ANSWERS TO OBJECTIVE TEST CASE QUESTIONS
|To monitor and review the effectiveness of||the||ü|
|newly established internal audit function|
|To evaluate the balance of skills, experience and||ü|
|independence of board members|
|To take responsibility for the appointment||and||ü|
|removal of the external auditors|
|To monitor and review the effectiveness of internal||ü|
|financial controls established by the company|
The audit committee should be responsible for monitoring the effectiveness of the internal audit function and the company’s internal control system. The board should take collective responsibility to ensure they have the appropriate balance of skills, experience and independence. The audit committee makes recommendations regarding the appointment and removal of the external auditors but does not take responsibility for this.
NEDs’ remuneration should not be tied to the performance of Sistar Co as this can compromise their independence. NEDs’ remuneration should be based on the time committed to carry out the role.
To ensure effectiveness of the internal audit function they should report into the audit committee. Maria Marquez should be appointed Head Internal Auditor as she has audit experience and is independent of the company. Paul Belling helped design and implement the current control system which creates a self-review threat. Only one of the remaining internal audit staff members has audit experience therefore more staff should be appointed with audit experience.
The assignment described represents a value for money audit as it is focused on assessing the economy, efficiency and effectiveness of Sistar Co’s capital expenditure.
- C, E
Authorisation of transactions and performing reconciliations are types of control procedures. Internal audit should not design and implement internal control procedures as this will create a self-review threat when they subsequently test the effectiveness of the controls implemented. Internal audit should report any deficiencies identified and provide recommendations for improvement. Management is responsible for implementing the recommendations.
As Foliage is a listed company, Jane Leaf should not serve as the Engagement Quality Control Reviewer for a period of two years.
Bark & Co should assess whether audit and non-audit fees would represent more than 15% of gross practice income for two consecutive years. If the recurring fees are likely to exceed 15% of annual practice income this year, additional consideration should be given as to whether the taxation and non-audit assignments should be undertaken by the firm. In addition, if the fees do exceed 15% then this should be disclosed to those charged with governance at Foliage. It is highly unlikely Bark will need to resign as auditors.
There will be a familiarity between the audit manager in their new capacity at Bark and the audit team. The audit team may be too trusting of their previous colleague. A self-review threat would be created if an employee of the client joined the audit firm and was assigned to the audit of their previous employer. A self-interest threat would have arisen during the recruitment process as the judgment of the audit manager may have been affected by the desire to be appointed financial controller. As the audit manager has been recruited this threat is no longer present.
ANSWERS TO OBJECTIVE TEST CASE QUESTIONS : SECTION 3
|Clearly defined laws for the auditor to follow||ü|
|Useful in a dynamic environment||ü|
|A set of guidelines with which the auditor||uses||ü|
|judgment to apply to specific circumstances|
|Easy to know what is allowed and not allowed||ü|
The conceptual framework provides guidelines with the objective that the auditor chooses the most appropriate course of action in the circumstances. This allows flexibility to deal with all possible situations which is useful in a dynamic environment. The guidelines followed are professional guidance but are not law. Laws clearly outline what is acceptable and not acceptable in specific circumstances.
- A, E
Professional scepticism, professional judgment and being independent are important characteristics for an auditor but they are not fundamental ethical principles.
The audit will need to be planned carefully to ensure that the work is not predictable, especially as the new financial controller is an ex-employee of the firm and will know the firm’s procedures.
The composition of the audit team should be considered and anyone who has remained in close contact with the new financial controller should be removed from the team to avoid a familiarity threat.
It is unlikely that a significant familiarity threat would arise from an audit senior joining the audit client. The significance of the threat increases with the seniority of the person, e.g. an audit partner, therefore the audit firm would not need to resign.
It is the audit firm’s responsibility to manage any ethical threats and take appropriate action. They cannot stop someone from taking a job with another organisation.
A self-interest threat would be created as the audit team may not wish to upset the client in any way for fear of losing the discount.
A discount of 40% is unlikely to be a trivial sum and therefore the most appropriate option is to reject the discount. Approval would be sought from the audit partner not the audit manager. The ACCA Code of Ethics allows acceptance of goods and hospitality that are considered trivial and inconsequential.
|The partner and the finance director have||ü|
|known each other socially for many years|
|20% of the fee for last year’s audit is still||ü|
The social relationship gives rise to a familiarity threat. Outstanding fees can create self-interest and intimidation threats.
Discussion and a repayment plan is the best option to both keep the audit client and also ensure that all outstanding fees are repaid.
There is no requirement for an audit firm to consult with ACCA and request permission when a conflict of interest such as the one described arises.
The audit teams of each client would sign a confidentiality agreement but it would not be necessary to have all employees of the firm sign confidentiality agreements.
|The audit partner must be rotated||ü|
|The proposal of 20% of the audit fee being based on|
|profit is acceptable if appropriate safeguards are||ü|
|Being appointed internal as well as external auditor||ü|
|for Winnie Co will create a confidentiality threat|
Partner rotation is only a requirement for listed companies and only once the partner has been in place for seven years. Contingent fees are specifically prohibited by the ACCA Code of Ethics for audit and assurance work. Self-review is the main threat created with internal auditors and external auditors being from the same firm although it could also create self-interest and intimidation threats if fee levels from the one client become excessive.
A contingent fee arrangement such as the one described creates a self-interest threat. The auditor would have a financial interest in the client achieving a higher profit and may ignore misstatements which would reduce profit if adjusted. The proposal must be rejected as the Code of Ethics does not allow contingent fee arrangements for assurance work.
ANSWERS TO OBJECTIVE TEST CASE QUESTIONS : SECTION 3
- B, C
In the case of situations A and D, the auditor has an obligation to disclose details of their clients’ affairs to third parties.
