AUDIT EVALUATION AND REVIEWS QUESTIONS AND ANSWERS

QUESTION I

You are the audit manager of Kilimanjaro Co., a company which designs and manufactures aircraft engine parts. The audit of the financial statements for the year ended 31 December 2015 is nearing completion and you are reviewing the papers addressing the going concern section of audit file. The draft financial statements recognise a loss of Sh.50 million (2014 – profit Sh.76 million) and total assets of Sh,138 million (2014 – Sh.144 million).

The audit senior has left the following note for your attention:

“1 have performed analytical review on Kilimanjaro Co.’s year end financial statements. The current ratio is 0.8 (2014 – 1.2), the quick ratio is 0.5 (2014 – 1.6). The latest management accounts show that ratios have deteriorated further since the year end, and the company now has a cash balance of only Sh.2, 500,000. Kilimanjaro Co. has a long- term loan outstanding of Sh.8 million with a covenant attached, which states that if the current ratio falls below 0.75, the loan can be immediately be recalled by the lender.

You are also aware that one of the Kilimanjaro CO.’s best selling product Mofire, has become technically obsolete during 2015 as customers now prefer more environmentally friendly engine parts. Historically the Mofire has generated 45% of the company’s revenue. In response to customers preference, Sh.130m has been spent on designing a new product G-fire, due to launch in February 2016 which will be marketed as an environmentally friendly product.

A cash flow forecast has been prepared for the year ending 31 December 2016, indicating that based on certain assumptions, the company cash balance is predicted to increase to Sh.22 million by the end of the forecast period Assumptions include:

Successful launch of the G-fire product.
The sale of plant and machinery which was used to manufacture Mofire generating cash proceeds of Sh.0.5 million, forecast to take place in January 2016.
A reduction in payroll costs of 15%, caused by redundancies in the Mofire manufacturing plant
The receipt of grant of Sh.300, 000 from a government department which encourages innovation environmentally friendly products, scheduled to be received in February 2016.

Required:

Explain the matters which cast doubt on the going concern status of Kilimanjaro Co.

Substantial operating losses e.g. profit reducing from Sh. 76M in 2014 to Sh. 50M loss in 2015
Decline in investment in total assets from Sh. 144 M in 2014 to Sh. 138M in 2015
Liquidity ratios:
- Current ratio 0.8 in 2015 from 1.2 in 2014 i.e. it has declined
- Quick cash ratio – 0.5 in 2015 from 1.6 in 2014, standard practice dictates it should be 1
Chances of violation of the loan agreement in case the Current ratio falls below 0.75: The company will be required to pay Sh 8M but it currently has a balance of Sh. 2.5M hence the company will not meet the obligation in full.
Reduced demand of the product due to obsolescence (Mofire) — another product to be launched but the auditor needs to determine whether the product will generate revenue of 45 % by suggesting test marketing should be done.

Explain the audit evidence you should expect to find in your file review in respect of the cash flow forecast.

Assumptions used to prepare the Cash Flow are realistic
Competence, skills and experience of personnel preparing the Cash Flow.
Arithmetic accuracy
Timing of inflows
Does the market exist for the sale of the asset
Reduction in pay roll costs
Costs attributable to redundancy, send-off packages should be reflected in the cash flow.
Receipt of a government grant affects in flows: do negotiations exist? Or is there a commitment?
Reasonableness of the amount to be incurred for research and development (Sh 130M) and what is the adequacy? Can it generate 45% of the company revenue as the Mofire product?

QUESTION 2

You are an audit manager in Hasibu and Co. working on the audit of Safari Group (The Group), whose financial year ended on 31 March 2015. This is the first time you have worked on group audit. The draft consolidated financial statements recognise profits before tax of Sh.600 million (2014 – Sh.900 million) and total assets of Sh.900 million (2014 – Sh.820 million). The group manufactures equipment used in telecommunication industry.

Goodwill of Sh. 100 million is recognised in the group statement of financial position having arisen on several business combinations over the last few years. An impairment review was conducted in March 2015 by the group finance director, from which an impairment of Sh.5, 000,000 is to be recognised in respect of goodwill.

The group finance director has prepared a file documentation to support the results of the impairment review, including notes on the assumptions used, his calculations and conclusions. He made the following comment:

“I don’t think you need any evidence other than that contained in my file. The assumptions used are straightforward, so you need to look into them in detail. The assumptions are consistent with how we conducted impairment reviews in previous years and your firm has always agreed with the assumptions used-, so you can check that back to last year’s audit file. All of the calculations have been checked by the head of group internal audit department”.

The group finance director has also informed you that two members of the sales team are suspected of paying bribes in order to secure lucrative customer contracts. The internal audit team were alerted of this when they were auditing cash payments and found significant payments to several new customers being made prior to the contract being signed. The Director has asked if Hasibu & Co. could perform a forensic investigation into the alleged bribery payments.

Required:

Explain the principal audit procedures to be performed on the impairment of goodwill.

Micro-economic conditions e.g. deterioration of foreign exchange
Cost factors e.g. cost of increase in raw materials
Negative cash flows/losses if any
Financial performance e.g. actual against budgeted, if there is a decrease, then goodwill is impaired..
Changes in the composition or carrying amount of net assets i.e if are impaired then goodwill is also impaired.
Assess a decrease in Share prices.
Changes in key management staff, strategies, customers e.g. performers leaving the organisation indicate impairment of goodwill.

QUESTION 3

Your client, Ikulu Ltd is a manufacturer of machinery used in the quarrying industry. The current audit is for the financial statements for the year ended 31 Dec 2014.

The company designs, constructs, and installs machinery for five key customers. Payment is due in three instalments:50% is due when the order is -confirmed,(Stage 1), 25% on delivery of the machinery(stage 2) and 25% on successful installation in the customers quarry (stage 3). Generally it takes six months from the time the order is finalized to the final installation.

As at 30 September 2014, Sh28.5 million was due to the company from Mukoma Quarry Ltd, one of the company’s clients, The amount relates to a disputed stage 3 payment. Mukoma Quarry Ltd has refused to pay until the machinery, which was installed in May 2014 is running at 100% efficiency.

One other customer, Roka Limited has submitted to Ikulu Ltd, through its lawyers, a claim for damages for injuries suffered by a drilling machine operator whose arm was severely injured when a machine supplied by Ikulu Ltd malfunctioned. The Chief Executive officer (CEO) of Ikulu Ltd. has advised you that the claim by Roka Limited is being ignored as it is generally known that Roka Limited has ti poor safety record and that the accident was their fault, Two orders which were placed by Roka Limited have been cancelled.

All machines are supplied with a .one year warranty. A warranty provision is recognized in the financial statements of lkulu Ltd. at Sh.25 million (2013: Sh: 24 million). The CEO estimates the cost of repairing defective machinery reported by customers and this estimate forms the basis of the warranty provision.

The management of Ikulu Ltd, has failed to provide management representations on the warranty provision as requested by the auditors,

In the context of International Standard on Auditing (ISA 580),-Management Representations”:

Explain the action the auditors should take with respect to failure by management to provide management representations on the warranty provision.

Discuss with management with a view to obtaining the reasons why the management have failed to avail the required representations.
Review/re-evaluate the integrity of management and the impact/effect that this might have on the reliability of other representations obtained orally or in written form and the audit evidence in general.
Prepare his own understanding of the representations on the warranty provisions and give the same to management to sign/acknowledge the receipt are appropriate.
Write to management and inform them that their refusal would lead to re-evaluation and could impact on the audit opinion.

Justify the audit opinion that the auditors should issue in their report on account of the warranty provisions in the financial statements.

If the warranty provision is material but not persuasive a qualified opinion is appropriate.

An additional paragraph could be included before the opinion paragraph describing reason for modification that is, management were reluctant to avail the representations on warranty provision hence inability to form an opinion.

The opinion paragraph will include “Except for”.

QUESTION 4

Peter Lawrence a new client of your audit firm was recently declared redundant lie is considering setting up a residential home for old people and has identified a house which he plans to convert into an old peoples’ home. Peter Lawrence and his wife propose to work full-time in the business, which he expects to be available for residents six months after the purchase of the house.

Each resident will have a bedroom and access to a communal sitting room. All meals will be provided in a communal dining-room. Long term nursing care will not be provided. People requiring long term nursing care will either be referred to hospitals or to other homes as appropriate.

