to supplier statements at the year-end. Reconcile supplier statement balances to the payables ledger. For invoices on the statements not in the ledger, agree to invoices entered after the year-end. Check the date of goods receipt per the GRN attached to the invoice. Where goods received pre-year end agree invoice to the payables accrual. For payments not included in the supplier statements, agree to the next month-end statement ensuring that the payment has been recorded. Review the payables ledger for old unpaid invoices. Enquire of the chief accountant the reason for non-payment. Review credit notes received post-year end ensuring that where they relate to pre-year end purchases that the payables accrual has been reduced. Ensure that payables have been included in the financial statements under the heading of current liabilities.

Reason for procedure To ensure that the list is accurate and that the total is represented by the individual balances (completeness assertion). To confirm that the total has been accurately recorded and that the balance in the financial statements is represented by valid payables (occurrence assertion). Provides initial indication of the accuracy and completeness of the list of payables. Confirms that the payables balance is due from Westra meeting the occurrence assertion. Ensures that the liabilities exist and belong to Westra at the year-end. Ensures that all liabilities were recorded at the year end, meeting the completeness and cut-off assertions.

Ensures that payments have been made to the correct supplier. Non-payment may be indicative of goods being returned for credit indicating that the payables figure may be overstated. Alternatively, taking additional credit from payables may be a going concern indicator. Ensures that payables are not over-stated at the year-end. Large credit notes may also be an indication of overstating payables deliberately to reduce profit. Confirm the correct classification of payables in the financial statements.

Controls include: –

Any amendment (addition, amendment or deletion) to the payables ledger should be authorised by a responsible official, for example, the chief accountant.

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Authorisation can be by a manual form being signed or by the chief accountant having restricted access password to amend the standing data.

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The computer should reject deletion of a supplier account where there is an outstanding balance (debit or credit).

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A record of amendments made to the payables ledger should be maintained within the ledger and reviewed on a regular basis by the chief accountant to ensure that the changes are bona fide.

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The chief accountant should review the list of suppliers on a regular basis (perhaps every four to six months) and delete those which are no longer used.

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A comparison should be made regularly (perhaps every month) between the authorised list of suppliers on the computerised list of suppliers and the payables ledger. Any new supplier on the list of suppliers should be added to the payables ledger in preparation for payment.

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A review of the computer control log regarding access to the payables standing data should be made on a regular basis and any unauthorised access identified and changes made under that access identified and if necessary reversed.

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A list of suppliers should be printed out occasionally (about every three months) and kept in a secure location in the chief accountant’s office. The chief accountant should then compare this list with the computerised list in three months time and account for any unauthorised additions.

(d) Use of CAATs Audit software may be used to identify old/obsolete balances in some of Westra’s systems eg outstanding deliveries and payments not being made to suppliers. However, the usefulness of the testing is limited and it is possible that the computer system already provides similar controls. Test data input by the auditor would be useful in checking the online payments system, perhaps by setting up some “dummy” accounts and ensuring that payments are sent to the correct suppliers. Other controls over payments such as access controls are more likely to be tested manually by the auditor. Use of Computer-Assisted Audit Techniques (CAATs) may be limited in Westra due to the lack of integration of computer systems. For example, the suppliers’ database is not connected to the payables ledger, limiting the use of test data to check transactions all the way through the purchases/payables system. There is no indication provided in the scenario regarding the extent and effectiveness of computer controls. Controls would have to be identified and assessed for reliability prior to reliance being placed. Given that some of Westra’s systems are bespoke, then it may not be cost effective to use CAATs given the time required to write specific test data or program audit software to use Westra’s data. Use of CAATs in the suppliers’ database may not be effective given that the database does not input directly into any financial accounting system. Testing GRNs to purchase invoice to ledgers, etc will provide greater assurance of the completeness and accuracy of purchases than testing the suppliers’ database.

Engagement letter

(a) Contents of an engagement letter – – – – – – – – – – –

Objective of the audit of the financial statements Management’s responsibility for the financial statements The scope of the audit with reference to appropriate legislation The form of any report or other communication of the results of the engagement The auditor may not discover all material errors Provision of access to the auditor of all relevant books and records Arrangements for planning the audit Agreement of management to provide a representation letter Request that the client confirms in writing the terms of engagement Description of any letters or reports to be issued to the client Basis of fee calculation and billing arrangements.

(b) Types of audit evidence –

Inspection – examination of records or documents in whatever form eg manual computerised, external or internal.

–

Observation – looking at the processes or procedures being carried out by others.

–

Inquiry – seeking information from knowledgeable persons, both financial or non-financial, either within or outside the entity being audited.

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Confirmation – the process of obtaining a representation of an existing condition from a third party eg a receivables letter.

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Recalculation – checking the mathematical accuracy of documents or records.

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Reperformance – this is the auditor’s independent execution of procedures or controls that were originally performed as part of the entity’s internal control system.

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Analytical procedures – evaluation of financial information made by a study of plausible relationships among both financial and non-financial data.

Emphasis of matter paragraph. Used where the auditor wishes to draw attention to an important item in the financial statements.

Qualification – limitation in scope. Used where the audit cannot obtain sufficient evidence regarding an item in the financial statements.

Qualification – disagreement. Used where the auditor disagrees concerning the amount or disclosure of an item in the financial statements.

(a) Threats to independence

Rotation of audit partner NorthCee Co have had the same audit partner for the last five years. An audit partner’s independence may be impaired where that position is retained for more than five years for a listed company. The reason being that the partner has become too close to the directors and staff in the firm and this may impair his judgement on the financial statements. However, NorthCee is currently not listed so this requirement does not apply.

As NorthCee is now being listed, Dark & Co should rotate the audit partner this year to avoid any familiarity threat. However, given that NorthCee was not a listed company up to this audit, may imply that the partner could continue this year, but would be recommended to be rotated before the 2008 audit.

Preparation of financial statements Apparently Dark have been preparing NorthCee’s financial statements as well as carrying out the audit in previous years. While this may not have been an independence issue in the past, it is likely to be now as in many jurisdictions auditors may not provide other services to their audit clients, especially listed client. Preparing financial statements as well as auditing them would provide Dark with a self-review threat, that is they may not see any errors, or want to report errors in material that they have previously prepared.

Dark should therefore decline from preparation of NorthCee’s financial statements.

Attendance at social event Attending the social event with respect to the new listing may be inappropriate as Dark may be seen as supporting NorthCee in this venture. There is an advocacy threat to independence. Support for a client may imply that the audit firm are “too close” to that client and may therefore lose their independent view regarding the audit. There is also a familiarity threat.

Dark should therefore politely decline the dinner invitation, clearly stating their reasons.

Unpaid taxation fee The unpaid fee in respect of taxation services could be construed as a loan to the audit client. Audit firms should not make loans to or receive loans from audit clients. An outstanding loan will affect independence as closure of the loan may be seen as more important than providing an appropriate audit opinion.

Dark need to discuss the situation with NorthCee again, suggesting that a payment on account could be made to show that the whole fee will be paid. Alternatively, audit work on the 2007 financial statements can be delayed until the taxation fee is paid.

Inheritance Under ACCA’s Code of Ethics and Conduct, audit partners may not hold beneficial shares in a client company. This provision includes audit staff where they are involved in the audit. The independence issue is simply that the shareholder (the auditor in this case) may be more interested in the value of the shares than providing a “correct “opinion on the financial statements.

The shares should be disposed of as soon as possible. However, given the inside knowledge of the listing, disposal now, or delaying disposal a few days to obtain a better price may be considered “insider dealing”. It may be better that the audit manager resigns from the audit immediately to limit any real or potential independence problems. Professional advice may be needed on when to sell the shares.

(b) Meeting corporate governance requirements Currently, the only action that the directors appear to have taken is to establish an audit committee. Given that NorthCee is going to be listed on a recognised stock exchange, then there are other corporate governance requirements to be met. These requirements include: – Ensuring that the chairman and the company chief executive officer (CEO) are different people. – Appointing non-executive directors (NEDs) to the board of NorthCee. The number of NEDs should be the same as the number of executive directors less the chairman. – Ensuring that at least one NED has relevant financial experience. 11

– – – – –

Appointing the NEDs to the audit committee, remuneration committee and possibly an appointments committee. The chairman will also have a seat on these committees. Establishing an internal audit department to review NorthCee’s internal control systems and make reports to the audit committee. Ensure that NorthCee has an appropriate system of internal control and that the directors recognise their responsibilities for establishing and maintaining this system. Establishing procedures to maintain contact with institutional shareholders and any other major shareholders. The evening reception for shareholders could become a regular event in this respect. Checking that the annual financial report contains information on corporate governance required by the stock exchange (eg a report on how directors monitor the internal control systems).

(c) Communication with the audit committee Under most systems of corporate governance, the external auditor’s primary point of contact with a company is the audit committee. There are various reasons for this:

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Initially, to ensure that there is independence between the board of directors and the audit firm. The audit committee consists of non-executive directors (NEDs), who by definition are independent of the company and can therefore take an objective view of the audit report.

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The audit committee will have more time to review the audit report and other communications to the company from the auditor (eg management letters) than the board. The auditor should therefore benefit from their reports being reviewed carefully.

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The audit committee can ensure that any recommendations from the auditor are implemented. The audit committee has independent NEDs who can pressurise the board to taking action on auditor recommendations.

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The audit committee also has more time to review the effectiveness and efficiency of the work of the external auditor than the board. The committee can therefore make recommendations on the re-appointment of the auditor, or recommend a different firm if this would be appropriate.

(a) Control weaknesses and recommendations

Control weakness Employees can be paid for work not done. There appears to be no check to ensure that hours recorded in the computer system actually relate to hours worked. There is no check to ensure that each employee inputs his/her employee number. One employee could input two numbers hiding the fact that one employee is absent. Fake or dummy employees can be put onto the payroll. The foreman can set up employee records for workers who do not exist. As payment is made automatically from the record of hours worked. The staff in the wages office could collude by setting up fake employee records in a similar way to the site foreman. Gross pay inflated by wages department staff. The staff in the wages department could add extra hours to the records of some employees, and remove the net pay from the payment received from the courier prior to making up the pay packets. 12

Internal control recommendation A record of hours worked by each employee should be printed from the computerised wages system and signed by the site foreman to confirm that the hours are accurate. The computerised wages system should print a list of employees present per the computer system during the day and the foreman should then sign this list to confirm it is accurate. The wages office should check the list of employees against personnel records of authorised employees. Any new employees particularly should be verified in this way before payment is made. The list of employees on the payroll should be checked for accuracy by a person outside of the wages department, for example the personnel department or the chief accountant. The list of net payments should be signed by this person to show it is correct. The computerised payroll system should be programmed to produce a list of all amendments made to the payroll. This list should be reviewed by a responsible official outside of the wages department prior to wages being paid. Alternatively, the computerised payroll system should produce payslips for each employee showing the hours worked, gross and net pay etc. Employees should then check that the cash paid agrees to the net payment recorded on the payslip.

(b) Fraud and External/Internal audit

Guidance on the auditorâ&#x20AC;&#x2122;s responsibility with respect to fraud can be found in ISA 240 The Auditorâ&#x20AC;&#x2122;s Responsibility to Consider Fraud in an Audit of Financial Statements.

Main reason for audit work

The external auditor is primarily responsible for the audit opinion on the financial statements. The main focus of audit work is therefore to ensure that the financial statements show a true and fair view. The detection of fraud is therefore not the main focus of the external auditorâ&#x20AC;&#x2122;s work.

The main focus of the work of the internal auditor is checking that the internal control systems in a company are working correctly. Part of that work may be to conduct detailed review of systems to ensure that fraud is not taking place.

Materiality

In reaching the audit opinion and performing audit work, the external auditor takes into account the concept of materiality. In other words, the external auditor is not responsible for checking all transactions. Audit procedures are planned to have a reasonable likelihood of identifying material fraud,

However, internal auditors may carry out a detailed review of transactions, effectively using a much lower materiality limit. It is more likely that internal auditors will detect fraud from their audit testing.

Identification of fraud

In situations where the external auditor does detect fraud, then the auditor will need to consider the implications for the entire audit. In other words, the external auditor has a responsibility to extend testing into other areas because the risk of providing an incorrect audit opinion will have increased.

Where internal auditors detect fraud, they may extend testing into other areas. However, audit work is more likely to focus on determining the extent of fraud and ensuring similar fraud has not occurred in other locations.

Qualification

The consultant should have a relevant qualification to show ability to undertake the work. In this case being a member of a relevant computer society or the Institute of Internal Auditors would be appropriate.

Experience

The consultant should be able to show relevant experience from previous projects for example, upgrading or amending wages systems for other clients.

References

Hopefully the consultant will be able to provide references from previous employers showing capability to undertake the work.

Project management skills

The consultant should be able to display appropriate project management skills as managing a team will be an important element of the systems change work.

Access to information

The consultant will need access to important and sensitive information in SouthLea. The chief accountant must ensure that this information will be made available to third parties. The consultant will have to sign a confidentiality agreement.

Acceptance by other staff

Employing a consultant can be difficult as other internal audit staff may feel threatened or resentful that a consultant has been employed. The chief internal auditor must ensure that the reasons for employing the consultant are understood by members of the internal audit department.

(a) Fire at warehouse

(i) Audit procedures –

Discuss the matter with the directors checking whether the company has sufficient inventory to continue trading in the short term.

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Enquire that the directors are satisfied that the company can continue to trade in the longer term. Ask the directors to sign an additional letter of representation to this effect.

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Obtain a schedule showing the inventory destroyed and if possible check this is reasonable given past production records and inventory valuations.

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Enquire that the insurers have been informed. Review correspondence from the insurers confirming the amount of the insurance claim.

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Consider whether or not EastVale can continue as a going concern, given the loss of inventory and potential damage to the company’s reputation if customer orders cannot be fulfilled.

(ii) Amendment to financial statements –

Enquire whether the directors have considered whether the event needs disclosure in the financial statements. Disclosure is unlikely given that the inventory was not in existence at the year-end and on the assumption that insurance is adequate to cover the loss.

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Amendment is not required as the fire did not affect any company property and the inventory would not have been in existence at the year end (inventory turn being very high).

(iii) Modification of audit report –

Consider modifying the audit report with an emphasis of matter paragraph to draw attention to the disclosure of the note on the fire in the financial statements.

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If the going concern status of EastVale is in doubt, then consider modifying the audit report with an emphasis of matter paragraph to this effect.

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If disclosure made by the directors is considered to be inadequate, then modify the audit report with an “except for” qualification.

(b) Batch of cheese

(i) Audit procedures –

Discuss the matter with the directors, determining specifically whether there was any fault in the production process.

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Obtain a copy of the damages claim and again discuss with the directors the effect on EastVale and the possibility of success of the claim.

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Obtain independent legal advice on the claim from EastVale’s lawyers. Attempt to determine the extent of damages that may have to be paid.

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Review any press reports about the contaminated cheese. Consider the impact on the reputation of EastVale and whether the company can continue as a going concern.

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Discuss the going concern issue with the directors. Obtain an additional letter of representation on the directors’ opinion of the going concern status of EastVale.

(ii) Amendment to financial statements –

The event should be disclosed in the financial statements in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assests as it may have a significant impact on EastVale. Over two-thirds of EastVale’s customers have either stopped purchasing products from the company or are considering taking this action.

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No adjustment is required for the event itself as it was not a condition at the balance sheet date.

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However, the event may become adjusting if company’s reputation has been damaged and the amount of the legal claim is significant. In this situation the directors may decide that EastVale is no longer a going concern so the financial statements may have to be re-drafted on a break-up basis. This action complies with International Accounting Standard 8; the break-up basis is used where the directors have no realistic alternative but to liquidate the company.

(iii) Modification of audit report

Modification of the audit report depends on the director’s actions above. –

If the financial statements are prepared on a breakup basis, and the auditor agrees with that assessment, then a modified report can be issued with an emphasis of matter paragraph drawing attention to the accounting basis used.

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However, if the financial statements are prepared on a going concern basis then the auditor should consider modifying the audit report with an emphasis of matter paragraph to draw attention to the disclosure of the note on the fire in the financial statements. This is providing that the auditor agrees that the going concern basis is appropriate.

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If the going concern status of EastVale is in doubt, then consider modifying the audit report with an emphasis of matter paragraph to this effect, drawing attention to disclosure made by the directors.

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If EastVale is not a going concern, and the financial statements have been prepared using this assumption, qualify the audit report with an adverse qualification stating that the company is not a going concern.

Pilot Paper F8 (INT) Audit and Assurance (International)

Marking scheme

(a) Audit procedures – purchases 12 marks. 1 for procedure and 1 for the reason. Limit to .5 mark in each category where stated briefly without full detail.

Audit procedure Reason for procedure Parts to GRN Check completeness Parts no GRN number System error or cut-off error GRN to computer Parts received were ordered – occurrence GRN agree to invoice Completeness of recording Review unmatched GRN file Completeness of recording of liabilities Paid invoice – GRN attached Confirms invoice in PDB Invoice details to payables ledger Completeness and accuracy of recording Review unmatched invoices file Indicate understatement of liability (lack of completeness) Payables ledger to purchase invoice Liability belongs to Westra Payables ledger to payments list Liability properly discharged – payments complete Payment list entries to invoice Payment made for bona fide liability Payments list to bank statement Confirms payment to supplier Bank statement entry to payments list Confirms payment relates to Westra GRN cut-off testing Accuracy of cut-off Maximum marks

(b) Audit procedures – payables 8 marks. 1 for procedure and 1 for the reason. Limit to 0.5 mark in each category where stated briefly without full detail.

Audit procedure Reason for procedure Obtain and cast list of payables Ensure that the list is accurate Total of payables to the general ledger and financial statements Confirm that the total has been accurately recorded Analytical procedures Indicates problems with the accuracy and completeness of payables Agree payables to supplier statements Confirm balance due from Westra Supplier statement reconciliation Liabilities exist and belong to Westra Reconcile invoices Confirms completeness and cut-off assertions Reconcile payments Payment to correct supplier Review ledger old unpaid invoices Credits OS or going concern indicator After date credit notes Payables not overstated FS categorisation payables Classification objective Maximum marks

Marks

Amendments authorised How authorised (form or access control) Reject deletion where outstanding balance Keep record of amendments Review list of suppliers – unauthorised amendments Update supplier list on computer regularly Review computer control log Review list of suppliers – unauthorised additions Other relevant points (each) Maximum marks

(d) Use of CAATs

Marks 5

Review computer control log Identify old / obsolete – computer may already do this Test data – online payments system Use of CAATs – limited – lack of computer system integration Need to assess computer controls prior to use of CAATs Not cost effective – bespoke systems Limited use of CAATs in suppliers ledger Other relevant points (each) Maximum marks 2

Engagement letter

(a) Contents of an engagement letter – 3 marks. 0.5 mark per point.

0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 3

(b) Types of audit evidence – 4 marks: 0.5 only for stating the type and 0.5 for explanation. Maximum 2 marks for simply providing a list of types of evidence.

Inspection Observation Inquiry Confirmation Recalculation Reperformance Analytical procedures Maximum marks

1 1 1 1 1 1 1 4

Emphasis of matter paragraph Qualification – limitation in scope Qualification – disagreement Maximum marks

1 1 1 3

Marks

(a) Audit risks 10 marks. 0.5 for identifying risk area, 1 for explanation of risk and 1 for stating how to resolve. Maximum 2.5 for each area.

Rotation of audit partner Preparation of financial statements Attendance at social event Unpaid taxation fee Inheritance Other relevant points (each) Maximum marks

(b) Meeting corporate governance requirements. 6 marks. 1 mark for each point.

Chief executive officer (CEO)/chairman split Appoint NED NED with financial experience NEDs to sub-committees of board Internal audit Internal control system Contact institutional shareholders Financial report information Other relevant points (each) Maximum marks

1 1 1 1 1 1 1 1 1 6

Independence from board Time to review audit work Check auditor recommendations implemented Review work of internal auditor (efficiency, etc.) Other relevant points (each) Maximum marks

1 1 1 1 1 4

(a) Control weaknesses and recommendations. 8 marks. 1 for explanation of weakness and 1 for internal control recommendation. Maximum 2 per weakness/recommendation.

Control weakness Recommendation Employees can be paid for work not done. No check hours actually worked Authorise hours worked on computer Fraudulent input employee number Reconcile computer to actual employees Fake or dummy employees can be put onto the payroll. Foreman setup Check employees against personnel records Wages office staff setup List of employees reviewed for accuracy Gross pay inflated by wages department staff. Add extra hours work done List amendments to payroll produced Other valid points Maximum marks

Marks

Mark

(b) Fraud and External/Internal audit. 6 marks. 1 for internal audit work and 1 for external audit. Maximum 2 per point

Main reason for audit work Materiality Identification of fraud Other relevant points Maximum marks

Qualification Experience References Project management skills Access to information Acceptance by other staff Other relevant points (each) Maximum marks

1 1 1 1 1 1 1 6

(a) Fire at warehouse

(i) Audit procedures. 5 marks for fire 1 per well-explained point.

Discuss the matter with the directors Letter of representation point Schedule of inventory destroyed – reasonable? Insurance Going concern status of company Other relevant points (each) Maximum marks

1 1 1 1 1 1 4

(ii) Amendment to financial statements 2 marks – 1 per well-explained point

Disclosure in FS – unlikely with reason No amendment to B/S etc Other relevant points Maximum marks

1 1 1 3

(iii) Modification of audit report 3 marks – 1 per well-explained point

Modification of report Going concern status? Inadequate disclosure by directors Other relevant points (each) Maximum marks

1 1 1 1 3

Marks

(b) Batch of cheese

(i) Audit procedures 5 marks for fire 1 per well-explained point.

Discuss with directors Copy of damages claim Legal advice Press reports (or other third party) on cheese Going concern? Other relevant points (each) Maximum marks

1 1 1 1 1 1 4

(ii) Disclosure of event 2 marks – 1 per well-explained point

Disclosure event – because significant impact No adjustment Going concern issue – reputation May result in amendment to FS Other relevant points (each) Maximum marks

1 1 1 1 1 3

(iii) Modification of audit report – 3 marks – 1 per well-explained point

Preparation of FS breakup basis Prepared going concern basis – emphasis of matter to note this Prepared going concern – but in doubt – emphasis of matter to note this Prepared going concern and disagree – qualify report Maximum marks

1 1 1 1 3

Audit and Assurance (International) Wednesday 5 December 2007

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

7D–INTPA Paper F8INT 7D–INTAA Paper F8INT

ALL FIVE questions are compulsory and MUST be attempted 1

DinZee Co assembles fridges, microwaves, washing machines and other similar domestic appliances from parts procured from a large number of suppliers. As part of the interim audit work two weeks prior to the company year-end, you are testing the procurement and purchases systems and attending the inventory count. Procurement and purchases system Parts inventory is monitored by the stores manager. When the quantity of a particular part falls below re-order level, an e-mail is sent to the procurement department detailing the part required and the quantity to order. A copy of the e-mail is filed on the store manager’s computer. Staff in the procurement department check the e-mail, allocate the order to an authorised supplier and send the order to that supplier using Electronic Data Interchange (EDI). A copy of the EDI order is filed in the order database by the computer system. The order is identified by a unique order number. When goods are received at DinZee, the stores clerk confirms that the inventory agrees to the delivery note and checks the order database to ensure that the inventory were in fact ordered by DinZee. (Delivery is refused where goods do not have a delivery note.) The order in the order database is updated to confirm receipt of goods, and the perpetual inventory system updated to show the receipt of inventory. The physical goods are added to the parts store and the paper delivery note is stamped with the order number and is filed in the goods inwards department. The supplier sends a purchase invoice to DinZee using EDI; invoices are automatically routed to the accounts department. On receipt of the invoice, the accounts clerk checks the order database, matches the invoice details with the database and updates the database to confirm receipt of invoice. The invoice is added to the purchases database, where the purchase day book (PDB) and suppliers individual account in the payables ledger are automatically updated. Required: (a) List SIX audit procedures that an auditor would normally carry out on the purchases system at DinZee Co, explaining the reason for each procedure. (12 marks) (b) List FOUR audit procedures that an auditor will normally perform prior to attending the client’s premises on the day of the inventory count. (2 marks) (c) On the day of the inventory count, you attended depot nine at DinZee. You observed the following activities: 1. 2. 3.

4. 5. 6.

Prenumbered count sheets were being issued to client’s staff carrying out the count. The count sheets showed the inventory ledger balances for checking against physical inventory. All count staff were drawn from the inventory warehouse and were counting in teams of two. Three counting teams were allocated to each area of the stores to count, although the teams were allowed to decide which pair of staff counted which inventory within each area. Staff were warned that they had to remember which inventory had been counted. Information was recorded on the count sheets in pencil so amendments could be made easily as required. Any inventory not located on the pre-numbered inventory sheets was recorded on separate inventory sheets – which were numbered by staff as they were used. At the end of the count, all count sheets were collected and the numeric sequence of the sheets checked; the sheets were not signed.

Required: (i)

List the weaknesses in the control system for counting inventory at depot nine.

(3 marks)

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

7D–INTAA Paper F8INT

(d) (i)

State the aim of a test of control and the aim of a substantive procedure.

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

7D–INTAB Paper F8INT

(30 marks)

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

(5 marks)

(b) ISA 570 Going Concern provides guidance to auditors in respect of ensuring that an entity can continue as 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)

7D–INTAC Paper F8INT

(10 marks)

Matalas Co sells cars, car parts and petrol from 25 different locations in one country. Each branch has up to 20 staff working there, although most of the accounting systems are designed and implemented from the company’s head office. All accounting systems, apart from petty cash, are computerised, with the internal audit department frequently advising and implementing controls within those systems. Matalas has an internal audit department of six staff, all of whom have been employed at Matalas for a minimum of five years and some for as long as 15 years. In the past, the chief internal auditor appoints staff within the internal audit department, although the chief executive officer (CEO) is responsible for appointing the chief internal auditor. The chief internal auditor reports directly to the finance director. The finance director also assists the chief internal auditor in deciding on the scope of work of the internal audit department. You are an audit manager in the internal audit department of Matalas. You are currently auditing the petty cash systems at the different branches. Your initial systems notes on petty cash contain the following information: 1. 2. 3. 4. 5. 6.

The average petty cash balance at each branch is $5,000. Average monthly expenditure is $1,538, with amounts ranging from $1 to $500. Petty cash is kept in a lockable box on a bookcase in the accounts office. Vouchers for expenditure are signed by the person incurring that expenditure to confirm they have received re-imbursement from petty cash. 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. Petty cash is counted every month by the accounts clerk, who is in charge of the cash. The petty cash balance is then reimbursed using the ‘imprest’ system and the journal entry produced to record expenditure in the general ledger. The cheque to reimburse petty cash is signed by the accountant at the branch at the same time as the journal entry to the general ledger is reviewed.

Required: (a) Explain the issues which limit the independence of the internal audit department in Matalas Co. Recommend a way of overcoming each issue. (8 marks) (b) Explain the internal control weaknesses in the petty cash system at Matalas Co. For each weakness, recommend a control to overcome that weakness. (12 marks) (20 marks)

[P.T.O.

7D–INTAD Paper F8INT

Delphic Co is a wholesaler of furniture (such as chairs, tables and cupboards). Delphic buys the furniture from six major manufacturers and sells them to over 600 different customers ranging from large retail chain stores to smaller owner-controlled businesses. The receivables balance therefore includes customers owing up to $125,000 to smaller balances of about $5,000, all with many different due dates for payments and credit limits. All information is stored on Delphic’s computer systems although previous audits have tended to adopt an ‘audit around the computer’ approach. You are the audit senior in charge of the audit of the receivables balance. For the first time at this client, you have decided to use audit software to assist with the audit of the receivables balance. Computer staff at Delphic are happy to help the auditor, although they cannot confirm completeness of systems documentation, and warn that the systems have very old operating systems in place, limiting file compatibility with more modern programs. The change in audit approach has been taken mainly to fully understand Delphic’s computer systems prior to new internet modules being added next year. To limit the possibility of damage to Delphic’s computer files, copy files will be provided by Delphic’s computer staff for the auditor to use with their own audit software. Required: (a) Explain the audit procedures that should be carried out using audit software on the receivables balance at Delphic Co. For each procedure, explain the reason for that procedure. (9 marks) (b) Explain the potential problems of using audit software at Delphic Co. For each problem, explain how it can be resolved. (8 marks) (c) Explain the concept of ‘auditing around the computer’ and discuss why this increases audit risk for the auditor. (3 marks) (20 marks)

7Dâ&#x20AC;&#x201C;INTAE Paper F8INT

(a) You are the audit manager in JonArc & Co. One of your new clients this year is Galartha Co, a company having net assets of $15 million. The audit work has been completed, but there is one outstanding matter you are currently investigating; the directors have decided not to provide depreciation on buildings in the financial statements, although International Accounting Standards suggest that depreciation should be provided. Required: State the additional audit procedures and actions you should now take in respect of the above matter. (6 marks) (b) Unfortunately, you have been unable to resolve the matter regarding depreciation of buildings; the directors insist on not providing depreciation. You have therefore drafted the following extracts for your proposed audit report. 1.

â&#x20AC;&#x2DC;We conducted our audit in accordance with International Standards on Auditing. Those Standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement (remaining words are the same as a normal unmodified report).

As discussed in Note 15 to the financial statements, no depreciation has been provided in the financial statements which practice, in our opinion, is not in accordance with International Accounting Standards.

The charge for the year ended 30 September 2007, should be $420,000 based on the straight-line method of depreciation using an annual rate of 5% for the buildings.

Accordingly, the non-current assets should be reduced by accumulated depreciation of $1,200,000 and the profit for the year and accumulated reserve should be decreased by $420,000 and $1,200,000, respectively.

In our opinion, except for the effect on the financial statements of the matter referred to in the preceding paragraph, the financial statements give a true and fair view ... (remaining words are the same as for an unmodified opinion paragraph).â&#x20AC;&#x2122;

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)

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

(ii) JonArc & Co were appointed auditors after the end of the financial year of Galartha Co. Consequently, the auditors could not attend the year end inventory count. Inventory is material to the financial statements. Note: you are not required to draft any audit reports. (4 marks) (20 marks)

End of Question Paper

Answers

7D–INTIX Paper F8INT 7D–INTAA Paper F8INT

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

(b)

December 2007 Answers

Audit procedures procurement and purchases system Procedure

Reason for procedure

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

Ensure that all orders are recorded and that the order details are correct.

Obtain a sample of orders in the order database, record details of the order and trace to the paper delivery note filed in the goods inwards department.

To confirm that all goods ordered were received.

For the sample of orders above, agree to the inventory database.

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

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

To confirm that inventory received has been recorded in DinZee’s accounting system and that liabilities are therefore not understated.

For a sample of orders in the orders database, agree details to the payables ledger database, confirming details against the purchase invoice.

To confirm complete and accurate recording of the inventory liability in the payables database. Note: To ensure goods received have been recorded as a payables liability the sample selected from the order database should be only those orders that have been received. The invoice number in the order database is then noted and traced to the payables ledger in the purchase database.

Within the purchase database, obtain a sample of invoices recorded in the purchase day book, agree details of price and supplier to the purchase invoice record in the database.

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

For a sample of purchase invoices in the purchase day book, agree details to the delivery notes for items on that invoice.

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

For the sample of purchase invoices above, agree details to the individual payables account in the payables database.

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

For a sample of supplier invoices, cast and cross cast invoice price and quantities confirming price to the original order.

To confirm the arithmetical accuracy of invoices and ensure the company was charged the correct price for goods received.

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

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

Using computer-assisted audit techniques, cast the purchase day book and agree total of liability incurred to the general ledger.

To confirm the completeness and accuracy of the liability recorded in the general ledger.

Audit procedures prior to inventory count attendance 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.

7D–INTAA Paper F8INT

(c)

(d)

Weaknesses in counting inventory Weakness

Reason for weakness

How to overcome weakness:

Inventory sheets stated the quantity of items expected to be found in the store

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

Count sheets should not state the quantity of items so as not to pre-judge how many units will be found.

Count staff were all drawn from the stores

Count staff are also responsible for the inventory. There could be a temptation to hide errors or missing inventory that they have removed from the store illegally.

Count teams should include staff who are not responsible for inventory to provide independence in the count.

Count teams allowed to decide which areas to count

There is a danger that teams will either omit inventory from the count or even count inventory twice due to lack of precise instructions on where to count.

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

Count sheets were not signed by the staff carrying out the count

Lack of signature makes it difficult to raise queries regarding items counted because the actual staff carrying out the count are not known.