There is no requirement the company to communicate with the shareholders on a monthly basis. The audit committee will oversee the financial reporting processes and has a role to play in ensuring the independence of the external auditor. The audit committee will be responsible for overseeing the effectiveness of internal controls within the organisation which will improve awareness of internal controls within Cameron Co.
|Mr Osbourne is the chairman and chief executive||ü|
|All of the current NEDs are independent||ü|
|Once established, the finance director will head||ü|
|the audit committee|
The chairman and chief executive roles should be performed by different people to avoid too much power being held by one person. Independent non-executive directors are more likely to ensure the company takes decisions which are in the best interests of the shareholders. The audit committee should comprise independent non-executive directors. If the finance director was in charge of the committee a self-review threat would be created as the audit committee would need to make recommendations to the board of directors regarding financial reporting matters the finance director was responsible for on a day to day basis. Any matters that reflected the finance director in a negative light may be ignored.
- 1D, 2C
To balance the board of directors, two more non-executive directors need to be appointed. It is unlikely that a company would reduce the number of directors to achieve a balance. Directors, both executive and non-executive, should be appointed based on experience and ability to do the job.
|The Chairman of the company, Mr Osbourne, should be||ü|
|responsible for setting the remuneration of each director|
|The remuneration of executive directors should be||ü|
|sufficient to attract, retain and motivate|
|An element of the executive directors remuneration should||ü|
|be performance related|
Remuneration should be set by the remuneration committee to ensure a fair transparent process. Remuneration of executive directors should be sufficient to attract, retain and motivate. Executive directors should be paid a basic salary and a performance related element to encourage them to improve the financial performance of the company and maximise shareholder wealth. This should be related to the long term performance of the company rather than short term profits which could provide incentive to manipulate results. Non-executive directors should be paid a fixed salary to improve their independence.
A risk committee is not mandatory and if one does not exist the audit committee should assume responsibility for monitoring risk management.
The fundamental principle at risk is professional competence and due care as many of the audit team are new and do not have relevant experience in relation to the specialised industry in which Fir operates. It is not appropriate to reinstate the previous partner as in line with the ACCA Code of Ethics and Conduct, the previous partner has been rotated after seven years to prevent a familiarity threat. The audit firm should offer appropriate training for the audit team to ensure they have the necessary knowledge to carry out the work.
As the previous audit manager has taken up employment with the client as the finance director, there is a familiarity threat due to the ongoing relationship between the old and new audit manager. The familiarity threat is not so severe that the firm would need to resign. It is not practical to prevent the audit manager speaking to the finance director during an audit as this will reduce the efficiency and effectiveness of the audit. A new audit manager should be appointed.
|Routine maintenance of payroll records||ü|
|Assistance with the selection of a new non-||ü|
|Tax services whereby Sycamore & Co would||ü|
|liaise with the tax authority on Fir Co’s behalf|
As per the ACCA Code of Ethics and Conduct, the following threats would be created from carrying out the non-audit services requested by Fir Co:
Payroll – Self-review as the auditor will also be involved in auditing the figures included in the financial statements in relation to wages and salaries.
Recruitment – Self-interest as the auditor would be involved in selecting an officer of the company who has significant influence over the financial statements and audit.
Tax – Advocacy as the auditor may be perceived to be representing and promoting Fir Co’s interest in liaising with the tax authority.
Using separate teams will not address the self-interest threat from the fee levels as separating the teams will not alleviate the firm’s potential financial dependence on Fir Co and therefore the risk that work is not carried out independently for fear of the losing the client.
As per ACCA Code of Ethics and Conduct 140.7.b – Confidential information may be disclosed when such disclosure is required by law.
PLANNING AND RISK ASSESSMENT
Oil and gas companies are heavily regulated therefore the effect of non-compliance is likely to be a significant audit risk. Provisions and contingent liabilities may arise if there are issues such as oil spills or injury to employees in the workplace given the hazardous nature of the industry. Gas and oil reserves will need to be estimated to be included in the statement of financial position. These will be inherently difficult to estimate. Trade payables may be a risk for certain clients but in relation to the other risks stated, is unlikely to be a significant risk.
- B, E
Detection risk is greater due to the lack of knowledge and experience of the client. In order to address this, the auditor must spend time obtaining an understanding of the client. The auditor can request copies of working papers from the previous auditor to help with this.
A is 16% of profit and 1.2% of revenue and is therefore too high based on the standard benchmark calculations. As Veryan Co is a new audit client it is likely that materiality will be set at the lower end of the materiality scale to reflect the increased detection risk.
|Cut-off of revenue is an audit risk||ü|
|Completeness of revenue is an audit risk||ü|
|Occurrence of revenue is an audit risk||ü|
Revenue has increased by 24% compared with 12% in previous years. Revenue may be overstated due to cut-off errors where sales relating to next year have been included in this year. Revenue may be overstated if sales have not occurred and are fictitious. Completeness would be a risk if revenue was lower than expected, however, as the profit margin has increased from 6% to 7% revenue appears to be overstated rather than understated.
- 1E, 2G, 3F
To assess the recoverability of receivables, reviewing correspondence with customers may highlight any disputes which indicate that payment will not be made. Direct confirmation of a customer balance confirms existence of the debt but does not provide evidence that it will be paid.
Impairment of non-current assets would necessitate an increased depreciation charge. Reviewing the depreciation charge for adequacy would enable the auditor to assess whether an impairment charge has been made. Inspection of the exploration sites is not a practical or effective audit procedure.
Amortisation of intangible assets can be checked by calculating the expected amortisation charge and comparing it with management’s figure. Inspecting the licence agreement will only confirm the terms of the licence but will not state the amortisation charge that should be made each year.
|Receivables days||34.9||(121/1267) × 365|
|Payables days||31.5||(87.5/1013) × 365|
|Inventory days||21.6||(60/1013) × 365|
|Quick ratio||2.8||(121 + 123)/87.5|
The risk of revenue cut-off errors increases with employees aiming to maximise their current year bonus. The increased risk of a reduction in profits as a result of irrecoverable debts is a business risk. Revenue is more likely to be overstated in order to achieve a higher bonus. The bonus would have no impact on the customer response level to direct confirmation requests.
Cut-off testing would not provide relevant evidence to the potential valuation issue caused by the increased risk of irrecoverable debts.
- C, D
Option A refers to the use of analytical procedures at the final review or completion stage of the audit. Option B refers to the use of analytical procedures to obtain substantive evidence during the fieldwork stage of the audit.