The house identified for purchase is in a poor state of repair. It will require considerable structural alterations (building works) and repairs to make it suitable for an old peoples’ home. The following will also be required:

New furnishings such as carpets, beds, wardrobes for the residential rooms, furniture for the sitting room and dining room.
Decoration of the house comprising painting, woodwork and covering of the walls with wail paper.
Equipment for the kitchen and for use by residents living with disabilities.

Peter Lawrence has already obtained some estimates of the conversion costs and information on the income and expected running costs of the home. The purchase price of the house he proposes to buy is Sh 8,000,000 while the structural alteration and repair cost the house is estimated at Sh 8,000,000.

Peter Lawrence has received Sh 4,800,000 with respect to his redundancy pay at his place of work and expects to receive a further Sh 6,000,000 from the sale of his house (after repaying his mortgage).

He has prepared a draft capital expenditure forecast, a profit forecast and a cash flow forecast and requested you to verify them before he submits them to the bank in order to obtain finance.

Required:

Discuss the factors to consider and the audit procedures you would carry out in verifying:

The capital expenditure forecast

The forecast should include all costs relating to the acquisition of the house and those should be checked against relevant documentation. For example lawyers correspondences and estate agent details. The expenditure should include;

Sale price agreed by the seller Survey fees
Legal cost
Stamp duty

The costs required structural alterations repairs and redecorations should be checked against estimates obtained by Peter Lawrence.

Cost of specialised equipment should be checked against supplier’s price lists and written confirmation of discounts available for “bulk” purchases.

Competitors of the capital expenditure should be assessed in the light of the firms experience if any, of similar ventures

The profit forecast

It is necessary to recognise that the residential home will not be able to generate any income until bulk of capital expenditure has been incurred. However, whilst no income can be anticipated the business will have started to incur expenditure in form of loan interest, rates and insurance.

The only income from the new building will be rent recivable from residents.The rentals which Peter Lawrence is proposing to change should be assessed for reasonableness in light of similar rentals in similar homes in the area.

In projecting income it would be necessary to anticipate that it is likely to take some time before the home could anticipate full occupancy.

The expenditures are likely to include:

Salaries and wages – the number of staff and rates of pay should be assessed for reasonableness against projected levels.
Rates and water bills; – an estimate of likely cost should be available from local council or estate agents.
Food – expenditures on food should be based on the projected levels, of staff and residents. Heat and light – The estimates of heat, light and cooking facilities should be processed in the light of experience of similar checks.
Insurance – Peter Lawrence should have obtained estimates of premium costs for both employer and public liability insurance.
Advertising – There is likely to be quite a high initial cost of advertising for both residents and staff.
Depreciation charge should be assessed for reasonableness with capital costs insured being charged to the capital exp,enditure forecast.

Loan and interest charges – These should be checked against the bank current rates and principal amounts agreed

The cash flow forecast

The timing of the capital expenditures will need to be estimated accurately in order to determine where the funds will be needed.
The timing of cash flows and revenue expenditures will be closely related to the, details within the profit forecast.
Income from residents would normally be receivable monthly in advance.
Wages would be payable monthly.
Major utilities would also be paid monthly.
Insurance premiums are normally paid annually in advance.

QUESTION 5

Assess in each case below whether or not management representation would be a substitute for other audit evidence. If not state what other types of audit evidence you would obtain.

Management’s plans to alleviate adverse financial conditions that caused the auditor to have initial doubt about the entity’s ability to continue as going concern.
Management’s plans with respect to disposal of a segment of a business.

Representations about obsolete and damaged inventory.

Management represents that all financial records have been made available for review by the auditor.
Representations about the collection of a material related party receivable.

Management representation might be the only source of evidence available about which specific actions management takes among various alternatives and these representatives should be obtained. However, other audit evidence would certainly be available to the auditor such as those actions that management might already have after year end.

Evaluation of the feasibility of the management expressed plans.

Management’s representations may be the only available source of evidence relative to plans for the disposal of a segment: Once it has been established that the segment will be disposed of, other audit evidence would be available which should be examined by auditor such as appraisals of property and equipment to he disposed of and the results of operations through the disposal date based on historical performance.
Representations about obsolete and damaged inventory.

The representation would not be a substitute. Other sources of audit evidence are available including physical observation of materials, analysis of inventory turns, and report of slow- moving items and review of sales of discounted prices.

Representation on availability of all financial records.

In this case the representation would be a substitute; this is because management representations are the major source of evidence that all records were made available.

Although, the auditor might raise questions if certain financial records would normally available are missing, the representations are the main source.

Representation about the collection of a material related party receivable is not only source available. Although management’s representations about the collection of material related-party receivable would be important, that is not the only available source. Other evidence that should be obtained would include financial statements of the related party. evaluation of the collateral underlying the receivable and the history of payment by the receivable.

QUESTION 6

Premia is a non-governmental organisation (NGO) involved in advocacy for land rights. The only source of income for Preinia is donations from three. major- donors X. Y and Z.

Advise the auditor on how best to address the following matters in the financial statements:

Donor X whose contribution amounted to about 70% of Premia’s revenue has indicated that their company is experiencing difficulties and is unable to continue funding the project.

The auditor should assess by discussion with Premia Management the NGO’s financial needs and how they may cope without financing of the major donor.

In case the NGO still needs the funds and has no alternative source, the auditor may issue a qualified opinion or emphasis of matter on amount of going concern doubts.

The financial statement may need to he presented on market value basis as opposed to consideration of future value:

Donor Y did not meet its commitment in funding one programme of Premia. In-addition, Donor Y has requested Preinia to transfer excess funds from one of its programmes to Paraxo, another Non-Governmental Organisation (NGO). Premia is reluctant to transfer the funds contending that Donor Y failed to provide funds on another programme though there was a written agreement. Donor Y has threatened to go to court.

On the issue of failure of Y to meet in funding commitment, this may be presented in financial statements as a receivable since generally, donations can only be recognised on a cash basis not accrual basis. It’s almost inconceivable for Prernia to seek legal redress to compel Y to meet its funding commitment.

On the issue of request to transfer for excess funds to another NGO, Premia may have no option but to comply. In many instances donor funds are given for specific projects and excesses are normally returned to the donor.

Premia may need to seek advice on the funding agreement’s provisions.

Considerations on effect on reputation must greatly affect Premia’s next cause of action.

QUESTION 7

a) You are an audit manager in Mwangi & Co., Certified Public Accountants, responsible for the audit ofTemesi Ltd., a large company which provides information technology services to businesses. The finance director of Temesi Ltd has contacted you to inform you of a fraud being perpetuated by members of its sales team.

It appears that several sales representatives have been claiming reimbursement for fictitious travel and client entertainment expenses and also inflating actual expenses incurred. Specifically, it has been alleged, that the sales representatives had claimed for the following:

Items such as gills for clients and office supplies which were never actually purchased.
Business class airline tickets but in reality they had purchased economy tickets.
Non-existent business mileage.
The sales representatives were also alleged to have used the company credit card to purchase items for personal use.

The finance director of Temesi Ltd. is worried about this fraud as travel and client entertainment is one of the company’s largest expenses. All of the alleged fraudsters have been suspended pending investigations, which he would like your audit firm to conduct.’

Temesi Ltd. will prosecute these employees in an attempt to recoup its losses if evidence shows that a fraud has indeed occurred. Your audit team will be expected to provide an expert witness in the event of a court case.

Temesi Ltd. has a small internal audit department and in previous years, the evidence obtained as part of the external audit has indicated that the control environment of the company is generally good.

The audit opinion on the financial statements of Temesi Ltd. on 31 March 2013 was unmodified. The finance director wishes to meet with you to discuss the investigation into this fraud. Required:

Explain the matters that should be discussed in the meeting with the finance director in respect of planning the investigation into the alleged fraudulent activity.

Discuss the purpose, nature and scope Of the investigation. In particular confirm whether evidence gathered will be used in criminal proceedings and in support of an insurance claim.