All count sheets should be signed to confirm who actually carried out the count of individual items.

Inventory not marked to indicate it has been counted

As above, there is a danger that inventory will be either omitted or included twice in the count.

Inventory should be marked in some way to show that it has been counted to avoid this error.

Recording information on the count sheets in pencil

Recording in pencil means that the count sheets could be amended after the count has taken place, not just during the count. The inventory balances will then be incorrectly recorded.

Count sheets should be completed in ink.

Count sheets for inventory not on the pre-numbered count sheets were only numbered when used

It is possible that the additional inventory sheets could be lost as there is no overall control of the sheets actually being used. Sheets may not be numbered by the teams, again giving rise to the possibility of loss.

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

(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’s financial statements.

(ii)

Regarding the inventory count: Test of control Observe the count teams ensuring that they are counting in accordance with the client’s inventory count instructions.

7D–INTAB Paper F8INT

Substantive procedure Record the condition of items of inventory to ensure that the valuation of those items is correct on the final inventory summaries.

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

7D–INTAB Paper F8INT

Confidentiality. A professional accountant should respect the confidentiality of information acquired during the course of providing professional services and should not use or disclose such information without obtaining client permission. Professional behaviour. A professional accountant should act in a manner consistent with the good reputation of the profession and refrain from any conduct which might bring discredit to the profession.

7D–INTAC Paper F8INT

(b)

(a)

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 uncertainty exists 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 cash flow problems.

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 finance director will also be responsible for some of the financial systems that the internal auditor is reporting on. Similarly, the chief internal 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 means that the finance director may try and influence the chief internal auditor regarding the areas that the internal audit department is 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 limits independence 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 controls have already been established, another member of the internal audit should carry out the audit of petty cash to provide some limited 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 be very familiar with the systems being reviewed and therefore may not be sufficiently objective to identify errors in those systems. To ensure independence, the existing staff should be rotated into different areas of internal audit work and the chief internal auditor 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 for the running of the company, it is possible that there will be bias in the appointment of the chief internal auditor; the CEO may appoint 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 appointment agreed by the whole board.

7D–INTAD Paper F8INT

7D–INTAC Paper F8INT

(b)

(a)

Internal control weaknesses – petty cash Weakness

Suggested control

The petty cash balance is approximately three months expenditure. This is excessive and will increase the possibility of petty cash being stolen or errors not being identified.

The petty cash balance should be $2,000, being about one month’s expenditure.

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

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

Petty cash appears to be used for some larger items of expenditure (up to $500). Vouchers are only authorised after expenditure is incurred indicating that some significant expenditure can take place without authorisation.

A maximum expenditure limit (e.g. $50) should be set before which prior authorisation is required.

Petty cash vouchers are only signed by the person incurring the expenditure, indicating a lack of authorisation control for that expenditure.

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

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

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

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

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

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

Petty cash vouchers should be pre-numbered and the numbering checked in the petty cash book to confirm completeness of recording of expenditure.

Audit procedures using audit software Procedure

Reason for procedure

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

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

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

To check for violation of system rules.

Review the balances in the receivables ledger to ensure no balance exceeds total sales to that customer.

To check for unreasonable items in the ledger.

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

To obtaining new/relevant statistical information.

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

To select items for audit testing.

Produce an aged receivables analysis to assist with the identification of irrecoverable receivables.

To assist with receivables valuation testing.

7D–INTAD Paper F8INT

(b)

Problems of using audit software Cost There may be substantial setup costs to use the software, especially where the computer systems of the client have not been fully documented, as is the situation in Delphic Co. A cost benefit analysis from the audit point-of-view should be carried out prior to deciding to use audit software. Lack of software documentation The 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 year to avoid extensive setup costs which cannot be recouped due to system changes. Change to clients’ systems Changes to clients’ computer systems can result in costly amendments to the audit software. Given that Delphic’s systems will change next year, this is almost certain to result in amendments to the software. Starting to use audit software this year is therefore not advisable. Outputs obtained The audit manager needs to be clear exactly what audit assertions are to be tested with the audit software and what outputs are expected. Starting testing just to obtain knowledge of the system is inappropriate as testing may be too detailed and output produced that is not required, increasing the cost for the client. Use of copy files The use of copy files means that the auditor will not be certain that these are the actual files being used within Delphic’s computer systems, especially as the provenance of those files will not be checked. To ensure that the files are genuine either the 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 inputs to the computer are agreed to the expected outputs from the computer. This method of auditing increases audit risk because: –

7D–INTAE Paper F8INT

–

(a)

Audit procedures regarding non-depreciation of buildings – – – – – – –

(b)

The actual computer files and programs are not tested; the auditor has no direct evidence that the programs are working as documented. Where errors are found in reconciling inputs to outputs, it may be difficult or even impossible to determine why those errors occurred. Constructive amendments to clients’ systems cannot be made and there is an increased likelihood of audit qualifications.

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.

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 out the 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 the IAS) 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 the financial statements may be incorrect in this respect.

7D–INTAE Paper F8INT

Extract 3. The meaning of the extract. It shows how the IAS would normally be applied to non-current tangible assets – in this case a standard 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 $420,000. Extract 4. The meaning of the extract. It shows the overall impact of non-compliance with the IAS – with specific focus on the overstatement on non-current assets of $1,200,000. 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 be altered. Extract 5. The meaning of the extract. That the auditor disagrees with the depreciation figure provided by the directors – the auditor’s calculation of depreciation is materially different from this hence the auditor’s disagreement with the financial statements figure. 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 statements show a true and fair view in respect of depreciation. (c)

Other reporting options (i)

– –

(ii)

– –

The auditor would still disagree with the lack of depreciation on non-current assets so a modified opinion on the grounds of disagreement would be required. As the financial statements need significant amendment (profit becoming a large loss) then the auditor may conclude that the financial statements do not show a true and fair view and issue an adverse report (rather than an ‘except for’ report). The auditors normally attend the inventory count to confirm the existence of inventory. As the count was not attended, the existence of inventory cannot be confirmed. The auditor will be uncertain regarding existence and consequently valuation of inventory. An ‘except for’ audit report will be issued noting that adjustments may be necessary to the inventory value.

7D–INTMS Paper F8INT

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International)

December 2007 Marking Scheme Marks

(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

(b)

––– 12 ––– –––

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 Maximum marks

(c)

––– 2 ––– –––

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 ––– Maximum marks 12 ––– –––

(d)

1 mark each for: Test of control aim Substantive procedure aim Stating test of control relevant to inventory count Stating substantive procedure relevant to inventory count Maximum marks Total marks

––– 4 ––– ––– —– 30 ––– –––

7D–INTMS Paper F8INT

Marks 2

(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

––– 5 ––– –––

Maximum marks (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

––– 5 ––– ––– —– Total marks 10 ––– ––– Note to markers – allow 0·5 mark where candidate lists audit procedures such as review cash flow forecasts, review management accounts post year end, etc. Maximum marks

(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

Maximum marks (b)

––– 8 ––– –––

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

Maximum marks Total marks

––– 12 ––– ––– —– 20 ––– –––

7D–INTMS Paper F8INT

Marks 4

(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

––– 9 ––– –––

Maximum marks

Note to markers – no distinction is made between test of control and substantive procedures for this question. Marks can be obtained 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

––– 8 ––– –––

Maximum marks (c)

Explanation of auditing around computer = 1 mark 1 mark for max two problems – – –

Actual computer files not tested Difficult to track errors Other relevant points 2 ––– 3 ––– ––– —– 20 ––– –––

Maximum marks Total marks

7D–INTMS Paper F8INT

Marks 5

(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

Maximum marks

(b)

––– 6 ––– –––

1 mark per point Para 1 Work in accordance with external standards Work to identify material misstatements May be other material misstatements Para 2 Shows auditor disagrees with directors Shows auditor view based on standards Para 3 Quantifies effect of non-compliance Shows what depreciation policy normally is Para 4 Confirms quantification of effect on financial statements So members can see total effect Para 5 ‘Except for’ = material qualification Everything else OK in FS Other relevant points

––– 10 ––– –––

Maximum marks

(c)

1 mark per point (i)

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

(ii)

Uncertainty on one item only = modify report Qualification = material ‘except for adjustments that may be necessary’

Maximum marks Total marks

––– 4 ––– ––– —– 20 ––– –––

Audit and Assurance (International) Wednesday 4 June 2008

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 1

Introduction – audit firm You are an audit senior in Brennon & Co, a firm providing audit and assurance services. At the request of an audit partner, you are preparing the audit programme for the income and receivables systems of Seeley Co. Audit documentation is available from the previous year’s audit, including internal control questionnaires and audit programmes for the despatch and sales system. The audit approach last year did not involve the use of computerassisted audit techniques (CAATs); the same approach will be taken this year. As far as you are aware, Seeley’s system of internal control has not changed in the last year. Client background – sales system Seeley Co is a wholesaler of electrical goods such as kettles, televisions, MP3 players, etc. The company maintains one large warehouse in a major city. The customers of Seeley are always owners of small retail shops, where electrical goods are sold to members of the public. Seeley only sells to authorised customers; following appropriate credit checks, each customer is given a Seeley identification card to confirm their status. The card must be used to obtain goods from the warehouse. Despatch and sales system The despatch and sales system operates as follows: 1.

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

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

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

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

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

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

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

Error reports are produced showing breaks in the GDN sequence.

Information on receivables The chief accountant has informed you that receivables days have increased from 45 to 60 days over the last year. The aged receivables report produced by the computer is shown below: Number of receivables 15 197 153 23 –––– 388 –––– ––––

Range of debt

Total debt $

Current $

Less than $0 $0 to $20,000 $20,001 to 50,000 $50,001 or more

(87,253) 2,167,762 5,508,077 1,495,498 –––––––––– 9,084,084 –––––––––– ––––––––––

(87,253) 548,894 2,044,253 750,235 –––––––––– 3,256,129 –––––––––– ––––––––––

1 to 2 months old $

More than 2 months old $

643,523 2,735,073 672,750 –––––––––– 4,051,346 –––––––––– ––––––––––

975,345 728,751 72,513 –––––––––– 1,776,609 –––––––––– ––––––––––

In view of the deteriorating receivables situation, a direct confirmation of receivables will be performed this year.

Required: (a) Explain the steps necessary to check the accuracy of the previous yearâ&#x20AC;&#x2122;s internal control questionnaires. (4 marks) (b) Using information from the scenario, list SIX tests of control that an auditor would normally carry out on the despatch and sales system at Seeley Co and explain the reason for each test. (12 marks) (c) State and explain the meaning of FOUR assertions that relate to the direct confirmation of receivables. (4 marks) (d) (i)

Describe the procedures up to despatch of letters to individual receivables in relation to a direct confirmation of receivables. (5 marks)

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

(5 marks) (30 marks)

(a) List and explain FOUR factors that will influence the auditorâ&#x20AC;&#x2122;s judgement regarding the sufficiency of the evidence obtained. (4 marks) (b) ISA 580 Management Representations provides guidance on the use of management representations as audit evidence. 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 the audit 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)

[P.T.O.

(a) With reference to ISA 520 Analytical Procedures explain (i)

what is meant by the term ‘analytical procedures’;

(2 marks)

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

(3 marks)

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

(3 marks)

Zak Co sells garden sheds and furniture from 15 retail outlets. Sales are made to individuals, with income being in the form of cash and debit cards. All items purchased are delivered to the customer using Zak’s own delivery vans; most sheds are too big for individuals to transport in their own motor vehicles. The directors of Zak indicate that the company has had a difficult year, but are pleased to present some acceptable results to the members. The income statements for the last two financial years are shown below: Income statement

Revenue Cost of sales Gross profit Operating expenses Administration Selling and distribution Interest payable Investment income Profit/(loss) before tax Financial statement extract Cash and bank

31 March 2008 $000 7,482 (3,520) –––––– 3,962

31 March 2007 $000 6,364 (4,253) –––––– 2,111

(1,235) (981) (101) 145 –––––– 1,790 –––––– ––––––

(1,320) (689) (105) – –––––– (3) –––––– ––––––

–––––– 253 –––––– ––––––

–––––– (950) –––––– ––––––

Required: (b) As part of your risk assessment procedures for Zak Co, identify and provide a possible explanation for unusual changes in the income statement. (9 marks) (c) Confirmation of the end of year bank balances is an important audit procedure. Required: Explain the procedures necessary to obtain a bank confirmation letter from Zak Co’s bank.

(3 marks) (20 marks)

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

(8 marks)

(b) MonteHodge Co has a sales income of $253 million and employs 1,200 people in 15 different locations. MonteHodge Co provides various financial services from pension and investment advice to individuals, to maintaining cash books and cash forecasting in small to medium-sized companies. The company is owned by six shareholders, who belong to the same family; it is not listed on any stock-exchange and the shareholders have no intention of applying for a listing. However, an annual audit is required by statute and additional regulation of the financial services sector is expected in the near future. Most employees are provided with on-line, real-time computer systems, which present financial and stock market information to enable the employees to provide up-to-date advice to their clients. Accounting systems record income, which is based on fees generated from investment advice. Expenditure is mainly fixed, being salaries, office rent, lighting and heating, etc. Internal control systems are limited; the directors tending to trust staff and being more concerned with making profits than implementing detailed controls. Four of the shareholders are board members, with one member being the chairman and chief executive officer. The financial accountant is not qualified, although has many years experience in preparing financial statements. Required: Discuss the reasons for and against having an internal audit department in MonteHodge Co.

(12 marks) (20 marks)

Smithson Co provides scientific services to a wide range of clients. Typical assignments range from testing food for illegal additives to providing forensic analysis on items used to commit crimes to assist law enforcement officers. The annual audit is nearly complete. As audit senior you have reported to the engagement partner that Smithson is having some financial difficulties. Income has fallen due to the adverse effect of two high-profile court cases, where Smithson’s services to assist the prosecution were found to be in error. Not only did this provide adverse publicity for Smithson, but a number of clients withdrew their contracts. A senior employee then left Smithson, stating lack of investment in new analysis machines was increasing the risk of incorrect information being provided by the company. A cash flow forecast prepared internally shows Smithson requiring significant additional cash within the next 12 months to maintain even the current level of services. Smithson’s auditors have been asked to provide a negative assurance report on this forecast. Required: (a) Define ‘going concern’ and discuss the auditor’s responsibilities in respect of going concern.

(4 marks)

(b) State the audit procedures that may be carried out to try to determine whether or not Smithson Co is a going concern. (8 marks) (c) Explain the audit procedures the auditor may take where the auditor has decided that Smithson Co is unlikely to be a going concern. (4 marks) (d) In the context of the cash flow forecast, define the term ‘negative assurance’ and explain how this differs from the assurance provided by an audit report on statutory financial statements. (4 marks) (20 marks)

End of Question Paper

Answers

Fundamentals Level – Skills Module, F8 (INT) Audit and Assurance (International) 1

(a)

(b)

(c)

(d)

June 2008 Answers

– Prior year internal control questionnaires –

Obtain the audit file from last year’s audit. Ensure that the documentation on the sales system is complete. Review the audit file for indications of weaknesses in the sales system and note these for investigation this year.

–

Obtain system documentation from the client. Review this to identify any changes made in the last 12 months.

–

Interview client staff to ascertain whether systems have changed this year and to ensure that the internal control questionnaires produced last year are correct.

–

Perform walk-through checks. Trace a few transactions through the sales system to ensure that the internal control questionnaires on the audit file are accurate and can be relied upon to produce the audit programmes for this year.

–

During walk-through checks, ensure that the controls documented in the system notes are actually working, for example, verifying that documents are signed as indicated in the notes.

– Tests of control Test of control

Reason for test

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

Ensures that the goods despatched are correctly recorded on the GDNs.

Review a sample of GDNs for signature of the accounts staff.

Ensures that the GDN details have been entered onto the computer system.

Observe despatch system ensuring Seeley staff have seen the customers’ identification card prior to goods being loaded into customers’ vans.

Ensures that goods are only despatched to authorised customers.

Review the error report on numeric sequence of GDNs produced in the accounts department and enquire action taken regarding omissions.

Ensures that the sequence of GDNs is complete.

Observe despatch process to ensure that the customers’ credit limit is reviewed prior to goods being despatched.

Ensures that goods are not despatched to poor/bad credit risks.

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

Ensures the accurate transfer of goods despatched information from the GDN to the invoice.

Note: reviewing credit limits is not specifically stated in the scenario; however, most despatch/ sales systems will have this control and most candidates mentioned this in their answers. Hence marks were awarded for this point.

Assertions – receivables Assertion Existence

Application to direct confirmation of receivables 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 to Seeley again by replying to the confirmation.

Valuation and allocation

Receivables are included in the financial statements at the correct amount – the receivable will dispute any amounts that do not relate to that account.

Cut-off

Transactions and events have been recorded in the correct accounting period. The circularisation will identify reconciling items such as sales invoices/cash in transit.

(i)

Receivables circularisation – procedures –

Obtain a list of receivables balances, cast this and agree it to the receivables control account total at the end of the year. Ageing of receivables may also be verified at this time.

–

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

(ii)

(a)

(b)

(c)

–

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.

Specific receivables for selection: 1.

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

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

Receivables in the range $0 to $20,000. This group is unusual because it has a relatively higher proportion of older debts. Additional testing may be necessary to ensure that the receivables exist and to confirm that Seeley is not overstating sales income by including many smaller receivables balances in the ledger.

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

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

Sufficiency of evidence –

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

–

The materiality of the item. More evidence will normally be collected on material items whereas immaterial items may simply 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 and internal 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 business and 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 over receivables) 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).

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 end of the reporting period that need disclosure in the financial statements.

Additional audit procedures –

The auditor could expand the amount of test of controls in that audit area. This may indicate that the control weakness was 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 aware of the problem.

–

The auditor could perform additional substantive procedures on the audit area. This action will help to quantify the extent of 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 exact wording depending on the materiality of the errors found.

(a)

(i)

Explanation of analytical procedures Analytical procedures are used in obtaining an understanding of an entity and its environment and in the overall review at the end of the audit. ‘Analytical procedures’ actually means the evaluation of financial and other information, and the review of plausible relationships in that information. The review also includes identifying fluctuations and relationships that do not appear consistent with other relevant information or results.

(ii)

Types of analytical procedures Analytical procedures can be used as: –

Comparison of comparable information to prior periods to identify unusual changes or fluctuations in amounts.

–

Comparison of actual or anticipated results of the entity with budgets and/or forecasts, or the expectations of the auditor in order to determine the potential accuracy of those results.

–

Comparison to industry information either for the industry as a whole or by comparison to entities of similar size to the client to determine whether receivable days, for example, are reasonable.

(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 entity and assess the risk of material misstatement. Audit procedures can then be directed to these ‘risky’ areas. Analytical procedures as substantive procedures Analytical procedures can be used as substantive procedures in determining the risk of material misstatement at the assertion level during work on the income statement and statement of financial position (balance sheet). Analytical procedures in the overall review at the end of the audit Analytical procedures help the auditor at the end of the audit in forming an overall conclusion as to whether the financial statements as a whole are consistent with the auditor’s understanding of the entity. (b)

Net profit Overall, Zak’s result has changed from a net loss to a net profit. Given that sales have only increased by 17% and that expenses, at least administration expenses, appear low, then there is the possibility that expenditure may be understated. Sales – increase 17% According to the directors, Zak has had a ‘difficult year’. Reasons for the increase in sales income must be ascertained as the change does not conform to the directors’ comments. It is possible that the industry as a whole, has been growing allowing Zak to produce this good result. Cost of sales – fall 17% A fall in cost of sales is unusual given that sales have increased significantly. This may have been caused by an incorrect inventory valuation and the use of different (cheaper) suppliers which may cause problems with faulty goods in the next year. Gross profit (GP) – increase 88% This is a significant increase with the GP% changing from 33% last year to 53% in 2008. Identifying reasons for this change will 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 increase in line with sales. There may be a mis-allocation of expenses from administration or the age of Zak’s delivery vans is increasing resulting in additional service costs. Interest payable – small fall Given that Zak has a considerable cash surplus this year, continuing to pay interest is surprising. The amount may be overstated – reasons for lack of fall in interest payment e.g. loans that cannot be repaid early, must be determined. Investment income – new this year This is expected given cash surplus on the year, although the amount is still very high indicating possible errors in the amount or other income generating assets not disclosed on the balance sheet extract.

(c)

(a)

Obtaining a bank letter –

Review the need to obtain a bank letter from the information obtained from the preliminary risk assessment of Zak.

–

Prepare a standard bank letter in the format agreed with banks in your jurisdiction.

–

Obtain authorisation on that letter from a director of Zak for the bank to disclose information to the auditor.

–

Where Zak has provided their bank with a standing authority to disclose information to the auditors, refer to this authority in the bank letter.

–

The auditor sends the letter directly to Zak’s bank with a request to send the reply directly back to the auditors.

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 and ensure 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 access to specialist skills that the company may not be able to afford if the internal audit department was run internally. Set up time The department can be set up in a few weeks rather than taking months to advertise and recruit appropriate staff. Costs Costs for the service will be agreed in advance. This makes budgeting easier for the recipient company as the cost and standard of service expected are fixed. Flexibility (staffing arrangements) Staff can be hired to suit the workloads and requirements of the recipient company rather than full-time staff being idle for some parts of the year. Disadvantages of outsourcing internal audit Staff turnover The internal audit staff allocated to one company may change frequently; this means that company systems may not always be fully understood, decreasing the quality of the service provided. External auditors Where external auditors provide the internal audit service there may be a conflict of interest (self-review threat), where internal audit work is then relied upon by external auditors. Cost The cost of the outsourced service may be too high for the company, which means that an internal audit department is not established 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 should provide confidentiality clauses, this may not stop breaches of confidentiality e.g. individuals selling data fraudulently. Control Where internal audit is provided in-house, the company will have more control over the activities of the department; there is less 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 able to offer VFM services or review potential upgrades to these systems checking again whether value for money is provided. Accounting system While not complex, accounting systems must provide accurate information. Internal audit can audit these systems in detail ensuring that fee calculations, for example, are correct.

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 client monies are safe with MonteHodge. Corporate governance Although MonteHodge does not need to comply with corporate governance regulations, internal audit could still recommend policies for good corporate governance. For example, suggesting that the chairman and chief executive officer roles are split. Compliance with regulations MonteHodge is in the financial services industry. In most jurisdictions, this industry has a significant amount of regulation. An internal audit department could help ensure compliance with those regulations, especially as additional regulations are expected in the future. Assistance to financial accountant The financial accountant in MonteHodge is not qualified. Internal audit could therefore provide assistance in compliance with financial reporting standards, etc as well as recommending control systems. Against establishing of internal audit department No statutory requirement As there is no statutory requirement, the directors may see internal audit as a waste of time and money and therefore not consider establishing the department. Accounting systems Many accounting systems are not necessarily complex so the directors may not see the need for another department to review their operations, check integrity, etc. Family business MonteHodge is owned by a few shareholders in the same family. There is therefore not the need to provide assurance to other shareholders on the effectiveness of controls, accuracy of financial accounting systems, etc. Potential cost There would be a cost of establishing and maintaining the internal audit department. Given that the directors consider focus on profit and trusting employees to be important, then it is unlikely that they would consider the additional cost of establishing internal audit. Review threat Some directors may feel challenged by an internal audit department reviewing their work (especially the financial accountant). They are likely therefore not to want to establish an internal audit department.

(a)

Going concern Going concern means that the enterprise will continue in operational existence for the foreseeable future without the intention or necessity of liquidation or otherwise ceasing trade. It is one of the fundamental accounting concepts used by auditors and stated in IAS 1 Presentation of Financial Statements. The auditor’s responsibility in respect of going concern is explained in ISA 570 Going Concern. The ISA states ‘when planning and performing audit procedures and in evaluating the results thereof, the auditor should consider the appropriateness of management’s use of the going concern assumption in the preparation of the financial statements’. 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 going concern.

(ii)

To ensure that the organisation’s management have been realistic in their use of the going concern assumption when preparing the financial statements.

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

(c)

(d)

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 and try 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 cash shortfall 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-end and whether this matches the cash flow forecast.

–

Enquire about the possible lack of capital investment within Smithson identified by the employee leaving. Review current levels 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 human resources 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 services being provided to clients. Where possible, consider the financial impact on Smithson and whether insurance is available to 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 months can 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.

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 financial statements 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 the auditor will have to modify the audit report.

–

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

–

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

Negative assurance Negative assurance means that nothing has come to the attention of an auditor which indicates that the cash flow forecast contains 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 financial statements 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 can therefore 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 cash flow relates to the future and therefore the auditor cannot obtain all the evidence to guarantee its accuracy. Financial statements relate to the past, and so the auditor should be able to obtain the information to confirm they are correct; hence the use of positive assurance.

Fundamentals Level – Skills Module, F8 (INT) Audit and Assurance (International)

June 2008 Marking Scheme Marks

(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

Maximum marks (b)

––– 4 –––

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 Maximum marks

(c)

––– 12 –––

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 Maximum marks

––– 4 –––

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 5

(ii)

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

Negative balances Material balances $0 to $20,000 balances Old balances Random sample remaining balances Other relevant points 5 ––– 10 ––– 30 ––– –––

Maximum marks

(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

––– 4 –––

Maximum marks (b)

Management representation letter contents 0·5 mark per valid point

––– 3 –––

Maximum marks (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

––– 3 ––– 10 ––– –––

Maximum marks

Marks 3

(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

––– 8 –––

Maximum marks (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 ––– Maximum marks 9 ––– (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

––– 3 ––– 20 ––– –––

Maximum marks

Marks 4

(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 Maximum marks

––– 8 –––

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

––– 12 ––– 20 ––– –––

Maximum marks

Marks 5

(a)

Going concern meaning 1 mark each for: – – – – – – – –

Definition ISA 570 explanation (don’t need the ISA 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

––– 4 –––

Maximum marks (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

––– 8 –––

Maximum marks (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

––– 4 –––

Maximum marks (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

––– 4 ––– 20 ––– –––

Maximum marks

Audit and Assurance (International) Wednesday 3 December 2008

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 1

Introduction Blake Co assembles specialist motor vehicles such as lorries, buses and trucks. The company owns four assembly plants to which parts are delivered and assembled into the motor vehicles. The motor vehicles are assembled using a mix of robot and manual production lines. The ‘human’ workers normally work a standard eight hour day, although this is supplemented by overtime on a regular basis as Blake has a full order book. There is one shift per day; mass production and around the clock working are not possible due to the specialist nature of the motor vehicles being assembled. Wages system – shift workers Shift-workers arrive for work at about 7.00 am and ‘clock in’ using an electronic identification card. The card is scanned by the time recording system and each production shift-worker’s identification number is read from their card by the scanner. The worker is then logged in as being at work. Shift-workers are paid from the time of logging in. The logging in process is not monitored as it is assumed that shift-workers would not work without first logging in on the time recording system. Shift-workers are split into groups of about 25 employees, with each group under the supervision of a shift foreman. Each day, each group of shift-workers is allocated a specific vehicle to manufacture. At least 400 vehicles have to be manufactured each day by each work group. If necessary, overtime is worked to complete the day’s quota of vehicles. The shift foreman is not required to monitor the extent of any overtime working although the foreman does ensure workers are not taking unnecessary or prolonged breaks which would automatically increase the amount of overtime worked. Shift-workers log off at the end of each shift by re-scanning their identification card. Payment of wages Details of hours worked each week are sent electronically to the payroll department, where hours worked are allocated by the computerised wages system to each employee’s wages records. Staff in the payroll department compare hours worked from the time recording system to the computerised wages system, and enter a code word to confirm the accuracy of transfer. The code word also acts as authorisation to calculate net wages. The code word is the name of a domestic cat belonging to the department head and is therefore generally known around the department. Each week the computerised wages system calculates: (i) gross wages, using the standard rate and overtime rates per hour for each employee, (ii) statutory deductions from wages, and (iii) net pay. The list of net pay for each employee is sent over Blake’s internal network to the accounts department. In the accounts department, an accounts clerk ensures that employee bank details are on file. The clerk then authorises and makes payment to those employees using Blake’s online banking systems. Every few weeks the financial accountant reviews the total amount of wages made to ensure that the management accounts are accurate. Termination of employees Occasionally, employees leave Blake. When this happens, the personnel department sends an e-mail to the payroll department detailing the employee’s termination date and any unclaimed holiday pay. The receipt of the e-mail by the payroll department is not monitored by the personnel department. Salaries system – shift managers All shift managers are paid an annual salary; there are no overtime payments. Salaries were increased in July by 3% and an annual bonus of 5% of salary was paid in November.

Required: (a) List FOUR control objectives of a wages system.

(2 marks)

(b) As the external auditors of Blake Co, write a management letter to the directors in respect of the shift-workers wages recording and payment systems which: (i) Identifies and explains FOUR weaknesses in that system; (ii) Explains the possible effect of each weakness; (iii) Provides a recommendation to alleviate each weakness. 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 managersâ&#x20AC;&#x2122; salary system. For each procedure, state your expectation of the result of that procedure. (6 marks) (d) Audit evidence can be obtained using various audit procedures, such as inspection. APART FROM THIS PROCEDURE, in respect of testing the accuracy of the time recording system at Blake Co, explain FOUR procedures used in collecting audit evidence and discuss whether the auditor will benefit from using each procedure. (8 marks) (30 marks)

(a) ISA 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 and objectivity 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 of the 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 which provides appropriate evidence for each assertion. (4 marks) (10 marks)

[P.T.O.

You are a manager in the audit firm of Ali & Co; and this is your first time you have worked on one of the firm’s established clients, Stark Co. The main activity of Stark Co is providing investment advice to individuals regarding saving for retirement, purchase of shares and securities and investing in tax efficient savings schemes. Stark is regulated by the relevant financial services authority. You have been asked to start the audit planning for Stark Co, by Mr Son, a partner in Ali & Co. Mr Son has been the engagement partner for Stark Co, for the previous nine years and so has excellent knowledge of the client. Mr Son has informed you that he would like his daughter Zoe to be part of the audit team this year; Zoe is currently studying for her first set of fundamentals papers for her ACCA qualification. Mr Son also informs you that Mr Far, the audit senior, received investment advice from Stark Co during the year and intends to do the same next year. In an initial meeting with the finance director of Stark Co, you learn that the audit team will not be entertained on Stark Co’s yacht this year as this could appear to be an attempt to influence the opinion of the audit. Instead, he has arranged a balloon flight costing less than one-tenth of the expense of using the yacht and hopes this will be acceptable. The director also states that the fee for taxation services this year should be based on a percentage of tax saved and trusts that your firm will accept a fixed fee for representing Stark Co in a dispute regarding the amount of sales tax payable to the taxation authorities. Required: (a) (i)

Explain the ethical threats which may affect the auditor of Stark Co.

(ii) For each ethical threat, discuss how the effect of the threat can be mitigated. (b) Discuss the benefits of Stark Co establishing an internal audit department.

(6 marks) (6 marks) (8 marks) (20 marks)

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

(4 marks)

The EuKaRe charity was established in 1960. The charity’s aim is to provide support to children from disadvantaged backgrounds who wish to take part in sports such as tennis, badminton and football. EuKaRe has a detailed constitution which explains how the charity’s income can be spent. The constitution also notes that administration expenditure cannot exceed 10% of income in any year. The charity’s income is derived wholly from voluntary donations. Sources of donations include: (i) Cash collected by volunteers asking the public for donations in shopping areas, (ii) Cheques sent to the charity’s head office, (iii) Donations from generous individuals. Some of these donations have specific clauses attached to them indicating that the initial amount donated (capital) cannot be spent and that the income (interest) from the donation must be spent on specific activities, for example, provision of sports equipment. The rules regarding the taxation of charities in the country EuKaRe is based are complicated, with only certain expenditure being allowable for taxation purposes and donations of capital being treated as income in some situations. Required: (b) Identify areas of inherent risk in the EuKaRe charity and explain the effect of each of these risks on the audit approach. (12 marks) (c) Explain why the control environment may be weak at the charity EuKaRe.