A new audit client increases detection risk. Competence should have been considered before accepting. It is not professional to resign immediately after accepting an engagement. The audit firm should have contacted the outgoing auditor before accepting to enquire about any professional matters which would affect the acceptance decision. Increased audit risk arising from increased detection risk will result in increased quality control procedures such as the need for an engagement quality control review.
By not testing the sample sizes documented in the audit plan the audit plan has not been followed. Sample sizes will have been chosen based on the judgment of the auditor responsible for planning taking into consideration the requirement to obtain sufficient appropriate evidence. It is not acceptable to defer conclusions to the audit manager. If the sample sizes are considered acceptable at the lower quantities, the audit plan should be updated to reflect this. However, sample sizes should not be reduced simply to save time. If sufficient appropriate evidence is not obtained, material misstatements may go undetected and an inappropriate audit opinion could be issued.
|Enquiry does not provide sufficient appropriate evidence on||ü|
|The auditor has demonstrated a lack of professional||ü|
|A written representation should have been obtained from|
|management confirming that they have disclosed all||ü|
|subsequent events to the auditor|
|The auditor only needs to perform procedures if they are||ü|
|made aware of any subsequent events|
Up to the date of the auditor’s report the auditor must perform procedures to identify subsequent events and ensure they have been appropriately reflected in the financial statements. It is only after the auditor’s report has been signed that they only need to take action if they become aware of any subsequent events. Enquiry alone is not sufficient. Choosing to rely only on enquiry of management demonstrates a lack of professional scepticism.
The firm would not report their staff to the ACCA. The matter will be dealt with internally through communication and training. Disciplinary measures may be taken by the firm if they consider it necessary to do so.
Post-issuance reviews are performed after the file has been archived and as such no further amendments should be made. A review of significant judgments affecting the audit is performed in a pre-issuance review. A pre-issuance review is also known as a ‘hot’ review. A post-issuance review is known as a cold review. A post-issuance review is part of the firm’s monitoring procedures. If issues are identified it may result in the firm’s policies and procedures being revised.
|The audit partner will review all working papers on the audit||ü|
|file before issuing an opinion|
|If working papers have been reviewed there is no quality||ü|
|control issue arising from the lack of documentation|
|All working papers should be signed by the person who||ü|
|All team members’ work should be reviewed by someone||ü|
|more senior than the preparer|
|(5.5/12.5 × 100)||(7/15 × 100)|
|(0.5/12.5 × 100)||(1.9/15 × 100)|
Gross margin = gross profit/revenue × 100
Operating margin = operating profit (PBIT)/revenue × 100
|(3.1/12.5 × 365)||(2/15 × 365)|
|(1.6/7 × 365)||(1.2/8 × 365)|
Receivables days = receivables/revenue × 365
Payables days = payables/cost of sales × 365
A, B and F are audit risks as they clearly describe how the financial statements may be materially misstated. C, D and E are business risks as they describe issues the directors would be concerned about but which would not necessarily result in the financial statements being materially misstated.
- B, C
Options B and C will allow the auditor to make an assessment of the appropriateness of the change. Option D is of no audit value as it is known the policy has changed in the year. In relation to option A, the auditor will still need to assess the appropriateness of the change in useful life and discuss the matter with management if it is not deemed appropriate. Whilst the change may not have a material impact this year, it may become material in subsequent years therefore the issue should be addressed as soon as it is identified.
|Risk of material misstatement|
|The risk that the financial statements are||ü|
|materially misstated prior to audit. This consists of|
|two components – Inherent risk and Control risk|
|The amount set by the auditor at less than|
|materiality for the financial statements as a whole||ü|
|to reduce to an appropriately low level the|
|probability that the aggregate of uncorrected and|
|undetected misstatements exceeds materiality for|
|the financial statements as a whole|
Risk assessment refers to the company’s own processes for determining the business risks to be managed.
|1||The goods received should be agreed to the authorised|
|purchase order before signing the delivery note to|
|ü||ensure that Coastal Co does not accept goods not|
|ordered. The supplier’s delivery note will record what|
|has been sent which may not be the same as the|
|2||Matching the purchase invoice to the GRN ensures the|
|ü||goods being paid for have been received. Matching the|
|GRN to the order ensures the goods received were|
|ordered. Keeping the documents filed together provides|
|a complete audit trail to support the transaction.|
|3||Monthly reviews of standing data by the department|
|ü||manager ensures that the correct details are held on a|
|regular basis. Any employees who have left the company|
|would be identified and could be removed from the|
|payroll records before an invalid payment is made.|
|4||Pre-printed payroll sheets ensure that only genuine|
|ü||employees are paid. If any names are added to the|
|sheets this will highlight a potential fraud or error which|
|can be investigated before payment is made.|
By reviewing the payment list the finance director will be able to identify any unusual names or duplicate names. This control will ensure only valid employees are paid. The bank transfer list will only show details of names and net pay therefore will not identify incorrect classification of costs, incorrect hours, or incorrect calculations unless a significant error was made.
|Narrative notes||Internal control|
|Can be prepared in advance||ü|
|Easy to understand||ü||ü|
|May overstate the controls||ü|
|Some controls may be missed||ü||ü|
Narrative notes are simple to record and easy to understand. However, controls may be difficult to pick out from the detail.
Internal control questionnaires are prepared in advance which can ensure that all typical controls are covered. However, the ICQ may not identify unusual controls. Clients may overstate the controls by stating that they have the controls listed when in fact they don’t. As the questionnaire is standardised it is easy to understand.
|Test of control||Substantive|
|Recalculate the total of the bank transfer list||ü|
|Inspect the bank transfer list for evidence of||ü|
|the finance director’s signature|
|For a sample of employees, agree the salary|
|details in the standing data files to the||ü|
|calculation of the employee’s monthly salary|
|as per the payslip|
|Review the procedures to ensure payroll files||ü|
|and documents are kept secure and|
- 1C, 2A, 3D, 4B
- Availability of inventory is not checked at the time of ordering
- Telephone orders are not recorded immediately
- Order forms are not sequentially numbered
- The online ordering system allows customers to exceed their credit limit
- Risk of orders not being fulfilled on a timely basis
- Risk of incorrect orders being despatched
- Orders may go missing leading to unfulfilled orders
B Risk of irrecoverable debts
- A, D
The system should not allow credit limits to be exceeded by any amount. Changes to credit limits should only be performed by a responsible senior official.