Confirm that Temesi Ltd’ s objectives are to identify those involved with the fraud and to quantify, the amount of the fraud. This will help to clarify the terms of the engagement, which will be detailed in an engagement letter.
Determine the time-scale involved, whether the finance director needs the investigation to commence as soon as possible and the deadline for completing the investigation. This is necessary to determine, the resources needed to perform the investigation and whether resources need to be diverted from other assignments.
Enquire as to how many sales representatives have been suspended (that is due suspected of involvement in the fraud). This will help the firm to determine the potential scale of the investigation.
Obtain an understanding as to how the fraud came to light for instance, was it uncovered by internal audit or a member of the sales department) and who reported their suspicions to the finance director for example by interviewing the whistle blower).
Determine whether Ternesi Ltd. will provide resources to help with the investigation for example, members of the internal audit team would provide assistance in obtaining evidence.
Ask for director’s opinion as to why the fraud had not been prevented or detected by the company’s internal controls. In particular, enquire if there has been a breakdown in controls over authorisation of expenses.
Determine whether recommendations to improve controls are required as an output of the investigative work.
Discuss the investigative techniques which may be used (for example interviewing the alleged fraudsters, detailing review of expenses) and ensure that investigators will have unrestricted access to individuals and documentation.
Enquire as to whether the police have been informed and if so, the name and contact details of the person informed. lt,is likely that a criminal investigation by the police will take place as well as Mwangi & Co.’s own investiaation.
Confirm that Temesi Ltd. grants permission to Mwangi & Co.’s investigation team to communicate with third parties such as the police and the company’s lawyers regarding the investigation.

Summarise the auditor’s responsibilities for the appropriateness of the going concern assumption as a basis for the preparation of financial statements.

Auditor’s responsibilities for the appropriateness of the going concern assumption are:
- To consider the appropriateness of management’s use of the going concern assumption in the preparation of the financial statements.
- Consider whether there are any material uncertainties about the entity’s ability to continue as a going concern that need to be disclosed.
- The auditor should consider the same period as that used by management in making its assertions. This should be at least twelve months from the balance sheet date
- When events or conditions have been identified which cost significant doubt on the entity’s ability to continue as a going concern the auditor should:
  - Review management’s plan for future action.
  - Gather sufficient appropriate audit evidence to confirm or dispel whether or not a material uncertainty exists.
  - Seek written representations from management regarding its plan for future action.

Where the auditors consider that there is a significant level of concern about the ability of the company to continue but do not disagree with the preparation of the financial statements on a going concern basis, an unqualified opinion should be issued provided disclosures are adequate.
If the disclosures are inadequate the auditor would issue a qualified or adverse opinion depending on the circumstances.

if the auditor disagrees with the basis of preparation an adverse opinion will be issued on the basis that the financial statements are seriously misleading

QUESTION 8

Audit procedures to be followed by an auditor of a hank for the audit of contingent liabilities:

The primary concern of the auditor in contingent liabilities is seeking reasonable assurance that all contingent liabilities are identified and properly valued. To this end the auditor should .generally follow the ‘procedure given below.

The auditor should ensure that there exists a system for the non-fund based facilities or additional ad hoc credit facilities.
Ascertain whether there are adequate internal controls to ensure that transactions giving rise to contingent liabilities are executed only by persons authorised to do so and-in accordance with laid down procedures.
The auditor should also ensure that in case of LCs for import of goods as required, the payment to the overseas suppliers is made on the basis of shipping documents and after ensuring that the said documents are in strict conformity with the terms of LCs.
6 Ascertain whether the accounting system of the bank provides for maintenance of adequate records in respect of such obligations and whether the internal controls ensure that contingent liabilities are properly identified and recorded.
Perform substantive audit tests to establish the completeness of the recorded obligations. Such tests include confirmation procedures as well as examination of relevant records in appropriate cases.
Review the reasonableness of the year and amount of contingent liabilities in the light of previous experience and knowledge of the current year’s activities.
Review whether comfort letters issued by the bank has been considered for disclosure of contingent liabilities

Verify whether the bank has extended any non-fund facility or additional credit facilities to other than its regular customers. In such cases, auditor should ensure concurrent of existing hankers of such borrowers and enquire regarding financial position of those customers.

QUESTION 9

Ben Chalo and Alex Chalo are directors of KKC Traders Ltd. Their sister Sharon Chalo runs an interior design company, Lantern Ltd. During a review of board minutes performed as part of the planning of KKC Traders Ltd.’s audit, it was discovered that KKC Traders Ltd. paid Sh.5 million to Lantern Ltd. in respect of refurbishment of development properties.

On further inquiry it was also discovered that Lantern Ltd. leases an office space from KKC Traders Ltd. under an informal agreement between the two companies.

Required:

Describe the audit procedures to be performed in relation to KKC Traders Ltd.’s transactions with Lantern Ltd.

Review invoices received from Lantern to verify the amount of the expenses.
Confirm cash payments to the cash book.
Inspect Lantern Ltd.’s trade payables to confirm any amount outstanding at the year end.
Compare the cost of refurbished carried out by Lantern Ltd.to the cost of refurbishment carried out by other suppliers to determine if the transaction is at arm’s length.
Discuss the informal lease with management and obtain a written representation regarding • the nature of the arrangement, and whether any amount is payable to Lantern Ltd.
Confirm through enquiry with management the date the lease arrangement commenced and the expected period of the lease.
Enquire if any written documentations exist regarding the lease arrangement. if so, review and place on file.
Perform re-computations to confirm accuracy.
Review the disclosure made regarding these transactions in the draft financial statements.
Review board of directors minutes for approval.

QUESTION 10

International Standard on Auditing (ISA) 570: ‘Going Concern’ provides examples of events that, individually or collectively, may cast significant doubt on the going concern assumption. Summarise the possible financial indicators of going concern problems.

Net liability or net current liability position
Fixed term borrowings approaching maturity without realistic prospects of renewal or repayment, or excessive reliance on short-term borrowings to finance long term assets

Indications of withdrawal of financial support by creditors

Negative operating cashflows indicated by historical or prospective financial statements – Adverse key financial ratios
Substantial operating losses or significant deterioration in the value of assets used to generate cash
Inability to pay creditors on due dates

QUESTION 11

(a) According to International Standard on Auditing (ISA) 550: ‘Related panics’ where the financial reporting frameworks establish specific accounting and disclosure requirements for related party transactions relationships and balances to enable users of the financial statements to understand their nature, the auditor has a responsibility to perform audit procedures to identify, assess and respond to the risks of material misstatement arising from the entity’s failure to appropriately account for or disclose related party relationships transactions or balances.

The auditor should therefore place emphasis on testing material transactions with panics he knows are related to the reporting entity. Certain relationships such as parent-subsidiary or investor – investee, may he clearly evident. However, determining the existence of other relate,d party relationships requires the application of specific audit procedures.

The auditor could also devise detailed procedures intended to provide guidance for identifying material transactions with parties known to be related and for identifying material transactions that may be indicative of the existence of previously undetermined relationships.

Required:

Design the specific audit procedures that could he relied upon to ascertain the existence of related parties.

Evaluate the company’s procedures for identifying and properly accounting for related party transactions.
Request from appropriate management personnel the names of all related parties and inquire whether there were any transactions with those parties during the period.
Where the company is listed on the stock exchange; review filings by the reporting entity with the stock exchange commission and other regulatory agencies for the names of

related parties and for other business in which officers and directors occupy directorship or management positions.

Determine the names of all pension and other trusts established for the benefit of employees and the names of their officials and trustees.
Review stockholder listings of closely held companies to identify principal stockholders.
Review prior year working papers for the names of known related parties.
Inquire of predecessor, principal, or other auditors of related entities concerning their knowledge of existing relationships and the extent of management involvement in material transactions.
Review material investment transactions during the period under audit to determine whether the nature and extent of investments during the period created related parties.

. Describe the detailed procedures an auditor could perform to identify transactions with related parties.

Provide audit personal performing segments of the audit or auditing and reporting entity with the names of known related parties so that they may become aware of transactions with such parties during their audits.
Review the minutes of meetings of the board of directors and executive or operating committees for information about material transactions authorised or discussed at their meetings.
Review proxy and other materials filed with the securities commission and comparable data filed with other regulatory agencies for information about material transactions with related parties.
Review conflict-of-interest statements obtained by the company from its management.
Review the extent and nature of business transacted with major customers, suppliers, borrowers and lenders for indications of previously undisclosed relationships.
Consider whether transactions are occurring, but are not being given accounting recognition such as receiving or providing accounting management or other services at no charge or major stockholder absorbing corporate expenses.
Review accounting records for large, unusual or non-recurring transactions or. balances, paying particular attention to transactions recognised at or near end of the repOrting period
Review confirmation of compensating balance arrangements for indications that balances are or were maintained for or by related parties.
Review invoices from law firms that have performed regular or special services for the company for indications of the existence of related services or related party transaction.
Review confirmation of loans receivable and payable for indications of guarantees. When guarantees are indicated, determine their nature and the relationships, if any, of the guarantors to the reporting entity.