(4 marks) (20 marks)

The date is 3 December 2008. The audit of ZeeDiem Co is nearly complete and the financial statements and the audit report are due to be signed next week. However, the following additional information on two material events has just been presented to the auditor. The company’s year end was 30 September 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. There have been no sales of this mattress; it was due to be marketed in the next few weeks. The company’s insurers estimate that inventory to the value of $750,000 has been affected. The insurers also estimate that the mattresses are now only worth $225,000. No claim can be made against the supplier of springs as this company is in liquidation with no prospect of any amounts being paid to third parties. The insurers will not pay ZeeDiem for the fall in value of the inventory as the company was underinsured. All of this inventory was in the finished goods store at the end of the year and no movements of inventory have been recorded post year-end. Event 2 – Occurred 5 November 2008 Production at the ShamEve factory was halted for one day when a truck carrying dye used in colouring the fabric on mattresses reversed into a metal pylon, puncturing the vehicle allowing dye to spread across the factory premises and into a local river. The Environmental Agency is currently considering whether the release of dye was in breach of environmental legislation. The company’s insurers have not yet commented on the event. Required: (a) For each of the two events above: (i)

Explain whether the events are adjusting or non-adjusting according to IAS 10 Events After the Reporting Period. (4 marks)

(ii) Explain the auditors’ responsibility and the audit procedures and actions that should be carried out according to ISA 560 (Redrafted) Subsequent Events. (12 marks) (b) Assume that the date is now 20 December 2008, the financial statements and the audit report have just been signed, and the annual general meeting is to take place on 10 January 2009. The Environmental Agency has issued a report stating that ZeeDiem Co is in breach of environmental legislation and a fine of $900,000 will now be levied on the company. The amount is material to the financial statements. Required: Explain the additional audit work the auditor should carry out in respect of this fine.

(4 marks) (20 marks)

End of Question Paper

Answers

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

Control Objectives – wages system – – – – – – –

(b)

December 2008 Answers

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.

The Directors Blake Co 1701 Any Street Big Town 31911 Acountry 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 to alleviate those weaknesses. (i) Weakness:

(ii) Possible effect:

(iii) Recommendation:

The logging in process for employees is not monitored.

Employees could bring cards for absent employees to the assembly plant and scan that card for the employee; absent employees would effectively be paid for work not done.

The shift manager should reconcile the number of workers physically present on the production line with the computerised record of the number of employees logged in for work each shift.

Overtime is not authorised by a responsible official.

Employees may get paid for work not done e.g. they may clock-off late in order to receive ‘overtime’ payments.

All overtime should be authorised, either by the shift manager authorising an estimated amount of overtime prior to the shift commencing or by the manager confirming the recorded hours in the payroll department computer system after the shift has been completed.

The code word authorising the accuracy of time worked to the wages system is the name of the cat of the department head.

The code word is not secure and could be easily guessed by an employee outside the department (names of pets are commonly used passwords).

The code word should be based on a random sequence of letters and numbers and changed on a regular basis.

The total amount of net wages transferred to employees is not agreed to the total of the list of wages produced by the payroll department.

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

Prior to net wages being sent to the bank for payment, the financial accountant should agree the total of the payments list to the total of wages from the payroll department.

Details of employees leaving the company are sent on an e-mail from the personnel department to payroll.

There is no check to ensure that all There needs to be a control to ensure e-mails sent are actually received in the all e-mails are received in personnel – payroll department. prenumbering of e-mails or tagging the e-mail to ensure a receipt is sent back to the personnel department will help meet this objective.

(i) Weakness:

(ii) Possible effect:

(iii) Recommendation:

In the accounts department, the accounts clerk authorises payment of net wages to employees.

It is inappropriate that a junior member of staff should sign the payroll; the clerk may not be able to identify errors in the payroll or could even have included ‘dummy employees’ and is now authorising payments to those ‘people’.

The payroll should be authorised by a senior manager or finance director.

If you require any further information on the above, please do not hesitate to contact us. Yours faithfully Global Audit Co. (c)

Substantive analytical procedures Substantive analytical procedure

Expectation

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

Assuming that the number of shift managers has remained unchanged, the total salary expenditure should have increased by inflation only.

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

Total salary should be approximately number of managers multiplied by average salary.

Obtain a listing of total salary payments made each month.

The total payments should be roughly the same apart from July onwards when salaries increased and November when the annual bonus was paid.

(d) Audit procedure

Benefit to auditor in testing accuracy of time recording system

Confirmation Confirmation is the process of obtaining a representation of information or of an existing condition directly from a third party.

Obtaining information from a third party will be difficult. The manufacturer of the time recording system could be approached to discuss known errors with the system; however, information provided may be limited by the need to protect the manufacturer’s integrity. It is therefore unlikely that the auditor will benefit from this procedure.

Observation This procedure involves watching a procedure being performed by others – in this case watching shift-workers using the time recording system.

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

Inquiry Inquiry involves obtaining information from client staff or external sources.

Inquiry only confirms that shift-workers confirm they clock-in or out. It does not directly confirm the action actually happened or the accuracy of the recording of hours worked.

Audit procedure

Applicability in testing accuracy of time recording system

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

Recalculation can confirm the hours worked are correctly calculated as the difference between the clocking in and out times in the time recording system. When used with reperformance evidence this will confirm the overall accuracy of the time recording system.

Reperformance This is the auditor’s independent execution of procedures or controls that were originally performed as part of the entity’s internal control.

If the auditor notes the time of clocking in and out, then these times can be agreed to the time recording system confirming the accuracy of recording (or confirm that client staff actually perform this control). Reperformance is therefore a good source of audit evidence.

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

(a)

Competence and objectivity of experts – – –

(b)

The expert’s professional qualification. The expert should ideally be a member of a relevant professional body or have the necessary licence to perform the work. The experience and reputation of the expert in the area in which the auditor is seeking audit evidence. The independence of the expert from the client company. The expert should not normally be employed by the client.

Auditor rights – – – – –

(c)

This procedure will be useful for the auditor as the total time recorded for each employee should be standard hours plus any estimate of the overtime worked.

Right of access to the company’s books and records at any reasonable time to collect the evidence necessary to support the audit opinion. Right to require from the company’s officers the information and explanations the auditor considers necessary to perform their duties as auditors. Right to receive notice of and attend meetings of the company in the same way as any member of the company. Right to speak at general meetings on any matter affecting the auditor or previous auditor. Where the company uses written resolutions, a right to receive a copy of those resolutions.

Tangible non-current assets – assertions –

Completeness – ensure that all non-current assets are recorded in the non-current asset register by agreeing a sample of assets physically verified back to the register.

–

Existence – ensure non-current assets exist by taking a sample of assets from the register and physically seeing the asset.

–

Valuation and allocation – ensure assets are correctly valued by checking the reasonableness of depreciation calculations.

–

Rights and obligations – ensure the company owns the asset by seeing appropriate document of ownership for example, a purchase invoice.

–

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

Note: only four assertions were required.

(a)

Ethical threats Ethical threat

Mitigation of threat

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

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

This means he may be too familiar with the client to be able to make objective decisions due to this long association. There is no ethical rule which stops Mr Son recommending Zoe for the audit, or letting Zoe take part in the audit. However, there may be the impression of lack of independence as Zoe is related to the engagement partner. Zoe could be tempted not to identify errors in case this prejudiced her fatherâ&#x20AC;&#x2122;s relationship with the client. As long as Mr Far paid a full fee to Stark Co for the investment advice, then there is no ethical threat. This would be a normal commercial transaction and Mr Far would not gain any benefit.

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

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

However, continued use of client services could imply a lack of independence especially if Mr Far is not paying a full fee and therefore receiving a benefit from the client. The audit team have been offered a balloon flight at the end of the audit. Acceptance of gifts from a client, unless of an insignificant amount, is not allowed. The fact that the flight costs less than the yacht expense is irrelevant, independence could still be impaired. Agreeing to accept taxation work on the percentage of the tax saved is essentially accepting a contingent fee. There will be pressure to gain the highest tax refund for the client and this could tempt the audit firm to suggest illegal tax avoidance schemes. Representing Stark Co in court could be seen as an advocacy threat â&#x20AC;&#x201C; that is the audit firm is promoting the position of the client.

The balloon flight should not be accepted. Investigation would also be needed to find out why hospitality was accepted in previous years.

The audit firm must confirm that assistance with taxation work is acceptable, although the fee must be based on time and experience for the job, not the contingent fee.

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

Objectivity could be compromised because the audit firm is seen to take the position that the client is correct, affecting judgement on the tax issue. (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 are regulatory controls and reports that Stark must produce or comply with. Establishing an internal audit department will enable Stark to produce those reports more efficiently and show compliance with the regulatory regime. Even if internal audit is not required 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 audit department will be able to monitor the accuracy of those reports, especially those not audited by the external auditors. This function 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 place reliance 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 handling significant amounts of client cash. Internal audit can review the effectiveness of those controls and make recommendations to management for improvement where necessary.

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 costeffectiveness of the various control systems or whether investment advice being provided is cost-effective given the nature of products 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 portfolio matched the client’s risk profile and Stark Co’s risk appetite. Any weaknesses in this area would result in a recommendation to 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 a taxation 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 was available in house when necessary.

(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 aggregated with misstatements, assuming that there are no related controls. The risk of such misstatement is greater for some assertions and related classes of transactions, account balances, and disclosures than for others. Control risk is the risk that a material error could occur in an assertion that could be material, individually or when aggregated with other misstatements, will not be prevented or detected on a timely basis by the company’s internal control systems. Detection risk is the risk that the auditors’ procedures will not detect a misstatement that exists in an assertion that could be material, individually or when aggregated with other misstatements.

(b)

Inherent risks in charity Area of inherent risk

Effect on audit approach

Income is from voluntary donations only. There is a risk that donations will fall, especially where donors’ own income is limited by the ‘credit crunch’ etc.

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

Completeness of income – where there are no controls to ensure income is complete for example sales invoices are not raised to obtain donations and donations could be stolen by staff.

Audit tests are unlikely to be effective to meet the assertion of completeness. The audit report may need to be modified and qualified to explain the lack of evidence stating that completeness of income cannot be confirmed.

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

Careful review of expenditure will be necessary to ensure that expenditure is not ‘ultra vires’ the objectives of the charity.

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

The auditor will need to review the constitution of the EuKaRe charity carefully in this respect. Taxation rules relevant to charities. There is a risk that the rules will be broken due to lack of correct analysis of income/expenditure.

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

Requirement to report expenditure in accordance with the constitution – administration expenditure can be no more than 10% of total income. Risks here include income being overstated to allow expenditure to be overstated.

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

Donations to charity for specific activities for example provision of sports equipment. There is a risk that donations are not spent in accordance with donors’ instructions.

Documentation for any donation will need to be obtained and then expenditure agreed to the terms of the documentation. Any discrepancies will have to be reported to management.

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

(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 including segregation of duties cannot be implemented. Staff are likely to be unclear as to their exact responsibilities as they are not formal ‘employees’ and are not part of the formal authority structure in the charity. Volunteer staff Many staff are volunteers and so will only work at the charity on an occasional basis. Controls will be performed by different staff on different days making the system unreliable. Lack of qualified staff (human resource issues) Selection of staff is limited – people tend to volunteer for work when they have time – and so they are unlikely to have professional qualifications or experience to implement or maintain good control systems. No internal audit department (lack of organisational structure) Any control system will not be monitored effectively, mainly due to the lack of any internal audit department. The charity will not have the funds or experience to establish internal audit. Attitude of the trustees It is not clear how the charity’s trustees view risk. However, where trustees are not professionally trained or have little time to devote to the charity, then there may be an impression that controls are not important. The overall control environment may therefore be weak as other charity workers do not see the importance of maintaining good controls.

(a)

Event 1 (i)

The problem with the mattress inventory provides additional evidence of conditions existing at the end of the reporting period as the inventory was in existence and the faulty springs were included in the inventory at this time. The value of the inventory is overstated and should be reduced to the lower of cost and net realisable value in accordance with IAS 2 Inventories. An adjustment for this decrease in value must be made in the financial statements. The mattresses should therefore be valued at $225,000 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 statements and 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 $225,000 is 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 further insurance 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 defective springs.

–

Obtain the amended financial statements and ensure that the directors have included $225,000 as at the end of the reporting period and that the year-end value of inventory has been decreased to $225,000 on the statement 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 further adjustments are not required to any other inventory.

–

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

–

Finally, assessing the effect on the audit opinion after the decision of the directors regarding the inventory value is known. A qualified opinion may be required where appropriate adjustments are not made to the financial statements.

Event 2 (i)

The release of dye occurred after the end of the reporting period, so this is indicative of conditions existing after the end of 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 illegal pollution so as a material event it will need disclosure in the financial statements.

(ii)

As with event 1, the event takes place before the signing of the audit report, therefore the auditors have a duty to identify material events affecting the financial statements. Audit procedures will include:

(b)

–

Obtain any documentation on the event, for example board minutes, copies of environmental legislation and possibly 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 the directors accordingly.

–

Where disclosure is not made and the auditor considers disclosure is necessary, modify the audit opinion on the grounds 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 to continue as a going concern, draw the members’ attention to this in an emphasis of matter paragraph.

The notification of a fine has taken place after the audit report has been signed. Audit procedures will include: –

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-draft and re-date the audit report as appropriate.

–

Where the directors decide not to amend the disclosure in the financial statements, the auditor can consider other methods of contacting the members. For example, the auditor can speak in the upcoming general meeting to inform the members 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 not take place before the AGM so the auditor should speak at the AGM instead.

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International)

December 2008 Marking Scheme Marks

(a)

0·5 mark for each valid objective

––– 2 –––

Maximum marks (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 monitored Overtime not authorised Poor password control (cat’s name) Transfer total wages not checked Employees leaving details sent on e-mail Other valid points 4 points * 3 marks each =

Letter format (that is not a report or memo at beginning) Overall presentation Maximum marks (c)

1 mark for each valid procedure and 1 for expectation of result of procedure = 2 marks for each procedure Total salary cost Average salary List of payments each month Other valid points

––– 6 –––

Maximum marks (d)

1 1 ––– 14 –––

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 of answer to obtain this mark) = 2 marks for each procedure Confirmation (note limited use) Observation Inquiry Recalculation Reperformance Analytical procedures Note inspection procedure not valid as stated in question. Maximum marks Total marks

––– 8 ––– 30 –––

Marks 2

(a)

1 mark for each factor Professional qualification Experience and reputation Independence Other valid points (including but not limited to Reputation Not employed by client Not related to client)

––– 3 –––

Maximum marks (b)

1 mark for each right of the auditor Access to company books Obtain information/explanation company officers Receive notice of/attend certain meetings Speak at certain meetings Receive copies certain resolutions Other valid points

––– 3 –––

Maximum marks (c)

0·5 for each assertion and 0·5 for each procedure Completeness Existence Valuation Rights and obligations Presentation and disclosure

––– 4 ––– 10 –––

Maximum marks Total marks

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 accounting period. Allow therefore any valid asssertion.

Marks 3

(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 service Engagement partner’s daughter takes part in audit Payment for investment advice Gift of balloon flight from client Contingent fee – taxation work Representing client in court Self-review threat from taxation service Fixed fee – normally calculate on time and experience? Other valid points

––– 12 –––

Maximum marks (b)

Up to 2 marks per well-explained point Regulation Reports to the board Liaison with external auditors Monitor effectiveness of internal controls Value for money audit Risk assessment Taxation services Decrease external audit fee Monitor overall strategy of company Improve customer confidence in company Other valid points

––– 8 ––– 20 –––

Maximum marks Total marks

(a)

1 mark for explanation of each term Audit risk Inherent risk Control risk Detection risk

––– 4 –––

Maximum marks (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 only Completeness of income Funds spent in accordance with charity objectives Taxation rules Reporting of expenditure Donation for specific activities Administration not exceed 10% of income Misallocation of capital donations Other valid points

––– 12 –––

Maximum marks (c)

1 mark for each point on weak control environment Lack of segregation of duties Volunteer staff Lack of qualified staff No internal audit Attitude of trustees Other valid points

––– 4 ––– 20 –––

Maximum marks Total marks

Marks 5

(a)

(i)

Explanation of whether events adjusting or not. 2 marks for each event Defective inventory Release of dye

––– 4 –––

Maximum marks (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 report From audit report date to AGM Defective inventory Audit must identify material events post reporting period Need to check value of $225,000 is receivable Documentation from insurers Payment from third party Disclosure in financial statements Total inventory value end of year Other inventory affected? Management representation point Discuss with directors May be a going concern issue Other valid points Release of dye Ensure that material event is disclosed appropriately in financial statements Documentation of event Extent of disclosure in financial statements Action if disagree with amount of disclosure Possibility of modified audit report Management representation letter Contact insurance company Going concern may be impaired Other valid points

––– 12 –––

Maximum marks (b)

1 mark for each audit procedure Discuss with directors Audit any amendment to financial statements Produce revised audit report Inform members in other methods – speak at meeting Resignation? Note not effective.

––– 4 ––– 20 –––

Maximum marks Total marks

Audit and Assurance (International) Wednesday 3 June 2009

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 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 purchasing themed souvenirs from gift shops. The park is open all year and has been in operation for the last seven years. It is located in a country which has very little rainfall – the park is open-air so poor weather such as rain results in a significant fall in the number of customers for that day (normally by 50%). During the last seven years there have been on average 30 days each year with rain. B-Star is now very successful; customer numbers are increasing at approximately 15% each year. Ticket sales Customers purchase tickets to enter the theme park from ticket offices located outside the park. Tickets are only valid on the day of purchase. Adults and children are charged the same price for admission to the park. Tickets are preprinted and stored in each ticket office. Tickets are purchased using either cash or credit cards. Each ticket has a number comprising of two elements – two digits relating to the ticket office followed by six digits to identify the ticket. The last six digits are in ascending sequential order. Cash sales 1. 2. 3. 4.

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. Cash is collected regularly from each ticket office by two security guards. The cash is then counted by two accounts clerks and banked on a daily basis. The total cash from each ticket office is agreed to the sales information that has been transferred from each office. Total cash received is then recorded in the cash book, and then the general ledger.

Credit card sales 1. 2. 3. 4.

Payments by credit cards are authorised online as the customers purchase their tickets. Computers in each ticket office record the sales information which is transferred electronically to the accounts office. Credit card sales are recorded for each credit card company in a receivables ledger. When payment is received from the credit card companies, the accounts clerks agree the total sales values to the amounts received from the credit card companies, less the commission payable to those companies. The receivables ledger is updated with the payments received.

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

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

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

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

List the substantive analytical procedures that may be used to give assurance on the total income from ticket sales for one day in B-Star;

(ii) List the substantive analytical procedures that may be used to give assurance on the total income from ticket sales in B-Star for the year. (8 marks) (d) List the audit procedures you should perform on the credit card receivables balance.

(4 marks) (30 marks)

[P.T.O.

(a) List and explain FOUR methods of selecting a sample of items to test from a population in accordance with ISA 530 (Redrafted) Audit Sampling and Other Means of Testing. (4 marks) (b) List and explain FOUR assertions from ISA 500 Audit Evidence that relate to the recording of classes of transactions. (4 marks) (c) In terms of audit reports, explain the term ‘modified’.

(2 marks) (10 marks)

Following a competitive tender, your audit firm Cal & Co has just gained a new audit client Tirrol Co. You are the manager in charge of planning the audit work. Tirrol Co’s year end is 30 June 2009 with a scheduled date to complete the audit of 15 August 2009. The date now is 3 June 2009. Tirrol Co provides repair services to motor vehicles from 25 different locations. All inventory, sales and purchasing systems are computerised, with each location maintaining its own computer system. The software in each location is the same because the programs were written specifically for Tirrol Co by a reputable software house. Data from each location is amalgamated on a monthly basis at 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’s audit software to interrogate the computerised inventory systems in each location of Tirrol Co (except for head office) as part of inventory valuation testing. However, you have also been informed that any computer testing will have to be on a live basis and you are aware that July is a major holiday period for your audit firm. Required: (a) (i)

Explain the benefits of using audit software in the audit of Tirrol Co;

(4 marks)

(ii) Explain the problems that may be encountered in the audit of Tirrol Co and for each problem, explain how that problem could be overcome. (10 marks) (b) Following a discussion with the management at Tirrol Co you now understand that the internal audit department are prepared to assist with the statutory audit. Specifically, the chief internal auditor is prepared to provide you with documentation on the computerised inventory systems at Tirrol Co. The documentation provides details of the software and shows diagrammatically how transactions are processed through the inventory system. This documentation can be used to significantly decrease the time needed to understand the computer systems and enable audit software to be written for this year’s audit. Required: Explain how you will evaluate the computer systems documentation produced by the internal audit department in order to place reliance on it during your audit. (6 marks) (20 marks)

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

(8 marks)

(b) Conoy Co designs and manufactures luxury motor vehicles. The company employs 2,500 staff and consistently makes a net profit of between 10% and 15% of sales. Conoy Co is not listed; its shares are held by 15 individuals, most of them from the same family. The maximum shareholding is 15% of the share capital. The executive directors are drawn mainly from the shareholders. There are no non-executive directors because the company legislation in Conoy Co’s jurisdiction does not require any. The executive directors are very successful in running Conoy Co, partly from their training in production and management techniques, and partly from their ‘hands-on’ approach providing motivation to employees. The board are considering a significant expansion of the company. However, the company’s bankers are concerned with the standard of financial reporting as the financial director (FD) has recently left Conoy Co. The board are delaying provision of additional financial information until a new FD is appointed. Conoy Co does have an internal audit department, although the chief internal auditor frequently comments that the board of Conoy Co do not understand his reports or provide sufficient support for his department or the internal control systems within Conoy Co. The board of Conoy Co concur with this view. Anders & Co, the external auditors have also expressed concern in this area and the fact that the internal audit department focuses work on control systems, not financial reporting. Anders & Co are appointed by and report to the board of Conoy Co. The board of Conoy Co 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)

[P.T.O.

One of your audit clients is Tye Co a company providing petrol, aviation fuel and similar oil based products to the government of the country it is based in. Although the company is not listed on any stock exchange, it does follow best practice regarding corporate governance regulations. The audit work for this year is complete, apart from the matter referred to below. As part of Tye Co’s service contract with the government, it is required to hold an emergency inventory reserve of 6,000 barrels of aviation fuel. The inventory is to be used if the supply of aviation fuel is interrupted due to unforeseen events such as natural disaster or terrorist activity. This fuel has in the past been valued at its cost price of $15 a barrel. The current value of aviation fuel is $120 a barrel. Although the audit work is complete, as noted above, the directors of Tye Co have now decided to show the ‘real’ value of this closing inventory in the financial statements by valuing closing inventory of fuel at market value, which does not comply with relevant accounting standards. The draft financial statements of Tye Co currently show a profit of approximately $500,000 with net assets of $170 million. Required: (a) List the audit procedures and actions that you should now take in respect of the above matter.

(6 marks)

(b) For the purposes of this section assume from part (a) that the directors have agreed to value inventory at $15/barrel. Having investigated the matter in part (a) above, the directors present you with an amended set of financial statements showing the emergency reserve stated not at 6,000 barrels, but reported as 60,000 barrels. The final financial statements now show a profit following the inclusion of another 54,000 barrels of oil in inventory. When queried about the change from 6,000 to 60,000 barrels of inventory, the finance director stated that this change was made to meet expected amendments to emergency reserve requirements to be published in about six months time. The inventory will be purchased this year, and no liability will be shown in the financial statements for this future purchase. The finance director also pointed out that part of Tye Co’s contract with the government requires Tye Co to disclose an annual profit and that a review of bank loans is due in three months. Finally the finance director stated that if your audit firm qualifies the financial statements in respect of the increase in inventory, they will not be recommended for re-appointment at the annual general meeting. The finance director refuses to amend the financial statements to remove this ‘fictitious’ inventory. Required: (i)

State the external auditor’s responsibilities regarding the detection of fraud;

(4 marks)

(ii) Discuss to which groups the auditors of Tye Co could report the ‘fictitious’ aviation fuel inventory; (6 marks) (iii) Discuss the safeguards that the auditors of Tye Co can use in an attempt to overcome the intimidation threat from the directors of Tye Co. (4 marks) (20 marks)

End of Question Paper

Answers

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

June 2009 Answers

Audit strategy document Section of document

Purpose

Example from B-Star

Understanding the entity’s environment

Provides details of the industry area that Size of the theme park sector and the company is in along with specific expected growth over the next few years. information about the activities and strategies of the individual client.

Understand the accounting and internal Details of accounting policies of the control systems client and previous assessments of internal control systems indicating the expected extent of reliance on those systems. Risk and materiality

Accounting policy for sales – sales are stated net of sales taxes. Reliance on control systems in B-Star may be limited due to lack of documentation of controls.

The assessment of risk for the client and Materiality for sales to be 5% of turnover. risk of fraud and error and the B-Star receives cash sales – audit work identification of significant audit areas. required to determine the completeness The materiality level for audit planning of sales. purposes.

Consequent nature, timing and extent of Details of the focus on audit work on Audit software could be used to provide audit procedures specific areas. Detail on the extent of use analytical procedures on the sales of of audit software and possible reliance B-Star. on internal audit. Co-ordination, supervision and review of Details the extent of involvement of B-Star has only one location – audit staff audit work experts, client locations and staffing will be required to work there for X requirements for the audit. weeks. (b)

(i)

Risk affecting completeness – – – – –

(ii)

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

Use of tests of controls and substantive procedures Tests of controls Tests of control are designed to ensure that documented controls are operating effectively. If controls over the completeness of income were expected to operate correctly, then the auditor would test those controls. In B-Star, while controls could be in operation, e.g. the account clerks agreeing physical cash to computer summaries, there is no indication that the control is documented; that is the computer summary is not signed to show the comparison has taken place. The auditor could use the test of inquiry – asking the clerks whether the control has been used, and observation – actually watching the clerks carry out the controls. As noted above though, lack of documentation of the control does mean relying on tests of control for the assertion completeness of income has limited value. Substantive procedures Substantive procedures include analytical procedures and other procedures. Analytical procedures include the analysis of significant ratios and trends and subsequent investigation of any trends or relationships that appear to be abnormal. These procedures can be used effectively in B-Star as an approximation of income that can be obtained from sources other than the cash receipt records. Other procedures, or tests of detail, are normally used to verify statement of financial position assertions and include obtaining audit evidence relevant to specific assertions. However, they could be used in B-Star to trace individual transactions through the sales/cash systems to ensure all ticket sales have been recorded (completeness assertion). The use of other procedures will be time consuming.

(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.

– – – (ii)

Substantive analytical procedures – completeness of income for the year – –

– –

(d)

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.

Obtain the sales income from the previous year. Multiply this by 115% to provide a rough estimate of the income for this year. Obtain information on the number of days with rain during the last year. Where this is more or less than 30, adjust the 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 decreases total 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, obtain explanations from the directors.

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, – –

– –

(a)

Obtain direct confirmation from the credit card company of the amount due to B-Star using a receivables confirmation letter. Where direct confirmation is not possible, obtain evidence of cash receipt after the end of the financial year. Agree the amount on the bank statements post year end of B-Star to the amount due in the receivables ledger (less any commission due). 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.

Sampling methods Methods of sampling in accordance with ISA 530 Audit Sampling and Other Means of Testing: Random selection. Ensures each item in a population has an equal chance of selection, for example by using random number tables. Systematic selection. In which a number of sampling units in the population is divided by the sample size to give a sampling interval. Haphazard selection. The auditor selects the sample without following a structured technique – the auditor would avoid any conscious bias or predictability. Sequence or block. Involves selecting a block(s) of continguous items from within a population. Tutorial note: Other methods of sampling are as follows: Monetary Unit Sampling. This selection method ensures that each individual $1 in the population has an equal chance of being 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. For example, 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.

(a)

(i)

Benefits of using audit software Standard systems at client The same computerised systems and programs as used in all 25 branches of Tirrol Co. This means that the same audit software can be used in each location providing significant time savings compared to the situation where client systems are different in each location. 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 printouts or screen images. The latter could be incorrect, by accident or by deliberate mistake. The audit firm will have more confidence that the ‘real’ files have been tested. Test more items Use of software will mean that more inventory records can be tested – it is possible that all product lines could be tested for obsolescence rather than a sample using manual techniques. The auditor will therefore gain more evidence and have greater confidence that inventory is valued correctly. Cost The relative cost of using audit software decreases the more years that software is used. Any cost overruns this year could be offset against the audit fees in future years when the actual expense will be less.

(ii)

Problems on the audit of Tirrol Timescale – six week reporting deadline – audit planning The audit report is due to be signed six weeks after the year end. This means that there will be considerable pressure on the auditor to complete audit work without compromising standards by rushing procedures. This problem can be overcome by careful planning of the audit, use of experienced staff and ensuring other staff such as second partner reviews are booked well in advance. Timescale – six week reporting deadline – software issues The audit report is due to be signed about six weeks after the year end. This means that there is little time to write and test audit software, let alone use the software and evaluate the results of testing. This problem can be alleviated by careful planning. Access to Tirrol Co’s software and data files must be obtained as soon as possible and work commenced on tailoring Cal & Co’s software following this. Specialist computer audit staff should be booked as soon as possible to perform this work. First year audit costs The relative costs of an audit in the first year at a client tend to be greater due to the additional work of ascertaining client systems. This means that Cal & Co may have a limited budget to document systems including computer systems. This problem can be alleviated to some extent again by good audit planning. The manager must also monitor the audit process carefully, ensuring that any additional work caused by the client not providing access to systems information including computer systems is identified and added to the total billing cost of the audit. Staff holidays Most of the audit work will be carried out in July, which is also the month when many of Cal & Co staff take their annual holiday. This means that there will be a shortage of audit staff, particularly as audit work for Tirrol Co is being booked with little notice. The problem can be alleviated by booking staff as soon as possible and then identifying any shortages. Where necessary, staff may be borrowed from other offices or even different countries on a secondment basis where shortages are acute. Non-standard systems Tirrol Co’s computer software is non-standard, having been written specifically for the organisation. This means that more time will be necessary to understand the system than if standard systems were used. This problem can be alleviated either by obtaining documentation from the client or by approaching the software house (with Tirrol Co’s permission) to see if they can assist with provision of information on data structures for the inventory systems. Provision of this information will decrease the time taken to tailor audit software for use in 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 accidental amendment or deletion of client data systems compared to testing copy files. To limit the possibility of damage to client systems, Cal & Co can consider performing inventory testing on days when Tirrol Co is not operating e.g. weekends. At the worst, backups of data files taken from the previous day can be re-installed when Cal & Co’s testing is complete.

Computer systems The client has 25 locations, with each location maintaining its own computer system. It is possible that computer systems are not common across the client due to amendments made at the branch level. This problem can be overcome to some extent by asking staff at each branch whether systems have been amended and focusing audit work on material branches. Usefulness of audit software The use of audit software at Tirrol Co does appear to have significant problems this year. This means that even if the audit software is ready, there may still be some risk of incorrect conclusions being derived due to lack of testing, etc. This problem can be alleviated by seriously considering the possibility of using a manual audit this year. The manager may need to investigate whether a manual audit is feasible and if so whether it could be completed within the necessary timescale with minimal audit risk. (b)

Reliance on internal audit documentation There are two issues to consider; the ability of internal audit to produce the documentation and the actual accuracy of the documentation itself. The ability of the internal audit department to produce the documentation can be determined by: – –

–

Ensuring that the department has staff who have appropriate qualifications. Provision of a relevant qualification e.g. membership of a computer related institute would be appropriate. Ensuring that this and similar documentation is produced using a recognised plan and that the documentation is tested prior to use. The use of different staff in the internal audit department to produce and test documentation will increase confidence in its accuracy. Ensuring that the documentation is actually used during internal audit work and that problems with documentation are noted and investigated as part of that work. Being given access to internal audit reports on the inventory software will provide appropriate evidence.

Regarding the actual documentation: – – –

(a)

Reviewing the documentation to ensure that it appears logical and that terms and symbols are used consistently throughout. This will provide evidence that the flowcharts, etc should be accurate. Comparing the documentation against the ‘live’ inventory system to ensure it correctly reflects the inventory system. This comparison will include tracing individual transactions through the inventory systems. Using part of the documentation to amend Cal & Co’s audit software, and then ensuring that the software processes inventory system data accurately. However, this stage may be limited due to the need to use live files at Tirrol Co.