- D, E
Requisitions and discounts received are elements of a purchases system. A control objective should also refer to the risk the control is designed to mitigate, rather than the control itself.
Orders should be sequentially pre-numbered and a regular sequence check performed to ensure the sequence is complete. Pre-numbered orders may not be sequential therefore does not provide any improvement in control. Instructing customers not to place orders by telephone may result in sales being lost. A better system would be to enter the orders into the system immediately whilst the customer is placing the order.
|Internal control questionnaire|
|An efficient method of systems documentation||ü|
|Does not consider all likely controls in a system||ü|
|Usually very easy to identify missing controls||ü|
|Facilitates understanding by junior team members||ü|
Internal control questionnaires are prepared in advance which makes them an efficient method of documentation and can ensure that all likely controls are considered.
Narrative notes are simple to record and easy to understand. However, due to the level of detail, missing controls may be difficult to identify.
Tracing a transaction through the system to ensure it is recorded in the sales day book is a substantive procedure testing the assertion of completeness.
|Daily backups of the system||ü|
|Authorisation of purchase orders||ü|
|Minimum order quantities||ü|
|Automatic updating of inventory once||ü|
|goods are sold|
Backups relates to the whole computer system therefore are a general control. Authorisation, minimum order quantities and automatic updating of inventory relate to individual aspects of the purchasing and inventory systems therefore are application controls.
Reviewing inventory levels immediately before and after a sales order has been processed enables the auditor to ensure the inventory level is updated automatically. Counting a sample of items to agree the quantities in the system does not prove the system updates automatically. The quantities may agree because that type of inventory may not have been sold recently and the quantities reflect the results of the last inventory count. Reviewing the inventory quantities in the system does not confirm the quantities held in the warehouse or that the system updates automatically. The auditor would not contact a customer to make an enquiry such as the one described.
|The inventory system is automatically updated to reflect that||ü|
|inventory has been allocated to a sales order|
|The system will flag if there is insufficient inventory to fulfil the||ü|
|When inventory falls to a minimum level a purchase order is||ü|
|automatically created and sent to the purchasing manager for|
|The purchase order is automatically sent electronically to the||ü|
|approved supplier for that item|
As all of the controls stated are computerised controls, a dummy order can be used to test them.
- A, C
To rely on the internal auditor’s work, the external auditor should review the internal auditor’s working papers and re-perform a sample of the tests again. An expert would not need to be used in this situation as the auditor can easily see if the internal auditor has performed the work properly by re-performing a sample of tests.
The cut-off assertion relates to transactions being recorded in the correct accounting period. In this case, payroll costs reflect payroll transactions for the period to 31 October 20X6. Options A, B and C relate to the assertions of classification, accuracy and completeness.
The most reliable evidence will be the work performed by the audit team member as auditor generated evidence is the most reliable. Verbal confirmation is the least reliable form of evidence as it can be disputed or retracted. Written confirmation is the next least reliable form of evidence as it is client generated.
Prior year expense: $17,000,000
Employee numbers reduce from 500 to 450, a decrease of 10%. Effect of redundancies: $17,000,000 × 90% = $15,300,000.
Effect of pay rise: ($15,300,000 × 2/12) + ($15,300,000 × 106/100 × 10/12) = $16,065,000
Effect of bonus: $16,065,000 + (450 × $1,500) = $16,740,000. Alternatively, the calculation can be done as follows:
|Prior year salaries adjusted for redundancies||= $17m × 0.9||= $15.3m|
|Adjust for wage rise for remaining staff||= $15.3m × 6% × 10/12||= $0.765m|
|Include bonus||= 1,500 × $450||= $0.675m|
- C, D
Analytical procedures evaluate trends and relationships between data. The auditor should investigate any unusual relationships which don’t fit in with their expectation as it may indicate misstatement. A comparison to the prior year with an investigation of differences and a proof in total calculations are both examples of substantive analytical procedures. Recalculation is a simple arithmetical check. Agreeing the wages expense per the payroll system to the draft financial statements involves inspection.
|Review the treatment of a sample of post||ü|
|Select a sample of goods despatched notes||ü|
|and agree to invoices in the sales day book|
|Select a sample of invoices from the sales||ü|
|day book and agree to goods despatched|
|Select a sample of invoices and recalculate||ü|
|the invoiced amount agreeing to price list|
The occurrence assertion means transactions have occurred and pertain to the entity, i.e. the sale is a genuine transaction of the business. Post year-end returns would mean the transaction had not really occurred and should be removed from sales. Agreeing a sample of invoices to GDNs allows the auditor to confirm the sale is genuine. Selecting items from outside of the accounting records and tracing them into the records is a test for completeness. Recalculating invoices and confirming prices enables the auditor to test accuracy.
Where completeness is the key assertion, the sample should be selected to verify where the balance may be understated and therefore should include suppliers with material balances, suppliers with a high volume of business with Poppy Co and major suppliers with no outstanding balance at the year-end.
In order to determine if the balance with Lily Co is understated, the auditor should determine if the goods should be included in payables at the year-end by inspecting the goods received note.
To confirm the balance with Carnation Co, the auditor must determine if the liability exists for the disputed items at the year-end by reviewing pre year-end goods returned notes and post year-end credit notes to verify that the goods have been returned and the order cancelled by the supplier.
Although the control error is immaterial, the auditor must reach a conclusion on the population based on the sample selected. In order to do so the effect of the error must be considered in relation to the whole population. It is not appropriate to project a one-off error across the population as by its nature it is not representative of the population.
|Selecting a sample of supplier balances for testing using||ü|
|monetary unit sampling|
|Recalculating the ageing of trade payables to identify||ü|
|balances which may be in dispute|
|Calculation of trade payables days to use in analytical||ü|
|Inputting dummy purchase invoices into the client||ü|
|system to see if processed correctly|
Test data involves inputting fake transactions into the client’s system to test how the transactions are processed. The other options are examples of audit software.