QUESTION 13

Your client Birnba Ltd. Sells machines subject to a warranty of one year included in the statement of financial position of Bimba Ltd. as at 30 April 2011 is a warranty provision of Sh 300,000,000 2010: Sh 290,000,000 the managing director who owns 60% of the shares of the company estimates the cost of repairing detective machinery reported by customers. The estimates from the managing director form the basis of the warranty provision.

This is your first year as the auditors of Bimba Ltd whose turnover is Sh 15 billion for the year 2011 compared to Sh 13 billion for the year 2010.

Required:

Explain the audit procedures that should be performed during the final audit in respect of the estimated warranty provision included in the statement of financial position of the company as at 30 April 1 2011.

Audit procedures that should be performed during final audit in respect of the estimated warranty provision

Review and test the process used by management to develop the estimate

Correspondence with customers during the year should be reviewed to gain an understanding of claims already in progress at the year end.
Re compute the warranty provision.
Contracts or orders for the terms of the warranty should be reviewed to gain an understanding of the obligation of the client
Agree the percentage applied in the calculation to the stated accounting policy of the company.
Review board minutes for discussion of on-going warranty claims, and for approval of the amount provided.
Use Management accounts should be used to ascertain normal level of warranty rectification costs during the year.
Discussions on assumptions used to determine the percentage used in his calculations should be held with the managing director
Analytical procedures should be performed to compare the level of warranty provision year by year and compare actual to budgeted provisions.
Consider whether the assumptions used are consistent with the auditor’s understanding of the business.
Compare prior year’s provision with actual expenditure on warranty claims in the accounting period.
Review any Work carried out after the year end on specific faults that have been provided for should be reviewed.
Agree cash expended on rectification work in the post reporting period to the cash books.
Cash expended on rectification during the post-reporting period should be agreed to supplier’s invoices.

QUESTION 14

You are the audit manager at Niche Electronics Limited (NEL), a local private company which sells television sets, fridges, digital video disks (DVDs) and similar products through its two division mail order division and on-line ordering on the internet division. Nelia a new audit client of your firm of auditors

You are commencing the planning of the audit for the year ended 31 October 2009. In an initial meeting with the directors of the company you have been provided with the following information:

The directors plan to expand the range of goods sold through the Internet division to include toys and fashion clothes. The directors believe that when one product has been sold on the Internet, then any other product could also sell through the internet.
The company’s turnover is in excess of Sh.96 million with net profits ofSh.8.2 million. All profits are currently earned in the mail order division, although the internet division is expected to return a small- profit during the year ending 31 October 2010. Sales revenue is growing at the rate of 15 % per annum. However, the. net profit has remained almost the same for the last four years.
The accounting systems used in recording sales by the mail order division is relatively old.
it relies heavily on manual input to transfer orders received into .NEL’s computer systems. Recently errors have occurred in the input of orders and in invoicing of goods following dispatch. The directors maintain that the errors were negligible and the information produced by the current accounting system is reliable. The company has not employed a qualified accountant.
The directors estimate that their expansion plans will require a bank loan of approximately Sh. 16 million partly to finance the enhanced website and also to provide working capital to increase inventory levels. A meeting with the bank has been scheduled for three months after the year end. The directors expect an unqualified auditor’s report to be signed prior to this meeting.

Required:

Explain the audit procedures you would perform in order to form an opinion on whether Niche Electronics limited was -likely. to remain a going concern.

1AS 1 presentation of financial statements provides that when preparing financial statements, management should make an assessment of an entity’s ability to continue as a going concern. Furthermore according to ISA 570 going concern the auditor, when performing audit procedures should consider the appropriateness of the going concern assumption underlying the preparation of financial statements. Financial statements should be prepared on a going concern basis unless management intends to liquidate rite entity or to cease trading or has no realistic alternative but to do so.

Audit Procedures include:

Check out minutes of the meetings of shareholders, the board of directors and important committees for reference to financial difficulties.
Confirmation of the existence, legality and enforceability of arrangements to provide or maintain financial support with relate and third parties and assess the financial ability to repay.

Discussing cash flow, profit and other relevant forecasts with management. iv. Consider the firm’s new product line and its profitability and the effect of a lack of a dedicated accounting system.

Analyzing and discussing any available interim financial statements

QUESTION 15

The International Auditing Practices Committee requires that doubts about the going concern presumption be detected and adequately disclosed in the financial statements and auditors’ reports.

Required:

Explain the term “going concern” ill relation to the preparation of financial statement.
Describe the audit procedures the auditor should undertake in order to obtain sufficient audit evidence to be able to form an opinion on the going concern status of the company. e) List six factors which might cast doubt on the going concern status of a company.
Discuss briefly how the present responsibilities of the auditor regarding the going concern status of company could be extended.

QUESTION 16

You are auditing the financial statements of Twendelee Trading Co Ltd., a listed company, for the year ended 3 I October 2002. The audit assignment partner has asked you to consider the auditors responsibilities for identifying subsequent events. Also, he has asked you to describe the audit procedures, which examine subsequent events. has suggested that an example of one point in answer to part (b) below would be:

“Checking accounts receivable cash, received after the year-end to determine the realizability of accounts receivable balances at the year-end and highlight doubtful balances on the accounts receivable ledger”.

The detailed audit work was completed on the morning of Friday 6 December 2002. It is proposed that:

The audit report is signed on Friday 20 December.
The ‘financial statements are sent to shareholders on Monday 6 January 2003.
The company’s annual general meeting will be held on Wednesday 29 January 2003. At this meeting the shareholders will vote to approve the financial statements.

You are required to:

Consider the auditor’s responsibilities for detecting material subsequent events in the periods: i) 3 I October to 6 December 2002. ii) 6 December to 20 -December 2002 iii) 20 December 2002 to 6 January 2003 iv) 6 January 2003 to 29 January 2003. v) After 29 January 2003.

In the period 31 October to 6 December 2002, the auditor should carry out sufficient appropriate audit work so that he/she has a reasonable expectation of detecting and quantifying material subsequent events. Examples of the types of audit procedures carried out are included in part (la) of this answer.
In the period 6 December 2002 to 19 December 2002 the auditor’s responsibilities are the same as in the period (a)(i) above.
The period from i 9 December 2002 to 5 January 2003, the standard says that the auditor should reasonably expect the directors to inform him/her of any material subsequent events detected in this period, which may affect the financial statements. During this period auditors do not have any obligation to perform procedures or make enquiries regarding financial statements.

When the auditor becomes aware of material subsequent events in this period, he/she should carry out appropriate audit procedures to determine whether the subsequent event has a material effect on the financial statements.

If the directors amend the financial statements; the auditor should produce a new report on the amended financial statements.

If the directors do not amend the financial statements, and the subsequent event is material, the auditor should consider how the shareholders can be informed of the subsequent event. This may include the auditors making a statement at the annual general meeting at which the financial statements are approved by the shareholders. The auditor may consider taking legal advice, and it points out that auditors do not have a statutory right to communicate directly in writing to shareholders.

In the period from 6 January to 28 January 2003, the auditors have no duty to seek out whether any material subsequent events have occurred in this period. However, if the auditor

becomes aware of a material subsequent event in this period, he should consider whether he should withdraw his audit report. He will probably have to take legal advice on the matter. Also, he should discuss the problem with the company. It may be necessary for either the directors or the auditors to make a statement at the annual general meeting (AGM)

If the directors revise the financial statements, the auditor will have to audit these revisions and come to a conclusion on whether the revised financial statements show a true and fair view. The audit report on the revised financial statements should refer to the note in the financial statements which describes the changes and it should refer to the earlier audit report. The audit report on the revised financial statements should not be dated before the date the directors approve those financial statements (normally, the dates are the same).

If the directors do not revise the financial statements, and do not make a statement at the AGM, the auditor should take legal advice on the course of action he should take. Normally, he should make a statement to shareholders at the AGM.

