AUDIT CLEARANCE AND REPORTING QUESTION AND ANSWERS

QUESTION 1

Kenya Lab Instruments Ltd. is an established manufacturing company producing laboratory instruments. The following extracts are from the company’s final draft statement of financial position and income statement for the year ended 30 April 2015.

Income statement:

 

  Year 2015 Year 2014
  Sh 000 Sh 000
Sales 351,760 378,845
Gross Profit    
Net Profit    

 

Statement of Financial Position:

 

Fixed assets 183,060 176,400
Cost    
Accumulated Depreciation    
     
Current Assets    
Stock 185,336 86,111
Debtors
     
     
Current Liabilities    
Creditors 20,691 17,379
Overdraft 95,461 37.634
  116,152
Net Assets 204,878  

 

 

The following issues arose during the audit assignment of which you are the manager:

  1. Sales during the second half of the year were 40% below those in the first half.
  2. Kenya Lab Instruments Ltd.’s main competitor Focus Instruments Ltd. has launched a new range of specialist equipment causing Kenya Lab Instruments Ltd.’s forward orders to fall significantly.
  3. The current overdraft limit is Sh.700 million.
  4. Plant and machinery costing of Sh40 million, is fully depreciated and the production director advises that new machinery must be acquired within one year to avoid incurring excessive repair costs.

 

 

Required:

A file memorandum reviewing the above results and information and raising any issues which need to be resolved prior to the signing of the audit report.

A file memorandum reviewing and raising any issues which need to be resolved prior to the signing of the audit report

  • Sales decrease (declining revenue) — discussion with management as this is an indication /implication of business continuity or Going concern.
  • Inquire whether management has mitigation plans i.e. recovering from other services, if nothing, the going concern is inappropriate.
  • Loss of market segment (to competitor): what strategies does the management have to counter the move? e.g. new innovations.
  • Overdraft limit: If 700M, the company’s liquidity is affected as it has exceeded the limit or further 0/D will not be approved:
  • Whether a capital budget has been prepared to acquire the equipment, if fully depreciated, can we dispose it as a scrap?

QUESTION 2

You are the audit manager assigned to the audit of Plasma Industrial Products’Limited. You are reviewing the working papers with respect to the financial statements of the company for the year ended 31 March 2011, including the directors’ report and the chairman’s statement.

Meanwhile, on 15 April 2011, one of the customers of the company who owed Sh.3.6 million as at 31 March 2011 was declared bankrupt.

The reported profit before tax for the company for the year ended 31 March 2011 was Sh.IS million while trade receivables as at 31 March 2011 amounted to Sh.84 million.

The directors of the company have advised you that they would not amend the financial statements to provide for bad debts of Sh           million.

Required:

  1. Explain the responsibilities of the auditors with respect to:
  2. Financial statements of Plasma Industrial Products Limited. ii. Information contained in the directors’ report and the chairman’s statement.

The Companies Act covers the auditor’s responsibilities

  • Whether in his opinion proper books of account have been kept and proper returns received from branches of the entity.
  • To state whether he has received all information and explanations from the clients necessary for the audit of the financial statements.
  • Whether the financial statements are in agreement with the books of account. Whether in his opinion the information contained in the financial statements comply with the provisions of the Companies Act in all material respects.
  • Whether the financial statements portray a true and fair view.
  • All the above matters are contained in the 7th schedule and should be stated in the auditor’s report.
    • Any proposed dividends) Information contained in the director’s report

      These matters are a requirement of the companies Act under section 157 and include; 6 Results from the company’s operations, that is earnings or profit before tax,

    • Any proposed allocation to reserves
    • Principal activities of the entity.
    • Directors who held office and their nationality

    It is the responsibility of ensuring that such information is properly reflected as required the law and is consistent with the financial statements. Matters contained in chairman’s statement

    • This includes issues that directors were unable to provide in the director’s report. such as interpretation of general prevailing economic conditions and the company’s progress.