Role of internal and external auditors – differences Objectives The main objective of internal audit is to improve a company’s operations, primarily in terms of validating the efficiency and effectiveness of the internal control systems of a company. The main objective of the external auditor is to express an opinion on the truth and fairness of the financial statements, and other jurisdiction specific requirements such as confirming that the financial statements comply with the reporting requirements included in legislation. Reporting Internal audit reports are normally addressed to the board of directors, or other people charged with governance such as the audit committee. Those reports are not publicly available, being confidential between the internal auditor and the recipient. External audit reports are provided to the shareholders of a company. The report is attached to the annual financial statements of the company and is therefore publicly available to the shareholders and any reader of the financial statements. Scope of work The work of the internal auditor normally relates to the operations of the organisation, including the transaction processing systems and the systems to produce the annual financial statements. The internal auditor may also provide other reports to management, such as value for money audits which external auditors rarely become involved with. The work of the external auditor relates only to the financial statements of the organisation. However, the internal control systems of the organisation will be tested as these provide evidence on the completeness and accuracy of the financial statements. Relationship with company In most organisations, the internal auditor is an employee of the organisation, which may have an impact on the auditor’s independence. However, in some organisations the internal audit function is outsourced. The external auditor is appointed by the shareholders of an organisation, providing some degree of independence from the company and management.

(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 recently left the company and has not yet been replaced. This may mean that financial reporting in Conoy Co is limited or that the other non-financial directors spend a significant amount of time keeping up to date on financial reporting issues. An audit committee will assist Conoy Co by providing specialist knowledge of financial reporting on a temporary basis – at least one of the new appointees should have relevant and recent financial reporting experience under codes of corporate governance. This will allow the executive directors to focus on running Conoy Co. 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. This means that internal control within Conoy Co may be inadequate or that employees may not recognise the importance of internal control systems within an organisation. The audit committee can raise awareness of the need for good internal control systems simply by being present in Conoy Co and by educating the board on the need for sound controls. Improving the internal control ‘climate’ will ensure the need for internal controls is understood and reduce control errors. Reliance on external auditors Conoy Co’s internal auditors currently report to the board of Conoy Co. As previously noted, the lack of financial and control expertise on the board will mean that external auditor reports and advice will not necessarily be understood – and the board may rely too much on external auditors If Conoy Co report to an audit committee this will decrease the dependence of the board on the external auditors. The audit committee can take time to understand the external auditor’s comments, and then via the non-executive director, ensure that the board 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 become too familiar with the external auditors and so appoint on this friendship rather than merit. If an audit committee is established, then this committee can recommend the appointment of the external auditors. The committee will have the time and expertise to review the quality of service provided by the external auditors, removing the independence issue. Corporate governance requirements – best practice Conoy Co do not need to follow corporate governance requirements (the company is not listed). However, not following those requirements may start to have adverse effects on Conoy. For example, Conoy Co’s bank is already concerned about the lack of transparency in reporting. Establishing an audit committee will show that the board of Conoy Co are committed to maintaining appropriate internal systems in the company and providing the standard of reporting expected by large companies. Obtaining the new bank loan should also be easier as the bank will be satisfied with financial reporting standards. Given no non-executives – independent advice to board Currently Conoy Co does not have any non-executive directors. This means that the decisions of the executive directors are not being challenged by other directors independent of the company and with little or no financial interest in the company. The appointment of an audit committee with one non-executive director on the board of Conoy Co will start to provide some non-executive input to board meetings. While not sufficient in terms of corporate governance requirements (about equal numbers of executive and non-executive directors are expected) it does show the board of Conoy Co are attempting to establish appropriate governance systems. Advice on risk management Finally, there are other general areas where Conoy Co would benefit from an audit committee. For example, lack of corporate governance structures probably means Conoy Co does not have a risk management committee. The audit committee can also provide advice on risk management, helping to decrease the risk exposure of the company.

(a)

Valuation of aviation inventory – – – –

Review GAAP to ensure that there are no exceptions for aviation fuel or inventory held for emergency purposes which would suggest a market valuation should be used. Calculate the difference in valuation. The error in inventory valuation is $105 * 6,000 barrels or $630k, which is a material amount compared to profit. Review prior year working papers to determine whether a similar situation occurred last year and ascertain the outcome at that stage. Discuss the matter with the directors to obtain reasons why they believe that market value should be used for the inventory this year.

– – –

– –

(b)

(i)

Warn the directors that in your opinion, aviation fuel should be valued at the lower of cost or net realisable value (that is $15/barrel) and that using market value will result in a modification to the audit report. If the directors now amend the financial statements to show inventory valued at cost, then consider mentioning the issue in the weakness letter and do not modify the audit report in respect of this matter. If the directors will not amend the financial statements, quantify the effect of the disagreement in the valuation method – the sum of $630,000 is material to the financial statements as Tye Co’s income statement figure is decreased from a small loss to a loss of $130,000 although net assets decrease by only about 0·3%. Obtain a management representation letter from the directors of Tye Co confirming that market value is to be used for the emergency inventory of aviation fuel. If the directors will not amend the financial statements, draft the relevant sections of the audit report, showing a qualification on the grounds of disagreement with the accounting policy for valuation of inventory. External auditor responsibilities regarding detection of fraud Overall responsibility of auditor The external auditor is primarily responsible for the audit opinion on the financial statements following the international auditing standards (ISAs). ISA 240 (Redrafted) The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements is relevant to audit work regarding fraud. The main focus of audit work is therefore to ensure that the financial statements show a true and fair view. The detection of fraud is therefore not the main focus of the external auditor’s work. An auditor is responsible for obtaining reasonable assurance that the financial statements as a whole are free from material misstatement, whether caused by fraud or error. The auditor is responsible for maintaining an attitude of professional scepticism throughout the audit, considering the potential for management override of controls and recognising the fact that audit procedures that are effective for detecting error may not be effective for detecting fraud. Materiality ISA 240 states that the auditor should reduce audit risk to an acceptably low level. Therefore, in reaching the audit opinion and performing audit work, the external auditor takes into account the concept of materiality. In other words, the external auditor is not responsible for checking all the transactions. Audit procedures are planned to have a reasonable likelihood of identifying material fraud. Discussion among the audit team A discussion is required among the engagement team placing particular emphasis on how and where the entity’s financial statements may be susceptible to material misstatement due to faud, including how fraud might occur. Identification of fraud In situations where the external auditor does detect fraud, then the auditor will need to consider the implications for the entire audit. In other words, the external auditor has a responsibility to extend testing into other areas because the risk of providing an incorrect audit opinion will have increased.

(ii)

Groups to report fraud to Report to audit committee Disclose the situation to the audit committee as they are charged with maintaining a high standard of governance in the company. The committee should be able to discuss the situation with the directors and recommend that they take appropriate action e.g. amend the financial statements. Report to government As Tye Co is acting under a government contract, and the over-statement of inventory will mean Tye Co breaches that contract (the reported profit becoming a loss), then the auditor may have to report the situation directly to the government. The auditor of Tye Co needs to review the contract to confirm the reporting required under that contract. Report to members If the financial statements do not show a true and fair view then the auditor needs to report this fact to the members of Tye Co. The audit report will be qualified with an except for or adverse opinion (depending on materiality) and information concerning the reason for the disagreement given. In this case the auditor is likely to state factually the problem of inventory quantities being incorrect, rather than stating or implying that the directors are involved in fraud. Report to professional body If the auditor is uncertain as to the correct course of action, advice may be obtained from the auditor’s professional body. Depending on the advice received, the auditor may simply report to the members in the audit report, although resignation and the convening of a general meeting is another reporting option.

(iii) Intimidation threat â&#x20AC;&#x201C; safeguards In response to the implied threat of dismissal if the audit report is modified regarding the potential fraud/error, the following safeguards are available to the auditor. Discuss with audit committee The situation can be discussed with the audit committee. As the audit committee should comprise non-executive directors, they will be able to discuss the situation with the finance director and point out clearly the auditorâ&#x20AC;&#x2122;s opinion. They can also remind the directors as a whole that the appointment of the auditor rests with the members on the recommendation of the audit committee. If the recommendation of the audit committee is rejected by the board, good corporate governance requires disclosure of the reason for rejection. Obtain second partner review The engagement partner can ask a second partner to review the working papers and other evidence relating to the issue of possible fraud. While this action does not resolve the issue, it does provide additional assurance that the findings and actions of the engagement partner are valid. Resignation If the matter is serious, then the auditor can consider resignation rather than not being re-appointed. Resignation has the additional safeguard that the auditor can normally require the directors to convene a general meeting to consider the circumstances of the resignation.

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

June 2009 Marking Scheme

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 example from 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

––– 8 –––

Maximum marks (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. Maximum marks

(ii)

––– 4 –––

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

––– 6 –––

Maximum marks (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

Maximum marks (ii)

––– 4 –––

Ticket sales for year – – – – –

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

––– 4 –––

Maximum marks

(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

––– 4 ––– 30 ––– –––

Maximum marks

(a)

1 mark for each method. 0·5 for stating the method and 0·5 for brief explanation. – – – – – –

Random Systematic Haphazard Sequence MUS Judgemental

––– 4 –––

Maximum marks (b)

1 mark per assertion. 0·5 for stating the assertion and 0·5 for explaining the assertion. – – – – –

Occurrence Completeness Accuracy Cut-off Classification

––– 4 –––

Maximum marks (c)

Up to 2 marks for valid explanation of –

Modified

––– 2 ––– 10 ––– –––

Maximum marks

(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

––– 4 –––

Maximum marks (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

––– 10 –––

Maximum marks (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

––– 6 ––– 20 ––– –––

Maximum marks

(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

––– 8 –––

Maximum marks (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.

Maximum marks

––– 12 ––– 20 ––– –––

(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

––– 6 –––

Maximum marks (b)

(i)

Auditor and fraud 1 mark each for each valid responsibility: – – – – –

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

––– 4 –––

Maximum marks (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

––– 6 –––

Maximum marks (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

––– 4 ––– 20 ––– –––

Maximum marks

Audit and Assurance (International) Wednesday 9 December 2009

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 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 firm of Chartered Certified Accountants for a number of years. The manager in overall charge of the audit has been discussing the audit plan with the audit team, of which you are a member, prior to commencement of the work. The audit manager has informed the team, among other things, that there has been a growing interest in poetry generally and that the company has acquired a reputation for publishing poets who are still relatively unknown. During your audit you determine: (i)

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

(ii) The computerised customer master file contains a code indicating whether a despatch is to earn a royalty for the author. This code is shown on the sales invoice and despatch note when they are prepared. (iii) A computerised royalties file is held, all entries therein bearing the invoice number and date. (iv) The company keeps detailed statistics of sales made, including trends of monthly sales by type of customer, and of colleges where its books are recommended as part of course material, based on reports from sales staff. (v) Bookshops have the right to return books which are not selling well, but about 10% of these are slightly damaged when returned. The company keeps similar records of returns as it does for sales. Required: (b) Describe TWO procedures used to ensure that the sales statistics kept by the company may be relied upon. (4 marks) (c) Describe THREE substantive tests you should perform to ensure that the royalties charge is accurate and complete, stating the objective of each test. (6 marks) (d) A material figure in the statement of financial position of Redburn Co is the amount attributed to inventory of books. Required: State TWO inherent risks that may affect the inventory figure and suggest ONE control to mitigate each risk. (4 marks) (e) The management of Redburn Co have told you that inventory is correctly valued at the lower of cost and net realisable value. You have already satisfied yourself that cost is correctly determined. Required: (i)

Define net realisable value;

(2 marks)

(ii) State and explain the purpose of FOUR procedures that you should use to ensure that net realisable value of the inventory is at or above cost. (8 marks) (30 marks)

(a) ISA 500 Audit Evidence requires audit evidence to be reliable. Required: List FOUR factors that influence the reliability of audit evidence.

(4 marks)

(b) ISA 260 (Revised and Redrafted) Communication with Those Charged with Governance deals with the auditorâ&#x20AC;&#x2122;s responsibility to communicate with those charged with governance in relation to an audit of financial statements. Required: (i)

Describe TWO specific responsibilities of those charged with governance;

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

(2 marks) (4 marks) (10 marks)

[P.T.O.

ISA 315 (Redrafted) Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment requires auditors to obtain an understanding of the entity and its environment, including its internal control. Required: (a) Explain why obtaining an understanding of the entity and its environment is important for the auditor. (4 marks) Letham Co is a large engineering company with ten manufacturing units throughout the country in which it is located. The manufacturing process is capital intensive and the company holds a wide variety of plant and equipment. The finance director is responsible for the preparation of a detailed non-current assets budget annually, which is based on a five-year budget approved by the whole board of directors after consultation with the audit committee. This annual budget, which is also approved by the full board, is held on computer file and is the authority for the issue of a purchase order. When the item of plant and equipment is delivered to the company, a pre-numbered goods received note (GRN) is prepared, a copy of which is sent to the accounting department, and used to update the non-current assets budget to reflect the movement. The equipment is carefully inspected by production personnel and tested for proper operation. An operational certificate is prepared by the production department and this is used by the accounting department, together with the GRN, to check against the purchase invoice when it is received. At the same time as the purchase invoice enters the purchasing system, a computerised non-current assets register is updated. Access to the non-current assets register is restricted to personnel in the accounting department. On a rolling basis throughout the year the non-current assets register is compared to plant and equipment on site by accounting department personnel, using identification numbers in the register and permanently marked onto each item in the factory. The internal audit department also tests on a sample basis the operation of the system from budget preparation to entry in the non-current assets register. Internal audit staff also compare a sample of entries in the non-current assets register with equipment on the shop floor. Required: (b) Identify SIX STRENGTHS in Lethamâ&#x20AC;&#x2122;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)

(a) Explain the difference between the interim audit and the final 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 finance 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 finance the expansion and also to maintain its working capital generally. To support its request for a loan, the company has prepared a cash flow 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 confirm the accuracy of the forecast. Following this request the company has asked you to examine the cash flow 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)

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

(4 marks) (20 marks)

[P.T.O.

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

(6 marks)

You are the audit senior responsible for the audit of Have A Bite Co, a company that runs a chain of fast food restaurants. You are aware that a major risk of their sector is that poor food quality might result in damage claims by customers. You had satisfied yourself at the interim audit that the companyâ&#x20AC;&#x2122;s control risk as regards purchases of food and its preparation in the kitchen was low. However, during your final audit it comes to your attention that one month before the year-end, a customer has sued the company for personal injury caused by food poisoning, claiming an amount of $200,000 in compensation. This amount is material to the stated profit of the company, but management believes that it has good defences against the claim. Required: (b) (i)

State TWO controls that the company should have in place to reduce the risk associated with purchases of food and its preparation in the kitchen; and (ii) State TWO audit procedures you should carry out during controls testing to satisfy yourself that control risk in this area is low. (4 marks)

(c) In respect of the potential claim state THREE items of evidence you should obtain and explain how they might enable you to form a conclusion on the likelihood of the claim being successful. (6 marks) Following your audit you have concluded that there is a possibility, but not a probability, that the claim will be successful. However, management have decided not to make a provision or disclosure in the financial statements in respect of this matter. Required: (d) Describe how the matter should be reported in the financial statements and explain the effect on your audit report. (4 marks) (20 marks)

End of Question Paper

Answers

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

December 2009 Answers

Audit planning is addressed by ISA 300 (Redrafted) Planning an Audit of Financial Statements. The standard notes that an audit plan will be developed after the overall audit strategy has been established and then states that adequate planning benefits the audit of financial statements in several ways, including the following: – – – – – –

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 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.

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

A description of the nature, timing and extent of planned risk assessment procedures sufficient to assess the risks of material misstatement. (ii) This would include assessment of inherent risk and control risk at both the entity and assertion level. An important element of the plan would be the understanding and assessment of the control environment of the organisation. (iii) A description of the nature, timing and extent of planned further procedures at the assertion level for each material class of transactions, account balance, and disclosure. (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 ISAs, for example, the use of external confirmations to obtain sufficient appropriate evidence at the assertion level. (Tutorial note: Marks would also be available for additional points such as: – – – (b)

Materiality Timetable of detailed audit work Allocation of work to team members.)

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 file are properly entered to ensure that the type of customer is properly identified. 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.)

(c)

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

(ii)

Test Compare the royalties charge with stated sales income and obtain explanations from management if the figures do not appear reasonable.

Objective To satisfy the auditor that the royalties charge in the income statement is reasonable in relation to stated sales income.

Compare budgeted royalties figure with actual figures. If variations are significant, obtain explanations from management.

To satisfy the auditor that the actual figures had been anticipated by management, thus providing evidence as to their reliability.

(iii) Review the sales statistics (proven in (b) above) to ascertain those despatches that attract royalties.

This would be evidence that the royalties charge was soundly based.

(iv) Take a sample of recorded sales entries and check: â&#x20AC;&#x201C; whether royalties are due in respect of the customer. â&#x20AC;&#x201C; if they are, that the entry in the computerised royalties file has been calculated at 10% according to the contracts agreed with the published poets.

These are detailed tests to prove that royalties were due on despatches and that the calculation of the royalty was accurate.

(v)

This is a test to prove that recorded royalty payments have resulted from despatches and sales attracting royalties.

Take a sample of royalty payments and agree to supporting despatch and sales documentation, checking in particular that all despatches are to individuals and organisations attracting royalties.

(vi) Select sales for 15 days before the year end and 15 days afterwards and compare with the dates of despatch notes.

This is to check that cut-off is accurate. The royalties charge should only include royalties on sales up to the cut-off date.

(vii) Calculate the expected level of royalty payments based on monthly trend information for type of customer. Obtain sales figures and multiply by 10%. Compare expectation to actual royalties and obtain explanations from management for any significant variations.

This test should provide the auditor with evidence as to the completeness and accuracy of royalties paid.

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 Risk of deterioration.

Mitigating controls 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. Identification of defective items at interim or period-end inventory counts.

Books may be attractive and easily transportable, making attempted theft likely.

Books to be kept in a secure location with restriction of 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 specific 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 the inventory count.

Movement of books out stopped during the count or only allowed by permission of authorised official in charge of the count. Book returns received during count held in separate area. Identification of last movements in and out.

Goods on sale or return are held by customers but should be included within inventory until the return period is passed.

Detailed records should be maintained of goods on sale or return and this should be reviewed at the year end to ensure that any goods within the return period have been included in inventory.

(e)

(i)

Net realisable value is defined in IAS 2 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 identified as slow-moving. (Tutorial note: Slowmoving books might be identified 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 identified 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.

(a)

The following five factors that influence the reliability of audit evidence are taken from ISA 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 difficult 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 financial 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.

(ii)

General audit matters that might be communicated to those charged with governance are addressed in ISA 260: (1) The auditor’s responsibilities in relation to financial statement audit. This would include: – –

A statement that the auditor is responsible for forming and expressing an opinion on the financial 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 final audits, including reporting deadlines. (3) Significant findings from the audit. This heading could include: – – –

Significant difficulties 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 financial 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 firm 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 identified.

(Tutorial note: The lists of examples listed under the above headings are not exhaustive and in practice many more specific matters would be communicated to those charged with governance such as: – – –

(a)

Modifications to the audit report. Any management representation points requested. Cases of suspected/actual fraud.)

The auditor obtains an understanding of the entity, its control environment and its detailed internal controls: (i)

to identify and assess the risks of material misstatements, whether due to fraud or error, at the financial statement and assertion levels. Risks would include inherent risk and control risk. An important objective would be to determine the extent to which the auditor would rely on the internal control system.

(ii)

to provide a basis for designing and implementing responses to the assessed risks of material misstatement in the financial statements. This would involve the design and performance of the audit procedures required to form an opinion on the truth and fairness of the financial statements. An important objective would be to determine the extent and nature of audit procedures to reduce detection risk, and therefore audit risk, to an acceptable level.

(iii) to set the scene for identifying assertions and collecting sufficient appropriate evidence to prove that the assertions are reasonable. (Tutorial note: Marks would also be available for additional points such as: – – – – (b)

To assess the adequacy of the accounting system as a basis for preparing financial 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.)

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: (i)

(ii)

Strengths Approval of the five-year and annual budgets by the board of directors.

Impact on control risk The annual budget is the ‘trigger’ for placing orders for equipment. Its approval by the board will ensure that only authorised non-current assets are purchased.

The budget is updated when the order for new equipment is placed.

The company can use the updated budget at any time to anticipate cash outflows. It will also ensure that there is no duplication of assets purchased.

(c)

Strengths (iii) Pre-numbered goods received notes and operational certificates are available to the accounting department for comparison with the purchase invoice.

Impact on control risk Only goods that have been received and are operating effectively will be paid for.

(iv) Informed people in the production department carefully assess the proper operation of the equipment.

This will help to ensure the operational effectiveness of plant and equipment.

(v)

The potential for fraudulent entries to cover theft/ unauthorised purchases will be reduced and the non-current assets register, an important non-current assets control document, cannot be manipulated by the people who hold the assets.

The accounting department, independent of the production facility, updates the non-tangible assets register and only the accounting department has access to it.

(vi) Accounting department personnel, independent of production, perform rolling tests to ensure that the non-current assets register and non-current assets on hand are in agreement with each other.

The risk of theft and loss of plant and equipment is reduced and the likelihood that all items in the register existing increased.

(vii) The internal audit department tests on a sample basis that recorded non-current assets are in existence, but see (c) below.

The internal auditing department will be more independent than the accounting department and hence will provide further comfort that the non-current assets register is not overstated.

(viii) Internal audit test the operation of the entire non-current assets recording system. (Tutorial note: Marks would also be available for additional strengths: – Pre-numbered goods received notes used to update the budget – Permanent identification numbers recorded on assets – Purchase invoice automatically updates the non-current assets register.)

Any controls which are not operating effectively are likely to be identified and rectified before significant errors can occur.

(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 floor 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.)

(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 difficult to perform at the year-end because of time pressure. The final audit, on the other hand, will take place after the year-end and concludes with the auditor forming and expressing an opinion on the financial statements for the whole year subject to audit. It is important to note that the final opinion takes account of conclusions formed at both the interim and final 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.

– – –

carrying out tests of control on the company’s internal control system and evaluating its effectiveness to determine the level of control risk. performing sufficient substantive testing of transactions and balances to be satisfied that the books and records are a reliable basis for the preparation of financial statements. identification of potential problems that may affect the final 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 final examination includes: – – – – –

Follow up of items noted at the inventory count. Obtaining confirmations from third parties, such as bankers and lawyers. Analytical reviews of figures in the financial statements. Reviews of events after the reporting period. Consideration of the going concern status of the organisation.

(Tutorial note: At the final 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 finance 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 firm would have formed a view in past years of their reliability by considering the background (including qualifications 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, whether there is likely to be effective communication between the internal auditors and the external auditor.

–

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 difficulties 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 flow 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 flow 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 flow forecast. For example, the company is experiencing a poor economic climate, so you would not expect cash flows 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 reflected 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 outflows. (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 outflows 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 figures. (8) Recalculate and cast the cash flow 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 flow forecast.

(d)

You would inform management that it would not be possible to give a report on the accuracy of the cash flow forecast. The forecast is an assessment of cash flows 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

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.

(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 figure appearing in the financial statements. This provides a series of objectives about that audit area and then the auditor searches for evidence to prove that each objective is met and that the assertion is valid or invalid.) (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.) (i)

(ii)

Controls Overall authority for food purchasing should be in the hands of a designated person to ensure that the food purchased is of the desired quality. This is often in the hands of the head chef.

Audit Procedures Review the company’s organisation chart and identify the person with overall responsibility for food purchasing. Discuss with management his or her background and expertise.

There should be a list of approved suppliers to ensure that the food comes from sources known for their quality.

Examine the list of approved suppliers of food and check that there are no purchases of food from other parties.

(iii) On receipt of food, whether meat, fish, or vegetables and fruit, it should be carefully inspected by informed people, including those responsible for food preparation. This would be to ensure that it was of the desired quality (as well as quantity). A goods received note (GRN) should be signed to provide evidence of receipt and inspection.

Examine a sample of GRNs to ensure that all bear an approved signature indicating that food has been inspected for quality on receipt.

(iv) Food purchased should be kept in a clean place and refrigerated, if necessary. This would be to ensure that it has kept its quality.

Examine the food storage areas, including refrigerators, on a surprise basis to ensure they are clean and tidy. Ensure that the refrigerators are maintained at the correct temperature. Another test in this area might be to examine reports of local authority and other inspectors to ensure they were happy that the food was being properly stored.

(v)

Check that there is no food on the premises which is past its use-by date. Discuss with management what happens to food which is past its use-by date, that is, how it is disposed of.

Strict adherence to use-by dates to ensure that no poor quality food is prepared. (Tutorial note: Marks would also be available for additional controls such as: – Staff training on basic food hygiene. – Rotation of inventory. – Recording temperatures of cooked/reheated food.)

(c)

Evidence collected by the auditor to enable a conclusion to be formed on the likelihood of the claim being successful (that is, whether a provision would be necessary according to IAS 37 Provisions, Contingent Liabilities and Contingent Assets) includes: (i)

(ii)

(d)

Evidence Obtain the written claim by the customer.

Explanation This would tell you the reason why the claim was being made and provide other relevant details, such as whether the customer dined in the restaurant or purchased carry-out food, and the date when the alleged food poisoning took place.

Review the controls in force over purchases and food preparation (see (b) above).

This would be to ensure that the company controls appeared to be effective.

(iii) Obtain written reports concerning any inspections that had been carried out by company staff or third parties in the food store and food preparation areas.

This would provide evidence about any problems that had arisen affecting food quality. Discuss with management the actions that were taken to correct any problems that had arisen.

(iv) Discuss the matter with the company’s lawyers to obtain their view on the likelihood of the claim being successful.

This would provide evidence from a professional third party as to the likelihood of the claim succeeding and the reasons why the lawyers had reached their conclusion.

(v)

This is internal evidence and should be approached with professional scepticism, but it would provide the auditor with the views of an informed group of people.

Obtain management representations regarding the likelihood of the claim succeeding. (Tutorial note: Marks would also be available for additional 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.)

As you have concluded that the likelihood of the claim being successful is only possible, it would be appropriate for the company to explain the contingent liability by way of note as required by IAS 37, giving a description of the nature of the contingent liability, an estimate of its financial effect, an indication of the uncertainties relating to the amount and timing and the possibility of any reimbursement. 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 modified opinion. (Tutorial note: An ‘except for’ qualification would be appropriate as the contingent loss is material only, that is, the uncertainty is not major.)

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International)

December 2009 Marking Scheme Marks

(a)

Audit planning Up to 1 mark for any of the following, but maximum 4. Important areas of the audit Potential problems Effective and efficient audit Selection of engagement team members and assignment of work Direction, supervision and review Coordination of work

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 ––– 6 –––

Maximum marks (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 ––– 4 –––

Maximum marks (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 ––– 6 –––

Maximum marks (d)

Inventory risks Up to 1 mark for each identified 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 ––– 4 –––

Maximum marks

Marks (e)

(i)

Define net realisable value 1 mark for each element of definition. Selling price Less estimated costs to completion, marketing, selling and distribution costs ––– 2 –––

Maximum marks (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 ––– 8 ––– 30 –––

Maximum marks

(a)

Reliability of audit evidence Up to 1 mark for identification 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 ––– 4 –––

Maximum marks (b)

(i)

Responsibilities of those charged with governance 1/

mark for identification 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 ––– 2 –––

Maximum marks (ii)

Matters to be communicated 1/

mark for identification 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 – Significant findings from audit – Independence issues – Modifications to the audit report – Management representation points – Cases of suspected/actual fraud ––– 4 ––– 10 –––

Maximum marks

Marks 3

(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 Identification of assertions Adequacy of accounting system as a basis for preparing financial statements Assessment of competence to perform the audit Understanding relevant law and regulations Consider the reliability of evidence sources ––– 4 –––

Maximum marks (b)

Strengths in control environment Up to 1 mark for identification 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 identification on assets Automatic update of register with purchase invoice ––– 12 –––

Maximum marks (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 identification 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 ––– 4 ––– 20 –––

Maximum marks

Marks 4

(a)

Difference between interim audit and final audit Up to 1 mark for each relevant explanation and maximum of 2 marks for examples of procedures at interim and final audit, but overall maximum 4. Interim audit and final audit parts of whole audit Interim audit performed during year but final audit at or after the year-end Interim audit performs procedures that cannot be performed at the final audit Interim audit forms interim conclusion, but final audit results in audit opinion Typical work at interim audit Typical work at final audit ––– 4 –––

Maximum marks (b)

Work of internal audit 1/ 2

mark for identification of each factor and up to 1 mark for full explanation, but maximum 6.

Independence – to whom report; links to audit committee Competence – qualifications and experience Effective communication – between internal and external auditors Professional care – properly planned and performed Management pressure to present favourable cash flow forecast ––– 6 –––

Maximum marks (c)

Examination of forecast Up to 1 mark for identification 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 flow forecast Review board minutes Review the work of the internal audit department ––– 6 –––

Maximum marks (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 ––– 4 ––– 20 –––

Maximum marks

Marks 5

(a)

Accounts payable assertions 1/

mark for identification of assertion and up to 1 mark for each explanation of assertion, maximum 6.

Rights and obligation Valuation and allocation Existence Completeness ––– 6 –––

Maximum marks (b)

Control risk and audit procedures Up to 1 mark for each control identified, 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 ––– 4 –––

Maximum marks (c)

Evidence on claim 1 mark for identification 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 ––– 6 –––

Maximum marks (d)

Reporting in financial 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 unqualified opinion Emphasis of matter paragraph if litigation exceptional Material matter if not disclosed Therefore ‘except for’ disagreement Disclosures in audit report ––– 4 ––– 20 –––

Maximum marks

Audit and Assurance (International) Wednesday 9 June 2010

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 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 offices. 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 significantly reducing prices and offering a four-month credit period, the companyâ&#x20AC;&#x2122;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. 2. 3. 4. 5.

The team prints the inventory quantities and descriptions from the system and these records are then compared to the inventory physically present. 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. Any damaged or old items are noted and they are removed from the inventory sheets. The sheets are then passed to the finance department for adjustments to be made to the records when the count has finished. 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 finance director (FD) and he immediately left the company. The company has temporarily asked the financial controller to take over the role while they recruit a permanent replacement. The old FD has notified 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 confident the claim has no merit.

Required: (a) Identify and explain the audit risks identified 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 confirming each of the following: (i)

The valuation of inventory;

(3 marks)

(ii) The completeness of provisions or contingent liabilities.

(3 marks) (30 marks)

[P.T.O.

(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: Define materiality and determine how the level of materiality is assessed.

(5 marks) (10 marks)

(a) (i)

Define 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. 2. 3. 4.

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. The contents of the cash box are counted each day and every few days these sums are banked by which ever member of the finance team is available. The cashier records the details of the cash received log into the cash receipts day book and also updates the sales ledger. Usually on a monthly basis the cashier performs a bank reconciliation, which he then files, 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 deficiencies in the system;

(3 marks)

(ii) Suggest controls to address each of these deficiencies; 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)

(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 financial controller of LV Fones was ill and hence unable to work. The company had no spare staff able to fulfil the role and hence a qualified 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 firm’s total fees. From a review of the correspondence files you note that the partner and the finance 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. (c) Describe the steps an audit firm should perform prior to accepting a new audit engagement.

(5 marks) (5 marks) (20 marks)

[P.T.O.

(a) Define 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 specific cold and flu 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 significantly declined. To make matters worse, in the past the company has not invested sufficiently in new product development and so has been trying to remedy this by recruiting suitably trained scientific staff, but this has proved more difficult 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 Medimadeâ&#x20AC;&#x2122;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 companyâ&#x20AC;&#x2122;s overdraft balance has grown substantially. The directors have produced a cash flow forecast and this shows a significantly 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 confident 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 Medimadeâ&#x20AC;&#x2122;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)

End of Question Paper

Answers

Fundamentals Level â&#x20AC;&#x201C; Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

June 2010 Answers

Identification of risk Smoothbrush supplies 60% of its goods to Homewares at a significantly reduced selling price, hence inventory may be overvalued.

Explanation of risk Per IAS 2 Inventories, inventory should be stated at the lower of cost and net realisable value (NRV). Therefore, as selling prices are much 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 credit period extended.

Smoothbrush has extended its credit terms 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 be accurate.

Smoothbrush imports goods from South Asia and 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. This could result in inventory balances being misstated.

Smoothbrush has introduced a continuous/perpetual inventory counting system in the year. These records 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 no longer has a slow moving provision.

Previously Smoothbrush maintained an inventory provision of 1%, however, this year it has decided to remove this. Unless all slow moving/obsolete items are identified 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 not be complete.

The companyâ&#x20AC;&#x2122;s finance director (FD) has left and 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 outflow 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 outflow of resources, or the amount of the obligation cannot be measured with sufficient reliability then a contingent liability should be disclosed, unless the likelihood of payment is remote.

Identification of risk Inherent risk is higher due to the changes in the finance department.