IAS 560 does not provide guidance on the auditor’s responsibilities after the financial statements have been approved by members at the annual general meeting. However, it does appear that the auditor has no responsibility for detecting subsequent events in this period. If, during this period, the directors find material mis-statements in the audited financial statements, and inform the auditor of the fact, the procedures will be the .similar to those described in part (a)(iv) above.

List and briefly explain audit procedures, which involve examination of subsequent events.

Checking cash received from debtors after the year-end to check recoverability of year- end and sales ledger balances. Any year-end balances which are unpaid at the time of the audit will be potential bad debts and further investigations should be carried out.
A debtor’s circularization carried out after the year-end could be a post balance sheet check of debtors at the year-end.
Checking sales after the year end to check recoverability of stock at the year end, if for stock held at the year end, the selling price after the year end is more than cost, then the stock can be valued at cost. However, if the selling price is less than cost, this stock should be valued at net realizable value.
Checking sales cut-off. Starting from the dispatch note, for sales before the year-end, the sales invoice should be posted to the sales ledger before the year-end. For sales after the year- end, the auditor should check the sales invoice is not posted to the sales ledger before the year end (technically, only this latter check is a check of subsequent event).
Checking purchases cut-off. Starting from the goods received before the year-end, the purchase invoice should either be posted to the purchase ledger before the • year-end or included in purchase accruals at the year-end. For goods after the year-end, the purchase invoice should be neither posted to the purchase ledger before the year-end nor included in purchase accruals at the year-end.
Checking supplier’s statements to the balances on the purchase ledger. If the balances agree, this is good evidence that the purchase ledger balance is correct. If there is a difference, it should be reconciled and the auditor should consider whether the differences are reasonable. Supplier’s statements are an effective way of checking purchases eut-off, and of detecting late issue of cheques after the year-end.
Check any saleS or disposals of fixed assets after the year-end. This will check whether these assets have been sold for more or less than their balance sheet value. If they are sold for less than their balance sheet value, normally they ‘should be written down to their realizable value at the year-end.
Checking returns of goods from customers and other sales credit given after the year-end. This helps determine whether the provision for these items in the financial statements is reasonable. Similar checks can be made for purchase items, such as goods returned before the year-end when the credit is received after the year-end, and other credits received from suppliers after the year-end.
Checking about legal claims against the company, which exist, at the year-end. This will involve asking the company secretary and the directors if there are any claims, and (with the clients permission) asking the company’s auditor, inspecting board minutes (see item (x) below) could highlight any claims against the company. The bank letter may include details of a claim against the company of Companies House may have some information (but this is uncommon).
Checking board minutes and management reports after the year-end, which relate to events at or before the year-end.
Checking management accounts after the year-end for any items, which should have been included at the year-end (e.g. bad debts, stock write-downs etc.)
Checking cashbook and petty cash transactions after the year-end to see if there are any unrecorded accruals and prepayments at the year-end, and to confirm those items in the financial statements. For instance, receipts after the year end may indicate sundry debtors at the year end and payments after the year end may highlight sundry creditors and accruals which existed at the year end (e.g, the payment of tax and national insurance in November would be good evidence of the liability at the year end.
Checking purchase invoices received after the year-end. Some of these may relate to pre- year end transactions (i.e. those which are dated before the year end). Purchase invoice for electricity received after the year-end are an effective way of determining the accrual at the year- end.
Checking the bank reconciliation to check if payments were actually made before the year end and there is no teeming and lading fraud (see answer to question 3(a). If there is a delay in clearing a significant value ,of cheques issued before the year-end, this indicates the actual payment (i.e. when the cheques were sent to the creditors) was made after the year-end. A delay in lodging cash received into the bank indicates a teeming and lading fraud. The fact that the cashbook balance can be reconciled to the balance on the bank statement is good evidence that the cash book balance in the Financial statements is correct.

Describe the work you will carry out in period (a) (ii) above

As no detailed audit work would have been carried out during the period, there is a risk that material. subsequent events may have occurred in this period. Thus, the auditor will have to ask the director’s and senior management, if any material subsequent events have occurred in this period or whether further evidence is available for uncertainties existing at 6 December 2002. Also the auditor should examine such documents as Board and Management minutes, management accounts and seek further evidence relating to uncertainties at 6 December 2002 (e.g. whether a doubtful debit at 6 December has been settled).

QUESTION 17

List the factors and explain reasons why these factors may indicate that a company may not be

2oing concern

According to the framework for preparation and presentation of financial statements, going concern is a fundamental assumption whereby it is assumed that; –

The entity will continue in operation in the foreseeable future.
The entity has is neither the intention nor the need to liquidate or curtail materially its scale of operations

Thus, the going concern assumption assumes that the company will be able to discharge its operations normally and meet its financial obligations as they fall due.

Describe any further investigations you would carry out to decide:

Whether the company is a going concern and

Inability to pay the creditors on the due dates.

Major suppliers could withdraw credit or demand cash on delivery. This could mean that as the company maybe unable to collect its debtors as quickly as it is required to settle its liability then it will be unable to meet financial obligations as they fail due.

Excessive holding of stocks and debtors

Cash is what pays liabilities and not other assets therefore, inability to collect cash or to convert stock and liabilities to cash could lead to inability to pay creditors.

Use of short term finance for example overdraft to finance long term assets g. fixed assets or research and development on new products, a company can still be in a net asset position but due to the unrealisability of fixed assets still find that its not a going concern as it has no readily realizable assets to pay off its current liabilities.
Use of expensive finance or being highly geared.

Few entities are able to achieve gross profit margin of over 50%, expensive finance e.g. Hire purchase, lease hire or company being highly geared means that the interest expense can reduce the margin such that little is left to finance other costs. Use of expensive finance also indicates inability to obtain normal credit and overdraft facilities.

Over trading

A company growing too fast may find itself unable to finance the necessary investment in finance and stock holding.

Dependence on one supplier, customer product or market.

This means that insolvency or loss of such suppliers or collapse of market for the product could precipitate crises that could lead to the death of the company.

Long term loan reaching maturity without realistic chances of obtaining alternative financing.

Such loans are usually secured on significant and indispensable assets of the company thus if new facilities cannot be negotiated quickly, the entity may lose its productive ‘facility as they are sold to settle the liability.

Receiving losses

Eventually a loss making company will run out of money thus have going concern problems.

Dividend arrears

Shareholders not getting a return on the investment will eventually withhold their support for the company and may not subscribe for more equity.

Whether it has a reasonable chance of recovering from the going concern problems.

ISA 570: – Going concern. The auditors should assess the adequacy of the means by which the directors have satisfied themselves that:

It is appropriate for them to adopt the going concern basis in preparing the

‘financial statements and

The financial statements include such disclosures, if any, relating to going concern as are necessary for them to give a true and fair view.

For this purpose:

The auditors should make enquiries of the directors and examine appropriate available financial information and
Having regard to the future period to which the directors have paid particular attention assessing going concern, the auditors should plans and perform procedures specifically designed to identify any material matters which could indicate concern about the entity’s ability to continue as a going concern.

Your answer should include details of checks you would carry out in verifying the company’s profit and cash flow forecasts

Preliminary assessment

The auditors approach includes a preliminary assessment, when the overall audit plan is being developed, of the risk that the entity may be unable to continue as a going concern. The auditor should consider:

Whether the period to which the directors have paid particular attention in assessing going concern is reasonable in the entity’s circumstances and In the light of the need for the directors to consider the ability of the entity to continue in operational existence for the foreseeable future.
The systems or other means (formal or informal), for timely identification of warnings of future risks and uncertainties the entity might face.
Budget and/or forecast information (cash flow information in particular) produced by the entity,. and the quality of the systems (or other means, formal or informal in place for producing this information and keeping it up to date.
Whether the key assumptions underlying the budgets and/or forecasts appear appropriate in the circumstances, This should include consideration of:

8 Projected profit;

Forecast levels of working capital;
The completeness of forecast expenditure;
Whether the client will have sufficient cash at periods of maximum need; • The financing of capital expenditure and long-term plans.

The sensitivity of budgets and/or forecasts to variable factors both within the control of the directors and outside their control.
Any obligations, undertakings or guarantees arranged with other entities (in particular, lenders, suppliers and group companies) for the giving or receiving of support.
The existence, adequacy and terms of borrowing facilities, and supplier credit.
The director’s plans for resolving any matters giving rise to the concern (if any) about the appropriateness of the going concern basis. In particular, the auditors may need to consider:
- Whether the plans are realistic;
- Whether there is a reasonable expectation that the plans are likely to resolve any problems foreseen; and
- Whether the directors are likely to put the plans into practice effectively.

