AUDITING AND ASSURANCE Dec 2010

QUESTION ONE

The National Metal Works Limited manufactures and retails door and window frames. The company recently dismissed their external auditors. The directors have approached your firm of accountants to act as their auditors and the directors have proposed a fee of KShs. 1, 000, 000 plus a bonus of 1% of profits after tax.

Required:

Describe the steps you would take before advising the partners of your firm whether to

accept the appointment as auditors or not. (8 marks)

State with reason whether professional auditors should accept the method of

remuneration as proposed by the directors of the client company. (6 marks) c) Explain the implications of fixing the audit fee by negotiation between the directors and the external auditors on the independence of the auditor. (6 marks)

(Total: 20 marks)

DECEMBER 2010

QUESTION ONE

The auditors should take the following steps before accepting nomination as auditors of Nairobi Metal Works: –
The auditors should ensure that they are professionally qualified to act as auditors and not disqualified for any legal, ethical or professional reasons from acting. For example the partners in your firm should confirm that they are not servants of the company and they have not breached any of the ICPAK guidelines on professional independence.
The auditors must be satisfied that the firm is able to service the clients‘ needs from existing resources by providing staff with the appropriate experience and qualifications at the right time to carry out the work.
The auditors should gain an understanding of the nature of the client, and check on their status. This information will assist your firm in evaluating the potential risk in engaging with this client. For example your firm should not associate with clients whose management has a reputation of dishonesty.
Your firm should seek references from other business associates of this proposed client. Again the references obtained will assist in evaluating the client for any potential risk.
According to statement no. 8 issued by ICPA (K), the auditors should, with the company‘s permission, communicate with the company‘s previous auditors. If permission is withheld, the auditors should not accept nomination. The new auditors should only accept the nomination if the previous auditors can confirm that there are no legal or professional reasons why they should not accept. If the previous auditors have been dismissed because of unwillingness to concur with unacceptable accounting policies or improper practice by the director, the new auditors should not be party to such a practice. If the reply from the old auditors indicates that such difficulties have arisen, the new auditors need to discuss them fully with the directors and be sure that they will not be faced with unacceptable ethical problems after accepting the appointment. The provisions of statement 8, are summarized in the following table: –

The fee charged by auditors should be based on the time taken and the seniority of the staff involved, taking into account the costs of the auditors practice overall. Normally, hourly rates of charge are used which will vary according to the complexity of the work and the level of responsibility assumed by the practice in relation to the work.

The use of a contingency fee or percentage basis for calculating the fee is not acceptable for normal audit work. In this case, the auditor‘s independence could be impaired by the use of a percentage of profits after taxation as a bonus, as it could tend to discourage the auditors from proposing adjustments that reduced the profit figure. The fixed £100,000 would be acceptable if the auditors were satisfied that it was reasonable in relation to the time taken and staff employed in carrying out the audit work.

Maintaining the auditors‘ independence is clearly essential if the audit opinion is to have credibility and the confidence of users of financial statements.

There are various ways in which the auditor‘s independence is preserved, even given the situation that audit fees are generally fixed by negotiation between the directors of a company and the auditors. Ethical guidance sets out various guidelines to safeguard the auditors‘ independence. T hese include a restriction on the percentageof total fees which a practice can obtain from a single client (15%) and restrictions preventing auditors from holding shares in the client company or otherwise being personally interested in the client‘s performance.

It is undeniable that auditors would be more independent of the client if they were not dependent on the client for fees.

The accounting profession takes the view that the best safeguards of auditor independence is provided by professional ethics and an objective attitude on the part of the auditors. It remains to be seen whether the public and the government will continue to concur with this view.

QUESTION TWO

Briefly explain the meaning of the following terms as used in auditing:
- The materiality concept. (3 marks) The going concern concept. (3 marks)
Explain five factors which would indicate to the auditor that the going concern assumption of the business entity he is auditing is threatened. (10 marks)

What is the form of audit opinion you would give if you concluded that the client company was experiencing going concern problems and:
- you have established that the financial statements give sufficient disclosure of the

going concern problems? (2 marks)

you have established that there is no disclosure of the going concern problems in the

financial statements? (2 marks)

(Total: 20 marks)

QUESTION TWO

Materiality, is defined in the International Accounting Standards Committees ―Framework for the preparation and presentation of financial statements in thefollowing terms:-

―Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.‖ Materiality dependson the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful. The concept of materiality therefore guides the auditor in carrying out the audit. For example if there is a suspected misstatement in an account balance that is deemed to be material to the financial statements the auditor will extend the level of testing because the results from the testing could have an impact on the kind of opinion that the auditor will issue.