Explanation of risk The financial controller has been appointed as temporary FD and this lack of experience could result in an increased risk of errors arising in the financial statements. In addition the previous FD is not available to help the finance or audit team.

Inventory may be over or understated if the perpetual inventory counts are not complete and accurate.

The inventory counts are to cover all of the inventory lines. If any areas of the warehouse are not counted then this will need to be done at the year end. In addition inventory adjustments arising from the counts must be verified and updated by an appropriate member of the finance 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 â&#x20AC;&#x2DC;to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levelsâ&#x20AC;&#x2122;. 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 identified 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 efficient 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 identified, 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 The inventory count team should be independent of the warehouse team.

Explanation Currently the team includes a warehouse staff member and 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 reviewed to ensure that all areas are counted.

The warehouse has been divided into 12 areas that are each 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 from the designated areas during continuous/ perpetual inventory counts.

Goods will continue to move in and out of the warehouse during the counts. Inventory records could be under/over stated if product lines are missed or double counted due to movements in the warehouse.

Inventory counting sheets should be pre-printed with a description or item code of the goods, but the quantities per the records should not be pre-recorded.

The inventory sheets produced for the count have the quantities pre-printed, therefore a risk arises that the counting team could just agree with the record quantities, making under counting more likely, rather than counting the inventory lines correctly.

Control A second independent team should check the counts performed by the inventory count team.

Explanation By counting the lines twice this should help to ensure completeness and accuracy of the counts, and hence that any inventory adjustments are appropriate.

Inventory checks should be performed from inventory physically present in the warehouse to the records.

Currently the team is comparing the records to the inventory in the warehouse. If the count is performed 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 moved to a designated area, where a responsible official then inspects it, it should not be removed from the sheets.

Damaged or obsolete goods should be written down or provided against to ensure that they are stated at the lower of cost and NRV. This may not involve fully 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 finance team, as opposed to the inventory count team.

After the count, the inventory count sheets should be compared to the inventory records, any adjustments should be investigated and if appropriate the records updated in a prompt manner by an authorised person.

At the year end the inventory of Smoothbrush will be based on the records maintained. Hence the records must be complete, accurate and valid. It is important that only individuals authorised to do so can amend records. Senior members of the finance team should regularly review the types and levels of adjustments, as recurring inventory adjustments could indicate possible fraud.

(d)

Substantive procedures to confirm 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 confirm: – 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 significant 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 significant 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 significant variations in the margin with management.

Substantive procedures to confirm completeness of provisions or contingent liability – – – – –

Discuss with management the nature of the dispute between Smoothbrush and the former finance 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 confirming 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.

(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 verification. 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 defined as follows: ‘Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be 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. 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 influence 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 financial information needs of users of the financial 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 profit before tax or 1% of gross revenue. These values are useful as a starting point for assessing materiality.

(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 official of any discounts allowed. Inspect customer statements for evidence of regular preparation.

Example substantive procedures over sales invoicing – – – (b)

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 significant fluctuations with management. Review post year end credit notes to identify if any pre year end sales should be removed.

Deficiency A junior clerk opens the post unsupervised. This could result in cash being misappropriated.

Control A second member of the accounts team or staff independent of the accounts team should assist with the mail, one should open the post and the second should record cash received in the cash log.

Test of Control Observe the mail opening process, to assess if the control is operating effectively.

Cash and cheques are secured in a small locked box and only banked every few days. A small locked box is not adequate for security of considerable cash receipts, as it can easily be stolen.

Cash and cheques should be ideally banked daily, if not then it should be stored in a fire proof safe, and access to this safe should be restricted to supervised individuals.

Enquire of management where the cash receipts not banked are stored. Inspect the location to ensure cash is suitably secure.

Deficiency Cash and cheques are only banked every few days and any member of the finance team performs this.

Control Cash and cheques should be banked every day.

Test of Control Inspect the paying-in-books to see if cash and cheques have been banked daily or less frequently. Review bank statements against the cash received log to confirm all amounts were banked promptly.

Cash should ideally not be held over-night as it is not secure. Also if any member of the team banks cash, then this could result in very junior clerks having access to significant amounts of money.

The cashier should prepare the paying-in-book from the cash received log. Then a separate responsible individual should have responsibility for banking this cash.

Enquire of staff as to who performs the banking process and confirm this person is suitably responsible.

The cashier updates both the cash book and the sales ledger. This is weak segregation of duties, as the cashier could incorrectly enter a 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.

The cashier should update the cash book from the cash received log. A member of the sales ledger team should update the sales ledger.

Observe the process for recording cash received into the relevant ledgers and note if the segregation of duties is occurring.

Bank reconciliations are not performed Bank reconciliations should be every month and they do not appear performed monthly. A responsible to be reviewed by a senior member of individual should then review them. the finance department. Errors in the cash cycle may not be promptly identified if reconciliations are performed infrequently. (c)

Substantive procedures over bank balance: – – – – – – – – – –

(a)

Review the file of reconciliations for evidence of regular performance and review by senior finance team members.

Obtain the company’s bank reconciliation and check the additions to ensure arithmetical accuracy. Obtain a bank confirmation 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 confirmation 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 significant delays obtain explanations from management. Agree all balances listed on the bank confirmation 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 confirmation letter for details of any security provided by the company or any legal right of set-off as this may require disclosure.

Compliance with ACCA’s Code of Ethics and Conduct fundamental principles can be threatened by a number of areas. The five 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

– – – –

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 influence the subject matter being reviewed Involvement in implementation of financial 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 firm being in a position to exert a direct or significant influence over the financial reports The discovery of a significant 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 (significant value) Over familiarity with management 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.

Intimidation – – – – (b)

Threat of litigation Threat of removal as assurance firm Dominant personality of client director attempting to influence decisions Pressure to reduce inappropriately the extent of work performed in order to reduce fees.

Ethical threat The audit team has in previous years been offered a staff discount of 10% on purchasing luxury mobile phones.

Managing risk The audit firm should ascertain whether the discount is to be offered to staff this year.

This is a familiarity threat. It would need to be confirmed if this discount is to be offered to this year’s team as well, as only goods of an insignificant value are allowed to be accepted. A discount of 10% may not appear to be significant, but as these are luxury mobile phones then this may still be a significant value.

If it is then the discount should be reviewed for significance. If it is deemed to be of significant value then the offer of discount should be declined.

An audit senior of Jones & Co has been on secondment as the financial controller of LV Fones and is currently part of the audit team.

The firm should clarify exactly what areas the senior assisted the client on. If he worked on areas not related to the financial statements then he may be able to remain in the audit team.

There is a self-review threat if the senior has prepared records or schedules that support the year end financial statements and he then audits these same documents.

However, it is likely that he has worked on some related schedules and therefore he should be removed from the audit team to ensure that independence is not threatened.

The total fee income from LV Fones is 16% of the total fees for the audit firm. If the fees for audit and recurring work exceed 15% then there is a self-interest threat.

The firm should assess if the recurring fees will exceed 15%. If this is the case then it might need to consider whether the appearance of independence will still be met if the tax and audit work is retained.

The fees for LV Fones include tax and audit that are assumed to be recurring, however the secondment fees would not recur each year.

No further work should be accepted in the current year from the client, and it might be advisable to perform external quality control reviews. It may also become necessary to consider resigning from either the tax or the audit engagement.

Ethical threat The partner and the finance director know each other socially and have holidayed together. Personal relationships between the client and members of the audit team can create a familiarity or self-interest threat.

Managing risk The personal relationship should be reviewed in line with Jones’s ethical policies.

ACCA’s Code of Ethics and Conduct does not specifically prohibit friendships between the audit client and the team. However, due to the senior positions held by both parties then there is a risk that independence may be perceived to have been threatened.

Consideration should be given to rotating the partner off this engagement and replacing with an alternative partner.

Last year’s audit fee is still outstanding. This amounts to 20% of the total fee and is likely to be a significant value.

Jones & Co should chase the outstanding fees.

A self-interest threat can arise if the fees remain outstanding, as Jones & Co may feel pressure to agree to certain accounting adjustments in order to have the previous year and the current year fee paid.

If they remain outstanding, the firm should discuss with those charged with governance the reasons for the continued non-payment, and ideally agree a payment schedule which will result in the fees being settled before 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 firm 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 significance must be considered. The firm 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 firm must communicate with the outgoing auditor to assess if there are any ethical or professional reasons why they should not accept appointment. The prospective firm 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 firm should undertake client screening procedures such as considering management integrity and assessing whether any conflict 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 sufficient for the level of anticipated risk.

(a)

The going concern assumption means that management believes the company will continue in business for the foreseeable future. Foreseeable future is not defined 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 financial statements on a going concern basis unless they believe that the company will soon cease trading.

(b)

Indicator Medimade has seen a significant decline in demand for its products.

Why could impact going concern If the company is not able to increase demand for its products then it will struggle to generate sufficient operating cash flows leading to going concern difficulties.

Medimade generates 90% of its revenue through sales of just two products, and this market has now become very competitive.

As the market is very competitive and Medimade has only two products then it is very dependent on these and must ensure that it makes sufficient sales as otherwise it may face difficulties 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 flows. Without new products to generate future income operating cash flows will be strained.

(c)

Indicator The company is struggling to recruit suitably trained scientific staff to develop new products.

Why could impact going concern The company has decided that it needs to develop new products, however, this is a highly specialised area and therefore it needs sufficiently 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 funding for its $2m investment in plant and machinery.

If Medimade was unable to obtain finance for its investment, then this could indicate that the banks 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 flow problems.

Some trade payables have been paid much later than their due dates.

Failing to make payments to suppliers on time could ultimately lead to some of them refusing to supply Medimade. Therefore the company may need to find alternative suppliers and they could be more expensive which will decrease operating cash flows and profits.

Some suppliers have withdrawn credit terms from Medimade resulting in cash on delivery payments.

As Medimade must now make cash on delivery payments, then it puts additional pressure on the 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 and is due for renewal next month.

Medimade’s overdraft has grown significantly and it is heavily dependent on it to pay its expenses. If the bank does not renew the overdraft and the company is unable to obtain alternative finance then it may not be able to continue to trade.

The cash flow forecast has shown a significantly worsening position.

The future cash outflows are greater than the inflows and this position is worsening rather than improving. If Medimade cannot start to reverse this position, then it may have difficulties in funding its operating activities.

Obtain the company’s cash flow forecast and review the cash in and out flows. Assess the assumptions for reasonableness 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 net cash in/out flow. 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 finance 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 figures in the cash flow 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 flow forecast reflects 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 financial difficulties for the company. Review post year end management accounts to assess if in line with cash flow 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 financial statements. Obtain a written representation confirming 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 unmodified. However, an emphasis of matter paragraph would be required.

This will state that the audit report is not modified, 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 modified. A material misstatement modification will be required, depending on the materiality of the issue this will be either qualified or an adverse opinion. A paragraph describing the matter giving rise to the modification 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 â&#x20AC;&#x2DC;except forâ&#x20AC;&#x2122; or the accounts are not fairly presented.

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International)

June 2010 Marking Scheme Marks

(a)

– – – – – – – – –

(b)

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 –––

Up to 1 mark per valid point – – – – – – – – – –

(c)

mark for each identification of risk and up to 1 per description of the risk

1/ 2

– – – – – – – –

ISA 315 requirement (1/2 mark only for ISA ref) Early identification of material errors Understand entity Identification of unusual transactions/balances Develop strategy Efficient audit Most appropriate team Reduce risk incorrect opinion Understanding fraud, money laundering Assess risk going concern

––– 4 –––

mark for each identification 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 floor to records Damaged/obsolete goods to specific area Records updated by authorised person

––– 10 –––

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 –––

(a)

Up to 1 mark per description of element: – – – – – – –

(b)

Intended user Responsible party Practitioner Suitable criteria Subject matter Appropriate evidence Assurance report

––– 5 –––

Up to 1 mark per valid point: – – – – – – – –

ISA 320 (1/2 mark only for ISA ref) Definition Amount Nature, or both Small errors aggregated Judgement, needs of users Performance materiality 5% profit before tax or 1% revenue

––– 5 ––– ––– 10 –––

Marks 3

(a)

(b)

Up to 1 mark each for definition of test of control and substantive procedures and up to 1 mark each for example test given – –

Definition of test of control (toc) Definition of substantive test

– –

Example toc Example substantive test

––– 2 ––– ––– 2 –––

Up to 1 mark for each deficiency identified 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 deficiencies Max 3 for controls Max 3 for test of controls

(c)

Up to 1 mark per substantive procedure – – – – – – – – – –

Check additions 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

––– 7 ––– ––– 20 –––

Marks 4

(a)

1/ 2

– – – – –

(b)

mark for each threat and 1/2 per example of a threat Self-interest Self-review Advocacy Familiarity Intimidation

––– 5 –––

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 –––

Marks 5

(a)

Up to 1 mark per point – – –

(b)

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 flow forecast shows worsening position

––– 8 –––

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: – – – – – – – – – – – – –

(d)

––– 2 –––

1/ mark per indicator and up to 1 mark per description of why this could indicate going concern problems 2 for Medimade:

– – – – – – – – –

(c)

Continue to trade for foreseeable future Foreseeable future not defined ISA 570, but IAS 1 states minimum 12 months after year end IAS 1 Accounts automatically on going concern basis

Review cash flow forecasts Sensitivity analysis Review bank agreements, breach of key ratios Review bank correspondence Discuss if alternative finance 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 –––

Up to 1 mark per point – – – – – –

Depends on adequacy of disclosures Adequately disclosed – unmodified Emphasis of matter para – after opinion Not adequately disclosed – modified Material misstatement Add paragraph before opinion and impact on opinion paragraph

––– 4 ––– ––– 20 –––

Audit and Assurance (International) Wednesday 8 December 2010

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 1

(a) Auditors have a responsibility under ISA 265 Communicating Deficiencies in Internal Control to those Charged with Governance and Management, to communicate deficiencies in internal controls. In particular SIGNIFICANT deficiencies 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 internal controls is significant. (5 marks) Greystone Co is a retailer of ladies clothing and accessories. It operates in many countries around the world and has expanded steadily from its base in Europe. Its main market is aimed at 15 to 35 year olds and its prices are mid to low range. The companyâ&#x20AC;&#x2122;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 to meet the key fashion trends then this resulted in significant inventory write downs. As a result of this the company has recently introduced a just in time ordering system. The fashion buyers make an assessment nine months in advance as to what the key trends are likely to be, these goods are sourced from their suppliers but only limited numbers are initially ordered. Greystone Co has an internal audit department but at present their only role is to perform regular inventory counts at the stores. Ordering process Each country has a purchasing manager who decides on the initial inventory levels for each store, this is not done in conjunction with store or sales managers. These quantities are communicated to the central buying department at the head office in Europe. An ordering clerk amalgamates all country orders by specified regions of countries, such as Central Europe and North America, and passes them to the purchasing director to review and authorise. As the goods are sold, it is the store managerâ&#x20AC;&#x2122;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 four weeks 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 the purchasing manager. If a customer requests an item of clothing, which is unavailable in a particular store, then the customer 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 individual stores. On receipt of goods the quantities received are checked by a sales assistant against the supplierâ&#x20AC;&#x2122;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 maximise sales. 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 time consuming process as some suppliers may have delivered to over 500 stores. Once the invoice has been agreed then it is sent to the purchasing director for authorisation. It is at this stage that the invoice is entered onto the purchase ledger.

Required: (b) As the external auditors of Greystone Co, write a report to management in respect of the purchasing system which: (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 to perform by those charged with governance. (6 marks) (30 marks)

[P.T.O.

(a) Explain the concept of TRUE and FAIR presentation.

(4 marks)

(b) Explain the status of International Standards on Auditing.

(2 marks)

(c) ISA 230 Audit Documentation deals with the auditorâ&#x20AC;&#x2122;s responsibility to prepare audit documentation for an audit of financial statements. Required: State FOUR benefits of documenting audit work.

(4 marks) (10 marks)

(a) In agreeing the terms of an audit engagement, the auditor is required to agree the basis on which the audit is to be carried out. This involves establishing whether the preconditions for an audit are present and confirming that there 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 are present. (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 audit manager has already had a planning meeting with the finance director. He has provided you with the following notes of his meeting and financial statement extracts. Redsmith’s management were disappointed with the 2009 results and so in 2010 undertook a number of strategies to improve the trading results. This included the introduction of a generous sales-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 credit period given to them. The finance director of Redsmith has reviewed the inventory valuation policy and has included additional overheads incurred this year as he considers them to be production related. He is happy with the 2010 results and feels that they are a good reflection of the improved trading levels. Financial statement extracts for year ended 30 September

Revenue Cost of Sales Gross profit Operating expenses Profit before interest and taxation

DRAFT 2010 $m 23·0 (11·0) ––––– 12·0 (7·5) ––––– 4·5 ––––– –––––

ACTUAL 2009 $m 18·0 (10·0) ––––– 8·0 (4·0) ––––– 4·0 ––––– –––––

Inventory Receivables Cash

2·1 4·5 –

1·6 3·0 2·3

Trade payables Overdraft

1·6 0·9

1·2 –

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 and describe the appropriate response to these risks. (10 marks) (20 marks)

[P.T.O.

(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 which are owned by the government. Two years ago management reviewed all aspects of hospital operations and instigated 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 review over the measures which have been implemented. Bluesberry has one centralised buying department and all purchase requisition forms for medical supplies must be forwarded here. Upon receipt the buying team will research the lowest price from suppliers and a purchase order is raised. This is then passed to the purchasing director, who authorises all orders. The small buying team receive in excess of 200 forms a day. The human resources department has had difficulties with recruiting suitably trained staff. Overtime rates have been increased to incentivise permanent staff to fill staffing gaps, this has been popular, and reliance on expensive temporary staff has been reduced. Monitoring of staff hours had been difficult but the hospital has implemented 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 that more operations could be performed and patient recovery rates are faster. However, currently there is a shortage of appropriately trained medical staff. A capital expenditure committee has been established, made up of senior managers, 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 the best value for money. (4 marks) (c) Describe TWO substantive procedures the external auditor of Bluesberry should adopt to verify EACH of the following 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 International Financial Reporting Standards.

(6 marks) (20 marks)

Greenfields Co specialises in manufacturing equipment which can help to reduce toxic emissions in the production of chemicals. The company has grown rapidly over the past eight years and this is due partly to the warranties that the company gives to its customers. It guarantees its products for five years and if problems arise in this period it undertakes 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 audit and 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, your team reviewed the ageing of this balance and found that no payments had been received from Yellowmix for over six months, and Greenfields would not allow this balance to be circularised. Instead management has assured your team that 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 performed testing over the calculations and assumptions which are consistent with prior years. The team has requested a written representation from management confirming the basis and amount of the provision are reasonable. Management has yet 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 the balance 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 the warranty 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 relation to the refusal to provide the written representation. (5 marks) (20 marks)

End of Question Paper

Answers

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

December 2010 Answers

Examples of matters the external auditor should consider in determining whether a deficiency in internal controls is significant include: – – – – – – – –

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 Management states that a significant deficiency in internal control is a deficiency or combination of deficiencies in internal control that, in the auditor’s professional judgement, is of sufficient importance to merit the attention of those charged with governance. (b)

Board of Directors Greystone Co 30 Any Street A Town X Country 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 for the year ended 30 September 2010. The report considers deficiencies in the purchases system, implications of those deficiencies and provides recommendations to address those deficiencies. (i) Deficiency The purchasing manager decides on the inventory levels for each store without discussion with store or sales managers. The purchasing manager may not have the appropriate knowledge of the local market for a store.

(ii) Implication This could result in stores ordering goods that are not likely to sell and hence require heavy discounting. In addition as a fashion chain, if customers perceive that the goods are not meeting the key fashion trends then they may cease to shop at Greystone at all.

(iii) Recommendation The purchasing manager should initially hold a meeting with area managers of stores; if meeting all store managers is not practical, he should understand the local markets before agreeing jointly goods to be purchased.

The purchase orders are only reviewed and authorised by a purchasing director in a wholly aggregated manner (by specified regions of countries).

It will be difficult for the purchasing director to assess whether overall the correct buying decisions are being made as the detail of the orders is not being presented and he is the only level of authorisation.

A purchasing senior manager should review the information prepared for each country and discuss with local purchasing managers the specifics of their orders. These should then be authorised and passed to the purchasing director for final review and sign off.

This could result in significant levels of goods being purchased that are not right for particular market sectors. The store managers are responsible for re-ordering goods through the purchasing manager.

If the store managers forget or order too late, then as the ordering process can take up to four weeks, the store could experience significant stock outs leading to loss of income.

Automatic re-order levels should be set up in the inventory management systems. As the goods sold reach the re-order levels the purchasing manager should receive an automatic re-order request.

(i) Deficiency

(ii) Implication

(iii) Recommendation

It is not possible for a store to order goods from other local stores for customers who request them. Instead they are told to contact the stores themselves, or use the company website.

Customers are less likely to contact individual stores themselves and this could result in the company losing out on valuable sales.

An inter-branch transfer system should be established between stores. This should help stores whose goods are below the re-order level but are awaiting their deliveries from the suppliers.

Deliveries from suppliers are accepted without being checked first.

The stores are receiving goods without checking that these are correct. Hence if a delivery is subsequently disputed there may be little recourse for the company.

In addition they are then checked by sales assistants to the supplierâ&#x20AC;&#x2122;s delivery note to agree quantities but not quality.

If the sales assistants are only checking quantities then goods which are not of a saleable condition may be accepted.

Sales assistants are producing the goods received note (GRN) on receipt of a supplierâ&#x20AC;&#x2122;s delivery note.

The assistants may not be adequately experienced to produce the GRN, and this is an important document used in the invoice authorisation process. Errors could lead to under or overpayments.

Goods are being received without any checks being made against purchase orders.

This could result in Greystone receiving and subsequently paying for goods it did not require.

In addition some goods which are slow moving in one store may be out of stock at another, if goods could be transferred between stores then overall sales may be maximised.

In addition if no check is made against order then the company may have significant purchase orders which are outstanding, leading to lost sales. Purchase invoices are manually matched to a high volume of GRNs from the individual stores.

A manual checking process increases the risk of error, resulting in invoices being accepted or rejected erroneously.

Deliveries from suppliers should only be accepted between designated hours such as the first two hours of the morning when it is quieter. The goods should then be checked on arrival for quantity and quality prior to acceptance from the supplier. A responsible official at each store should produce the GRN from the supplierâ&#x20AC;&#x2122;s delivery information.

A copy of the authorised order form should be sent to the store. This should then be checked to the GRN. Once checked the order should be sent to head office and logged as completed. On a regular basis the purchasing clerk should review the order file for any outstanding items. The checked GRNs should be logged onto the purchasing system, matched against the relevant order number, then as the invoice is received this should be automatically matched. The purchasing clerk should then review for any unmatched items.

The purchase invoice is only logged onto the system as it is being authorised by the purchasing director.

If the invoice is misplaced then payables may not be settled on a timely basis. In addition at the year-end the purchase ledger may be understated as invoices relating to the current year have been received but are not in the purchase ledger.

Upon receipt of an invoice this should be logged into a file of unmatched invoices. As it is matched and authorised it should then be moved into the purchase ledger. At the year-end items in the unmatched invoices file should be accrued for, to ensure liabilities are not understated.

Please note that this report only addresses any significant deficiencies identified during the audit and if further testing had been 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 contact us. Yours faithfully An audit firm

(c)

Substantive procedures over year-end trade payables – – – – – – – – – – – –

(d)

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.

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 to include controls testing over cash receipts and cash counts. As a retailer the stores will have a significant amount of cash at each premise and will have tight controls over the cash receipts process. These controls should be tested at each location as well 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 fed back 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 recommendations to 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 be asked to review the main areas of fraud risk and develop controls to mitigate these risks. If fraud is suspected then internal audit 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 internal audit 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 as the 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. The internal audit department could help ensure compliance with those regulations.

(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 in reviewing 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 the following meaning: True – Information is factual and conforms with reality in that there are no factual errors. In addition it is assumed that to be true it must comply with accounting standards and any relevant legislation. Lastly true includes data being correctly transferred from accounting records to the financial statements. Fair – Information is clear, impartial and unbiased, and also reflects plainly the commercial substance of the transactions of the entity.

(b)

International 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 financial statements by an independent auditor. The ISAs contain basic principles and essential procedures together with related guidance in the form of explanatory material and appendices. It is necessary to consider and understand the entire text of an ISA to understand and apply the basic principles 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 deems it necessary to depart from an ISA to achieve the overall aim of the audit, then this departure must be justified.

(c)

Documenting audit work – – – – – –

(a)

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.

ISA 210 Agreeing the Terms of Audit Engagements provides guidance to auditors on the steps they should take in accepting a new audit or continuing on an existing audit engagement. It sets out a number of processes that the auditor should perform including agreeing whether the preconditions are present, agreement of audit terms in an engagement letter, recurring audits and changes in engagement terms. To assess whether the preconditions for an audit are present the auditor must determine whether the financial reporting framework to be applied in the preparation of the financial statements is acceptable. In considering this the auditor should assess the nature of the entity, the nature and purpose of the financial statements and whether law or regulations prescribes the applicable reporting framework. In addition they must obtain the agreement of management that it acknowledges and understands its responsibility for the following: – – –

Preparation of the financial statements in accordance with the applicable financial reporting framework, including where relevant their fair presentation; For such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error; and To provide the auditor with access to all relevant information for the preparation of the financial statements, any additional information that the auditor may request from management and unrestricted access to persons within the entity 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 by law or regulation to do so, the auditor shall not accept the proposed audit engagement: – – (b)

If the auditor has determined that the financial reporting framework to be applied in the preparation of the financial statements is unacceptable; or If management agreement of their responsibilities has not been obtained.

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.

(c)

(i)

Ratios to assist the audit supervisor in planning the audit: Gross margin Operating margin Inventory days Receivable days Payable days Current ratio Quick ratio

(ii)

2010 12/23 = 52·2% 4·5/23 = 19·6% 2·1/11 * 365 = 70 days 4·5/23 * 365 = 71 days 1·6/11 * 365 = 53 days 6·6/2·5 = 2·6 (6·6 – 2·1)/2·5 = 1·8

2009 8/18 = 44·4% 4/18 = 22·2% 1·6/10 * 365 = 58 days 3·0/18 * 365 = 61 days 1·2/10 * 365 = 44 days 6·9/1·2 = 5·8 (6·9 – 1·6)/1·2 = 4·4

Audit risk Management were disappointed with 2009 results and hence undertook strategies to improve the 2010 trading results. There is a risk that management might feel under pressure to manipulate the results through the judgements taken or through the use of provisions.

Response to risk Throughout the audit the team will need to be alert to this risk. They will need to carefully review judgemental decisions and compare treatment against prior years.

A generous sales-related bonus scheme has been introduced in the year, this may lead to sales cut-off errors with employees aiming to maximise their current year bonus.

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

Revenue has grown by 28% in the year however, cost of sales has only increased by 10%. This increase in sales may be due to the bonus scheme and the advertising however, this does not explain the increase in gross margin. There is a risk that sales may be overstated.

During the audit a detailed breakdown of sales will be obtained, discussed with management and tested in order to understand the sales increase.

Gross margin has increased from 44·4% to 52·2%. Operating margin has decreased from 22·2% to 19·6%. This movement in gross margin is significant and there is a risk that costs may have been omitted or included in operating expenses rather than cost of sales. There has been a significant increase in operating expenses which may be due to the bonus and the advertising campaign but could be related to the misclassification of costs.

The classification of costs between cost of sales and operating expenses will be compared with the prior year to ensure consistency.

The finance director has made a change to the inventory valuation in the year with additional overheads being included. In addition inventory days have increased from 58 to 70 days. There is a risk that inventory is overvalued.

The change in the inventory policy will be discussed with management and a review of the additional overheads included performed to ensure that these are of a production nature.

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

Extended post year-end cash receipts testing and a review of the aged receivables ledger to be performed to assess valuation.

The current and quick ratios have decreased from 5·8 to 2·6 and 4·4 to 1·8 respectively. In addition the cash balances have decreased significantly over the year. Although all ratios are above the minimum levels, this is still a significant decrease and along with the increase of sales could be evidence of overtrading which could result in going concern difficulties.

Detailed going concern testing to be performed during the audit and discussed with management to ensure that the going concern basis is reasonable.

Detailed cost and net realisable value testing to be performed and the aged inventory report to be reviewed to assess whether inventory requires writing down.

(a)

A value for money audit focuses on whether the best combination of services has been obtained for the lowest level of resources. 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 Strengths Bluesberry has an internal audit department to monitor the internal control environment. This will help to provide advice over value for money.

Improvements This could be further improved in that the internal audit department could provide advice to departments on initial implementation of procedures rather than just reviewing them afterwards.

The centralised buying department purchases all medical supplies after researching for the lowest costs. This ensures that the hospital is being economical as the least amount of resources is being used.

However, care must be taken to ensure that the quality of the goods purchased is considered as well as the cost.

All orders are authorised by a purchasing director. This will ensure that only valid expenditure is incurred.

The purchasing director is a senior individual and it is not necessarily an efficient use of his time for him to authorise every purchase order, especially as there is a considerable number of them. The buying team receive in excess of 200 forms a day.

To improve the process the buying department could consider establishing an approved supplier listing. In order to be placed on the list both the cost and quality of goods has to be of an adequate level, hence improving the efficiency of the goods purchased.

Instead a purchasing supervisor should be designated to authorise orders up to a pre-set level with only orders above this level going to the director for authorisation. This should free the director to focus on other areas where costs can be reduced within the hospital. Bluesberry has introduced an overtime scheme which has seen a reduction in the use of temporary staff, which was expensive. This has resulted in an overall reduction in labour costs and possibly improved care levels with permanent rather than temporary staff working, who may better understand the patients’ needs.

Although overall costs may have been reduced, a smaller number of staff now has to cover all of the required staffing hours. Their efficiency levels must have reduced as they are working normal shifts and then overtime.

The hospital has implemented a new procedure of time clocking in and out cards to record the hours staff members have worked. This ensures that staff are only paid for the hours they have worked, as opposed to being paid with no record of whether they have actually worked for the required hours.

This system is also used to determine overtime payments; however, there does not appear to be any authorisation of this overtime and employees could be being paid simply for staying longer hours as opposed to filling a staffing gap.

Bluesberry has heavily invested in new surgical equipment, which has improved patient recovery rates and will lead to more operations being performed. With improving recovery rates and utilisation of equipment the overall effectiveness of the hospital will improve.

This equipment is not being utilised efficiently as there is a shortage of trained medical staff. In order to maximise the efficiency and effectiveness of this equipment it would be advisable to look at ways to address these staff shortages.

To improve this further the human resources department should embark on a recruitment drive to find permanent staff members to fill gaps and reduce overall overtime and temporary staff usage.

This could be further improved in that a report of overtime hours per staff member should be sent on a weekly basis to the department head for authorisation. This should ensure that the hospital keeps its labour costs to a minimum.

For example, there may be medical staff at other hospitals who wish to be seconded to Bluesberry to gain experience on this new type of surgical equipment.

Strengths A capital expenditure committee has been established to plan and authorise the purchase of significant capital items. This should ensure that significant cash flow expenditure is budgeted for, and that the expenditure will be for valid items only.

(c)

(i)

Valuation of property, plant and equipment (PPE): – – – – – –

(ii)

Improvements The committee is made up of senior managers, however, due to some capital expenditure being very significant in value, it would be improved further if board approval was required for any orders above a designated level. The board would have an overriding requirement to consider whether this expenditure would deliver value for money for the hospital.

Review depreciation policies for reasonableness by comparison to prior year, industry practices, the entity’s replacement 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.

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 statement of comprehensive income for items of a capital nature.

(iii) Rights and obligations of PPE: – – – –

(a)

Procedures the auditor should adopt in respect of auditing accounting estimates include: – – – – – – – – –

(b)

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.

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 judgments 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.

Receivables balance owing from Yellowmix Co (i)

The written representation proposed by management is intended to verify valuation, existence and rights and obligations of a material receivables balance. As management has refused to allow the auditor to circularise the balance and there has been little activity on the account for the past six months then there is very little evidence that has been obtained by the auditor. This representation would constitute entity generated evidence and this is less reliable than auditor generated evidence or evidence from an external source. If related control systems operate effectively then this evidence becomes more reliable. In addition if the representation is written as opposed to oral then this will increase the reliability as an evidence source. Overall this representation is a weak form of evidence, as there were more reliable evidence options available, such as the circularisation but this was not undertaken.