The nature and scope of the auditor’s procedures will depend on the circumstances; the extent will depend mainly on the excess of the financial resources available over the financial statements required:

The auditors and directors procedures can be very simple in some cases, particularly in the ease of smaller companies, where budgets and forecasts are not normally prepared and no specific systems are in place to monitor wing concern matters.

The auditor’s examination of borrowing -facilities The auditors will usually:

Obtain confirmations of the existence and terms of bank facilities; and
Make their own assessment of the intentions of the bankers relating thereto.

These procedures will become more vital in any of the following circumstances (for example).

There is a low margin of financial resources available to the entity 2. The entity is dependent on borrowing facilities shortly due for renewal.

Correspondence between the bankers and the entity reveals that the last renewal of facilities was agreed with difficulty, or that, since the last review of facilities, the bankers have imposed additional conditions as a prerequisite for continued lending.
A significant deterioration in cash flow is projected
The value of assets granted as security for borrowings is declining
The entity has breached the terms of borrowing covenants, or there are indications of potential breaches

If the auditors cannot satisfy themselves then, in accordance with the audit reporting standard (ISA 700) they should consider whether the relevant matters need to be:

Disclosed in the financial statements in order that they give a true and fair view and/or
Referred to in the auditors report (by explanatory paragraph or a qualified opinion).

QUESTION 18

“The management letter is a form of report by external auditors to the management. This report which in some respects is a report on the ability and effectiveness of management is useful to shareholders as the financial statements and should be distributed to the shareholders not just to management themselves.”

Required:

Discuss the merits and demerits of this proposition. How dpes it compare to the current practice?

The purposes of the auditor sending a management letter:

To enable the auditor to give his comments on the accounting records, systems and controls
To enable the auditor to bring to the attention of the management areas of weakness that might lead to material errors

To enable the auditor to communicate matters that may have an impact on future audits

To enable management to put right matters that may otherwise have led to audit report qualification
To enable the auditor point out areas where management could be more efficient or more effective or where economies could be made or resources used more effectively.

The contents of the report include:

A list of weakness in the structure of systems of accounting and internal controls. This means where the client has records or controls which are ill designed or inadequate. ii. A list of deficiencies in operation of the records or controls. This is principle good records and controls have been designed but they may be by-passed or not always carried out.

Unsuitable accounting policies and practices

Non-compliance with accounting standards or legislation
Explanations of the risks arising from each weakness
Comments on inefficiencies as well as weaknesses. vii. Recommendations of improvement.

Items (iii) and (iv) may require the auditor to qualify his report to the members as required by statute.

The proposal that the report to management .by the auditors should be distributed to the shareholders as well as the financial statements has some merits such as:

Giving the shareholders more information on how their funds are being controlled and thus giving them increased opportunities for monitoring their investment and’ checking the performance of the directors. It will alert the shareholders to breaches by the directors of legal and other requirements, items that due to materiality considerations do not appear in the auditor’s report to shareholders.
Bad investment decisions by the directors and inefficient, uneconomical and ineffective policies of the directors will be highlighted.

On the other hand, the main role of the auditors is not to judge on the ability of the management. Distributing the report to the shareholders would therefore have the following demerits:

Allows more conflict between the providers of funds and the controllers stifling possible initiative by the directors, yet the director’s performance can easily be monitored through the price movement on the stock exchange.
In most cases a good number of the directors, are themselves shareholders. Thus they are able to act to correct shortcomings on behalf to the rest of the directors.
Too much information to shareholders may counterproductive, as the shareholders attention will he detracted from the more important issues.

The current practice is not to send such a management letter to the shareholders, although in certain industries such as banking, building society or insurance, such information is provided freely not only to management but also to the regulatory authorities such as the central bank of Kenya and the commissioner of insurance.

Shareholders in the main tend to he interested in such a report to give their directors some leeway in operations.

QUESTION 19

Vintage Villas Ltd. operates five holiday centers on freehold sites in Kenya. The company’s financial statements for the year ended 30 April 2000 disclose total turnover of 456 million and net profit before taxation of Sh.50,400,000. The following matters have arisen for your audit work on these financial statements:

Costs of brochures and advertising of Sh.15„840,000 relating to the year ended 30 April 2000 for the peak season have been carried forward in the balance sheet as a prepayment.

Bar stocks at one of the holiday centers were not physically counted on 30 April 2000 but were estimated by the bar manager at Sh.840,000 based on the previous physical stocktaking at 31

March 2000 which disclosed a value of Sh.768,000. Sales during the month of April amounted to Sh.1,320,000. The subsequent physical stocktaking took place on 31 May 2000. using the estimated value on 30 April 2000, a review of the trading results for the month of April and May disclosed a gross profit_ percentage of 60% and 39% respectively, compared with an average of 46% for the other eleven months of the year.

The manger of each holiday center is responsible for paying casual labour employed during the six peak holiday weeks and for the shorter periods at other times of the year. These payments are made in cash ‘and amount to approximately Sh.4,800,000 per center for the year, but no receipts or-vouchers are available apart from the weekly lists of payments signed by each manager. – However all necessary PAYE and NSSF requirements have been complied with in respect of such payments. Provisions for liabilities and charges include a provision for future maintenance of Sh.24,000,000 representing one third of the estimated cost of totally renovating all building in the holiday centers. During February each year, one third of the properties on each side is fully renovated.

Required:

Comment on the further considerations required of each of the above matters in order to conclude the audit and to indicate the possible effects on the audit report.

Tinder the accruals assumption a prepayment is a payment made in one period but the benefit to be derived is properly for a future period. There must be a rational basis for determining the period over which the future benefit will be derived.

For the cost incurred of 15,840,000 to qualify as a prepayment consideration will have to be given to:

The normal accounting policy adopted by the company. Whether the treatment being adopted is consistent with previous years
Whether the brochures and advertising is to be utilized after 30 April even though paid for in advance, such as whether there are still TV shows to be aired.

The ability to measure with sufficient reliability when the expenditure will be fully utilized. iv. lbw close to the year end it was incurred and whether the benefits can be spread into the ‘future.

The figures prepaid represents 31% of the Profit before Tax. To, defer it would appear to be distort the profit figure. It is unlikely that it is justified to treat it as a prepayment. The most likely effect n the auditors’ report would he a qualification on disagreement although an emphasis of matter could suffice.

The analytical procedures indicate that the closing stock at 30 April 2000 was overstated However, the impact on the profit before tax of the possible misstatement is likely to be less than 1%.

If however the quantities can be determined based on sales and receipts of new supplies during the month of April 2000 then physical quantities can be determined and properly valued.

The materiality of the misstatement indicates a very small figure that would have no impact on the profit before tax.

Thus the impact on the auditor’s report is likely to be minimal and will not be mentioned. However, the auditors will refer to the matter in the management letter to the management.

The failure to take stocks is a major weakness in controls and should be rectified. A reference in the management letter will be sufficient.

Significant amounts of expenditure must be adequately supported to prove that they are complete, valid and. accurately recognized:

The evidence to support the casual labour absolutely inadequate. The list required by the managers are not adequate evidence of the expenditure. This represents a major limitation of scope and appropriate audit procedures with regard to the report should be undertaken.

The correct procedure for the treatment of provisions is authoritatively prescribed in TAS

The provision of future maintenance of shs.24,000,000 is not in accordance with IAS . the amount involved is material and should therefore be adjusted , failure to which the report should be qualified.

QUESTION 20

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.

planning the audit the auditor must:

Consider in particular whether there are any events, conditions and business risks which might cast doubt on the entity’s ability to continue as a going concern
Evaluate management’s assessment of the entity’s ability to continue as a going concern When events or conditions have been identified which cast significant doubt on the viability of the business the following additional actions should be taken:
Review management’s plans for future actions based on its going concern assessment and ensure that these are feasible and that the outcome of these plans will improve the situation. (Specific procedures might include analyzing and discussing cash flow, reviewing the terms of debentures and loan agreements)
Gather sufficient appropriate audit evidence to confirm or dispel whether or not a material uncertainty exists regarding going concern. This will involve considering any additional facts or information which has become available since management’s going concern assessment.
Seek written representations from management regarding its plans for future actions and the feasibility of these plans
Obtain information regarding the continuance of loan facilities from the company’s bankers.
Identify indications of cash flow problems e.g. determine whether there has been an increase in receivables days by reviewing the receivables ageing analysis

QUESTION 21

ISA 580 Subsequent Events explains the audit work required in connection with subsequent events.