A direct confirmation will confirm the amount outstanding but not the intention of the customer to pay this amount. The industry journal articles are unlikely to provide specific detail regarding a company’s ability to pay specific debts. Reviewing post year-end receipts will confirm actual recoverability of the outstanding balance therefore provides the most reliable evidence.
- B, C
Options A and D relate to valuation.
- A, B
A decrease in selling price may result in the cost of inventory being higher than net realisable value (NRV). Increased inventory levels for a company experiencing a reduction in sales may result in inventory not being sold and therefore NRV may be lower than cost. Inventory turnover would need to decrease to indicate valuation issues. There is nothing to indicate that the nature of the inventory would result in valuation issues. Eagle does not have the right to include third party inventory in their financial statements. Inclusion would overstate inventory but would not represent overvaluation.
|Test of control||Substantive|
|Observe the client’s staff to ensure they are||ü|
|following the inventory count instructions|
|Inspect the inventory for evidence of damage or||ü|
|Re-perform the reconciliation from the inventory||ü|
|count date to the year-end date for inventory to|
|assess the accuracy of the inventory quantities.|
Observing the count to ensure the count instructions are followed will provide the auditor with evidence that the controls over the inventory count are operating effectively. The other two tests are substantive in nature providing evidence over the accuracy, valuation and allocation assertion.
The auditor needs to establish whether the claim is probable to succeed before they can ask the client to recognise a provision. If the claim is not probable to succeed it should not be recognised. If it is possible to succeed it should be disclosed as a contingent liability. This evidence should be obtained from the legal adviser as they are an independent expert. The auditor would review board minutes to ascertain the view of the board as a whole in respect of the claim. It would not be appropriate for the auditor to contact the customer making the claim against the client.
There is no suggestion of any issue that would cause the auditor to consider resigning. The audit team should be fully briefed and advised to be vigilant. The finance director should also be advised that their assistance is likely to be requested by the audit team in the absence of a financial controller.
Lack of supplier reconciliations can mean misstatements within payables and accruals go undetected. As controls are not effective in this area, increased substantive testing will need to be performed. The auditor should not perform the reconciliations as this is the responsibility of Hawk. There is no need to send requests for confirmations if the client has received a supplier statement. The issue relates to the client not reconciling the statement to their own ledgers.
|Review correspondence between the financial controller and the||ü|
|Review board meeting minutes||ü|
|Review correspondence between the company and its lawyer||ü|
|Discuss the claim with the financial controller|
It would not be appropriate or professional for the auditor to discuss the claim with the financial controller, especially when legal proceedings are ongoing.
As the analytical procedures are being performed at the planning stage using the latest management accounts of Hawk, the financial statement figures are not being tested. Analytical procedures at the planning stage are performed to help identify areas of potential risk and to obtain an understanding of the client. When the draft financial statement figures are available, substantive analytical procedures can be used to help detect material misstatements.
- 1G, 2A, 3F
- Payables payment period has decreased from 75 to 40 days
- Gross profit margin has decreased from 26% to 17%
- Receivables collection period has increased from 29 to 38 days
G Payables may understated
- Website sales may not be completely recorded
F Receivables may be overstated
Option B, suppliers may be withdrawing credit terms is a business risk and not an audit risk. Option C, closing inventory may be overvalued would cause the gross profit margin to increase not decrease.
Option D, extended credit terms may have been given to customers is not an audit risk. Option E, revenue may have been recognised too early would cause the gross profit margin to increase not decrease.
86 1C, 2C, 3D, 4A
- Risk of material misstatement including the risk of fraud
- Use of professional sceptisicm
- Selection of the audit team
- Use of computer-assisted audit techniques
Audit strategy section
- Significant factors, preliminary engagement activities, and knowledge gained on other engagements
- Significant factors, preliminary engagement activities, and knowledge gained on other engagements
- Nature, timing and extent of resources
A Characteristics of the engagement
The fraud involves an employee stealing money from the company therefore is an example of misappropriation of assets. Detection risk will need to decrease as control risk is higher. For the employee to be able to commit this type of fraud, internal controls must not be working effectively therefore control risk is higher. The auditor can only assess control risk, they cannot influence it. Detection risk is the only component of audit risk the auditor can change. The risk of fraud must always be discussed with the audit team in accordance with ISA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements.
Exception reports and review of employee lists by department managers would detect if fictitious employees had been set up on the payroll system. However, this would be after the fraud had occurred. Comparison of the monthly payroll cost with the prior month may detect fraud if the fraud is of sufficient scale to cause a significant variance but will not prevent fraud. If employees working within the same department are related there is an increased risk of collusion which would circumvent any segregation of duties control. Therefore to prevent frauds occurring in the payroll department the people working together should not be related.
Reporting the matter to the police is a management function and therefore not an audit procedure to detect further frauds.
As the employee had created fictitious employees to be paid in the payroll system, the details on the payroll records will match the payments in the bank statements therefore further fraud would not be detected.
A discussion with management would be useful to identify any other suspected frauds. Searching for duplicate bank account numbers would identify possible other frauds that are occurring. Reconciling the number of employees to the number of people being paid will identify fictitious employees on the payroll system.
Procedures 3 and 4 are tests of control not substantive procedures.
The client performs the inventory count. The external auditor will perform a sample of test counts to ensure the count is accurate. The primary objective of the count is to ascertain accurate quantities. Some companies will produce items 24 hours a day. Provided the count is properly organised to ensure goods are not moved in and out of the counting area during the count the company does not need to cease production. ISA 501 Audit Evidence – Specific Considerations for Selected Items requires the auditor to attend the inventory count if inventory is a material balance.
If the timetable is not monitored, some areas could be missed and all inventory may not be counted at least once a year.
|Staple & Co must attend at least one count to||ü|
|ensure adequate controls are applied|
|Cut-off testing will only need to be performed if a||ü|
|full count is carried out at the year-end|
|All lines of inventory must be counted at least||ü|
|twice during the year|
|Staple & Co should visit the client’s premises at|
|least once a year to demand an instant inventory||ü|
Process 1 is a deficiency as counters may just agree with the quantity on the sheet and not actually count the goods. Process 2 ensures discrepancies are highlighted for further investigation. Process 3 will lead to understatement of inventory. Old or damaged items should be included until they are sold or scrapped. Process 4 could result in cut-off errors as it will be difficult to identify goods already counted or not counted if movements are happening during the counting process. Process 5 ensures inventory belonging to third parties is not recorded in Gloss Co’s inventory records.