(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. The team 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 evidence as to the level of future warranty claims. Hence the written representation, whilst being an entity generated source of evidence, 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: – – –

(c)

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.

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 requested from management but they refuse to provide. If management does not provide the requested written representation on the warranty provision the auditor of Greenfields should 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 have on 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 material misstatement 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 are unable to form an opinion on this balance. The opinion paragraph will be amended to state ‘except for’.

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International)

December 2010 Marking Scheme MARKS

(a)

Up to 1 mark per valid point Likelihood of deficiencies leading to errors Risk of fraud Subjectivity and complexity Financial statement amounts Volume of activity Importance of the controls Cause and frequency of exceptions Interaction with other deficiencies

(b)

5 –––

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 stores Purchase order reviewed in aggregate by purchasing director Store managers re-order goods No inter-branch transfer system Deliveries accepted without proper checks Sales assistants produce the goods received note Goods received but not checked to purchase orders Manual matching of goods received notes to invoice Purchase invoice logged late

(c)

Up to 1 mark per well explained substantive procedure Agree purchase ledger to general and financial statements Review payable to prior year Calculate trade payables After date payments review After date invoices/credit notes review Supplier statement reviews Payables’ circularisation Goods received not invoiced Cut-off testing Debit balances review Disclosure within current liabilities

(d)

14 –––

5 –––

Up to 1 mark per well explained point Cash controls testing Mystery shopper Financial/operational controls Fraud investigations IT system review Value for money review Regulatory compliance

6 ––– 30 ––– –––

MARKS 2

(a)

Up to 1 mark per valid point Accounts produced and auditors give opinion on true and fair view True – factual, conforms with reality True – conforms with standards and legislation True – correctly transferred from accounting records Fair – clear, plain and unbiased Fair – reflects commercial substance

(b)

Up to 1 mark per valid point Issued by IAASB Apply to audit of historical financial information Contain basic principles/essential procedures/explanatory material and appendices If depart from ISA – justify

(c)

(a)

2 –––

Up to 1 mark per valid point Evidence of conclusions Evidence of compliance with ISAs Helps team to plan and perform audit Helps supervision Team is accountable Record of matters of continuing significance

4 –––

4 ––– 10 ––– –––

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

(b)

½ mark per example of matter to consider in obtaining an understanding of the nature of an entity.

(c)

(i)

2 –––

½ mark per ratio calculation per year. – – – – – – –

(ii)

3 –––

Gross margin Operating margin Inventory days Receivable days Payable days Current ratio Quick ratio

5 –––

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 ––– –––

MARKS 4

(a)

Up to 1 mark per valid point Explanation of value for money audit Economy – description Efficiency – description Effectiveness – description

(b)

4 –––

½ mark for identification of and up to 1 mark for explanation of each well explained strength and up to 1 mark per improvement, if not well explained then only give ½ mark, but overall maximum of four points. Internal audit department Centralised buying department buys from lowest cost supplier Authorisation of all purchase order by purchasing director Reduction in use of temporary staff Employee clocking in cards to monitor hours worked New surgical equipment leading to better recovery rates Capital expenditure committee

(c)

10 –––

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. 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. 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 –––

2 ––– 6 ––– 20 ––– –––

MARKS 5

(a)

Up to 1 mark per well explained procedure Enquire of management how estimate made Review after the reporting period Review method and assumptions Test effectiveness of controls Develop expectation of estimate Consider management bias Overall assessment whether estimates reasonable or misstated Disclosures adequate Written representation

(b)

(i)

Up to 2 marks for each discussion of reliability of representations Receivable balance Warranty provision

(ii)

4 –––

Up to 1 mark per procedure, max of 3 marks per issue Receivable balance Discuss with management why circularisation not allowed Review post year-end receipts Review customer correspondence Board minutes and legal correspondence Discuss with management need for provision or write down Consider impact on audit opinion Warranty provision Review post year-end claims Compare prior year provisions to claims made Review board minutes

(c)

5 –––

3 –––

Up to 1 mark per point ISA 580 provides guidance Discuss with management Re-evaluate management integrity Consider impact on audit opinion Modified opinion Qualified opinion as not pervasive Additional paragraph describing modification ‘Except for’ opinion

5 ––– 20 ––– –––

Audit and Assurance (International) Wednesday 8 June 2011

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 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. The company’s year end is 31 May 2011. The company has a large manufacturing plant, four large warehouses and a head office. Upon manufacture, the toys are stored in one of the warehouses until they are despatched to customers. The company does not have an internal audit 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 received in writing from customers. The orders are entered by an order clerk and the system automatically checks that the goods are available and that the order will not take the customer over their credit limit. For new customers, a sales manager completes a credit application; this is checked through a credit agency and a credit limit entered into the system by the credit controller. The company has a price list, which is updated twice a year. Larger customers are entitled 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 goods ordered and a likely despatch date. The order is then sorted by address of customer. The warehouse closest to the customer 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 are sent 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 sales invoice is raised and checked to the GDN. Periodically a computer sequence check is performed for any missing sales invoice numbers. Fraud During the year a material fraud was uncovered. It involved cash/cheque receipts from customers being diverted into employees’ personal accounts. In order to cover up the fraud, receipts from subsequent unrelated customers would then 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 and prepared the weekly bank reconciliation; the other employee recorded customer receipts in the sales ledger. An unrelated sales ledger clerk was supposed to send out monthly customer statements but this was not performed. The bank reconciliations each had a small unreconciled amount but no-one reviewed the reconciliations after they were prepared. The fraud was only uncovered when the two employees went on holiday at the same time and it was discovered that cash receipts from different customers were being applied to older receivable balances to hide the earlier sums stolen. Required: (a) Recommend SIX tests of controls the auditor would normally carry out on the sales system of Tinkerbell, and explain the objective for each test. (12 marks) (b) Describe substantive procedures the auditor should perform to confirm Tinkerbell’s year-end receivables balance. (8 marks) (c) Identify and explain controls Tinkerbell should implement to reduce the risk of fraud occurring again and, for each 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)

(a) Auditors are required to document their understanding of the clientâ&#x20AC;&#x2122;s internal controls. There are various options available for recording the internal control system. Two of these options are narrative notes and internal control questionnaires. Required: Describe the advantages and disadvantages to the auditor of narrative notes and internal control questionnaires 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 and deals with the auditorâ&#x20AC;&#x2122;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)

[P.T.O.

(a) The auditor has a responsibility to design audit procedures to obtain sufficient and appropriate evidence. There are 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 companyâ&#x20AC;&#x2122;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 meeting with the client and to identify any relevant audit risks so that the audit plan can be completed. From your meeting you ascertain the following: In order to expand their flight network, Donald Co will need to acquire more airplanes; they have placed orders for another six planes at an estimated total cost of $20m and the company is not sure whether these planes will be received by the year end. In addition the company has spent an estimated $15m on refurbishing their existing planes. In order to fund the expansion Donald Co has applied for a loan of $25m. It has yet to hear from 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 given a 90-day credit period to pay Donald Co, however, due to difficult trading conditions 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 been booked and paid for online but Donald Co has no record of them and hence 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 closed it down and made the large workforce redundant. Required: Using the information provided, describe FIVE audit risks and explain the auditorâ&#x20AC;&#x2122;s response to each risk in planning the audit of Donald Co. (10 marks) (20 marks)

You are an audit manager in NAB & Co, a large audit firm which specialises in the audit of retailers. The firm currently audits Goofy Co, a food retailer, but Goofy Coâ&#x20AC;&#x2122;s main competitor, Mickey Co, has approached the audit firm to act as auditors. Both companies are highly competitive and Goofy Co is concerned that if NAB & Co audits both companies then 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 properly managed. (4 marks) Goofy Coâ&#x20AC;&#x2122;s year end is 31 December, which is traditionally a busy time for NAB & Co. Goofy Co currently has an internal audit department of five employees but they have struggled to undertake the variety and extent of work required by the company, hence Goofy Co is considering whether to recruit to expand the department or to outsource the internal audit department. If outsourced, Goofy Co would require a team to undertake monthly visits to test controls 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 audit department. (10 marks) (c) The audit engagement partner for Goofy Co has been in place for approximately six years and her son has just accepted a job offer from Goofy Co as a sales manager; this role would entitle him to shares in Goofy Co as part of his remuneration package. If NAB & Co is appointed as internal as well as external auditors, then Goofy Co has suggested that the external audit fee should be renegotiated with at least 20% of the fee being based on the profit 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 in respect of the audit of Goofy Co, and for each threat explain how it may be reduced. (6 marks) (20 marks)

[P.T.O.

You are the audit manager of Daffy & Co and you are briefing your team on the approach to adopt in undertaking the review and finalisation stage of the audit. In particular, your audit senior is unsure about the steps to take in relation to 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 relation to 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 is $10m. (i)

Depreciation has been calculated on the total of land and buildings. In previous years it has only been charged on buildings. Total depreciation is $2·5m and the element charged to land only is $0·7m. (4 marks)

(ii) Minnie Co’s computerised wages program is backed up daily, however for a period of two months the wages records and the back-ups have been corrupted, and therefore cannot be accessed. Wages and salaries for these two months are $1·1m. (4 marks) (iii) Minnie Co’s main competitor has filed a lawsuit for $5m against them alleging a breach of copyright; this case is ongoing and will not be resolved prior to the audit report being signed. The matter is correctly disclosed as a contingent liability. (4 marks) Required: Discuss each of these issues and describe the impact on the audit report if the above issues remain unresolved. Note: The mark allocation is shown against each of the three issues above. Audit report extracts are NOT required. (20 marks)

End of Question Paper

Answers

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

June 2011 Answers

Tests of control and objective of each test for the sales cycle of Tinkerbell Toys Co (Tinkerbell) Test of control

Objective of test

The auditor should attempt to enter an order for a fictitious customer account number. The system should not accept this order.

To ensure that orders are only accepted and processed for valid customers.

With the client’s permission, attempt to enter a sales order which will take a customer over the agreed credit limit, the system should reject the order.

To ensure that goods are not supplied to poor credit risks.

Inspect a sample of processed credit applications from the credit agency and follow through the credit limit agreed to the sales system.

To ensure that goods are only supplied to customers with good credit ratings.

Obtain a copy of the current price list and agree for a sample of invoices that relevant/current prices have been used.

To ensure that goods are only sold at authorised prices.

Confirm discounts applied to invoices agree to the customer To ensure that sales discounts are only provided to valid master file. customers. Attempt to process an order with a sales discount for a customer not normally entitled to discounts to assess the application controls. Inspect a sample of orders to confirm that an order acceptance email/letter has been generated.

To ensure that all orders are recorded completely and accurately.

Observe the sales order clerk processing orders and assess whether the order acceptance is automatically generated.

(b)

Visit a warehouse and observe the goods despatch process to assess whether all goods are double checked against the goods despatch note (GDN) and the despatch list prior to sending out.

To ensure that goods are despatched correctly to customers and that they are of an adequate quality.

Inspect a sample of GDNs and agree that a valid sales invoice has been correctly raised.

To ensure that all goods despatched are correctly invoiced.

Review the last system generated sequence check of sales invoices to identify any omissions.

To ensure completeness of income for goods despatched.

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 any non-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.

(c)

Controls to reduce the risk of fraud occurring again Tutorial note: This type of fraud is known as a teeming and lading fraud. Control

Mitigate risk

Members of staff who are related should not be permitted to This should reduce the risk of staff colluding and being able work in the same department whereby they can breach to commit a fraud without easily being discovered. segregation of duty controls. Cash receipts should be processed by two members of staff. This should reduce the risk of one person being able to steal cash receipts. In order to commit the fraud these two members of staff would need to collude and to avoid detection, also collude with other members of the finance team. Monthly customer statements should be sent out promptly to all customers. The sales ledger supervisor should review to ensure that all customers have been sent statements.

If customers receive regular statements then they would be in a position to flag to Tinkerbell that there was a delay in their payments being credited to their accounts. This should then flag a possible ‘teeming and lading’ fraud.

Bank reconciliations should be reviewed by a responsible official (different to the preparer of the reconciliation) on a regular basis. Any unreconciled amounts should be promptly investigated and resolved.

A small unreconciled amount can actually represent two large balances which almost cancel each other out and hence could indicate significant problems with cash and bank. Where fraud arises it can often be quickly spotted by performing and reviewing a bank reconciliation.

On a regular basis staff within the finance department should rotate duties.

If staff members know that they will need to rotate their roles then they will be less inclined to commit fraudulent activities, as the chances of them being caught increase significantly.

The sales ledger should be reconciled to the sales ledger control account on a monthly basis, and this reconciliation should be reviewed by a responsible official.

This will increase the likelihood of spotting errors in the receivable balances and help to create an environment of controls, which will decrease the likelihood of frauds occurring.

Management should consider establishing an internal audit department which could assess the effectiveness of controls and identify areas of weaknesses, as well as perform specific fraud investigations.

As there has been a significant breakdown in the internal controls then the mere presence of an internal audit department would help to deter employees committing fraud. In addition, fraudulent activities would be more likely to be identified quicker as internal controls would be tested.

Tutorial note: Marks will be awarded for any additional general fraud points made. (d)

Substantive procedures to confirm Tinkerbell’s revenue: – – – – – – – –

(a)

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 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.

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 discussions are easily written up as notes. Additionally, as the notes are simple to record, this can facilitate understanding by all members of the team, especially more junior members who might find alternative methods too complex.

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 identify control exceptions clearly. Questionnaires Internal control questionnaires are used to assess whether controls exist which meet specific objectives or prevent or detect errors 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 deficiencies are clearly highlighted. Questionnaires are simple to complete and therefore any members of the team can complete them and they are easy to use and 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 relating to potential controls. Without careful tailoring of the questionnaire to make it company specific, there is a risk that controls may be misunderstood and 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 and management or those charged with governance. Confirming that there is a common understanding between the auditor and management, or those charged with governance, 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: – – – – – – – – – – – – – – – – –

(a)

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.

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 other media, 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 and accurately.

–

Observe the goods received department to assess whether goods received are checked against purchase orders and reviewed for adequate quality.

Analytical procedures Analytical procedures consist of evaluations of financial information through analysis of plausible relationships among both financial and non-financial data. Analytical procedures also encompass such investigation as is necessary of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount. – –

Calculate the operating profit margin/overhead ratio and compare it to last year and budget and investigate any significant 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 outside the entity. – –

Discuss with management whether there have been any changes in the key suppliers used and compare this to the purchase 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 company authorisation process.

Recalculation Recalculation consists of checking the mathematical accuracy of documents or records. Recalculation may be performed manually 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 part of 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: Audit risk

Audit response

Donald Co has ordered six planes which may not have been Discuss with management as to whether the planes have received by the year end. Only assets which physically exist arrived, if so then physically verify a sample of these planes at the year end should be included in property, plant and to ensure existence. equipment. The existing planes have been refurbished at a cost of $15m. This expenditure needs to be reviewed to assess whether it is of a capital nature and should be included within assets or expensed as repairs.

Review a breakdown of the costs and agree to invoices to assess the nature of the expenditure and if capital agree to inclusion within the asset register and if repairs agree to the income statement.

Donald Co has applied for a loan of $25m. It has not received this loan yet, but it has already ordered the planes and if it does not receive the money in time then it may struggle to pay for the planes ordered and this could result in going concern difficulties.

Discuss with management the status of the loan application and if still outstanding whether any other banks have been approached for the loan. Perform a detailed going concern review.

The travel agents who sell tickets on behalf of the airline are Extended post year-end cash receipts testing and a review of struggling to pay their outstanding balances to Donald Co. the aged receivables ledger to be performed to assess This could result in an increase in irrecoverable debts and valuation. receivables being overvalued. An allowance for receivables to be discussed with management. Donald Co’s website has encountered difficulties with Extended controls testing to be performed over the sales recording sales, this could lead to errors in relation to cycle to assess the extent of the errors. Detailed testing to be completeness of income. performed over completeness of income. Due to the website errors tickets have been sold twice, therefore some customers will require refunds. At the year end there is a risk that the tickets to be refunded have not been removed from sales.

Review the cut-off of customer refunds around the year end to ensure that sales are complete and accurate.

Audit risk

Audit response

Donald Co is closing its call centre and making the workforce redundant; as it has announced this to the staff then under IAS 37 Provisions, Contingent Liabilities and Contingent Assets a redundancy provision will be required for any staff not yet paid at the year end.

(a)

Safeguards to be adopted to address the conflict of interest of auditing both Goofy Co and Mickey Co: – – –

– – – –

(b)

Discuss with management the status of the redundancy programme and review and recalculate the redundancy provision.

Both Goofy Co and Mickey Co should be notified that NAB & Co would be acting as auditors for each company and, if necessary, 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 period of 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 and secure data filing. Clear guidelines for members of each engagement team on issues of security and confidentiality. These guidelines could be 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.

Advantages of outsourcing Goofy Co’s internal audit department Staffing Goofy Co needs to expand its internal audit department from five employees as it is too small; however, if they outsource then there will be no need to recruit as NAB & Co will provide the staff members and this will be an instant solution. Skills and experience NAB & 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 ad hoc reviews are performed and, depending on the nature of these, it may find that the firm has specialist skills that Goofy Co may not be able to afford if the internal audit department continues to be run internally. Costs Any associated costs such as training will be eliminated as NAB & Co will train its own employees. In addition, the costs for the 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. Flexibility With the department being outsourced Goofy Co will have total flexibility in its internal audit service. Staff can be requested from NAB & Co to suit Goofy Co’s workloads and requirements. This will ensure that, when required, extra staff can be used to visit a large number of shops and in quieter times there may be no internal audit presence. Additional fees NAB & 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 systems NAB & Co will allocate available staff members to work on the internal audit assignment, this may mean that each month the staff members are different and hence they may not understand the systems of Goofy Co. This will decrease the quality of the services provided and increase the time spent by Goofy Co employees explaining the system to the auditors. Independence If 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 that separate teams were put in place as well as additional safeguards. Existing internal audit department Goofy Co has an existing internal audit department of five employees. If they cannot be redeployed elsewhere in the company then they may need to be made redundant and this could be costly for the company. Staff may oppose the outsourcing if it results in redundancies. Cost As well as the cost of potential redundancies, the internal audit fee charged by NAB & Co may, over a period of time, prove to be very expensive.

Loss of in-house skills If the current internal audit team is not deployed elsewhere in the company valuable internal audit knowledge and experience may 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. Timing NAB & Co may find that Goofy Co requires internal audit staff at the busy periods for the audit firm, and hence it might prove difficult to actually provide the required level of resource. Confidentiality Knowledge of company systems and confidential data will be available to NAB & Co. Although the engagement letter would provide confidentiality clauses, this may not stop breaches of confidentiality. Control Goofy Co will currently have more control over the activities of its internal audit department; however, once outsourced it will need to discuss areas of work and timings well in advance with NAB & Co. (c)

Ethical threats and managing these risks Ethical threat

Managing risk

A familiarity threat arises where an engagement partner is associated with a client for a long period of time. NAB & Co’s partner has been involved in the audit of Goofy Co for six years and hence may not maintain her professional scepticism and objectivity.

NAB & Co should monitor the relationship between engagement and client staff, and should consider rotating engagement partners when a long association has occurred. In addition, ACCA’s Code of Ethics and Conduct recommends that engagement partners rotate off an audit after five years for listed and public interest entities. Therefore consideration should be given to appointing an alternative audit partner.

The engagement partner’s son has accepted a job as a sales It is unlikely that as a sales manager the son would be in a manager at Goofy Co. This could represent a position to influence the financial statements and hence self-interest/familiarity threat if the son was involved in the additional safeguards would not be necessary. financial statement process. A self-interest threat can arise when an audit firm has a financial interest in the company. In this case the partner’s son will receive shares as part of his remuneration. As the son is an immediate family member of the partner then if he holds the shares it will be as if the partner holds these shares, and this is prohibited.

In this case as holding shares is prohibited by ACCA’s Code of Ethics and Conduct then either the son should refuse the shares or more likely the engagement partner will need to be removed from the audit.

Fees based on the outcome or results of work performed are NAB & Co will not be able to accept contingent fees and known as contingent fees and are prohibited by ACCA’s should communicate to Goofy Co that the external audit fee Code of Ethics and Conduct. Hence Goofy Co’s request that needs to be based on the time and level of work performed. 20% of the external audit fee is based on profit after tax would represent a contingent fee. 5

(a)

Misstatements ISA 450 Evaluation of Misstatements Identified During the Audit considers what a misstatement is and deals with the auditor’s responsibility in relation to misstatements. It identifies a misstatement as being: A difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance 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 that have 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 accounting estimates that the auditor considers unreasonable, or the selection or application of accounting policies that the auditor considers inappropriate.

(iii) Projected misstatements are the auditor’s best estimate of misstatements in populations, involving the projection of misstatements 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 very small amounts. Identified misstatements should be considered during the course of the audit to assess whether the audit strategy and plan should be revised.

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 make necessary 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 a relatively new auditing standard and the above has been presented as a teaching resource. (b)

Reliance on the work of an independent valuer ISA 500 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 any professional body or industry association. In addition, the auditor should meet with the expert and discuss with them their relevant expertise; in particular whether they have valued similar properties to Minnie Co in the past. Also consider whether they understand the accounting requirements of IAS 16 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-interest threat such as share ownership considered. The valuation should then be evaluated. The assumptions used should be carefully reviewed and compared to previous revaluations at Minnie Co. These assumptions should be discussed with both management and the valuer to understand where 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 IAS 16 Property, 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 this from the financial statements. If management refuse to amend this error then the audit report will need to be modified. As management has not complied with IAS 16 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 to the provision of depreciation on land and the effect on the financial statements. The opinion paragraph would be qualified ‘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 auditors should attempt to verify payroll in an alternative manner. If they are unable to do this then payroll for the whole year would 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 material balance 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 relation to 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 over two months of payroll records. The opinion paragraph will be qualified ‘except for’ – due to insufficient appropriate audit evidence.

(iii) Lawsuit The company is being sued by a competitor for breach of copyright. This matter has been correctly disclosed in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The lawsuit is for $5m which represents 50% of profit before tax (5·0m/10m) and hence is a material matter. This is an 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 appropriately disclosed but is fundamental to the users’ understanding of the financial statements; this will not affect the audit opinion which will be unmodified in relation to this matter. An emphasis of matter paragraph should be inserted after the opinion paragraph, the paragraph would explain clearly about the lawsuit and cross references to where in the financial statements the disclosure of this contingent liability can be found.

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International)

June 2011 Marking Scheme MARKS

(a)

Up to 1 mark per well explained control and up to 1 mark for each objective Process order for fictitious order Sales order over credit limit Inspect credit applications Agree prices used to relevant price list Confirm discounts used on invoices agree to customer master file Attempt to process a discount for a small customer Inspect orders to confirm order acceptance generated Observe sales order clerk processing orders to see if acceptance generated Observe goods despatch process Agree goods despatch notes (GDN) to invoices Sequence checks over invoices

(b)

Up to 1 mark per well explained procedure – – – – – – – – – – –

(c)

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 –––

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 department Cash receipts processed by two members of staff Monthly customer statements sent Bank reconciliations reviewed by responsible official Rotation of duties within finance department Sales ledger control account reconciliation regularly performed Consider establishing an internal audit department

(d)

12 –––

6 –––

Up to 1 mark per well explained procedure Analytical review over revenue compared to budget and prior year Analytical review of major categories of toy sales compared to prior year Gross margin review Recalculate discounts allowed for larger customers Recalculate sales tax Follow order to goods despatched note to sales invoice to sales ledger Sales cut-off Review post year-end credit notes

4 ––– 30 ––– –––

MARKS 2

(a)

Up to 1 mark per valid point Notes: Simple to understand Facilitate understanding by all team Cumbersome especially if complex system Difficult to identify missing controls Questionnaires: Quick to prepare and hence cost effective All internal controls considered and missing controls identified Easy to complete and use Easy to overstate controls Easy to misunderstand controls and miss unusual controls

(b)

(i)

Up to 1 mark per valid point Written agreement of terms of engagement Avoid misunderstandings

(ii)

(a)

1 –––

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 ––– –––

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. Inspection Observation Analytical procedures Inquiry Recalculation Reperformance

(b)

6 –––

10 –––

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 end Refurbishment of planes – capital or repairs Loan of $25m not received yet Recoverability of receivables Completeness of income Customer refunds Redundancy provision

10 ––– 20 ––– –––

MARKS 4

(a)

Up to 1 mark per well explained safeguard – – – – – – –

(b)

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 –––

Up to 1 mark per well explained advantage/disadvantage Staffing gaps addressed immediately Skills and experience increased Costs of training eliminated Possibly reduced fees Flexibility of service Additional fees for NAB & Co Knowledge of systems reduced Independence issues NAB & Co Existing internal audit department staff, cost of potential redundancies Fees by NAB & Co may increase over time Loss of in-house skills Timing of work may not suit NAB & Co Confidentiality issues Control of department reduced

(c)

10 –––

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 partner Self-interest threat – son gained employment at client company Self-interest threat – financial interest (shares) in client company Contingent fees

6 ––– 20 ––– –––

MARKS 5

(a)

Up to 1 mark per well explained point Definition of misstatements Definition of uncorrected misstatements Factual misstatements Judgemental misstatements Projected misstatements Auditor should accumulate misstatements Consider if audit strategy/plan should be revised Assess if uncorrected misstatements material Communicate to those charged with governance, request changes If refused then assess impact on audit report Request written representation

(b)

Up to 1 mark per valid point ISA 500 provides guidance Consider if member of professional body or industry association Assess whether relevant expertise Assess independence Evaluate assumptions Agree any further work required No reference in audit report of Daffy & Co

(c)

4 –––

Up to 1 mark per valid point, overall maximum of 4 marks PER ISSUE Discussion of issue Calculation of materiality Type of audit report modification required Impact on audit report

12 ––– 20 ––– –––

Audit and Assurance (International) Thursday 8 December 2011

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 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 payroll cycle, as well as preparing the audit programmes for the final audit. Chuck Industries Co manufactures lights and the manufacturing process is predominantly automated; however there is a workforce of 85 employees, who monitor the machines, as well as approximately 50 employees who work in sales 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 in and out using an employee swipe card, which identifies the employee number and links into the hours worked report produced by the computerised payroll system. Employees are paid on an hourly basis for each hour worked. There is no monitoring/supervision of the clocking in/out process and an employee was witnessed clocking in several employees 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 hours worked report multiplied by the hourly wage rate, with appropriate tax deductions. These calculations are not checked by anyone as they are generated by the payroll system. During the year the hourly wage was increased by the Human Resources (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, who operate 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 day then 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 July two administration staff joined; however, due to staff holidays in the HR department, they delayed informing the payroll 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 of Chuck Industriesâ&#x20AC;&#x2122; payroll charge. (6 marks) (c) Last week the company had a visit from the tax authorities who reviewed the wages calculations and discovered that incorrect levels of tax had been deducted by the payroll system, as the tax rates from the previous year had not been updated. The finance director has queried with the audit team why they did not identify this non-compliance with tax legislation during last yearâ&#x20AC;&#x2122;s audit. Required: Explain the responsibilities of management and auditors of Chuck Industries Co in relation to compliance with law and regulations under ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements. (4 marks)

(d) Chuck Industries has decided to outsource its sales ledger department and as a result it is making 14 employees redundant. 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 has asked 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 the work performed by a companyâ&#x20AC;&#x2122;s internal audit department. (4 marks) (30 marks)

[P.T.O.

(a) ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment requires auditors to understand the entity’s internal control. An entity’s internal control is made up of 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 content of 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)

(a) Explain the components of audit risk and, for each component, state an example of a factor which can result in increased audit risk. (6 marks) Abrahams Co develops, manufactures and sells a range of pharmaceuticals and has a wide customer base across Europe and Asia. You are the audit manager of Nate & Co and you are planning the audit of Abrahams Co whose financial year end is 31 January. You attended a planning meeting with the finance director and engagement partner and are now reviewing the meeting notes in order to produce the audit strategy and plan. Revenue for the year is forecast at $25 million. During the year the company has spent $2·2 million on developing several new products. Some of these are in the early stages of development whilst others are nearing completion. The finance director has confirmed that all projects are 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 is anticipated that there will be significant levels of work in progress. In addition the company uses a standard costing method to value inventory; the standard costs are set when a product is first manufactured and are not usually updated. In order to fulfil customer orders promptly, Abrahams Co has warehouses for finished goods located across Europe 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 information technology (IT) manager. The old and new packages were not run in parallel as it was felt that this would be too onerous for the accounting team. Two months after the system changeover the IT manager left the company; a new manager 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 million through issuing shares at a premium and $2·5 million through a long-term loan. There are bank covenants attached to the loan, the main one relating to a minimum level of total assets. If these covenants are breached then the loan becomes immediately repayable. The company has a policy of revaluing land and buildings, and the finance director has 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 to report results even earlier this year. Required: (b) Using the information provided, identify and describe FIVE audit risks and explain the auditor’s response to each 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)

[P.T.O.

(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. It provides specialist training in accounting and finance. The listing rules of the stock exchange require compliance with corporate governance principles, and the directors are fairly confident that they are following best practice in relation to this. However, they have recently received an email from a significant shareholder, who is concerned that Serena VDW Co does not comply with corporate governance principles. Serena VDW Co’s board is comprised of six directors; there are four executives who originally set up the company and two non-executive directors who joined Serena VDW Co just prior to the listing. Each director has a specific area 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 along with 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 chairman who make decisions on the appointment and remuneration of the external auditors. Again, to save costs, no internal 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. They are 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 by shareholders. Required: Describe SIX corporate governance weaknesses faced by Serena VDW Co and provide recommendations to address 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)

(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 signed on 13 December. Revenue for the year is $78 million and profit before taxation is $7·5 million. The following events 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 the financial statements; however correspondence has just arrived from the supplier indicating that they are willing to 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 water flooded the warehouse located in Bass. All of the inventory was damaged and has been disposed of. The insurance company has already been contacted. No amendments or disclosures have been made in the financial statements. 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)

End of Question Paper

Answers

Fundamentals Level â&#x20AC;&#x201C; Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

December 2011 Answers

Payroll system implications and recommendations Implication

Recommendation

As there is no supervision of the clocking in process then, as witnessed, employees can clock in multiple employees simply by using their employee swipe cards. This will result in a substantially increased payroll cost for Chuck Industries.

The clocking in and out procedures should be supervised by a responsible official to prevent one individual clocking in multiple employees. In addition, Chuck Industries could consider linking the access to the factory floor with the employee swipe card system. Hence employees can only access the factory one at a time upon presentation of their employee swipe card.

In addition, this could create a weaker control environment whereby employees consider it acceptable not to follow controls.

Employees should be reminded about the importance of following Chuck Industriesâ&#x20AC;&#x2122; policies and procedures, especially in relation to the clocking in/out process.

Clocking in process

Without supervision/monitoring of the clocking in or out Overtime hours should be reviewed by the production process, employees could try to boost their hours worked by supervisor prior to payment, to ensure that only previously clocking out several hours after their shift has finished, this authorised overtime is paid for. will lead to invalid and unauthorised overtime payments. Wages calculations The wages calculations are generated by the payroll system and there are no checks performed. Therefore, if system errors occur during the payroll processing then this would not be identified. This could result in wages being over or under calculated, leading to an additional payroll cost or loss of employee goodwill.

A senior member of the payroll team should recalculate the gross to net pay workings for a sample of employees and compare their results to the output from the payroll system. These calculations should be signed as approved before wages payments are made.

Hourly wage increase All increases of pay should be proposed by the HR The hourly wage has been increased by the Human department and then formally agreed by the board of Resources (HR) department and notified to the payroll department verbally. As payroll can be a significant expense directors. for a business, any decision to increase this should be made by the board as a whole and not just by HR. The payroll department should not accept verbal Written notification of the increase should be sent to payroll notifications of pay increases as it could be an unauthorised and HR and only then should the pay rise be incorporated increase, or an effort by an employee in HR to increase the into the payroll package. pay of certain members of staff, such as their friends. Wage payout The factory supervisor should not be given the pay packets of the night shift staff as this is a significant amount of cash, being approximately one-third of the workforce. This cash will not be in a secure location and so is open to the risk of theft.

Consideration should be given to operating a shift system for the payroll department on Fridays. This will ensure that there are sufficient payroll employees to perform the wages payout to the night shift employees. Therefore the same controls applied to the morning and late afternoon shifts can be put in place for the night shift.

In addition, the supervisor is not sufficiently independent to pay wages out. He could adjust pay packets to increase those of his close friends whilst reducing others.