Required

List the audit procedures that can be used prior to the auditors report being signed to identify events that may require adjustment or disclosure in the financial statements.

You are the auditor of OilRakers, a limited liability company which extracts, refines and sells oil and petroleum related products.

The audit of OilRakers for the year ended 30 June 20X5 had the following events:

Date	Event
15 August 20×5	Bankruptcy of major customer representing 11% of the trade receivables on the statement of financial position.
21 September 20×5	Financial statements approved by directors. ,
22 September 20×5	Audit work completed and auditors’ report signed.
1 November 20×5	Accidental release of toxic chemicals into the sea from the company’s oil refinery resulting in severe damage to the environment. Management had amended and made adequate disclosure of the event in the financial statements.
23 November 20×5	Financial statements issued to members of OilRakers.
30 November 20×5	Afire at one of the company’s oil wells completely destroys the well. Drilling a new well will take ten months with a consequent loss in oil production during this time

Required;-

For each of the following three dates:

15 August 20×5
1 November 20X5; and – 30 November 20×5.

States whether the events occurring on those dates are adjusting or non-adjusting according to IAS 10 Events after the reporting period, giving reasons for your decision.

Audit procedures

Reviewing procedures management has established to ensure that subsequent events are identified. Reading minutes of board minutes and any minutes of meetings with shareholders

Reading the latest available interim financial statements, budgets, cash flow forecasts and other related management reports

Reviewing correspondence with solicitors regarding any litigation or legal claims

Making inquiries of management as to whether events have occurred which might affect the financial statements. These inquiries would include:

Updates on any ongoing issues already Identified
Whether new commitments, borrowings or guarantees have been entered into
Whether sales or acquisitions of assets have occurred or are planned
Whether the issue of new shares or debentures has been made or is planned
Whether any assets have been destroyed eg by fire
Whether there have been any developments regarding risk areas and contingencies • Whether there are any events which call into question going concern

Explain the auditor’s responsibility and the audit procedures that should be carried out.

Three events: 1AS 10

15 August 20X5

The bankruptcy of the major customer is an adjusting event after the reporting period. It provides additional information concerning the recoverability of the debt at the reporting date and as it represents 11% of receivables is likely to be material to the financial statements. An adjustment should he made in the financial statements reducing the receivables balance and profits.

1 November 20X5

The accidental release of the chemicals is a non-adjusting event. It occurred after the reporting date and does not provide further information about conditions at the year end. On this basis the adjustment made is not necessary. However the impact of the leak is likely to be significant as the company may incur penalties or fines due to the environmental damage. Disclosure of the event and estimate of the financial effect should be made.

30 November 20X5

The fire at the well is a non-adjusting event. It occurred after the reporting date and does not relate to conditions which existed at the year end. Although there will be a loss of production and education in profits there i ; no indication that this is significant enough to call into question going concern. Disclosure should be made of the events surrounding the fire and an estimate of the financial effect.

Auditor’s responsibility and audit procedures

15 August 20X5

The bankruptcy of the major cu.stomer takes place after the year end but before the audit report is signed. In accordance with ISA 560 the auditor is required to perform audit procedures designed to obtain appropriate evidence that all events up to the date of the auditor’s report that may require adjustment of, or disclosure in, the financial statements have been identified.

These procedures would include the following:

Confirming the details of the bankruptcy to documents received by oilRakcrs from the liquidator
Agreeing the balance outstanding to the confirmation received from the customer as part of the audit of receivables. If this is not available agree the outstanding balance to pre year-end invoices.
Verifying that the adjustment has been made correctly in the financial statements receivables are i educed in the statement of financial position and profit in the income statement.
Requesting written representation that there are no further amounts due from this customer

1 November 20X5

This event takes place after the audit report has been signed but before the financial statements have been issued. After the date of the audit report the auditor does not have any responsibility to perform audit procedure or make inquiries. However in This east; as the auditor has been made aware of the chemical spill the situation should be discussed with management and an appropriate course of action decided.

Audit procedures would be as follows:

Confirm the details included in the disclosure notes in the accounts by discussing the situation with management, looking at press reports and any other records which are available. Assess the adequacy of the disclosure in compliance with IAS 10.
Confirm that no adjustment has been made in the accounts in respect of the spill.
Review correspondence with legal experts regarding any liability for environmental damage.
Obtain further written representations confirming that there are no events which should be brought to the auditors’ attention.

As the financial’ statements have been amended after the auditors report has been signer! a new audit report would need to be issued. This should be dated no earlier than the data of the revised financial statements. The revised report should include an emphasis of matter paragraph highlighting the events which are disclosed in the notes to the accounts.

30 November 20X5

The fire at the oil well takes place after the financial statements have been issued. The auditor has no obligation at all to make any inquiries regarding such financial statements by this date. When, as in this case, the auditor becomes aware of a fact which would have had an impact on the audit report, the auditor should consider whether the financial statements need revision, should discuss the matter with management and decide on the appropriate course of action.

Procedures would be as follows:

Clarify the facts by discussion with management, reading minute of board meetings and any reports submitted by expels on site.
Inspect insurance documents to confirm that the damage caused to the well and any consequential damage e.g. environmental, is covered. Assess the basis on which the ten month time period has been calculated for drilling the new well to determine whether it is reasonable. Both of these factors may affect the viability of the business which should be assessed.
Determine how management intends to deal with the issue. If the accounts are to be revised review the steps taken by management to ensure that anyone who had received the previously issued financial statements is informed of the situation.
If management does not revise the financial statements and the auditor considers that, revision is necessary, consider the means by which recipients of the initial financial statements can be contacted. Before any further action is taken legal advice should be sought.

QUESTION 22

Define the going concern assumption.

Linder the going concern assumption, an entity is viewed as continuing in business for the foreseeable future. When the use of going concern assumption is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realize its assets and discharge its liabilities in the normal course of business. Under 1AS 1 Presentation of financial statements, the minimum period for the foreseeable future is 12 months after the year end.

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 fl n 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 Medimade’s suppliers have been paid much later than usual and hence some of them have withdrawn credit terms meaning the company must pay cash on delivery: As a result of the above the company’s overdraft balance has grown substantially.

The directors have produced a cash 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:

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.

Indicator	Why indicator impacts on going concern
30% of Medimade’s (M’s) revenue comes from just two products in a competitive market	The dependence on just two products in a competitive market means, if competitors develop a similar or superior product at the same or lower prices, then M will probably struggle to make enough sales to cover expenses (already evidenced by declining demand)
There has been insufficient investment in product development which would appear essential in this competitive product driven market.	Existing products are in decline and there are not likely to be sufficient new products.to fill the cash flow void these declining products will leave.
Recruitment of suitably trained staff is proving difficult.	In the pharmaceutical industry, specialized staffs are needed to develop the products which will create cash Inflows. Without them, It will be difficult to see how new products and related revenue will be forthcoming.
$2m of investment in plant and machinery is needed but the company has been unable to secure funding for this	Again this will hold up new product development and also suggests the bank consider M a risky M I investment and have reservations about its financial health
Trade payables are being paid late and withdrawn credit terms	The company has to now pay cash on delivery and this adds further cash flow strain to M which is already utilizing its overdraft facility. Also some suppliers may not supply M and prevent them from getting their products into a saleable condition
The cash flow forecast shows a significantly worsening position over the next 12 months	The company already seems to have significant cash flow problems. A worsening position suggests further net cash outflows and the company may not be able to meet liabilities as they fail due, particularly given the bank’s cautious stance over providing finance.

Explain the audit procedures that the auditor of Medimade should perform in assessing whether or not the company is a going concern.

Review correspondence with the bank for indications of the likelihood of renewal of the overdraft facility
Obtain the cash flow forecasts and assess whether the cash inflows and outflows appear realistic and consistent with knowledge built up during the audit. Consider the reasonableness of the assumptions on which the forecasts are based and discuss any findings with management.
Review any post year end management accounts and compare the cash position they show with that forecast to help assess the reliability of the forecasts.
Review any available post year end correspondence with suppliers to see if the trend of withdrawal of credit terms has continued, or eased, since the year end date.