Going concern is one of the fundamental accounting assumptions and is defined by the International Standards on auditing, glossary of terms as ―an assumption that an enterprise will continue in operation for the foreseeable future, and that the enterprise has neither the intention nor the need to liquidate or to curtail materially the scale of its operations.‖

As a result, assets are valued on the basis of continued use, such as historical cost or replacement cost rather that net realizable value or liquidation value.

According to ISA 570, factors which would indicate that the going concern assumption of the business entity that he is auditing is threatened include:

Financial Indicators

Ø Net liability or net current liability position i.e. liabilities exceed assets.

Net current liability position i.e. where current liabilities exceed the current assets;

Fixed term borrowings approaching maturity without realistic prospects of

renewal or repayment or excessive reliance on short -term borrowings to

finance long term assets.

Ø Adverse key financial ratios e.g. current ratio of less than one. Ø Substantial operating losses

(c)

Arrears or discontinuance of dividends

(d)

Inability to pay creditors on due dates

Difficulty in complying with the terms of loan agreements

Change from credit to cash on delivery transactions with suppliers.

Inability to obtain financing for new essential product development and other

essential investments

Operating Indicators

ØLoss of key management without replacement
Ø Loss of a major market, franchise, license or principal supplier
- Labour difficulties or shortages of important supplies

Other indications

^Ø Non-compliance with capital or statutory requirements

Pending legal proceedings against the entity that may, if successful, result in judgments that could not be met
- _{Changes in legislation or government policy}

NB: The significance of such indications can often be mitigated by other factors e.g. the effect of an entity being unable to make its normal debt repayments may be counterbalanced by management‘s plans to maintain adequate cash flows by alternative means, such as by disposal of assets, rescheduling of loan repayments or obtaining additional capital.

If adequate disclosure is made in the financial statements, the auditor should ordinarily express an unqualified opinion and modify the auditor‘s report by adding an emphasis of matter paragraph that highlights the going concern problem by drawing attention to the note in the financial statements that discloses the matter set out in such a paragraph. The purpose of the emphasis of matters paragraph is to draw the attention of the user of the financial statement to the note in the financial statements that discusses the going concern issue for a better understanding.

If adequate disclosure is not made in the financial statements, the auditor should express a qualified or adverse opinion, as appropriate. This is because the financial statements will be misleading and the auditor needs to highlight this by either qualifying the report of by issuing an adverse opinion.

QUESTION THREE

You are the auditor of Bei Nafuu Supermarkets Limited across the country. The management has informed you that they intend to set up an internal audit function.

Required:

Identify and explain the function to be performed by the internal audit department in

Bei Nafuu Supermarkets Limited. (8 marks)

List four factors that you would consider before placing reliance on the work of the

auditors of Bei Nafuu Supermarkets Limited. (4 marks)

Explain four controls that you would expect to find in Bei Nafuu Supermarkets

Limited. (4 marks)

Explain how the quality of the internal audit department of Bei Nafuu Supermarkets

Limited can be assessed. (4 marks)

(Total: 20 marks)

QUESTION THREE

I would expect the internal auditors to carry out the work in the following areas: –

Reviewing accounting systems and internal controls. This would include e.g.

considering the adequacy of controls in an area like cash receipts at the supermarket and making suggestions for improvement.

Examining financial and operating information for management. Here, they would test the accuracy of the information contained in Bei Nafuu‘s financial and management accounts by performing both substantive procedures and tests of control.
Review of the economy, efficiency and effectiveness of operations and the functioning of non-financial controls. This might cover areas such as staff deployment or training, energy conservation, floor management.
Review of the implementation of corporate plans, policies and procedures This would involve internal auditors checking that any special company procedures were adhered to, either in the area of financial or administrative controls.

Special investigations. Internal audit could be required by management to carry out any kind of review that is relevant, e.g. research into the possible effects of a new accounting policy or detailed investigation into a suspected fraud. The work of internal audit spans a wide spectrum of activities from tests that are very similar to those performed by the statutory auditor to ‗one-off‘ exercises for internal use by company‘s‘ management.
Reviewing whether the supermarket is complying with the relevant laws and regulations such as council health standards, labour laws and taxation laws.