     

    Generally the auditor has no obligation over matters contained in the chairman’s statement; however, he should ensure such matters are consistent with his understanding of the environment and with the financial statements.

    Discuss the actions that the auditors should take if they consider the financial statement to be inconsistent with directors’ report and the chairman’s statement.

  • Where the financial statements are correctly presented but are inconsistent with the director’s report the auditor should advise the directors to amend their report.
  • if they fail to amend it, he may not qualify his report but may modify it to include an emphasis of matter” paragraph to explain the position.
  • Where the report is correct but the financial statements are incorrect the auditor should recommend amendments to the financial statements and if the client refuses he should qualify his report appropriately.

Justify the form of audit report you would issue to the members of Plasma Industrial Products Limited for the year ended 31 March 2011.

The management refusal to adjust the accounts amounts to a disagreement with the auditor meaning that the auditor should decide whether it is only material or both material and pervasive. An “except for” form of qualification may be appropriate in the circumstances

Justification

Relevant accounting principle

The bankruptcy of the customer indiC.:ates that company has overstated the profits and assets at the year-end Sh. 3.6 million. The information on the bankruptcy provides evidence relevant to events after the reporting period (ISA 10) and should therefore be treated as an adjusting event. Prudence concept would also dictate that the loss be provided in full in the financial statements as at 31 March 2011.

Materiality

The amount of the loss of Sh.3, 600,000 represents 20 % of the pre-tax profit and more than 40 % of the accounts receivable. It would therefore seem material in both income statement and statement of financial position terms.

 

QUESTION 3

With reference to International standard on Auditing 700, The Auditor’s Report on Financial Statements:

  • Explain two circumstances under which an auditor may not be able to express an unqualified opinion on a matter whose effect is or may he material to the financial statement.

There is a limitation on the scope of the auditors work or,

There is a disagreement with management regarding the acceptability of the accounting policies selected, the method of their application or adequacy of financial statement disclosures.

  • Describe the two types of audit reports that may be expressed the auditor in each of the circumstances explained in(i) above.
  • Qualified opinion- limitation of scope

The auditor qualifies the report on the basis of him being unable to obtain sufficient appropriate audit evidence on matters he considers material but not pervasive and whose impact on the financial statements is likely to lead to material misstatements. Such inability is mostly imposed the management when they refuse to provide information or records that the auditor considers important or places such conditions on the auditors that he is unable to carry out his work.

  • Disclaimer of opinion

This opinion is expressed the effect of a limitation on scope is so material and pervasive that the auditor was unable to obtain sufficient appropriate audit evidence on which to base his audit opinion on the financial statements

Disagreements with the management

Qualified opinion-except for

It arises when the matter in question is material but not pervasive to the true and fair view of the financial stratagem, It arises due to;

  • Material limitation in the scope of the audit
  • Material circumstances of disagreement with the directors.

Adverse opinion

This report is issued when the possible effect of a limitation of scope is so material and pervasive to the financial statements that the auditor concludes that a qualification of his report is not adequate to disclose the misleading or incomplete nature of the financial statements.

 

QUESTION 4

  1. a) You are the Audit manager of Mariana and Associates, a firm of Certified Public Accountants. You are reviewing the propoSed audit reports for two of your clients, alpha Ltd. and Deema Ltd. whose financial year end was 30 :lune 2009, submitted the Audit Senior.

The following are some matters relating to the two clients: Alpha Ltd

Alpha lid., a company listed on the stock exchange, permanently closed several factories in May 2009, with all costs of closure finalised and paid in June 2009 all the Factories produced the same item, which contributed 10 % of Alpha ltd. ‘s total revenue for the year ended 30 June 2009(2008 -23%). The closure has been disclosed accurately and fully in the chairman’s statement and directors report. However the disclosure is not mentioned in the notes to the financial statements nor separately disclosed in the financial statements.

The audit senior has proposed an unmodified audit opinion for Alpha Ltd. as the matter has been fully addressed in the chairman’s statement and directors’ report.