Agreeing the items listed on the count sheets to the physical inventory confirms existence.
When deciding whether to use sampling the population must be complete, accurate and appropriate for the purpose of the test. If the size of the population is small, sampling may not provide the most efficient method of obtaining evidence. Therefore the size of the population would need to be considered. The time the auditor has available and the ease of obtaining evidence should not influence their audit procedures.
Sampling involves selecting items for testing where all items have a chance of selection. Procedure 1 describes monetary unit selection (MUS) which is a sampling method given in ISA 530 Audit Sampling. Procedures 2 and 3 require items with specific characteristics to be tested therefore all items will not have a chance of selection and as a result do not constitute sampling methods.
Systematic sampling is where a sample is chosen with a constant interval. The starting point is chosen randomly.
- B, C
Occurrence is not a relevant assertion to the audit of payables. Occurrence is relevant to purchases. (Tutorial note: To test occurrence of purchases, the GRN should be inspected and the invoice should be inspected for the name of the client in order to ensure the goods pertain to the Hemsworth Co.) Procedure 1 will test the accuracy of the recorded amount. If supplier statement reconciliations have not been performed the auditor should request the client to perform them. The supplier would only need to be contacted if a supplier statement has not been received. If invoices are recorded incorrectly this could result in understatement or overstatement. Procedures 2 and 3 both address the completeness assertion as they may identify invoices not included within payables or accruals at the year-end. Procedure 2 uses client generated evidence of the cash book, GRN and payables ledger. Procedures 1 and 3 use third party generated evidence of purchase invoices and supplier statements.
The amount of testing should be increased before any further action is taken. The issue should then be discussed with the audit manager before discussing with the client. The audit opinion will only be modified if the errors are material and if they are not corrected by the client. This is the final action to be taken rather than the initial course of action.
|The actual computer files and programs are not|
|tested therefore the auditor has no direct evidence||ü|
|that the programs are working as expected|
|Where errors are found in reconciling inputs to|
|outputs, it may be difficult or even impossible to||ü|
|determine why those errors occurred|
As the system within the computer is not audited the audit trail can be difficult to follow. This will mean direct evidence that the programs are working as expected cannot be obtained and it will be difficult to determine why the errors occurred.
As there are 600 customers within the receivables listing, this makes the use of audit software much more beneficial to an auditor.
All are procedures that could be performed using audit software.
Audit software may slow Delphic Co’s systems down. Test data would need to be used to test the programmed controls. Audit software enables calculations and data sorting to be performed more quickly resulting in greater efficiency. Audit staff may need to be trained to use the software. Once the audit software has been designed there are no further costs (unless the client changes its systems). Therefore the audit will only be more costly in the year of set up.
If the partner advises Delphic Co which accounting system to choose a self-review threat will be created. The external audit team does not need to be present during the implementation and testing. This may be impractical in terms of time and resource required. To save unnecessary time and expense, the audit firm should delay the use of audit software to ensure it is designed to effectively work with the new system.
- B, E
The financial statements may still be manipulated to show a break even position or to meet a specific target or objective imposed on the organisation. The auditor’s report will be publicly available as taxpayers have a right to see the financial statements and associated auditor’s report. The time required for the audit will depend on many factors such as complexity of the organisation and its transactions, the volume of transactions, etc, as is the case with company audits. An audit team should always be competent therefore the team should include people with public sector experience.
An auditor’s report for a local government authority may need to refer to going concern uncertainties in the same way as for a company.
|Compare income by shop and category to the prior year||ü|
|Inspect credit notes issued post year-end|
|Agree totals on till receipts to the sales day book, bank statements||ü|
|and cash book|
|Obtain the sales day book and cast to confirm accuracy||ü|
Inspection of credit notes issued post year-end would identify possible overstatement of income rather than understatement.
All risks given are relevant to Stargazers.
|Management will have no financial qualifications|
|therefore there is a greater risk of material||ü|
|Internal control systems will not be as sophisticated||ü|
|as those for profit making companies|
|There are fewer auditing standards applicable to||ü|
|audits of charities|
|Charities such as Stargazers will have different|
|objectives to a profit making company therefore the||ü|
|auditors’ assessment of materiality will consider|
Some charities, particularly larger charities may have good internal control systems and predominantly qualified, paid staff responsible for the financial statements. Smaller charities may not have sufficient income to pay staff and may rely heavily on volunteers. Therefore options (1) and (2) MAY be true. Although ISAs are developed for audits of companies, they should still be followed in an audit of a charity or other NFP.
REVIEW AND REPORTING
If the loan is not renegotiated the company may experience cash flow difficulties. The loss of a major supplier could have a serious impact on Oak Co if no alternative can be found. Poor results in a product line expected to account for 30% of revenue could also have a significant impact on the company going forward.
|The company has||ü||The gross profit margin would improve|
|increased the sales||if sales prices charged to customers had|
|prices||charged to||increased while costs were maintained.|
|customers||while||Gross margin has decreased which|
|maintaining||costs||implies that the company is not making|
|at||a||level||as much return as in the prior year. This|
|comparable||to||would most likely be due to an increase|
|20X5||in cost of sales or reduction in sales|
|price. Therefore the comment regarding|
|an increase in sales price contradicts|
|the results of the analytical review.|
|The company has||The deterioration in the quick ratio|
|become||more||from 0.8 in 20X5 to 0.2 in 20X6 is|
|reliant||on||its||ü||consistent with increased reliance on an|
|during the year|
|Due||to||cash||The increase in payables days is|
|restrictions,||the||consistent with delays in paying|
|At the year-end||A low level of slow-moving inventory|
|inventory count, a||would result in a decrease in inventory|
|lower||level||of||days, however, inventory days have|
|slow-moving||ü||increased||significantly implying that|
|inventory||was||items are taking longer to sell. Given the|
|noted compared to||comment||regarding the observation|
|prior year||made at the inventory count, this would|
|warrant further investigation.|
The review of post year-end sales orders provides the best evidence that the new customer is genuine and is ordering goods. This will allow the auditor to assess the level of sales being made to the new customer and to determine whether this does mitigate the loss of Beech Co. Email correspondence will give an indication of the nature of the relationship between the company and customer but this is not as persuasive as actual sales orders being received.