(A) When the external auditor intends to use specific work of internal auditing, the external auditor should evaluate and test that work to confirm its adequacy for the external auditors purposes. Before evaluating any specific work with the intention of relying on it the auditor should carry out a preliminary evaluation of the function. In carrying out this evaluation the following factors should be considered:

Organization status

Since internal audit function is part of the entity it cannot be totally independent. To boost it‘s independence the status of the function within the organization should be such that the internal auditor reports to the highest level of management. The internal auditor should also be free of any other operating responsibility such as performing accounting functions, which may conflict with his role as an independent watchdog of controls and operations of the entity. There should be no restrictions placed upon his work by management. Such restrictions could impair

the effectiveness of the function.

Scope of the function

The external auditor should ascertain the nature and depth of coverage of internal audit assignments. He should also ascertain whether management considers and acts upon internal audit recommendations. Where the recommendations are not acted upon this represents a weakness in the function and hence the level of reliance

should consequently be reduced.

Technical competence

The external auditor should ascertain whether internal audit work is performed by persons having adequate technical training and proficiency as auditors. Qualifications

and experience of the internal audit staff should be considered.

Due professional care

The external auditor should ascertain whether internal audit work appears to be properly planned, supervised, reviewed and documented. Exercise of due professional care is evidenced by the existence of adequate audit manuals, work

programs and working papers.

Internal audit reports

The external auditor should consider the quality of the internal audit reports prepared and submitted for management action. He should ascertain whether management considers, responds to and acts upon internal audit reports and

whether there is evidence to prove that action.

Level of resources available

The external auditor should consider whether internal audit has adequate resources to be able to carry out their duties effectively. Such resources would include staff

and computer facilities.

If having carried out the above preliminary review the auditor concludes that the internal audit function is effective and he wishes to rely on some specific work done

by the internal auditor the following procedures should be carried out.

The work is performed by staff who have adequate technical training and proficiency as internal auditors;
the work of assistants is properly supervised, reviewed and documented;
sufficient appropriate audit evidence is obtained to form a reasonable basis for

the conclusions reached;

the conclusions reached are appropriate;
reports by the internal audit are consistent with the results of the work

performed;

any exceptions and unusual matters disclosed by internal audit are properly

resolved;

amendments to the external audit programme are required as a result of matters identified by the internal audit work;
there is a need to test the work of internal audit to confirm its adequacy.

NB: The nature timing and extent of the testing of the specific work of internalauditing will depend on the external auditors judgment as to the risk and materiality of the area concerned, the preliminary assessment of internal auditing and the evaluation of specific work by internal auditing.

Controls I would expect to find in Bei Nafuu Supermarkets:

Plan of Organization

I would expect to find the supermarket well organized in terms of different departments such as accounting and human resource departments, each with defined responsibility.

I would expect the shop floor to be organized into different sections where different products are kept e.g. detergents should be kept in one location different from where milk is kept.

I would expect to find a left luggage deposit area where customers leave their luggage whilst shopping.

Segregation of Duties, this refers to assigning duties in processing of transactionsto different individuals such that one person cannot carry out a complete transaction from initiation to final recording in the financial statements without his work being checked by another person.

Duties should be segregated especially within the purchase department. Functions, which should be segregated, include:

Authorization – This should be segregated such that different line managers are given various limits of authority which should depend on such factors such as their position in the organization, their integrity, qualification, competence and remuneration.

Thus, in the purchase department of Bei Nafuu, we expect authority limits to be commensurate with the cost of purchase e.g. the supermarket manager may authorize the purchase of more detergents, but the purchase of a new lorry should come from the board of directors or other senior management.

Execution of duties: – Limits of authority such that a person who authorized a given transaction cannot execute the same. Thus the person authorizing the purchase should not be the one to place the purchase order.

Custody of resultant assets: An official authorizing a given expenditure should not keep the asset arising out of such expenditure. Thus, the person authorizing

purchases should not store the items bought but rather these items should be stored by the store department.

In addition, custody of cash and stock should be in the hands of responsible officials with a high degree of integrity.

Recording: This should be done by a person independent of the above particularly the accounting department. The records should be kept by a person with integrity and responsibility to ensure that records cannot be changed, removed or destroyed.