Deema Ltd.

In July 2009, a legal claim was filed against Deema ltd. a retailer of toys. The claim is from a customer who slipped on a greasy step outside one of the retail outlets. The matter has been fully disclosed as a material liability in the notes to the financial statements. The audit working papers provide sufficient evidence that no provision is necessary as Deema Ltd., have stated in writing that the likelihood of the claim succeeding is remote. The amount of the claim is fixed and is adequately covered cash resources.

The Audit senior proposes that the audit opinion for Deema Ltd. should not be qualified, but that an emphasis of matter paragraphohould be included after the opinion to highlight the situation.

Required:

Explain the circumstances under which an auditor may issue a qualified opinion.

  1. Inherent uncertainties

 

  • The unavoidable risk that in the client’s financial statements material errors and frauds would occur during the audit.
  • The unavoidable risk that the client systems of controls and accounting systems are too complex for the auditor to understand or operate:
  1. Limitation in the scope of the audit

–    The audit procedures can be limited by;

  • Management of the client
  • Circumstances prevailing within the entity
  1. Circumstances of disagreement with directors
    • During the audit the auditor may disagree with directors on;
    • Accounting policies
    • Materiality misstatement discovered
  • Describe the various types of qualified audit opinions.
  1. Adverse opinion

This report is issued when the possible effect of a limitation of scope is so material and pervasive to the financial statements that the auditor concludes that a qualification of his report is not adequate to disclose the misleading or incomplete nature of the financial statements,

  1. Disclaimer of (minion

This report is issued when the possible effect of a limitation of scope is so material and pervasive that the auditor has not been able to obtain sufficient appropriate audit evidence and therefore is unable to express an opinion on the financial statements.

  1. ‘Except for’ form of qualification
    • It arises when the matter in question is material but not pervasive to the true and fair view of the financial statements.
    • It arises due to:
      • Material limitation in the scope of the audit
      • Material circumstances of disagreement with the directors.
  • With respect to the proposed audit reports for Alpha Ltd and Deerna Ltd., discuss the appropriateness of the proposed report and recommend amendments as appropriate.

A discontinued operation according to IFRS 5: Non-current assets held for sale and discontinued operations is defined as a component of an entity that either has been disposed of or is classified as held for sale and represents among others a major line of business. In this case they contributed 10% of the total revenue compared to 23% in the previous year. This represents a material contribution to the total revenue of the firm. IFRS 5 further indicates that the gain or loss of the discontinued operation should be presented as a single value on the face of the statement of comprehensive income. A detailed analysis of the loss or gain of the discontinued operation is presented in the notes or in the SCI in a section distinct from continuing operations. It further provides that the net cash flows attributable to the operating, investing and financing activities of a discontinued operation shall be separately disclosed on the face of the cash flows statement or disclosed in the notes, this is also a requirement of IAS 7 statement of cash flows.

Since

Alpha is a listed company, IFRS 8 operating segments requires separate segmental disclosure of discontinued operations. Failure to disclose the above is a material breach of IFRS.

  • The audit opinion should therefore be qualified on the grounds of disagreement on disclosure. The matter is material but not pervasive and therefore an “except for opinion” should be issued.
  • The opinion paragraph must clearly slate the reason for the disagreement and an indication of the financial significance of the matter.

 

 

Deema Ltd

1AS 37 provisions, contingent assets and contingent liability provides that if taking into account all the evidence, it is more likely that a present obligation exists at the balance sheet date, a provision should be made for that present obligation. If it is more likely present obligation exists, the entity should disclose a contingent liability, unless the possibility of an outflow of resources is remote. In the case of Deerna, the event is after the balance sheet. If the accident had occurred prior to year end, the claim would provide additional evidence of a condition existing at year end. The evidence points to the fact that the claim will not be successful and hence no need of a provision. The matter has since been fully disclosed as a material contingent liability in the notes to the financial statements in accordance with IAS 37 and IAS 10 events after the reporting period. There is therefore no disagreement or a limitation of scope and the audit senior is correct to propose an unqualified opinion.