Management should perform a going concern assessment up to the date of the financial statements, in this case, 31 May 20X7. If management assesses a period of less than twelve months from the date of the financial statements, the auditor must request them to extend the assessment to this date.
The client has made adequate disclosure uncertainty related to going concern therefore the opinion will be unmodified. As per ISA 570 Going Concern, where there is a matter of fundamental importance to the users’ understanding regarding an uncertainty related to going concern the auditor should include a Material Uncertainty Related to Going Concern paragraph. The inclusion of this paragraph does not modify the opinion.
As per ISA 560 Subsequent Events, the auditor has an active responsibility to carry out subsequent events procedures between the date of the financial statements and the date of the auditor’s report.
The auditor should not contact the finance director who is no longer an officer of the company, and the party involved in the claim, to confirm the level of damages payable. All other procedures would be appropriate.
|Unmodified||No additional communication|
|Qualified||Emphasis of matter paragraph|
|Adverse||Material uncertainty related to going concern|
|Disclaimer||Other matter paragraph|
The maximum damages of $150,000 is not material to the financial statements at 2.3% of profit before tax and 0.2% of revenue. Therefore no modification to the audit opinion or report is required.
- A, E
As per paragraph 9 of ISA 701 Communicating Key Audit Matters in the Independent Auditor’s Report, in determining key audit matters, the auditor shall determine from the matters communicated to those charged with governance, those which required significant auditor attention. Paragraph 2 gives the purpose of including key audit matters as providing additional information on significant audit matters to assist the users’ understanding of those matters.
- A, D
As per ISA 560 paragraph 15, in the circumstances described the auditor should initially discuss the matter with management and understand how management intends to address the matter in the financial statements.
The auditor must read the other information to ensure it is consistent with the financial statements and their knowledge of the entity obtained during the audit. They do not audit the other information. No assurance conclusion is expressed on the other information. Other information needs to be considered by the auditor if it is made available before the auditor’s report is signed. The client may not have this information prepared at the start of the audit but may provide it to the auditor during the audit.
Notes to the financial statements form part of the financial statements and are subject to audit.
The auditor’s report will include a section headed ‘Other Information’ which describes the auditor’s responsibilities in respect of the other information, such as the Chairman’s statement. The inconsistency between the Chairman’s statement and the financial statements should be described in this section. The auditor’s opinion does not cover the Chairman’s statement therefore will not need to be modified.
|Users may be misled if the other|
|information contains incorrect information|
|or information which contradicts the||ü|
|financial statements such as that in the|
|Users may believe the auditor has not|
|audited the financial statements properly if||ü|
|the inconsistency is not highlighted|
|The auditor must expose management’s||ü|
|The inconsistency may undermine the|
|credibility of your auditor’s report if not||ü|
Inconsistencies between the other information and the financial statements may undermine the credibility of the auditor’s report as it may be perceived that the auditor has not identified the inconsistencies and therefore the audit was not performed properly. If the inconsistencies are not brought to the attention of the user they may be misled by the incorrect or inconsistent information.
An Other Matter paragraph can be used to refer to matters concerning the auditor’s responsibility. Any restriction of liability should be included in that paragraph.
Materiality is calculated using the following benchmarks: ½ – 1% of revenue, 5 – 10% of profit before tax and 1 – 2% of total assets. The receivable is 3.3% revenue, 6.1% of profit before tax and 1.1% of assets. The irrecoverable debt is material by size. An irrecoverable debt is unlikely to be material by nature unless the effect of the adjustment was so significant it would change a profit to a loss.
From the scenario the customer has agreed the balance is outstanding but is struggling to make any payments. Confirming an already confirmed balance will not provide evidence over the level of adjustment required. Inspecting the sales invoice and GDN does not provide evidence of when the balance will be received.
The issue is only 6.1% of profit and 1.1% of assets and only affects receivables therefore is material but not pervasive. A qualified opinion is appropriate.
|Other Matter paragraph||ü|
|Emphasis of Matter paragraph||ü|
An Emphasis of Matter paragraph is only required if there is a matter disclosed adequately in the financial statements which the auditor considers to be fundamentally important and wishes to bring to the attention of the user. An Other Matter paragraph is only required if there is a matter not related to the financial statements that the auditor wishes to bring to the attention of the user such as further explanation of the auditor’s responsibilities.
- C, D
Option A would require the other information section of the report to provide a description of the inconsistency. Option B would require the inclusion of an Emphasis of Matter paragraph. Option E would be included in an Other Matter paragraph. These would not affect the audit opinion.
The directors will assess whether the company can continue to trade for the foreseeable future. They will prepare forecasts to help with this assessment. The auditor will evaluate the directors’ assessment to ensure that it is reasonable. The directors must make disclosure of going concern uncertainties in the financial statements. The auditor will highlight that disclosure in their auditor’s report. The auditor does not make disclosure in the financial statements. The directors must consider a period of twelve months from the reporting date.
Calculation of key ratios may identify indicators of going concern issues which need to be investigated further through audit procedures. However, the ratios do not provide evidence that the company is or is not a going concern. Ratios are calculated using historical information and the client may have already taken action to improve their financial position since that information was created. Reviewing the level of profit made in the past does not provide reliable evidence that the company will be able to trade in the future as the financial circumstances of the company may be different.
|opinion with||opinion||opinion with||opinion with|
|no additional||going concern||emphasis of|
|of going concern||ü|
|of going concern||ü|
|uncertainties is not|
The opinion will not be modified if the disclosures are adequate. The report will need to include a section referring to the Material Uncertainty Related to Going Concern. If the company does not make adequate disclosure the financial statements will be materially misstated which will require a modified opinion.
The financial statements should be prepared on the break up basis if the company has ceased trading, intends to cease trading or has no realistic alternative but to cease trading. If a company cannot pay its debts when they fall due the company will have no alternative but to cease trading. If there are material uncertainties relating to going concern the financial statements will still be prepared on a going concern basis but disclosure of the uncertainties should be included in the notes.