Physical Controls

These aim at limiting access to the companies‘ assets to only authorized persons at authorized times. Thus, Bei Nafuu‘s sensitive items e.g. cash and documents should be kept under lock and key. They should have security guards to provide security to the premises. They should fit fire protection devices in the company.

Any documents used should be pre-numbered and serialized to prevent misplacement of such documents. These documents include local purchase orders; goods received notes, invoices from suppliers and petty cash vouchers among others.

Installation of closed circuit TVs‘ on shop floor. Use of convex mirrors reflecting the customers actions watched by a guard positioned strategically.

Arithmetic and Accounting Controls

These are used to check the recording function of an organization to ensure that figures in the financial statements are genuine and authentic. This includes:

Periodic reconciliation of accounts e.g. the bank reconciliation, suppliers reconciliation (schedule or ledgers with suppliers statements)
Drawing of trial balance
Periodic balancing of accounts
Regular checking of totals in ledgers and agreeing them to control accounts 5. Use of electronic cash registers at paying point to record cash receipts.

These controls are essential as they provide management with information for decision-making purposes. Such information should be up to date, accurate complete and timely.

Personnel Controls

The controls in Bei Nafuu should be operated by qualified and competent personnel with personal integrity who understand the essence of controls.

Some of the responsibilities will call for periodic training and retraining of staff to meet the changing business conditions. The staff should be properly motivated as well.

Supervision

These include:

Low-level supervision – This should be directed to the personnel on the shop floor and should be done by trained and qualified supervisors.

Middle level – This should be done by line managers (effectively the branch managers of Bei Nafuu‘s Supermarkets) who ensure that company policies (e.g. of neat supermarket, fast moving queues) are implemented and adhered to. If

properly done, it boosts low-level supervision.

Managerial supervision and reviews: This will be executed by top management using tools such as budgets, standard costing statements and internal audit

feedback

It will also imply that managerial controls include supervisory controls and review to ensure that all other controls and company activities are operating smoothly to achieve predetermined goals.

Rotation of duties and vacations

Duties particularly routine duties (such as collecting cash from customers, receiving goods from suppliers) should be rotated to cut continuity of errors and fraud and act as a means of avoiding routine boredom.

More so, staff members should take up their annual leave when it falls due.

Routine and automatic checks

Such controls should be operated on a surprise basis and be directed to areas such as petty cash, cash collected by cashiers, wages payment and stock.

The quality of the internal audit department can be assessed by considering the following:

By reviewing internal audit reports to see whether management acts on the

recommendations by internal audit;

By ascertaining whether the department is staffed by competent people with the

required technical training;

By drawing from prior year‘s experience on the level of reliance placed on internal auditors work.

n Whether internal audit work is properly planned and reviewed.

The auditor should also evaluate the scope of the function and the extent of work carried out by internal audit.

QUESTION FOUR

You are a senior member of the audit team at Grain Millers Ltd., a company whose business is milling maize, wheat and other products for local consumption. The annual turnover for the year ended 30 September 2002 amounted to Sh. 1.5 million and most of its sales were on credit.

The audit team leader has assigned you the audit of the provision for bad and doubtful debts which has been set at Sh. 4.75 million; out of which Kshs 3.25 million relates to the provision against specific bad and doubtful debts and the balance of Sh. 1.5 million is a general provision determined as a percentage of overdue debtors with a higher percentage being applied against the longest overdue accounts.

Required:

Outline the audit procedure you would apply in verifying the general provision for

bad and doubtful debts. (10 marks) ii. Explain how you would verify the specific provision for bad and doubtful debts.

(3 marks)

What is meant by the following terms as used in auditing:

Cut off procedure? (3 marks)
Audit in depth? (4 marks)

(Total: 20 marks)

QUESTION FOUR

Procedures for verifying

General provision for bad and doubtful debts

The question is very specific and requires you to detail the procedures you would carry out ^{in verifying the general provisions.}

AUDIT OBJECTIVES

To verify that the bases applied in computing the general provision is reasonable;

To verify that the general provision is accurately computed;

To verify that the provision created is adequate.

AUDIT PROCEDURES

Obtain an understanding of the basis applied by the company in computing the general provision for bad debts. From your knowledge of the company and experience evaluate whether the basis chosen is appropriate. In particular, ensure that more provisions are

created for long overdue accounts.