Review board minutes for meetings held after the year end for issues which indicate further financial difficulties or issues/funding which will alleviate cash flow problems to some degree.

Obtain written representations from directors/management that they consider the company to be a going concerti.

The auditors have been informed that Medimade’s bankers will not make a decision on the “overdraft facility until after the audit report is completed. The directors have now agreed to include going concern disclosures.

Required:

Describe the impact on the audit report of Medimade if the auditor believes the company is a going concern but a material uncertainty exists.

The auditor agrees with the directors that the company is a going concern and this is the basis on which the accounts are drawn up. However, the directors have agreed to include going concern disclosures and these disclosures will need to-be assessed to see if they adequately describe the material uncertainty over going concern.

if the disclosure is inadequate the audit opinion will be modified on the grounds that the financial statements are material misstated.

If the inadequate disclosure is deemed a pervasive material misstatement, then an adverse opinion will be expressed stating the accounts are not presented fairly, in all material respects. The reason for the adverse opinion will be stated in a ‘basis for adverse opinion’ paragraph immediately before the opinion paragraph.

if the misstatement is not deemed pervasive, a qualified opinion will be expressed stating that except for the disclosure over going concern, the financial statements are presented fairly. The reason for the qualified opinion will be stated in a ‘basis for qualified opinion’ paragraph immediately before the opinion paragraph.

If the disclosure is adequate, then the accounts will be fairly presented in all material respects and an unmodified opinion will be issued, but as a material uncertainty exists, an emphasis on matter paragraph will be included after the opinion paragraph and will highlight this and refer to the disclosure provided by management.

QUESTION 23

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

Define going concern and discuss the auditor’s responsibilities in respect of going concern.

The going concern assumption is a fundamental principle in the preparation of financial statements. It assumes that an entity will continue in business for the foreseeable future with neither the intention not the necessity of liquidation, ceasing trading or seeking protection from creditors. Assets and liabilities are recorded on the basis that the entity will be able to realize its assets and discharge its liabilities in the normal course of business.

State the audit procedures that may be carried out to try to determine whether or not Smithson Co is’a going concern.

The auditor should discuss with Smithson’s management their opinion that the company cannot continue as a going concern, and the reasons for coming to this conclusion.

The auditor should consider the Impact of his findings on the audit report to be Issued at the end of the I audit, and explain to the directors the effect on the opinion if any disclosures required are not made, or if the accounts are prepared on an incorrect basis.

Where appropriates disclosure has been made, the opinion on the financial statements will not be modified, but the report will Include an emphasis of matter paragraph bringing readers attention to the material uncertainty that may affect the entity being able to continue as a going concern.
If the directors disagree and do not make additional disclosures that are required, the audit opinion will be qualified (except for) or adverse.

Explain the audit procedures the auditor may take where the auditor has decided that Smithson Co is unlikely to be a going concern.

Discuss with Smithson’s managements to ascertain whether they consider that the company is able to continue as a going concern
Review the cash flow forecast prepared, and consider the assumptions used in preparingit

Review and discuss with management Smithson’s latest available interim financial statements or management accounts
Review board minutes for references to financial difficulties
Review events after the year-end for issues that could affect Smithson’s ability to continue as a going concern
Discuss with Smithson’s legal advisers what the outcome of the two court cases is likely to be and whether there are any other cases pending or likely to result Discuss with relevant management whether any new contracts have been awarded to the company, given that several contracts have been withdrawn as a result of the adverse publicity caused by the legal cases
Obtain a written representation from management to confirm that Smithson can continue as a going concern
Discuss with management the situation regarding the equipment and what their intentions are – will they be replacing machines in the near future?
Discuss the requirement for additional finance by the company and how this will be acquired.
Review future cash flow projections and forecasts
Review current borrowings of the company and repayment terms and consider whether the company will be able to repay these

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.

Negative assurance’ is when an auditor gives an assurance that nothing has come to his attention which indicates that the cash flow forecast (in this case) is free from material misstatement. He therefore gives his assurance in the absence of any evidence to the contrary. The cash flow statement would have been, prepared using forecast information which cannot easily be verified as correct as it is based on assumptions about the future. Therefore, the auditor can only provide limited, negative assurance on it.

The audit report, however, provides reasonable assurance that the financial statements present fairly, in all material respects the financial position of the company (or give a true and fair view). It does not guarantee the accounts are correct, but that they are true and fair within a reasonable margin of error. The financial statements are prepared using historical information and therefore the figures can he verified by the auditor, hence his ability to provide reasonable, positive assurance as to their truth, and fairness:

QUESTION 24

You are the audit manager in charge of the audit of MSV Co for the year ended 28 February 20×7. 1VISV Co is based in a seaside town and hires motor boats and yachts to individuals for amounts of time between one-day and one week. The majority of receipts are in cash, with a few customers paying by debit card. Consequently, there are no trade receivables on the .statement of financial position. The main non-current, assets are the motor boats and yachts. The company is run by four directors who are also the major shareholders. Total income for the year was about $10 million.

The following issues have been identified during the audit.

Issue 1

Audit tests on sales indicate a deficiency in the internal control system, with a potential understatement of income in the region of $500,000. The deficiency occurred because sales

invoices are not sequentially numbered, allowing one of the directors to remove cash sales prior to recording in the sales day book. This was identified during analytical procedures of sales, when the audit senior noted that on the days when this director was working, sales were always lower than on the days when the director was not working.

Issue 2

During testing of non-current assets, one yacht was found to be located at the property of one of the directors. This yacht has,not been hired out during the year and enquiries indicate that the director makes personal use of it. The yacht is included In the non-current assets balance in the financial statements.

Required;-

For each of the issues above:

List the audit procedures you should conduct to reach a conclusion on these issues;

Audit procedures

Discuss the issue with the other directors of the company so that they are aware of the matter
Following these discussions, ascertain what action the other directors intend to take against the director in respect of the matter
Perform further substantive audit work, such as detailed analytical review, to confirm the extent of the understatement

Obtain written representation in relation to the estimate of the amount of the fraud

Assuming that you have performed all the audit procedures that you can, but the issues are still unresolved, explain the potential effect (if any) on the audit report.

As this issue is material, the understatement of sales income representing 5% of total revenue for the year, it is likely to be material and require a modification of the opinion in the auditor’s report.

The report should include a qualified opinion due to an inability to obtain sufficient appropriate audit evidence on sales for the year.

The audit report should provide details of this matter giving rise to the qualified opinion In a Basis for qualified opinion’ paragraph.

Issue 2 – personal use of boat i) Audit procedures

Discuss the issue in more detail with the director concerned and ask why it is located at his house

Through discussion, find out whether the director purchased the boat and if so, agree the amount to the cash book and bank statements and non-current asset register
Review financial statements to ensure correct disclosure as a director’s benefit within directors’ emoluments
Consider increasing procedures- for inspection of other non-current assets to ensure other assets are not used in the same way

ii) Potential effect on audit report

Non-current assets on the statement of financial position will be overstated since they include a boat that is used for personal use by one of the directors and not for the purposes of the business.

Given that non-current assets are likely to be material to the statement of financial position this issue may result in a qualified audit opinion on the basis that the overstatement of non¬current assets has resulted in the accounts being materially misstated.

The value of the boat should be taken off the statement of financial position and it should be reclassified as a benefit within the directors’ emoluments notes.

QUESTION 25

You are the audit manager in Jon Arc & 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 Financial Reporting 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,

Additional procedures and actions These would be as follows:

Confirm the facts of the situation and ensure that appropriate audit evidence has been collected-and recorded to date.
Consider whether there are any legitimate reasons why depreciation has not been provided
g a departure from IFRSs is required to give a true and fair .view.
Assess whether the potential adjustment is material to the financial statements, if it is not material no further action would be necessary.
Discuss the situation with management and obtain an explanation as to why depreciation has not been provided.
Explain to the management that in my opinion depreciation should be provided. Request that management adjust the financial statements and explain that failure to do so would result in a modified audit opinion.

Assess the potential impart of the matter to determine whether the modified audit opinion i,e material or pervasive.

Obtain a written representation stating that depreciation will not be charged on buildings. – Draft the relevant sections of the modified audit report.

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AUDIT EVALUATION AND REVIEWS QUESTIONS AND ANSWERS

Written by MJ

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