 

QUESTION 5

ISA 700 Forming an opinion and reporting on financial statements indicates the basic elements that will ordinarily be included in the audit report.

Required;-

List six basic elements of an auditor’s report. Briefly explain why each element is included in the report.

Six basic elements of an Audit report

Title

The audit report should have a title which includes the wording ‘Independent auditor’ to distinguish this report from others that may be prepared internally the company.

Addressee

The report should be appropriately addressed as required the engagement and local regulations. This is normally to the shareholders of the company or to those charged with governance.

Introductory paragraph

This section identifies the financial statements being audited, including the date and period covered. It also identifies the title of each statement that comprises the financial statements being audited.

Management’s responsibility for the financial statements

This part of the report is included to describe the responsibilities of those who are responsible for the preparation of the financial statements including those in respect of internal control

Auditor’s responsibility

This section describes the auditor’s responsibility for expressing an opinion, notifies users that the audit was carried out in accordance with ISAs and explains what an audit involves,

Opinion

This indicates the financial reporting framework used to prepare the accounts and states the auditor’s opinion as to whether the financial statements present fairly, in all material respects (or show a true and fair view of) the financial position of the audited entity in accordance with that framework.

Date

The audit report should be dated as at the completion of the audit, to show that the auditor has considered any events after the reporting period date up to the date of completion and how these might affect the financial statements. The report should not be dated earlier than the date on which the accounts are signed or approved managc,tment,

Auditor’s address

The audit report should name a specific location, which is normally the city or town where the auditor maintains the office that has responsibility for the audit.

Auditors’ signature

The audit report should be signed in the name of the audit firm, the personal name of the auditor, both, as appropriate. It is usually signed in the name of the firm because the firm assumes responsibility for the audit,

 

 

QUESTION 6

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..

  • ….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 from material misstatement (remaining words are the; same as a normal unmodified report).
  • As discussed in Note15 to the financial statements, no depreciation has been provided in the financial statements which practice, in our opinion, is not in accordance with International Financial Reporting Standards.
  • The provision for the year ended 31 September 20X7, 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 accumulated depreciation of $1,200,000 and the profit for the year and accumulated reserve should be decreased $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 present fairly, in all material respects … (remaining words are the same as for an unmodified opinion paragraph). The extracts have been numbered to help you refer to them in your answer,

Required

Explain the meaning and purpose of each of the above extracts in your draft audit report. a) State the effect on your audit report of the following alternative situations:

Extract 1 Meaning Purpose
International Standards on Auditing prescribe the principles and practices to be followed auditors in planning, designing and carrying out various aspects of their audit work. Members are expected to – follow these standards. This confirms to the leader that best practice has been adopted the auditor, assuring the reader that the audit has been properly conducted.
Ethical             requirements   refer    to             the professional code of conduct followed the auditor. This confirms that the auditor has acted professionally throughout the course of the audit
Reasonable assurance means that, based on the judgment of the auditor, sufficient work has been performed in order to form an opinion within a reasonable margin of error. This indicates however that not every balance and transaction has been considered in detail and result there could be additional errors apart the non-depreciation of buildings.
Audit   work    identifies         material misstatements i.e. those that would affect the reader’s Assessment of the financial statements. This confirms that audit work is designed to identify significant issues, not necessarily all issues and therefore the identification of the non- depreciation of buildings work carried out.
Extract 2 Meaning Purpose
This explains that the accounting treatment of non-depreciation adopted the company is not conducted in accordance with recognized practice as contained within the IFRSs. The basis of the auditor’s and conclusion that the accounts contain a misstatement is highlighted i.e the non-depreciation of buildings: The reference to the IFRSs gives authority to the -auditor’s opinion that the non-depreciation is incorrect
Extract 3 Meaning Purpose
The depreciation provision in the financial statements is understated $420,000. This explains the adjustment which should have been made in the financial statements and quantifies the effect of the non-depreciation so that the reader can assess the impact; it also indicates the depreciation policy so that the reader can understand the basis of the adjustment
Extract 4 Meaning Purpose
Non-current assets, profit for the year and accumulated reserves are all materially misstated. This quantifies more specifically the effect of the adjustment On both the position statement balances and income statement.
Extract 5 Meaning Purpose
Based on the professional judgment of the This highlights that the audit report is modified
auditors the financial statements are factual, are free from bias and reflect the commercial substance of the businesses transactions with the exception of the treatment of depreciation. This misstatement does materially affect the financial statements but does not render them meaningless overall. due on the basis the financial statements are not free from material misstatement. The .phrase ‘except for’ indicates that the misstatement -relates to one specific issue but that in other respects the financial statements give a true and fair view.
  • Depreciation had not been provided on any non-current asset for a number of years, the effect of which if corrected would he to turn an accumulated profit into a significant accumulated loss.
  • 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 fmandial statements.