Compute the ratio of general provisions to debtors and compare this with the previous period. Obtain explanations for any significant movements.
Using the method applied by the company and the debtors‘ balances recompute the expected provision and compare the amount with what is provided for by the company.
Compare the prior years general provision with the actual debts that were written off during the current year as a check for the reasonability of the method applied by the
Obtain representations from management that the provisions created are adequate.

Verifying the specific provision

Obtain a schedule of the debtors‘ accounts against which specific provisions

were created.

Obtain the reasons why these accounts were considered bad and verify whether the specific provision is adequate (whether this is below 100%)
Verify that all accounts that are considered bad, e.g. disputed balances are fully provided for.

Cut off Procedures

A cut-off procedure is a type of evidence gathering activity performed by auditors during the substantive testing stage. In particular, the cut-off procedures gathers evidence that transactions are recorded in the period to which they relate.

A cut off test, depending on its direction, provides evidence as to two types of misstatement,

namely:

A misstatement relating to completeness, where an economic event that occurs in the financial period being audited (i.e. up to and including the cut -off date) is recorded in the related account balance in the subsequent accounting period.

A misstatement relating to validity, where an economic event that occurs in the period following the period being audited (i.e. after the cut -off date) is recorded in the related

account balance in the period being audited.

A simple example in relation to accounts receivable and related sales transactions is as follows. On the cut-off date i.e. the balance sheet date the auditor obtains details (including details of the sequential identification number, customer name, product description and quantity delivered) of the last delivery advice to be issued on the cut-off date by physically examining the source documents at th e close of business.

If the auditor needs evidence as to the completeness of accounts receivable and related sales transactions, then subsequent to the cut-off date the auditor selects a number of delivery advices with identification numbers before or including the number of the last delivery advice issued on cut-off date. The details on the delivery advices (as noted above) are traced to the relevant sales invoices and then to the accounts receivable records to ensure that the sales have been included in the accounting records on or before the cut-off date. In addition, the auditor selects a sample of sales invoices recorded in accounts receivable records in the first few days of the month following the cut-off date. All invoices selected should refer to delivery advices with identification numbers after the number of the last delivery advice issued on the cut-off date.

Audit in depth

This refers to the carrying out of detailed substantive procedures. It is characterized by extensive vouching and verification of the underlying transactions and account balances.

ISA 500 ―Audit evidence‖ defines substantive procedures as tests performed to obtain auditevidence to detect material misstatements in the financial statements and are of two types: –

Tests of details of transactions and balances

Analytical procedures

QUESTION FIVE

A very important aspect of the audit of the financial statements by an external auditor is the observation of the physical stocktaking.

Required:

Why does the auditor need to attend a stock-take of the company that he audits?

(6 marks)

List four procedures that an auditor would need to undertake prior to attending a

company‘s stock-take. (4 marks)

Explain the audit tests that the auditor would apply to establish the physical qualities of

stock and their ownership. (4 marks)

How does the auditor satisfy himself that the procedure adopted by the management with regard to stocks have been applied throughout the financial period? (6 marks) (Total: 20 marks)

QUESTION FIVE

The overall purpose of the auditors‘ attendance is to assess the effectiveness of

n

The clients stock taking procedures. Verify that the stock take exercise is carried out per the stock instructions. This will assure the auditor that the exercise can be
- relied upon to provide complete and accurate figures of the stock balance;
- n To verify the physical existence of the stock;
n

To inspect the general condition of the stock, this will assist in concluding whether the stock is correctly valued. Note that the auditor does not attend the stock take to count stock but to observe how the exercise is being carried out.
- Before the stock taking, the auditor should carry out the following: –
- Review prior year‘s working papers, familiarize himself with the nature, volume and location of stocks, consider the controls and recording procedures over stock.
- Identify problem areas in relation to the system of internal control and decide whether reliance can be placed on internal auditors.
- If stock held by third parties is material, or the third party is insufficiently independent or reliable, then arrange a stock-take attendance at the third
party‘s premises otherwise, arrange third party confirmation.
- If the nature of the stocks is specialized then he will need to arrange expert help or to review the client‘s own arrangements.
- Examine the client‘s stock taking instructions: If found inadequate, the matter should be discussed with the client with a view to improving them prior to stock-take.
- Auditors should perform analytical procedures on stock as part of the planning process.
- During the stocktaking, the main task is to ensure that the clients staff are carrying out their duties effectively. The auditor should:
- Make two-way test counts from stores floor to stock sheets, and from stock sheets to stores floor.
- Make notes of items counted, damaged stock, instances where the stock
taking procedures are not being followed.
- Examine and test control over the stock sheets. The client should keep a stock sheet register.
- Examine cut off procedures. The auditor should examine the link between purchases records and stocks, and between sales records and stocks, to ensure that there is complete accord between stock and the financial records of purchases and sales, debtors and creditors. These are known as cut-off procedures.
Procedures the auditor would carry out to ensure correct cut off include:

Ø
- During stockgoods received note generated before the stock-take attendance note the serial numbers of the last sales invoice, dispatch note and -take.
Ø

After the stock-take, check the year end dispatch notes to sales invoices and the sales day book and vice versa to ensure that dispatches and the related invoice both fall before year end.

Ø
- Similarly for purchases, ensure year_{correctly treated in the current period.}-end goods receipts notes and related purchase invoices are
Ø

Take a sample of goods received and goods dispatched just after the year end and ensure that the related stock was not included in the count in the case of goods received, that it was included in the goods dispatched.

(v) Pay particular attention to goods held on behalf of third parties e.g. goods on consignment.
- Reach a conclusion as to whether or not the stock taking was satisfactory and hence provides reliable evidence supporting the final stock figure.
- To establish the physical quantities of stock, the auditor should attend the stocktake and observe how the clients‘ employees are counting stocks particularly: –
1. Are the client employees carrying out the work allotted to them properly and
are they following the stock-take instructions?
1. Does the stock appear to be recorded correctly on the stock sheets both as to description and quantity? iii. Are all slow moving, obsolete and substandard stocks properly identified?
NOTE:-

It may be sufficient to watch the counting and recording of stock as it is done by the clients‘ employees, but it will normally be advisable for the auditor to test the efficiency of the counting by arranging for a count or recount in his presence of selected items. Items checked should be marked or noted in a way appropriate to ensure that any subsequent change can be identified.

In an attempt to satisfy himself that the management procedures as regards stocks have been properly applied throughout the period, the auditor will carry out tests of control which include:-
- Observe physical security of stocks and environment in which they are held.
- Test procedures for recording of stock movements in and out of stock.
- Test authorization for adjustments to stock records.
- Test authorization for write off or scrapping of stocks vi. Test controls over recording of stock movements i.e. the use made of
authorized goods received and dispatch notes.
- Inspect reconciliation of stock counts to stock records.

Check sequences of dispatch notes and goods received notes for completeness.QUESTION SIX

State the evidence, which you, as the auditor, would like to find in place and pay attention to when vouching the following payments made by RR Paper Mills Ltd., during the financial year ended 31 October 2002.

Loans to three employees totaling Sh. 6 million. (4 marks)
The last call on 5, 000 ordinary shares at Sh, 15 per share. (4 marks)
Fire insurance premiums amounting to Sh. 10, 000 paid for the office block. (4 marks)
A loan amounting to Sh. 30 million obtained from a local bank and secured by the factory building. (4 marks) e) Salesmen‘s commissions amounting to Sh. 3, 000, 000. (4 marks)

(Total: 20 marks)

QUESTION SIX

(a) Loan to three employees

Proper authorization for the loan by the responsible official and in accordance with _{company policy.}

Supporting evidence as to whether the employees are bonafide employees of the

A repayment schedule of the loans. The period of repayment should not exceed the employees term of office

Ø Security given by the employees to secure the loan.

Evidence to satisfy himself that the debt is good and recoverable at the balance sheet date. This will include evidence of repayments by the employee.

Revision Questions and Answers

Interest on the loan should be charged on normal commercial basis or where there is a

concession that this is within the company‘s policy.

Last call on 5,000 ordinary shares at sh.15 per share.

ØVerify that the call has been made in accordance with the terms of the issue.
Ø Inspect paid cheques for cash paid on the last call.
Ø Inspect any cancelled share certificates for which the company never honoured the last call.

Ø _{Verify that proper authority was obtained to make the payment.}

Fire premiums

Examine policy documents issued by the insurance company to make sure that the policy relates to the office block.

Verify the receipt issued by the insurance company to ascertain that the amount paid was indeed sh.10, 000.00

Ensure that thover or under insured.e policy covers the office block against fire adequately i.e. it has not been

Verify that amount paid in current year compares favourably with the previous years.