If the basis of preparation is incorrect the financial statements will be materially misstated to such an extent they do not give a true and fair view. This is material and pervasive which would require an adverse opinion. The basis for opinion will change to a basis for adverse opinion and will include an explanation as to why the adverse opinion has been given.
Failure to recognise the warranty provision is likely to require an adverse opinion as the misstatement represents a substantial proportion of Paddington’s profit. An adverse opinion is issued when the financial statements are pervasively misstated. This will mean they are unreliable as a whole.
|Lawsuit||10.3% of profit||Material|
|Provision||86% of profit||Material and pervasive|
|Depreciation||3.4% of profit||Not material|
|Intangible assets||41% of profit||Material|
As the claim is only possible to succeed a contingent liability disclosure is required. A provision would only be required if the claim was probable to succeed. At 10.3% of PBT, the claim is material being greater than 5% of PBT.
The matter is correctly treated in the financial statements therefore the opinion should be unmodified. Paddington has sufficient cash to make the settlement therefore there is no uncertainty facing the company and hence an emphasis of matter paragraph is not necessary.
- 1D, 2B, 3A, 4E, 5C
|1||Title||Clearly identifies the report as an Independent|
|Auditor’s Report (D)|
|2||Addressee||Identifies the intended user of the report (B)|
|3||Basis for opinion||Provides a description of the professional standards|
|applied during the audit to provide confidence to|
|users that the report can be relied upon (A)|
|4||Key audit matters||Draws attention to any other significant matters of|
|which the users should be aware which have been|
|discussed with those charged with governance (E)|
|5||Name of engagement||To identify the person responsible for the audit|
|partner||opinion in case of any queries (C)|
A disclaimer of opinion states the auditor does not express an opinion.
An unmodified opinion means the financial statements give a true and fair view. An adverse opinion means the financial statements do not give a true and fair view.
A qualified opinion states ‘except for’ the issue described, the financial statements give a true and fair view.
|(0.3/7.5 × 100)|
|(0.6/7.5 × 100)|
|Type of event||Accounting treatment|
The receivable and lawsuit are both issues that were in existence at the year-end therefore are adjusting events. Adjusting events must be adjusted or recognised in the financial statements.
|Contact the customer directly and enquire when they are||ü|
|likely to pay the outstanding balance|
|Review correspondence between the customer and||ü|
|Humphries to assess whether there is any likelihood of|
|Review the post year-end period to see if any payments||ü|
|have been received from the customer|
|Inspect the original invoice and goods despatch note to||ü|
|confirm the customer received the goods and therefore|
|owes the money|
It would not be appropriate to contact the customer directly to enquire about payment of the outstanding balance. The auditor would have already inspected the original invoice and goods despatch note when the audit fieldwork was taking place. At the completion stage, the auditor would perform follow up procedures focusing on subsequent events such as whether payment had been received since the last time after date payments were checked and reviewing any correspondence that had been received since the last time a review of correspondence had taken place.
|Section Titles||Include in the|
|Auditor Responsibilities for the Audit of the Financial Statements||ü|
|Basis for opinion|
|Basis for qualified opinion||ü|
|Key Audit Matters|
|Responsibilities of Management and Those Charged With||ü|
As the adjustment is material, the opinion will need to be modified. The issue is material but not pervasive therefore a qualified opinion will be required. The section will be titled ‘Qualified Opinion’ and will be followed by a ‘Basis for Qualified Opinion’ section. Responsibilities of both management and auditors are included in every auditor’s report. Key audit matters are only compulsory for listed companies. As the scenario does not specify that Humphries is a listed client, it cannot be assumed that a Key Audit Matters section must be included in the auditor’s report.
The condition causing the damage occurred after the year-end therefore the event is non-adjusting. A non-adjusting event must be disclosed if it is material. If disclosure is required but not made the financial statements will be materially misstated which will impact the auditor’s report. The amount claimed from the insurance company could only be recognised in the financial statements if the event was an adjusting event and if it was virtually certain the claim would be paid.
A written representation is not appropriate in respect of the receivable balance.
This is because other procedures can be performed which provide more reliable evidence.
A written representation is appropriate in respect of the warranty provision.
This is because the matter involves management judgment.
The client cannot confirm with confidence that the customer will pay their outstanding balance. Therefore a written representation is not appropriate. Other procedures provide more reliable evidence such as after date cash testing. The warranty provision is decided by management based on their experience and judgment. As a result there are limited other procedures that can be performed that would provide sufficient appropriate evidence. Therefore a written representation is appropriate.
The refusal to provide a written representation may cast doubt over the reliability of any other evidence provided by the client which means it will have a material effect. The shareholders will be made aware of the issue if the auditor’s report is modified as the auditor will need to provide an explanation of why the report is being modified. The auditor will not need to specifically notify the shareholders of the issue in person. There is no requirement to notify an industry regulator in this situation.
- D, F
Written representations are required by ISA 580. Therefore without a written representation the auditor does not have sufficient appropriate evidence. If the auditor considers this to be material but not pervasive a qualified opinion will be issued. If it is deemed pervasive a disclaimer of opinion will be issued.
|Area of the audit||Required by an ISA|
|Fraud and error (ISA 240)||ü|
|Laws and regulations (ISA 250)||ü|
|Analytical procedures (ISA 520)||ü|
|Subsequent events (ISA 560)||ü|
|Required by ISA 580|
|Plans or intentions of management that affect carrying||ü|
|values of assets|
|Confirmation from management that they have||ü|
|provided the auditor with all information and access to|
|records during the audit|
|Confirmation from management that the financial||ü|
|statements are accurate/free from error|
|Confirmation from management that all transactions||ü|
|have been reflected in the financial statements|
|Confirmation from management that they have||ü|
|prepared the financial statements in accordance with|
|the applicable financial reporting framework|
Plans or intentions of management will be specific to the entity therefore only included if relevant but not included in every written representation letter. Management cannot confirm the financial statements are accurate or free from error due to estimates and areas of management judgment affecting the financial statements.