(Note. You are not required to draft any audit reports.)

  • Impact on audit report
    • The auditor would issue a modified audit opinion on the grounds that the accounts contain a material misstatement due to the continued non-depreciation of non-current assets.
    • Due to the significant impact of the adjustment (a profit to a significant loss) the auditor may conclude that the effect is both material and pervasive and issue an adverse opinion. Otherwise a qualified opinion will be issued.
  • The auditor would issue a modified audit opinion on the grounds the auditor was unable to obtain sufficient appropriate audit evidence. The auditor has been unable to confirm the existence of inventory attending the inventory count leading to uncertainty regarding the inventory valuation.

The opinion is likely to be an ‘except for the possible effects of opinion (rather than a disclaimer of opinion) indicating that whilst material adjustments may be required to the inventory balance in all other respects the financial statements give a true and fair view of the company’s financial position.

  1. The client’s accounting systems will be documented, or documentation prepared in prior year audits will be update
  2. An assessment will be made of inherent risk and control risk.
  3. Appropriate materiality levels will be estimated.
  4. The information obtained dining the planning stage will be documented along with an outline of the audit strategy to be followed.
  5. If control risk has been assessed as low in particular areas, then controls testing will need to be performed on the controls to confirm the initial assessment of the risk. These tests of controls will be started in the interim audit although they will generally need to be performed oh a sample of items extending right over the accounting period so may need to be completed at the final audit.
  6. The detailed audit approach should be prepared. Programmes of audit procedures, both tests of controls and substantive procedures, will be designed to show the work that needs to; be done and to enable subsequent review of audit completion.
  7. If substantive procedures are to be performed that involve auditing a sample of transactions j selected to cover the whole accounting period, it is likely that some of these procedures will also be started at the interim audit, but these will again be completed at the final audit.

Main audit procedures and practices during the final audit

  1. i) The tests that were started at the interim visit, both tests of controls and substantive procedures should be completed. ii) Year-end balances may be verified through confirmations obtained from third parties such’ as:
  • Receivables
  • Payables – Banks
  • If the client has carried out a year-end inventory count, detailed procedures will be carried out to verify the accuracy of the compilation of the year-end inventory lifting and also to follow up any evidence gathered the auditor when attending the inventory count.
  1. Detailed calculations will need to be obtained of any estimates the client has made at the year-end such as allowances for receivables, depreciation and provisions. Procedures will need to be performed to:
    • Assess the reasonableness of the methods used to make the estimates
    • Re-perform the calculations., or
    • Develop point estimates to evaluate management’s point estimates.
  2. Analytical procedures will be performed on the draft accounts to consider whether the view given the financial statements is in line with the auditor’s understanding of the business.
  3. The auditor must review the directors’ assessment of whether the business is a going concern. The auditor must consider whether the assumptions made the directors are reasonable and whether it is appropriate to prepare the accounts on the going concern basis
  • A review of events after the reporting period must be performed in order to assess whether any appropriate adjustments or disclosures as required IAS 10 have been

 

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