Loan amounting to Sh.30 million

Ø Ø

Gwith proper authority from the board.o through the board of directors‘ minutes to ensure that the loan was acquired

Ensure that the loan was obtained on behalf of R R Paper Mills and not for a

third party. To determine this, seek evidence regarding the utilization of the money within the company.
Ø Verify that the loan was utilised for the approved purpose

Determine whether the loan is being properly serviced in terms of interest and principal repayments. If no, consider the impact of the consequences of default to R Paper Mills, e.g. sale of the security, possible liquidation (hence

no longer a going concern).

Salesman‟s commissions amounting to Sh.3,000,000

Seek evidence that the salesmen are authorized to sell the company‘s products.Their names should appear in the records for salesmen.

Verify the terms of payment of commission. There should be a clearly laid down policy for

the payment of commissions.

^Ø Ensure that commissions are only paid against proof of sale.

Ø Ensure that commission paid is subjected to taxes as required by the law.

QUESTION SEVEN

State the basic element of the scope paragraph of an audit report. (4 marks)
Explain how auditors distinguish their responsibility from those of the directors in

respect of financial statements. (4 marks)

Explain the meaning of each of the following terms in relation to audit reports:
Circumstances of uncertainty. (4 marks) ii. Circumstances of disagreement. (4 marks)

Distinguish between the ―except for‖ and the ―subject to‖ audit opinions. (4 marks) (Total: 20 marks)

QUESTION SEVEN

(A) ―Scope‖ refers to the auditors‘ ability to perform audit procedures deemed necessary in the circumstances. The reader needs this as an assurance that the audit has been carried out in accordance with established auditing practices or standards.

The auditors report should include a statement that the audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatements.

It should also describe the scope of the audit by stating that the audit was conducted in accordance with ISA‘s or in accordance with relevant national standards or

practices as appropriate.

The auditors report should describe an audit as including: –

Examining, on a test basis, evidence to support the financial statement amounts and disclosures.
Assessing the accounting principles used in the preparation of the financial
Assessing any significant estimates made by management in the preparation of the financial statements.
Evaluating the overall financial statements presentation.

(c) The auditors distinguish their responsibilities from those of the directors in respect of the financial statements by including a statement of directors‘ responsibilities in the report.

Appropriate wording of this statement follows below: –

‗Company law requires the directors to prepare financial statements for each financial year which give a true and fair view of the state of affairs of the entity as at the end of the financial year and of the profit or loss of the entity for that year. In preparing those financial statements, the directors are required to:

Select suitable accounting policies and apply them consistently.
Make judgments and estimates that are reasonable and prudent.
State whether applicable accounting standards have been followed.
Prepare the financial statements on the gong concern basis unless it is inappropriate to presume that the entity will continue in business.

The directors are responsible for keeping proper accounting records which should disclose with reasonable accuracy at any time the financial position of the company and comply with the Company‘s Act and also take reasonable steps for the prevention and detection of fraud and other irregularities. They are also responsible for safeguarding the assets of the company.

Auditors are required to form an opinion as to whether: –

ØProper accounting records have been kept by the company.

Ø Proper returns adequate for their audit have been received from branches not visited by them.

The company‘s balance sheet and its_{records and returns} profit and loss account are in agreement with the accounting

Such information and explanations as auditors think necessary for the performance of their duties have been received from the company‘s officers

^Ø The auditors report is consistent with the financial statements.

c)(i) Uncertainties result from circumstances in which it is not possible for the auditor to reach any objective conclusion as to the outcome of a situation due to the circumstances themselves or as a result of a limitation on scope of the audit. Such uncertainties are resolved through the passage of time e.g. if the company is faced with a legal case say for breach of contact the actual impact on the financial statements will only be known after the case has been heard and determined. The auditor should form

an opinion on the adequacy of the accounting treatment of such uncertainty. This will involve consideration of:

The appropriateness of any accounting policies adopted by management in treating the effect of such uncertainties;

ⁿ The reasonableness of the estimates included in the Financial Statements;

n The adequacy of disclosure.

Some inherent uncertainties are fundamental. These are uncertainties where the degree of uncertainty and its potential impact on the view given by the financial statements may be very great.

In other situations uncertainty could be as a result of a limitation in the scope of the audit where the auditor has not been able to obtain some information that is considered necessary for the purposes of the audit.