Employees who miss the payout by the payroll department will need to wait until Monday for their pay. No factory supervisor should be allowed to hand out wages.

For employees absent on pay day, the supervisor retains the Pay packets of absent employees should be safely secured wages and only returns them on Monday. This cash is in the safe overnight and then banked on Monday. therefore not secure and is susceptible to loss or theft. Joiners/leavers Notification of joiners and leavers should be made on a timely basis to the payroll department, even if some staff are on holiday. Otherwise Chuck Industries could continue making payments to employees who have left, or pay new employees late, resulting in a loss of employee goodwill.

During periods of illness or holidays, key roles of the affected employees should be reallocated to other members of the team to ensure that controls are maintained. Forms for new joiners should be completed when they are appointed with appropriate start dates filled in, these should then be distributed to all relevant departments. This should reduce the risk of new joiners being missed out by the payroll department.

(b)

(c)

Payroll substantive procedures –

Agree the total wages and salaries expense per the payroll system to the detailed trial balance, investigate any differences.

–

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 included within 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 any significant variances.

–

Perform a proof in total of total wages and salaries, incorporating joiners and leavers and the pay increase. Compare this to 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 their first/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 cash subsequently 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 to confirm completeness.

–

Agree the individual wages and salaries per the payroll to the personnel records and records of hours worked per clocking in cards.

Laws and regulations Under ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements, management have a responsibility to ensure that the operations of Chuck Enterprises are conducted in accordance with the provisions of laws and regulations. This includes compliance with laws and regulations that determine amounts and disclosures in financial statements, 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 financial statements 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 financial statements. 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 disclosures in financial statements, but may impact the entity’s ability to continue to trade. Here the auditor’s responsibility is limited to specified audit procedures to help identify non-compliance with those laws and regulations that may have a material effect on the financial statements. This includes inquiring with management whether the entity is in compliance with such 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 audit procedures 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 the sales 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 formally announced.

–

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 supporting documentation.

–

Review the post year-end period to identify whether any redundancy payments have been made, compare actual payments 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 Liabilities and Contingent Assets.

(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 reliance on 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 the finance department. In addition, consideration should be given as to who IA reports to, whether this is directly to those charged 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 a professional 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 have been 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 throughout the year.

(a)

Internal control components ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment considers 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 actions of those charged with governance and management concerning the entity’s internal control and its importance in the entity. 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 operating style, 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 risks relevant to the preparation of financial statements in accordance with the entity’s applicable financial reporting framework. It estimates their significance, assesses the likelihood of their occurrence, and decides upon actions to respond 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 the procedures and records designed and established to initiate, record, process, and report entity transactions (as well as events 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. Control activities, whether within information technology or manual systems, have various objectives and are applied at various organisational and functional levels. (v)

Monitoring of controls Monitoring of controls is a process to assess the effectiveness of internal control performance over time. It involves assessing the effectiveness of controls on a timely basis and taking necessary remedial actions. Management accomplishes 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 regular management 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, this distinguishes this report from any other. Addressee – The auditor’s report shall be addressed as required by the circumstances of the engagement, it is determined by law or regulation but is usually to the shareholders.

Introductory paragraph – The introductory paragraph in the auditor’s report shall identify the entity whose financial statements have been audited, state that the financial statements have been audited, identify the title of each statement that comprises the financial statements, refer to the summary of significant accounting policies and other explanatory information, and specify 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 of those in the organisation who are responsible for the preparation of the financial statements. The description shall include an explanation that management is responsible for the preparation of the financial statements in accordance with the applicable financial reporting framework, and for such internal control it determines is necessary to enable the preparation of the financial 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 the financial statements based on the audit and that the audit was conducted in accordance with International Standards on Auditing and ethical requirements and that the auditor plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. Opinion paragraph – When expressing an unmodified opinion the auditor’s opinion shall either state that the financial statements ‘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 be addressed 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 partner is 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 obtained sufficient 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.

(a)

Components of audit risk Inherent risk The susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that could be material, 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 risk The risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and 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 risk The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement 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.

(b)

Audit risks and responses Audit risk

Audit response

The finance director of Abrahams is planning to capitalise the full $2·2 million of development expenditure incurred. However in order to be capitalised it must meet all of the criteria under IAS 38 Intangible Assets.

A breakdown of the development expenditure should be reviewed and tested in detail to ensure that only projects which meet the capitalisation criteria are included as an intangible asset, with the balance being expensed.

There is a risk that some projects may not reach final development stage and hence should be expensed rather than capitalised. Intangible assets could be overstated and this risk is increased due to the loan covenant requirements to maintain a minimum level of assets. The inventory valuation method used by Abrahams is standard costing. This method is acceptable under IAS 2 Inventories; however, only if standard cost is a close approximation to actual cost.

The standard costs used for the inventory valuation should be tested in detail and compared to actual cost. If there are significant variations this should be discussed with management, to ensure that the valuation is appropriate.

Abrahams has not updated their standard costs from when the product was first developed and hence there is a risk that the standard costs could be out of date, resulting in over or undervalued inventory. The work in progress balance at the year end is likely to be material; however there is a risk that due to the nature of the production process the audit team may not be sufficiently qualified to assess the quantity and value of work in progress leading to misstated work in progress.

Consideration should be given as to whether an independent expert is required to value the work in progress. If so this will need to be arranged with consent from management and in time for the year-end count.

Over one-third of the warehouses of Abrahams belong to third parties. Sufficient and appropriate evidence will need to be obtained to confirm the quantities of inventory held in these locations in order to verify completeness and existence.

Additional procedures will be required to ensure that inventory quantities have been confirmed for both third party and company owned locations.

In September Abrahams Co introduced a new accounting The new system will need to be documented in full and system. This is a critical system for the accounts preparation testing should be performed over the transfer of data from and if there were any errors that occurred during the the old to the new system. changeover process, these could impact on the final amounts in the trial balance. The new accounting system is bespoke and the IT manager who developed it has left the company already and his replacement is not due to start until just before the year end. The accounting personnel who are using the system may have encountered problems and without the IT manager’s support, errors could be occurring in the system due to a lack of knowledge and experience. This could result in significant errors arising in the financial statements.

This issue should be discussed with the finance director to understand how he is addressing this risk of misstatement. In addition, the team should remain alert throughout the audit for evidence of such errors.

Significant finance has been obtained in the year, $1 million of equity finance and $2·5 million of long-term loans. This finance needs to be accounted for correctly, with adequate disclosure made. The equity finance needs to be allocated correctly between share capital and share premium, and the loan should be presented as a non-current liability.

Check that the split of the equity finance is correct and that total financing proceeds of $3·5 million were received. In addition, the disclosures for this finance should be reviewed in detail to ensure compliance with relevant accounting standards.

The loan has a number of covenants attached to it. If these are breached then the loan would be instantly repayable and would be classified as a current liability. This could result in the company being in a net current liability position. If the company did not have sufficient cash flow to meet this loan repayment then there could be going concern implications.

Review the covenant calculations prepared by Abrahams Co and identify whether any defaults have occurred; if so then determine the effect on the company.

The team should maintain their professional scepticism and be alert to the risk that assets have been overstated to ensure compliance with covenants.

Audit risk

Audit response

The land and buildings are to be revalued at the year end, it Review the reasonableness of the valuation and recalculate is likely that the revaluation surplus/deficit will be material. the revaluation surplus/deficit to ensure that land and The revaluation needs to be carried out and recorded in buildings are correctly valued. accordance with IAS 16 Property, Plant and Equipment; otherwise non-current assets may be incorrectly valued. The reporting timetable for Abrahams Co is likely to be reduced. The previous timetable was already quite short and any further reductions will increase detection risk and place additional pressure on the team in obtaining sufficient and appropriate evidence. (c)

(i)

(ii)

(a)

The timetable should be confirmed with the finance director. If it is to be reduced then consideration should be given to performing an interim audit in late December or early January, this would then reduce the pressure on the final audit.

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 warehouse providers 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 in operation 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 over inventory.

–

Inspect any documentation in respect of third party inventory.

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, and how often these are reviewed and updated.

–

Review the level of variances between standard and actual costs and discuss with management how these are treated.

–

Obtain a breakdown of the standard costs and agree a sample of these costs to actual invoices or wage records to assess their reasonableness.

Corporate governance Corporate governance is the system by which companies are directed and controlled. According to the UK Corporate Governance Code the ‘purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can 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, the need 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 charged with governance who run the company, but the owners are the shareholders and they are not involved in the running of the business. For these shareholders their only opportunity to raise concerns is at the annual general meeting, which only occurs once a year 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 for them to be informed as to how the business is operating.

(b)

Corporate governance weaknesses and recommendations Weakness

Recommendation

The chairman of Serena VDW Co, Daniel Brown, is both the chairman and chief executive. There should be a clear division of responsibility at the head of the company and no one individual should have such unrestricted levels of decision-making, as this can lead to an abuse of power.

The roles of chairman and chief executive should be split and not performed by the same individual. Daniel Brown should remain as chief executive, but one of the non-executives should be appointed as chairman. Corporate Governance principles would recommend that the chairman should be an independent non-executive director.

The board is comprised of four executives and two non-executive directors. There should be an appropriate balance of executives and non-executives, to ensure that the board makes the correct objective decisions, which are in the best interest of the stakeholders of the company, and no individual or group of individuals dominates the board’s decision-making.

At least half of the board should be comprised of non-executive directors. Hence Serena VDW Co should consider recruiting and appointing an additional one to two non-executive directors.

(c)

Weakness

Recommendation

The finance director is the only member of the board who reviews the financial statements and budgets. However, the board as a whole should be presented with an understandable assessment of Serena VDW Co’s financial position and prospects. They should be aware of the financial implications of any business decisions made.

The finance director should produce financial information and budgets and present this to either the audit committee or the full board. This will allow all directors to understand the financial position of the company and to make informed business decisions.

The audit committee is comprised of two non-executives, the chairman and the finance director. The audit committee is supposed to be made up of independent non-executives as opposed to having executive directors as well. The chairman can, for smaller companies, sit on the committee provided that he is an independent non-executive, which is not the case for Serena VDW Co.

The audit committee must be comprised of non-executives only; the chairman and finance director should resign from the committee. If Serena VDW Co does appoint additional non-executives, then they should be invited to sit on the audit committee as well.

The task of appointing and remunerating the external auditors is undertaken by the chairman and the finance director. This should be performed by the audit committee so as to strengthen the independence of the external auditors. If executive directors are responsible, the auditors may feel that if they do not provide an unmodified audit opinion then they could be removed.

The audit committee should have primary responsibility in appointing the auditors and in setting their remuneration.

In order to reduce costs, Serena VDW Co has not established an internal audit function. The audit committee should consider the effectiveness of internal controls and internal audit could perform this role. Where there is no internal audit function, the audit committee is required to annually consider the need for one.

Further consideration should be given to establishing an internal audit function. Both costs and benefits should be considered, as it is not sufficient to solely consider cost savings.

The remuneration for the directors is set by the finance director and chairman. However, no director should be involved in setting their own remuneration as this may result in excessive levels of pay being set.

There should be a fair and transparent policy in place for setting remuneration levels. The non-executive directors should decide on the remuneration of the executives. The finance director or chairman should decide on the pay of the non-executives.

Executive remuneration is comprised of a salary and annual bonus. However, the pay should motivate the directors to focus on the long-term growth of the business. Annual targets can encourage short-term strategies rather than maximising shareholder wealth.

The remuneration of executives should be restructured to include a significant proportion aimed at long-term company performance. 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. The shareholders should review on a regular basis that the composition of the board of directors is appropriate, and they do this by re-electing directors.

The directors should be subject to re-election by the shareholders at regular intervals not exceeding three years. At the current year’s AGM it should be proposed that a number of the directors are subject to re-election. The remaining directors could then be subject to re-election next year.

Client confidentiality ACCA’s Code of Ethics and Conduct addresses the area of auditor confidentiality and states that auditors acquiring information in the course of their professional work should not disclose any such information to third parties without first obtaining permission from their clients. Confidentiality is an implied term of auditors’ contracts with their clients. For this reason auditors should not disclose confidential information to other persons, against their client’s wishes. The obligation of confidentiality continues even though a 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 auditor suspects the client is involved in money laundering, terrorism or drug trafficking in which case they must immediately notify the 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.

Voluntary In certain circumstances auditors are free, as opposed to obliged, to disclose information without obtaining the client’s permission 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 in the ‘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 proper authority overrides the duty of confidentiality; Non-governmental bodies – Auditors may be approached by non-governmental bodies seeking information concerning suspected acts of misconduct not amounting to a crime or civil wrong. Disclosure should only be made to those bodies with statutory powers to compel disclosure.

(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 occurring between 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 audit procedures 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’s report. 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, determine whether the financial statements need amendment and, if so, inquire how management intends to address the matter in the financial statements. If management amends the financial statements, the auditor shall carry out the necessary audit procedures, extend the subsequent events testing to the date of the new auditor’s report, and provide a new auditor’s report on the amended financial statements.

(b)

Humphries Co Receivable A customer, owing $0·3 million at the year end, is experiencing significant going concern difficulties. This information was received after the year end but provides further evidence of the recoverability of the receivable balance at the year end. Under IAS 10 Events after the Reporting Period, if the customer is experiencing cash flow difficulties just a few months after the year 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 the use 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) and therefore, although overstated, it does not require adjustment. However, the $0·3m should be noted in the summary of unadjusted 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 the settlement 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 provision of $0·6 million being recorded.

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 representation confirming 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 qualified opinion would be necessary. A basis for qualified opinion paragraph would be required and would need to include a paragraph explaining the material misstatement in relation to the lack of a provision and the effect on the financial statements. The opinion paragraph would be 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 the company has insurance in place. This event occurred after the year end and the flood would not have been in existence at 30 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 disclosure of the nature of the event and any estimates of the financial impact may be required. If the amount is not material then it may 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 the short 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 uninsured level 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 the audit report. If disclosure of this subsequent event is required and management refuse to make these disclosures, then the audit report will 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, consideration should be given to modifying the audit report opinion. This would involve including an emphasis of matter paragraph drawing attention to the possible risk in relation to going concern.

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International)

December 2011 Marking Scheme Marks

(a)

Up to 1 mark per well explained implication and up to 1 mark for each well explained recommendation Multiple employees can be clocked in Weaker control environment Unauthorised overtime hours Payroll system errors not identified Payroll increases to be agreed by the board Written notification of pay increases to payroll department Night shift wages susceptible to risk of theft Factory supervisor not independent Absent night shift employees’ pay not secure over weekend Joiners/leavers notified on timely basis

(b)

Up to 1 mark per substantive procedure Agree wages and salaries per payroll to trial balance Cast payroll records Recalculate gross and net pay Recalculate statutory deductions, agree relevant to current year rates Compare total payroll to prior year Review monthly payroll to prior year and budget Proof in total of payroll Verify joiners/leavers and recalculate first/last pay Agree salaries paid per payroll to bank transfer list and cashbook Agree total cash withdrawn from bank equates to wages paid and surplus cash banked Agree tax liabilities to payroll and post year-end cashbook Agree the individual wages and salaries as per the payroll to the personnel records and records of hours worked per clocking in cards

(c)

4 –––

Up to 1 mark per substantive procedure Discuss with directors whether formal announcement made of redundancies Review supporting documentation to confirm present obligation Review board minutes to confirm payment probable Cast breakdown of redundancy provision Recalculate provision and agree components of calculation to supporting documentation Review post year-end period to compare actual payments to amounts provided Written representation to confirm completeness Review disclosures for compliance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets

(e)

6 –––

Up to 1 mark per valid point Management responsibility to comply with law and regulations Auditors not responsible for preventing non-compliance Auditors – reasonable assurance financial statements free from material error Law and regulations – Direct effect responsibility Law and regulations – Indirect effect responsibility Remain alert/Professional scepticism

(d)

12 –––

4 –––

Up to 1 mark per well explained point Objectivity – independence, status and to whom report Technical Competence – qualifications and experience Due professional care – properly planned and performed Communication – between internal and external auditors

4 ––– 30 ––– –––

Marks 2

(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 management Control 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 risk Information system relevant to financial reporting – procedures and records to record an entity’s transactions, assets and liabilities and to maintain accountability Control activities – policies and procedures to help ensure management directives are carried out Monitoring controls – assess effectiveness of internal controls

5 –––

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 responsibility Auditor’s responsibility Opinion paragraph Other reporting responsibilities Signature of the auditor Date of the auditor’s report Auditor’s address

(a)

5 ––– 10 ––– –––

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 risk Control risk Detection risk

(b)

6 –––

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 treatment Standard costing for valuation of inventory Expert possibly required in verifying work in progress Third party inventory locations New accounting system introduced in the year Lack of support by IT staff on new system may result in errors in accounting system New finance obtained; loans and equity finance treatment Loan covenants and risk of going concern problems Revaluation of land and buildings Reduced reporting timetable

(c)

10 –––

1 mark per well explained procedure, maximum of 2 marks for each of (i) and (ii) (i)

(ii)

Third party locations Letter requesting direct confirmation Attend inventory count Review other auditor reports and documentation

2 –––

Standard costing Discuss with management basis of standard costs Review variances Breakdown of standard costs and agree to actual costs

2 ––– 20 ––– –––

Marks 4

(a)

Up to 1 mark per valid point System by which companies are directed and controlled Considers directors’ responsibilities, board structure, importance of good internal controls and relationship with external auditors Management run the business but shareholders own the company Shareholders only have annual general meeting to raise concerns Shareholders need process in place to ensure their needs met and kept informed

(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 executive Two of six directors are non-executive, should be at least half Finance director alone reviews financial information and budgets Audit committee comprised of non-executives, chairman and finance director Finance director and chairman appoint and remunerate external auditors No internal audit function to save costs Finance director and chairman decide on the remuneration for the executive directors Remuneration all in form of salary and yearly bonus No director subject to re-election for the last five years

(c)

3 –––

12 –––

Up to 1 mark per valid point ACCA’s Code of Ethics and Conduct – auditors should not disclose information without client consent Confidentiality implied term of engagement contract Obligatory disclosure in certain circumstances Statutory right or duty to disclose Compelled by process of law Voluntary disclosure in certain circumstances Public interest Protect member’s interest Authorised by statute/laws Non-governmental bodies

5 ––– 20 ––– –––

Marks 5

(a)

Up to 1 mark per valid point Auditor shall perform audit procedures to identify subsequent events requiring adjustment or disclosure No 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 report Determine if adjustments required, if so discuss with management If amended then audit adjustment, extend subsequent events testing, provide new auditor’s report

(b)

5 –––

Up to 1 mark per valid point, overall maximum of 5 marks per event. Receivable Provides evidence of conditions at the year end Receivable to be adjusted via write down or allowance Review correspondence with customer Discuss with management Review post year-end period for cash receipts Calculation of materiality No audit report modification required

5 –––

Lawsuit Provides evidence of present obligation at the year end Provision required and not contingent liability disclosures Discuss with company lawyer Review correspondence with supplier Discuss with management and obtain written representation Calculation of materiality Type of audit report modification required Impact on audit report Warehouse Provides evidence of conditions that arose subsequent to the year end No adjustment required, possible disclosure of any uninsured sums Discuss with management whether sufficient levels of inventory to continue operating Obtain written representation that going concern status appropriate Obtain schedule of damaged inventory and review reasonableness Review correspondence with insurance firm to assess levels of uninsured goods Calculation of materiality Type of audit report modification required Impact on audit report

5 –––

5 ––– 20 ––– –––

Audit and Assurance (International) Thursday 14 June 2012

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 1

Pear International Co (Pear) is a manufacturer of electrical equipment. It has factories across the country and its customer base includes retailers as well as individuals, to whom direct sales are made through their website. The company’s year end is 30 September 2012. You are an audit supervisor of Apple & Co and are currently reviewing documentation 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 website is 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 the customer has received the goods. Over the past 12 months there have been customer complaints about the delay between sales orders and receipt of goods. Pear has investigated these and found that, in each case, the sales order had 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 sales ledger 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 staff changes 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 as supervisors. In the past six months Pear has changed part of its manufacturing process and as a result some new equipment has been purchased, however, there are considerable levels of plant and equipment which are now surplus to requirement. Purchase requisitions for all new equipment have been authorised by production supervisors and little has 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 plant and 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 addition to the external audit; however, he is unsure how much assurance would be gained via these engagements and how 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)

Pearâ&#x20AC;&#x2122;s directors are considering establishing an internal audit department next year, and the finance director has asked about the differences between internal audit and external audit and what impact, if any, establishing an internal audit department 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 Pear International Co was to establish an internal audit department. (4 marks) (30 marks)

[P.T.O.

(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. (c) Describe the three types of modified audit opinions.

(3 marks) (3 marks) (10 marks)

(a) Explain the external auditorsâ&#x20AC;&#x2122; 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), who specialise in the provision of loans and financial advice to individuals and companies. Currant & Co has audited Orange for many years. The directors are planning to list Orange on a stock exchange within the next few months and have asked if the engagement partner can attend the meetings with potential investors. In addition, as the finance director of Orange is likely to be quite busy with the listing, he has asked if Currant & Co can produce the financial statements for the current year. During the year, the assistant finance director of Orange left and joined Currant & Co as a partner. It has been suggested that due to his familiarity with Orange, he should be appointed to provide an independent partner review for 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 these engagements, however, Orange has implied that in order to gain this work Currant & Co needs to complete the external audit quickly and with minimal questions/issues. The finance director has informed you that once the stock exchange listing has been completed, he would like the engagement 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 reduced interest rate. Required: (b) (i)

Explain SIX ethical threats which may affect the independence of Currant & Coâ&#x20AC;&#x2122;s audit of Orange Financials 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 and has asked for some advice in relation to this. Required: Explain the benefits to Orange of establishing an audit committee.

(4 marks) (20 marks)

(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-end inventory. (8 marks)

(b) Pineapple Beach Hotel Co (Pineapple) operates a hotel providing accommodation, leisure facilities and restaurants. Its year end was 30 April 2012. You are the audit senior of Berry & Co and are currently preparing the audit programmes for the year end audit of Pineapple. You are reviewing the notes of last weekâ&#x20AC;&#x2122;s meeting between 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 the straight-line method. Food poisoning Pineappleâ&#x20AC;&#x2122;s directors received correspondence in March from a group of customers who attended a wedding at the hotel. They have alleged that they suffered severe food poisoning from food eaten at the hotel and are claiming substantial damages. Pineappleâ&#x20AC;&#x2122;s lawyers have received the claim and believe that the lawsuit against the company is unlikely to be successful. Required: Describe substantive procedures to obtain sufficient and appropriate audit evidence in relation to the above two 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 the audit team. (4 marks) (20 marks)

[P.T.O.

(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 the following 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 Strawberry has ceased trading, and it is unlikely any of this will be received. However the balance is included within the financial statements 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 as negative for the forthcoming financial year. As a result of this, the company has been slow in paying its suppliers and some 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 loan covenants, the bank has asked that the loan of $4·8m be repaid in full within six months. The directors have decided that in order to conserve cash, no final dividend will be paid in 2012. Financial statements extracts for year ended 30 April: DRAFT 2012 $m

ACTUAL 2011 $m

Current Assets Inventory Receivables Cash

3·4 1·4 –

1·6 2·2 1·2

Current Liabilities Trade payables Overdraft Loans

1·9 0·8 4·8

0·9 – 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 going concern. (6 marks) (d) Having performed the going concern audit procedures, you have serious concerns in relation to the going concern status of Strawberry. The finance director has informed you that as the cash flow issues are short term he does not 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 Kitchen Designs 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)

End of Question Paper

Answers

Fundamentals Level â&#x20AC;&#x201C; Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

June 2012 Answers

Pear Internationalâ&#x20AC;&#x2122;s (Pear) internal control Deficiency

Control

Currently the website is not integrated into inventory system.

Test of control

The website should be updated to include an interface into the inventory system; this should check inventory This can result in Pear accepting levels and only process orders if customer orders when they do not have adequate inventory is held. If inventory the goods in inventory. This can cause is out of stock, this should appear on them to lose sales and customer the website with an approximate waiting goodwill. time.

Test data could be used to attempt to process orders via the website for items which are not currently held in inventory. The orders should be flagged as being out of stock and indicate an approximate waiting time.

For goods despatched by local couriers, customer signatures are not always obtained.

Select a sample of despatches by couriers and ask Pear for proof of despatch by viewing customer signatures.

This can lead to customers falsely claiming that they have not received their goods. Pear would not be able to prove that they had in fact despatched the goods and may result in goods being despatched twice.

Pear should remind all local couriers that customer signatures must be obtained as proof of despatch and payment will not be made for any despatches with missing signatures.

There have been a number of situations Once goods are despatched they should Review the report of outstanding sales where the sales orders have not been be matched to sales orders and flagged orders. If significant, discuss with a fulfilled in a timely manner. as fulfilled. responsible official to understand why there is still a significant time period This can lead to a loss of customer between sales order and despatch date. goodwill and if it persists will damage the reputation of Pear as a reliable The system should automatically flag Select a sample of sales orders and supplier. any outstanding sales orders past a compare the date of order to the goods predetermined period, such as five days. despatch date to ascertain whether this This report should be reviewed by a is within the acceptable predetermined responsible official. period. Customer credit limits are set by sales ledger clerks. Sales ledger clerks are not sufficiently senior and so may set limits too high, leading to irrecoverable debts, or too low, leading to a loss of sales.

Credit limits should be set by a senior member of the sales ledger department and not by sales ledger clerks. These limits should be regularly reviewed by a responsible official.

For a sample of new customers accepted in the year, review the authorisation of the credit limit, and ensure that this was performed by a responsible official. Enquire of sales ledger clerks as to who can set credit limits.

Sales discounts are set by Pearâ&#x20AC;&#x2122;s sales team.

All members of the sales team should be given authority to grant sales discounts up to a set limit. Any sales In order to boost their sales, members of discounts above these limits should be the sales team may set the discounts authorised by sales area managers or too high, leading to a loss of revenue. the sales director.

Discuss with members of the sales team the process for setting sales discounts.

Regular review of sales discount levels should be undertaken by the sales director, and this review should be evidenced.

Review the sales discount report for evidence of review by the sales director.

Supplier statement reconciliations should be performed on a monthly basis for all suppliers and these should be reviewed by a responsible official.

Review the file of reconciliations to ensure that they are being performed on a regular basis and that they have been reviewed by a responsible official.

Supplier statement reconciliations are no longer performed. This may result in errors in the recording of purchases and payables not being identified in a timely manner.

Deficiency Changes to supplier details in the purchase ledger master file can be undertaken by purchase ledger clerks. This could lead to key supplier data being accidently amended or fictious suppliers being set up, which can increase the risk of fraud. Pear has considerable levels of surplus plant and equipment. Surplus unused plant is at risk of theft. In addition, if the surplus plant is not disposed of then the company could lose sundry income.

Purchase requisitions are authorised by production supervisors. Production supervisors are not sufficiently independent or senior to authorise capital expenditure. (b)

Control

Test of control

Only purchase ledger supervisors should have the authority to make changes to master file data. This should be controlled via passwords.

Request a purchase ledger clerk to attempt to access the master file and to make an amendment, the system should not allow this.

Regular review of any changes to Review a report of master data changes master file data by a responsible official and review the authority of those and this review should be evidenced. making amendments. Regular review of the plant and Observe the review process by senior equipment on the factory floor by senior factory personnel, identifying the factory personnel to identify any old or treatment of any old equipment. surplus equipment. As part of the capital expenditure process there should be a requirement to confirm the treatment of the equipment being replaced.

Review processed capital expenditure forms to ascertain if the treatment of replaced equipment is stated.

Capital expenditure authorisation levels Review a sample of authorised capital to be established. Production expenditure forms and identify if the supervisors should only be able to correct signatory has authorised them. authorise low value items, any high value items should be authorised by the board.

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: Audit External Audit – A high but not absolute level of assurance is provided, this is known as reasonable assurance. This provides comfort that the financial statements are true and fair and are free of material misstatements. Other review engagements Other review engagements where an opinion is being provided, the practitioner gathers sufficient evidence to be satisfied that the subject matter is plausible; in this case negative assurance is given whereby the practitioner confirms that nothing has come to his attention which indicates that the subject matter contains material misstatements.

(d)

Differences between internal and external audit External Audit

Internal Audit

Objective The main objective of internal audit is to improve a The main objective of the external auditor is to express an opinion on the truth and fairness of the financial statements. company’s operations, by reviewing the efficiency and effectiveness of the company’s internal controls. Reporting Internal auditors normally report to management or those External auditors report to the shareholders or members of the company. External audit reports are contained within the charged with governance. Internal audit reports not publicly available and are only intended to be seen by the addressee financial statements and hence are publicly available. of the report. The reports are normally provided to the board of directors and those charged with governance such as the audit committee.

External Audit

Internal Audit

Scope of work The external auditor’s work is limited to verifying the truth and fairness of the financial statements of the company.

The internal auditor can have a wide scope of work and it is determined by the requirements of management or those charged with governance. Commonly internal audit focus on the company’s internal control environment, but any other area of a company’s operations can be reviewed.

Relationship with company Internal auditors are appointed by management. As internal auditors are normally employees of the company they lack independence. However, the internal audit department can be outsourced and this can increase their independence.

External auditors are appointed by the company’s shareholders. They are independent of the company.

(e)

Impact on interim and final audit Interim audit Apple & Co could look to rely on any internal control documentation produced by internal audit (IA) as they would need to assess 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 purchase systems, then Apple & Co could review and possibly place reliance on this work. This may result in the workload reducing and 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 possible that the IA department may have conducted a risk assessment and so Apple could use this as part of their initial planning process. Apple & Co would need to consider the risk of fraud and error and non-compliance with law and regulations resulting in misstatements in the financial statements. This is also an area for IA to consider, hence there is scope for Apple & Co to review the work and testing performed by IA to assist in this risk assessment. Final audit It is possible that the IA department may assist with year-end inventory counting and controls and so Apple & Co can place some reliance on the work performed by them, however, they would still need to attend the count and perform their own reduced testing.

(a)

Benefits of audit planning Audit planning is addressed by ISA 300 Planning an Audit of Financial Statements. It states that adequate planning benefits the audit of financial statements in several ways: – – – – – –

(b)

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.

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 random number generators or tables. Systematic selection – This involves having a constant sampling interval, such as every 40th item being selected, the starting point for testing is determined randomly. Monetary Unit Sampling – This is a type of value-weighted selection in which sample size, selection and evaluation results in a conclusion in monetary amounts. Haphazard selection – Here the auditor selects the sample without following a structured technique. The auditor must ensure that 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 cannot ordinarily be used in audit sampling because most populations are structured such that items in a sequence can be expected to have similar characteristics to each other, but different characteristics from items elsewhere in the population.

(c)

Audit report modifications As per ISA 705 Modifications to the Opinion in the Independent Auditor’s Report identifies three types of modifications which result in the opinion being modified: Qualified opinion – Arises where the auditor concludes, having obtained sufficient evidence, that material BUT NOT pervasive misstatements 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 the possible effect on the financial statements is material BUT NOT pervasive. Adverse opinion – Where the auditor, having obtained sufficient appropriate audit evidence, concludes that misstatements are BOTH 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 the opinion, and the auditor concludes that the possible effects on the financial statements of undetected misstatements could be BOTH material and pervasive.

(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 of Financial Statements is responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from 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 financial statements due to fraud. The auditor will need to obtain sufficient appropriate audit evidence regarding the assessed risks of material misstatement due 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 effective in 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 a discussion is held within the team. For members not present at the meeting the engagement partner should determine which matters are to be communicated to them.

(b)

Ethical threats and managing these risks Ethical Threat

Managing Risk

Orange Financials Co (Orange) has asked the engagement partner of Currant & Co to attend meetings with potential investors. This represents an advocacy threat as the audit firm may be perceived as promoting investment in Orange and this threatens objectivity.

The engagement partner should politely decline this request from Orange, as it represents too great a threat to independence.

Due to the stock exchange listing, Orange has requested that Currant & Co produce the financial statements. This represents a self-review threat. As Orange is currently not a listed company then Currant & Co are permitted to produce the financial statements and also audit them.

Ideally, Currant & Co should not undertake the preparation of the financial statements. Due to the imminent listing, this would probably represent too high a risk.

However, Orange is seeking a listing and therefore these financial statements will be critical to the potential investors and this increases audit risk. The assistant finance director of Orange has joined Currant & Co as a partner and has been proposed as the review partner. This represents a self-review threat, as he was in a position to influence the financial statements whilst working at Orange; if he is the review partner there could be a risk of him reviewing his own work.