Circumstances of disagreement arise where the auditor disagrees with the accounting treatment or disclosure of a matter such as the non-provision of a doubtful debt.

Thus, circumstances giving rise to a disagreement will include:

Failure to follow an IAS

Ø An unacceptable policy not allowed by IAS
Ø Compliance with an IAS where this does not in the circumstances give a true and fair view. b) Disagreement as to facts or amounts included in financial statements
Disagreement as to the manner or extent of disclosure of facts or amounts
Failure to comply with legislation.

( e) Before the adoption of International Standards on Auditing (ISA) in Kenya in 1999 (auditors were governed by the Kenyan auditing guidelines), the ―subject to‖ opinion was issued when there was a limitation in scope that was material (but not fundamental) whereas the except for opinion was given when there was a disagreement between management and auditor which was material but not fundamental.

However, with the adoption of the ISAs in 1999, an except for opinion is now issued where there is a limitation in scope or a disagreement that is material but not fundamental. This implies that a ‗subject to‘ opinion no longer exists under our current framework of the ISAs.

QUESTION EIGHT

Your firm of accountants has been the auditors of Leather Merchants Limited, a company that exports both raw and semi-finished leather products to European and Asian markets. The company has decided to introduce a comprehensive computer system to manage its accounting and administrative functions.

Required :

Outline the practical difficulties you would encounter as an auditor as a result of the proposed introduction of a computerized accounting system. (10 marks)
Explain how you would overcome the difficulties identified in (a) above. (5 marks)
Identify and explain the benefits that the company would derive as a result of putting in

place a comprehensive computerized accounting system. (5 marks)

(Total: 20 marks)

QUESTION EIGHT

A & B

The practical difficulties I would encounter as an auditor as a result of the proposed introduction of a computerized accounting system would arise from the characteristics of a computerized system which distinguish it from a manual system.

These difficulties and the ways they can be overcome include: –

Concentration of controls in the computer department.

The need to standardize procedures and utilize the computer resources of Leather merchants may lead to this. There is a danger of deliberate or inadvertent corruption of data of which other departments are unaware by the computer department.

AUDITING I

During my audit work, especially during the planning stage, I will identify the extent of these controls. If such controls are concentrated in the computer department, the adequate functioning of the department will be fundamental to my audit.

Lack of primary records.

If Leather Merchants introduce an on-line system, then some conventional day books (such as purchase journal) may not be created. Originating documents (such as sales order) may not be created as well.

To eliminate this problem, the auditor should advise Leather Merchants to provide for computer-generated reports which will keep track of these activities.

Loss of audit trail

A computerized system is usually designed to limit the volume of printed data. Control is implemented by exception reporting principles so that detailed print outs of magnetically stored data are not available.

The auditor, is therefore unable to trace an individual transaction through the system from originating document to financial statements (loss of visible audit trail.)

This may result in a need for the auditor to use computer assisted audit techniques to obtain appropriate evidence that controls have functioned adequately.

Data needed for audit purposes may be overwritten.

When data is stored on magnetic tape or disk, it will eventually be overwritten with new data.

The auditor will need to plan audit testing to ensure that the appropriate data is available to him. He may need to make frequent visits to his clients‘ premises to ensure that he covers an adequate spread of transactions during the year.

The need for specialist expertise.

It is important that the auditor employs competent staff to carry out the audit of Leather Merchants.

This may prove rather expensive, as staff need to be knowledgeable in computer functions and processes.

Availability of computer time

The use of computer assisted audit techniques involves the use of the client‘s computer facilities. There may be need to organize such facilities well ahead of the required dates.

Benefits to client using a computerized accounting system

Computerization gives rise to a strong internal control system, which prevents chances of error and frauds in an organization. (Possible if system is properly designed and implemented).
Computerization facilitates preparation of management reports that are designed to meet the information needs of all employees. This assists in decision-making and in running the affairs of the organisation more efficiently.

It reduces overtime costs (as accounts are prepared much faster), which are

associated with manual accounting system.

Computers produce clear and neat work particularly in computations, ledgers,

records and financial statements.

Computers enhance arithmetic accuracy (as human error is eliminated) thus leading to more accurate accounting records.

Departures from acceptable accounting policies/practices:-

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QUESTION THREE

QUESTION FOUR

QUESTION FIVE

Salesman‟s commissions amounting to Sh.3,000,000

QUESTION EIGHT

Written by MJ

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