If Currant & Co choose to produce the financial statements then separate teams should undertake each assignment and the audit team should not be part of the accounts preparation process. This partner must not be involved in the audit of Orange for a period of at least two years. An alternative review partner should be appointed.

Ethical Threat

Managing Risk

Orange has several potential assurance assignments available and Currant & Co wish to be appointed to these. There is a potential self-interest threat as these assurance fees along with the external audit fee could represent a significant proportion of Currant & Co’s fee income.

The firm should assess whether these assignments along with the audit fee would represent more than 15% of gross practice income for two consecutive years. These assurance assignments will only arise if the company obtains its listing and hence will be a public interest company. If the recurring fees are likely to exceed 15% of annual practice income then additional consideration should be given as to whether these assignments should be sought by the firm.

Orange has implied to Currant & Co that they must complete The engagement partner should politely inform the finance the audit quickly and with minimal questions/issues if they director that the team will undertake the audit in accordance wish to obtain the assurance assignments. with all relevant ISAs and their own quality control procedures. This means that the audit will take as long as is This creates an intimidation threat on the team as they may necessary to obtain sufficient, appropriate evidence to form feel pressure to cut corners and not raise issues, and this an opinion. If any residual concerns remain or the could compromise the objectivity of the audit team. intimidation threat continues then Currant & Co may need to considering resigning from the engagement. The finance director has offered the team a free weekend As it is unlikely that a weekend at a luxury hotel for the away at a luxury hotel. This represents a self-interest threat whole team has an insignificant value, then this offer should as the acceptance of goods and services, unless insignificant be politely declined. in value, is not permitted. The finance director has offered a senior team member a loan at discounted interest rates.

This loan must not be accepted by the audit senior due to the preferential terms.

Orange does provide loans and hence the provision of a However, if the terms of the loan are amended so that the loan is within the normal course of business. However, if the interest rate charged is in line with Orange’s normal levels, loan is on preferential rates, as this is, then it would then the provision of the loan is acceptable. represent a self-interest threat. (c)

Benefits of audit committee for Orange Financials Co Appointing an audit committee will benefit Orange in the following ways: – – –

– – – –

(a)

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 audit committee 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 outside experience to the executive directors as well as challenging their decisions and contributing to an independent judgement. The finance director will benefit in that he will be able to raise concerns and discuss accounting issues with the audit committee. 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 the independence of IA. The audit committee can also provide advice on risk management to the executive directors. They can create a climate of discipline and control and reduce the opportunity for fraud, and increase the public confidence in the credibility and objectivity of the financial statements.

Financial statement assertions and inventory substantive procedures for balances at the year end. (i)

Existence Assets, liabilities and equity interests exist. Substantive procedures During the inventory count select a sample of assets recorded in the inventory records and agree to the warehouse to confirm the assets exist. Obtain a sample of pre year-end goods despatch notes and agree that these finished goods are excluded from the inventory records.

(ii)

Rights and obligations The entity holds or controls the rights to assets, and liabilities are the obligations of the entity.

Substantive procedures Confirm during the inventory count that any goods belonging to third parties are excluded from the inventory records and count. For year-end raw materials and finished goods confirm title belongs to the company by agreeing goods to a recent purchase invoice in the company name. (iii) Completeness All assets, liabilities and equity interests that should have been recorded have been recorded. Substantive procedures Obtain 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 the inventory records. (iv) Valuation and allocation Assets, liabilities and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded. Substantive procedures Select a 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 net realisable value is above cost 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 industry averages. Review the capital expenditure budgets for the next few years to assess whether there are any plans to replace any of the 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 depreciation policies. Select a sample of leisure equipment and recalculate the depreciation charge to ensure that the non-current asset register is correct. Perform a proof in total calculation for the depreciation charged on the equipment, discuss with management if significant fluctuations arise. Review the disclosure of the depreciation charges and policies in the draft financial statements.

Food poisoning – – – – – – – (c)

Review the correspondence from the customers claiming food poisoning to assess whether Pineapple has a present obligation 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.

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.

– – – –

(a)

Objective of work/test – the aim of the work being performed, could be the related financial statement assertion; this provides 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.

Analytical procedures Analytical procedures can be used at all stages of an audit; however, ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment and ISA 520 Analytical Procedures identify three particular stages. During the planning stage analytical procedures must be used as risk assessment procedures in order to help the auditor to obtain 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 can either 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 overall conclusion 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 result in a significant loss of future revenues and profit, and unless this customer can be replaced then there will be a reduction of 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 the company’s sales, as Strawberry has already lost a major customer, then without an experienced sales director to generate new 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 to have 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 supply Strawberry 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 the amounts owed already and this will further increase the pressure on cash flows. In addition, other suppliers may hear about 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 now all repayable. The company only has six months to raise $4·8m; as it currently stands they do not have this level of cash available and unless they are able to raise alternative finance or sell non-current assets, it is difficult to see how they 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 shareholders losing faith in the company and they may attempt to sell their shares; in addition, they are highly unlikely to invest further equity, 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 loan becoming repayable. (c)

Going concern procedures – – – – – – –

–

– – –

Review any correspondence with shareholders to assess whether any of these are likely to increase their equity investment in the company. Review post year-end correspondence with suppliers to identify if any others have threatened legal action or refused to supply goods. Enquire of the lawyers of Strawberry as to the existence of any additional litigation and request their assessment of the likely 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 going concern not being appropriate. Review the post year-end board minutes to identify any other issues that might indicate further financial difficulties for the 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.

(i)

Reporting in relation to going concern to the directors of Strawberry Kitchen Designs Co

– – – –

(d)

Kiwi & Co has a responsibility to report to the directors in relation to any events or conditions which may cast doubt on Strawberry’s ability to continue as a going concern. These include: – – – (ii)

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.

Audit report The directors do not wish to make any amendments to the financial statements. However, if we believe that Strawberry is not a going concern then the audit report will need to be modified. An adverse opinion will be required regardless of whether or not the financial statements include disclosure of the inappropriateness of management’s use of the going concern assumption as the financial statements are materially misstated, and the misstatements are material and pervasive to the financial statements. The basis for adverse opinion paragraph will require an explanation that the use of the going concern basis is inappropriate. The opinion paragraph will state that the financial statements do not present fairly or are not true and fair.

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International)

June 2012 Marking Scheme Marks

(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 system Customer signatures Unfulfilled sales orders Customer credit limits Sales discounts Supplier statement reconciliations Purchase ledger master file Surplus plant and equipment Authorisation of capital expenditure

(b)

15 –––

Up to 1 mark per substantive procedure, max of 2 for additions and max of 2 for disposals. Additions Cast list of additions and agree to non-current asset register Vouch cost to recent supplier invoice Agree addition to a supplier invoice in the name of Pear to confirm rights and obligations Review additions and confirm capital expenditure items rather than repairs and maintenance Review board minutes to ensure authorised by the board Physically verify them on the factory floor to confirm existence Disposals Cast list of disposals and agree removed from non-current asset register Vouch sale proceeds to supporting documentation such as sundry sales invoices Recalculate the profit/loss on disposal

(c)

Up to 1½ marks per well explained point External audit – Reasonable assurance Other review engagements – Negative assurance

(d)

3 –––

Up to 1 mark per well explained point Objective Whom they report to Reports – publicly available or not Scope of work Appointed by Independence of company

(e)

4 –––

Up to 1 mark per well explained point Interim audit Systems documentation Testing of systems such as payroll, sales, purchases Risk assessment Fraud and error, non-compliance with law and regulations Final audit Inventory count procedures

4 ––– 30 ––– –––

Marks 2

(a)

Up to 1 mark per well explained point Important areas of the audit Potential problems Effective and efficient audit Selection of engagement team members and assignment of work Direction, supervision and review Coordination of work

(b)

Up to 1 mark per well explained point, if the method is identified but not explained then maximum of ½ mark. Random selection Systematic selection Monetary unit sampling Haphazard selection Block selection

(c)

3 –––

Up to 1 mark per well explained point Qualified opinion – misstatements which are material but not pervasive Qualified opinion – cannot obtain sufficient evidence, possible misstatements which are material but not pervasive Adverse opinion Disclaimer of opinion

(a)

4 –––

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 meeting Preparation of financial statements Assistant finance director as review partner on audit Total fee income Pressure to complete audit quickly and with minimal issues Weekend away at luxury hotel Provision of loan at preferential rates

(c)

3 ––– 10 ––– –––

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 error Identify and assess the risks of material misstatement due to fraud Obtain sufficient appropriate audit evidence Respond appropriately to fraud or suspected fraud identified during the audit Maintain professional scepticism throughout the audit Discussion within the engagement team

(b)

4 –––

12 –––

Up to 1 mark per well explained point Improve the quality of the financial reporting Improve the internal control environment of the company Non-executives will bring outside experience to the executive directors The finance director will be able to raise concerns with the audit committee The audit committee will be responsible for appointing the external auditors Establishing an audit committee will improve the independence of IA Provide advice on risk management to the executive directors

4 ––– 20 ––– –––

Marks 4

(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 procedure Rights and obligations – explanation and relevant substantive procedure Completeness – explanation and relevant substantive procedure Valuation and allocation – explanation and relevant substantive procedure

(b)

8 –––

Up to 1 mark per relevant substantive procedure, max of 4 marks for each issue. Depreciation Review the reasonableness of the depreciation rates and compare to industry averages Review the capital expenditure budgets Review profits and losses on disposal for assets disposed of in year Recalculate the depreciation charge for a sample of assets Perform a proof in total calculation for the depreciation charged on the equipment Review the disclosure of depreciation in the draft financial statements Food poisoning Review the correspondence from the customers Send an enquiry to the lawyers as to the probability of the claim being successful Review board minutes Review the post year-end period to assess whether any payments have been made Discuss 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

(c)

8 –––

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 date Subject Working paper reference Preparer Date prepared Reviewer Date of review Objective of work/test Details of work performed Results of work performed Conclusion

4 ––– 20 ––– –––

Marks 5

(a)

Up to 1 mark per well explained point Planning stage – risk assessment procedures During the final audit – substantive procedures Review stage – form overall conclusion

(b)

3 –––

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 customer Loss of sales director Negative monthly cash flows Slow payment to suppliers Potential legal action Breach of covenants and loan now repayable No final dividend Low current ratio

(c)

6 –––

Up to 1 mark per well explained point Review cash flow forecasts Sensitivity analysis Discuss if sales director replaced and new customers obtained Review post year-end sales and order book Review the loan agreement and recalculate the covenant breached to confirm timing and amount of the loan repayment Review bank agreements, breach of covenants Review bank correspondence Discuss if alternative finance obtained Review shareholders’ correspondence Review suppliers’ correspondence Enquire of lawyers any further litigation by suppliers Subsequent events Board minutes Management accounts Consider going concern basis appropriate Written representation

(d)

(i)

Up to 1 mark per well explained point Events or conditions constitute a material uncertainty Use of the going concern assumption is appropriate Adequacy of disclosures in the financial statements

(ii)

6 –––

2 –––

Up to 1 mark per well explained point Not going concern therefore modified opinion Adverse opinion Basis for adverse opinion paragraph, going concern basis not appropriate Opinion paragraph, financial statements not true and fair

3 ––– 20 ––– –––

Audit and Assurance (International) Thursday 6 December 2012

Time allowed Reading and planning: Writing:

15 minutes 3 hours

ALL FIVE questions are compulsory and MUST be attempted.

The Association of Chartered Certified Accountants

Paper F8 (INT)

Fundamentals Level â&#x20AC;&#x201C; Skills Module

ALL FIVE questions are compulsory and MUST be attempted 1

Lily Window Glass Co (Lily) is a glass manufacturer, which operates from a large production facility, where it undertakes continuous production 24 hours a day, seven days a week. Also on this site are two warehouses, where the companyâ&#x20AC;&#x2122;s raw materials and finished goods are stored. Lilyâ&#x20AC;&#x2122;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 of raw materials, such as sand, used in the manufacture of glass. The following arrangements have been made for the inventory count: The warehouse manager will supervise the count as he is most familiar with the inventory. There will be ten teams of counters and each team will contain two members of staff, one from the finance and one from the manufacturing department. 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 is systematic, it is not felt that the team will need to flag areas once counted. Once the team has finished counting an aisle, 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 they will perform inventory counts. The count sheets are sequentially numbered, and the product codes and descriptions are printed on them but no quantities. If the counters identify any inventory which is not on their sheets, then they are to enter the item on a separate sheet, which is not numbered. Once all counting is complete, the sequence of the sheets is checked and any 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 be left 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 goods in 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 that this will be an immaterial balance. In addition, the raw materials quantities are to be approximated by measuring the height and width of the raw material piles. In the past this task has been undertaken by a specialist; however, the warehouse 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)

You are the audit senior of Daffodil & Co and are responsible for the audit of inventory for Lily. You will be attending the 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 and substantive testing in auditing Lily Window Glass Coâ&#x20AC;&#x2122;s inventory. Required: (b) Describe the procedures to be undertaken by the auditor DURING the inventory count of Lily Window Glass Co 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)

[P.T.O.

(a) In order for auditors to operate effectively and to provide an opinion on an entityâ&#x20AC;&#x2122;s financial statements, they are given 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 Its Environment 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 the maintenance of a control account. Required: Apart from maintenance of a control account, explain FOUR control activities a company may undertake to prevent and detect fraud and error. (4 marks) (c) Describe THREE limitations of external audits.

(3 marks) (10 marks)

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 you with 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, the audit manager has asked you to undertake some research in order to gain an understanding of Sunflower, so that you are able to assist in the planning process. He has then asked that you identify relevant audit risks from the notes below 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 their central warehouse has been extended and a smaller warehouse, which was only occasionally used, has been disposed 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 supermarkets on 31 December. Inventory is valued at selling price less an average profit margin as the finance director believes that this is a close approximation to cost. Prior to 2012, each of the supermarkets maintained their own financial records and submitted returns monthly to head office. During 2012 all accounting records have been centralised within head office. Therefore at the beginning of the year, each supermarket’s opening balances were transferred into head office’s accounting records. The increased workload at head office has led to some changes in the finance department and in November 2012 the financial controller 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 in planning 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)

[P.T.O.

(a) Identify and explain each of the FIVE fundamental principles contained within ACCAâ&#x20AC;&#x2122;s Code of Ethics and Conduct. (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 have been brought to your attention. (i)

Trade payables and accruals Roseâ&#x20AC;&#x2122;s finance director has notified you that an error occurred in the closing of the purchase ledger at the year end. Rather than it closing on 1 November, it accidentally closed one week earlier on 25 October. All purchase invoices received between 25 October and the year end have been posted to the 2013 year-end purchase ledger. (6 marks)

(ii) Receivables Roseâ&#x20AC;&#x2122;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 the receivables balance is now material. The audit senior has undertaken a receivables circularisation for the balances at the year end; however, there are a number who have not responded and a number of responses with differences. (5 marks) (iii) Reorganisation The company recently announced its plans to reorganise its health and fitness clubs. This will involve closing some clubs for refurbishment, retraining some existing staff and disposing of some surplus assets. These plans were agreed at a board meeting in October and announced to their shareholders on 29 October. Rose is 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 in relation to the above three matters. Note: The mark allocation is shown against each of the three matters above. (20 marks)

(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 the bank 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 the completeness 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 clients for 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 been corrupted by a computer virus. Daisy’s finance director was able to produce the financial statements prior to this occurring; however, the audit team has been unable to access the sales ledger to undertake detailed testing of revenue or year-end receivables. All other accounting records are unaffected and there are no backups available for 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 cash flow 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 statements on a going concern basis with no additional disclosures; the audit senior is highly sceptical about this. The prior year financial statements showed a profit before tax of $1·2m; however, the current year loss before tax is $4·4m and 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)

End of Question Paper

Answers

Fundamentals Level â&#x20AC;&#x201C; Skills Module, Paper F8 (INT) Audit and Assurance (International) 1

(a)

December 2012 Answers

Inventory count arrangements Deficiencies

Recommendations

The warehouse manager is planning to supervise the inventory count. Whilst he is familiar with the inventory, he has overall responsibility for the inventory and so is not independent. He may want to hide inefficiencies and any issues that arise so that his department is not criticised.

An alternative supervisor who is not normally involved with the inventory, such as an internal audit manager, should supervise the inventory count. The warehouse manager and his team should not be involved in the count at all.

There are ten teams of counters, each team having two members of staff. However, there is no clear division of responsibilities within the team. Therefore, both members of staff could count together rather than checking each otherâ&#x20AC;&#x2122;s count; and errors in their count may not be identified.

Each team should be informed that both members are required to count their assigned inventory separately. Therefore, one counts and the second member checks that the inventory has been counted correctly.

The internal audit teams are undertaking inventory counts rather than reviewing the controls and performing sample test counts. Their role should be focused on confirming the accuracy of the inventory counting procedures.

The internal audit counters should sample check the counting undertaken by the ten teams to provide an extra control over the completeness and accuracy of the count.

Once areas are counted, the teams are not flagging the aisles as completed. Therefore there is the risk that some areas of the warehouse could be double counted or missed out.

All aisles should be flagged as completed, once the inventory has been counted. In addition, internal audit or the count supervisor should check at the end of the count that all 20 aisles have been flagged as completed.

Inventory not listed on the sheets is to be entered onto separate sheets, which are not sequentially numbered. Therefore the supervisor will be unable to ensure the completeness of all inventory sheets.

Each team should be given a blank sheet for entering any inventory count which is not on their sheets. This blank sheet should be sequentially numbered, any unused sheets should be returned at the end of the count, and the supervisor should check the sequence of all sheets at the end of the count.

The sheets are completed in ink and are sequentially numbered, however, there is no indication that they are signed by the counting team. Therefore if any issues arise with the counting in an aisle, it will be difficult to follow up as the identity of the counting team will not be known.

All inventory sheets should be signed by the relevant team upon 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, and instead the counter is just noting on the inventory sheets the level of damage. However, it will be difficult for the finance team to decide on an appropriate level of write down if they are not able to see the damaged goods. In addition, if these goods are left in the aisles, they could be inadvertently sold to customers or moved to another aisle.

Damaged goods should be clearly flagged by the counting teams and at the end of the count appropriate machinery should be used to move all damaged windows to a central location. This will avoid the risk of selling these goods.

Lily Window Glass Co (Lily) undertakes continuous production and so there will be movements of goods during the count. Inventory records could be under/overstated if goods are missed or double counted due to movements in the warehouse.

It is not practical to stop all inventory movements as the production needs to continue. However, any raw materials required for 31 December should be estimated and put to one side. These will not be included as raw materials and instead will be work-in-progress.

A senior member of the finance team should then inspect these goods to assess the level of any write down or allowance.

The goods which are manufactured on 31 December should be stored to one side, and at the end of the count should be counted once and included within finished goods. Any goods received from suppliers should be stored in one location and counted once at the end and included as part of raw materials. Goods to be despatched to customers should be kept to a minimum for the day of the count.

Deficiencies

(b)

The warehouse manager is to assess the level of work-in-progress and raw materials. In the past, a specialist has undertaken this role. It is unlikely that the warehouse manager has the experience to assess the level of work-in-progress as this is something that the factory manager 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 with the raw materials, if he makes a mistake in assessing the quantities then inventory could be materially misstated.

With regards to the warehouse manager, he could estimate the raw materials and the specialist could check it. This would give an indication as to whether he is able to accurately assess the quantities for subsequent inventory counts.

Procedures during the inventory count – – – – – – – – – –

(c)

Recommendations

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.

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 year to 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 may require 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/or cost. 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 year end; 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 updated into 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.

– – – – – –

(a)

Auditors’ rights – – – – – –

(b)

As this is the first time that CAATs will be used on Lily’s audit, then the team may require training on the specific CAATs to be utilised. If Lily’s inventory system is likely to change in the foreseeable future, then costly revisions may be required to the designed CAATs. The inventory system may not be compatible with the audit firm’s CAATs, in which case bespoke CAATs may be required, 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.

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.

Control activities Segregation of duties – assignment of roles/responsibilities to different people, thereby reducing the risk of fraud and error occurring. Information processing – computer controls including general IT controls, which cover a range of applications and support the overall IT environment and application controls which are manual or automated controls which operate on a cycle/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 reducing the risk of theft. Performance reviews – comparison or review of the performance of the business by looking at areas such as budget v actual results. 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, such as 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 methodologies in 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 their judgement 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 human error. In addition, there is the possibility of controls override by management and of collusion and fraud. It is impossible to remove all of these inherent limitations and as the auditor relies on the internal control systems, this can reduce the usefulness of the audit. Evidence is persuasive not conclusive – the opinion is based on audit evidence gathered; however, while this evidence can indicate possible issues affecting the audit opinion, evidence involves estimates and judgements and hence does not give a definite conclusion. Audit report format – the format of the opinion is determined by International Standards on Auditing. However, the terminology used is not usually understood by non-accountants. This means that users may not actually understand the audit opinion given. Historic information – the audit report is often issued some time after the year end, and so the financial information can be quite different to the current position. In the current marketplace where companies’ financial positions can change quite quickly, the audit opinion may no longer be relevant as it is out of date.

(a)

(b)

Understanding an entity Source of information Prior year audit file

Information expect to obtain Identification of issues that arose in the prior year audit and how these were resolved. Also whether any points brought forward were noted for consideration for this year’s audit.

Prior year financial statements

Provides information in relation to the size of the entity as well as the key accounting policies and disclosure notes.

Accounting systems notes

Provides information on how each of the key accounting systems operates.

Discussions with management

Provides information in relation to any important issues which have arisen or changes to the company during the year.

Current year budgets and management accounts of Sunflower Stores Co (Sunflower)

Provides relevant financial information for the year to date. Will help the auditor to identify whether Sunflower has changed materially since last year. In addition, this will be useful for preliminary analytical review and risk identification.

Permanent audit file

Provides information in relation to matters of continuing importance for the company and the audit team, such as statutory books information or important agreements.

Sunflower’s website

Recent press releases from the company may provide background on changes to the business during the year as this could lead to additional audit risks.

Prior year report to management

Provides information on the internal control deficiencies noted in the prior year; if these have not been rectified by management then they could arise in the current year audit as well.

Financial statements of competitors

This will provide information about Sunflower’s competitors, in relation to their financial results and their accounting policies. This will be important in assessing Sunflower’s performance in the year and also when undertaking the going concern review.

Audit risks and auditor responses Audit risk

Auditor response

Sunflower has spent $1·6m on refurbishing its 25 food supermarkets. This expenditure needs to be reviewed to assess whether it is of a capital nature and should be included within non-current assets or expensed as repairs.

Review a breakdown of the costs and agree to invoices to assess the nature of the expenditure and, if capital, agree to inclusion within the asset register and, if repairs, agree to the income statement.

During the year a small warehouse has been disposed of at a profit. The asset needs to have been correctly removed from property plant and equipment to ensure the non-current asset register is not overstated, and the profit on disposal should be included within the income statement.

Review the non-current asset register to ensure that the asset has been removed. Also confirm the disposal proceeds as well as recalculating the profit on disposal.

Sunflower has borrowed $1·5m from the bank via a five year loan. This loan needs to be correctly split between current and non-current liabilities.

During the audit the team would need to confirm that the $1·5m loan finance was received. In addition, the split between current and non-current liabilities and the disclosures for this loan should be reviewed in detail to ensure compliance with relevant accounting standards.

In addition, Sunflower may have given the bank a charge over its assets as security for the loan. There is a risk that the disclosure of any security given is not complete.

The loan agreement should be reviewed to ascertain whether any security has been given, and this bank should be circularised as part of the bank confirmation process.

Sunflower will be undertaking a number of simultaneous inventory counts on 31 December including the warehouse and all 25 supermarkets. It is not practical for the auditor to attend all of these counts; hence it may not be possible to gain sufficient appropriate audit evidence over inventory counts.

The team should select a sample of sites to visit. It is likely that the warehouse contains most goods and therefore should be selected. In relation to the 25 supermarkets, the team should visit those with material inventory balances and/or those with a history of inventory count issues.

Consideration should be given as to whether the profit on disposal is significant enough to warrant separate disclosure within the income statement.

Audit risk

Auditor response

Sunflower’s inventory valuation policy is selling price less Testing should be undertaken to confirm cost and NRV of average profit margin. Inventory should be valued at the inventory and that on a line-by-line basis the goods are lower of cost and net realisable value (NRV) and if this is not valued correctly. the case, then inventory could be under or overvalued. IAS 2 Inventories allows this as an inventory valuation In addition, valuation testing should focus on comparing the method as long as it is a close approximation to cost. If this cost of inventory to the selling price less margin to confirm is not the case, then inventory could be under or overvalued. whether this method is actually a close approximation to cost. The opening balances for each supermarket have been transferred into the head office’s accounting records at the beginning of the year. There is a risk that if this transfer has not been performed completely and accurately, the opening balances may not be correct.

Discuss with management the process undertaken to transfer the data and the testing performed to confirm the transfer was complete and accurate.

There has been an increased workload for the finance department, the financial controller has left and his replacement will only start in late December.

The team should remain alert throughout the audit for additional errors within the finance department.

Computer-assisted audit techniques could be utilised by the team to sample test the transfer of data from each supermarket to head office to identify any errors.

This increases the inherent risk within Sunflower as errors In addition, discuss with the finance director whether he will may have been made within the accounting records by the be able to provide the team with assistance for any audit overworked finance team members. The new financial issues the new financial controller is unable to resolve. controller may not be sufficiently experienced to produce the financial statements and resolve any audit 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 and management 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, then the greater the need for an IA department. At Sunflower there are 25 supermarkets and a head office and therefore it would 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 envisage IA performing. He should consider whether he wishes them to undertake inventory counts at the stores, or whether he would 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 managers or 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 or stores 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 to possibly undertake fraud investigations. As Sunflower operates 25 food supermarkets, it will have a significant risk of fraud of both inventory and cash.

(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 a client receives competent professional services, and to act diligently and in accordance with applicable technical and professional standards. Confidentiality – to respect the confidentiality of information acquired as a result of professional and business relationships and, therefore, not to disclose any such information to third parties without proper authority, nor use the information for personal advantage. Professional Behaviour – to comply with relevant laws and regulations and avoid any action that discredits the profession.

(b)

Substantive procedures (i)

Trade payables and accruals – – – – – – – – –

(ii)

Calculate the trade payable days for Rose Leisure Clubs Co (Rose) and compare to prior years, investigate any significant 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.

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 – – – – – – – –

(a)

Review the board minutes where the decision to reorganise the business was taken, ascertain if this decision was made 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.

Written representations Written representations are necessary information that the auditor requires in connection with the audit of the entity’s financial statements. 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 governance that they believe they have fulfilled their responsibility for the preparation of the financial statements and for the completeness of the information provided to the auditor. Written representations are needed to support other audit evidence relevant to the financial statements or specific assertions in 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 internal controls of which management are aware. Written representations are normally in the form of a letter, written by the company’s management and addressed to the auditor. The letter is usually requested from management but can also be requested from the chief operating officer or chief financial officer. Throughout the fieldwork, the audit team will note any areas where representations may be required.

During the final review stage, the auditors will produce a draft representation letter. The directors will review this and then produce 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 are liabilities 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 the future deny having given this representation, and the auditors would have no documentary evidence to prove what the directors had said. This evidence is obtained from management rather than being auditor generated, and is therefore less reliable. Management may wish to provide biased evidence in order to reduce the amount of liabilities in the financial statements. The auditors are unbiased 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 would be 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 revenue and 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 PBT and 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 the year. Attempt to perform analytical procedures, such as proof in total or monthly comparison to last year, to gain comfort in 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 relation to 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 evidence over revenue and receivables. The opinion paragraph will be a disclaimer of opinion and will state that we are unable to 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 cash outflow. However, the financial statements have been prepared on a going concern basis, even though it is possible that the company is not a going concern. The prior year financial statements showed a profit of $1·2m and the current financial 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 following procedures 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 adequate going concern disclosures, then the audit report will need to be modified. As the going concern basis is probably incorrect and 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 fair view.

Fundamentals Level – Skills Module, Paper F8 (INT) Audit and Assurance (International)

December 2012 Marking Scheme Marks

(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 count No division of responsibilities within each counting team Internal audit teams should be checking controls and performing sample counts No flagging of aisles once counting complete Additional inventory listed on sheets which are not sequentially numbered Inventory sheets not signed by counters Damaged goods not moved to central location Movements of inventory during the count Warehouse manager not qualified to assess the level of work-in-progress Warehouse manager not experienced enough to assess the quantities of raw materials

(b)

Up to 1 mark per well described procedure Observe the counters to confirm if inventory count instructions are being followed Perform test counts inventory to sheets and sheets to inventory Confirm procedures for damaged goods are operating correctly Inspect damaged goods to confirm whether the level of damage is correctly noted Observe procedures for movements of inventory during the count Obtain a photocopy of the completed inventory sheets Identify and make a note of the last goods received notes and goods despatched notes Observe the procedures carried out by warehouse manager in assessing the level of work-in-progress Discuss with the warehouse manager how he has estimated the raw materials quantities Identify inventory held for third parties and ensure excluded from count

(c)

12 –––

(i)

Up to 1 mark per well described procedure, max of 4 procedures Calculate inventory days Produce an aged inventory analysis to identify any slow moving goods Cast the inventory listing Select a sample of items for testing to confirm net realisable value (NRV) and/or cost Recalculate cost and NRV for sample of inventory Computer-assisted audit techniques (CAATs) can be used to confirm cut-off CAATs can be used to confirm whether inventory adjustments noted during the count have been updated to inventory records.

(ii)

6 –––

4 –––

Up to 1 mark per well explained advantage Test a large volume of inventory data accurately and quickly Cost effective after setup CAATs can test program controls as well as general IT controls Test the actual inventory system and records rather than printouts from the system CAATs reduce the level of human error in testing CAATs results can be compared with traditional audit testing Free 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 high Team may require training on the specific CAATs to be utilised Changes in the inventory system may require costly revisions to the CAATs The inventory system may not be compatible with the audit firm’s CAATs If testing the live system, there is a risk the data could be corrupted or lost If using copy files rather than live data, there is the risk that these files are not genuine copies Adequate systems documentation must be available

4 ––– 30 ––– –––

Marks 2

(a)

Up to 1 mark per well stated right, max of 3 rights – – – – – –

(b)

Right Right Right Right Right Right

of to to to to to

access to books and records require information or explanations receive all written resolutions receive all notices of any general meeting attend any general meeting of the company be heard at the annual general meeting

Up to 1 mark per well explained control activity Segregation of duties Information processing Authorisation Physical controls Performance reviews Arithmetical controls Account reconciliations

(c)

4 –––

Up to 1 mark per well explained limitation Sampling Subjectivity Inherent limitations of internal control systems Evidence is persuasive not conclusive Audit report format Historic information

(a)

3 ––– 10 ––– –––

½ mark for source of documentation and ½ mark for information expect to obtain, max of 2½ marks for sources and 2½ marks for information expect – – – – – – – – –

(b)

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 –––

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 expenditure Disposal of warehouse Bank loan of $1·5m Attendance at year-end inventory counts Inventory valuation Transfer of opening balances from supermarkets to head office Increased inherent risk of errors in finance department and new financial controller

(c)

3 –––

10 –––

Up to 1 mark per well described point Costs versus benefits of establishing an internal audit (IA) department Size and complexity of Sunflower should be considered The role of any IA department should be considered Whether existing managers/employees can undertake the roles required Whether the control environment has a history of control deficiencies Whether the possibility of fraud is high

5 ––– 20 ––– –––

Marks 4

(a)

Up to 1 mark per well explained point, being ½ mark for the principle and ½ mark for the explanation. Integrity Objectivity Professional competence and due care Confidentiality Professional behaviour

(b)

5 –––

Up to 1 mark per well described procedure (i)

(ii)

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 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

(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

6 –––

5 –––

4 ––– 20 ––– –––

Marks 5

(a)

Up to 1 mark per well explained point – – – – – – – –

(b)

Written representations are necessary information the auditor needs in connection with the audit of the 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

Up to 1 mark per well described point Relevance Reliability – oral v written Reliability – client v auditor generated Reliability – better external evidence could be obtained

(c)

5 –––

3 –––

Up to 1 mark per valid point, overall maximum of 6 marks PER ISSUE Discussion of issue Calculation of materiality Procedures at completion stage Type of audit report modification required Impact on audit report

12 ––– 20 ––– –––