AUDITING AND ASSURANCE November 2004

QUESTION ONE

  • What is an ―interim audit‖? (2 marks)
  • Identify any four circumstances under which an interim audit would be ideal.
    • marks)
  • List and briefly explain five disadvantages of an interim audit. (10 marks)
  •     Suggest solutions to any four disadvantages you have identified in (c) above.
    • marks)

(Total: 20 marks)

NOVEMBER 2004

 

QUESTION ONE

 

  •  This is an audit carried out within the financial year, normally after six to nine months after the start of the financial period. The auditor carries out some audit while leaving the bulk of the work to be audited in a final audit.

 

The results of audit tests carried out during the interim audit form part of final audit, since they will be subjected to further tests at the final audit stage.

 

    • Where the company is empowered by the Articles of Association to pay interim dividends, in which case the auditor will ascertain the company‘s interim performance for this purpose.
    • Where it is a law requirement for a company to publish interim performance

e.g. banks.

  • Where an organization is operating in a volatile market and the owners wish to

keep track of the interim performance.

  • Where there is need to test the adequacy and compliance of the system of internal control.

 

  • Cost

The audit process is made expensive especially for small firms, hence it may only be suitable for large companies with many transactions.

 

  • Disruption

Interim audit may disrupt client operations since the auditor has to be attended to by client staff for information.

 

  • Alteration of entries

Client staff may alter already audited figures before the year end.

 

  • Unanswered questions

Questions posed at the interim audit stage may remain unanswered and this may distort final opinion as answers obtained later may not be of substance.

 

  • Inadequate diligence

Due to the fact that final audit will be performed anyway, the interim audit may not be done with the seriousness it deserves.

 

  • Note-taking

Interim audits entail a lot of note-taking e.g. of interim balance carried forward or even budgeted performance figures to be used to facilitate final audit.

 

  • Dependency Problem

Client staff may be dependent upon the interim auditing to solve their accounting problems which may compromise the objectivity of audit staff.

 

 

Proper Planning

This will solve the problem of disruption since with proper communication between the directors and auditors, the audit process should not take much time.

 

  • Use of Journal Entries

Alteration of entries should be done using journal entries which should then be listed for the auditor‘s attention.

 

  • Noting down questions

Notes should be taken of any questions raised so that relevant answers can be obtained of a later date without loss of relevance.

 

  • Supervision by superiors

The audit staff should be adequately supervised to solve the problem of inadequate diligence.

 

                 Clarification of auditor‟s responsibility

This will ensure that client staff do not depend on auditor‘s work to solve their own accounting problems.

 

 

 QUESTION TWO

  • Outline the professional guidelines that would assist the external auditor in avoiding being unduly dependent on a single client. (5 marks)
  • Identify and briefly explain the statutory and ethical matters you would consider  before accepting appointment as an auditor of a company. (10 marks)
  • In the context of the Companies Act (Cap. 486), state the rights of an auditor.

(5 marks)

(Total: 20 marks)

QUESTION TWO

 

  • With reference to guidelines issued by ICPAK, the following are the areas of risk that may compromise the work of an external auditor. The auditor needs to use the guidelines as references to avoid being unduly dependent on a single client;

 

  • Fees

Recurring fees paid by a client to an audit firm should not exceed 15% of its gross recurring income. Note the client should be a firm or a group of connected firms.

 

  • Beneficial shareholding

An auditor should generally refuse an appointment by a client in which he has beneficial interest in shares and investments, amounting to 5% or more.

 

  • Loans

An auditor should not make loans to or receive loans from a client.

 

  • Family & Other Personal Relationships

An auditor should refuse appointment by a client in which an employee is closely related (connected with a partner or staff member in the firm).

 

  • Undue Hospitality

An auditor should instruct his staff not to accept goods or services from the client, unless they are availed at market prices. He should shum from excess generosity from the client.

 

Provision of other services

The auditor can only provide services related to routine clerical functions or services of an emergency nature. He should not perform management functions to make management decisions.

 

  • Commission

The auditor should not pay a commission to obtain a client, nor should his employees do so to obtain clients for him.

 

  • Overdue Fees

 

Should overdue fees, aggregated with current assignment fees be significant enough to amount to a loan, the auditor independence could be jeopardized.

 

 

 

 

Past Papers

  • Voting rights

Where a partner or staff owns shares in any capacity in an audit client, he should not vote at any general meeting in the company in relation to appointment, removal or remuneration of auditors.

 

  • Statutory Matters

 

  • The firm should be a holder of a practicing certificate issued in accordance to section 21 of the Accountants Act.
  • Ensure the firm is not disqualified to act as the auditors of the company under  section 161 (2) of the Companies Act, that is:

The auditor is an officer of the company

  • The auditor is in employment of an officer or servant of the company.
  • The auditor/firm is a body corporate
    • Ensure that all the auditors in the firm are legally and professionally qualified to act as auditors.
  • The auditor should then request client permission to communicate with the previous auditors, to avail all the information to enable him decide whether his             is prepared to accept nomination.
  • If such permission is denied, the auditor should decline nomination.

 

Ethical Matters

  • Auditor should check if the firm is related to the client in any manner that may endanger the firm‘s independence.
  • He should check whether the firm has adequate resources in terms of skills and expertise knowledge necessary to service the needs of the potential client.
  • Check the current commitments of the firm that may affect its ability to carry out the audit and complete it effectively.
  • Check the risk exposures associated to the client as regards the firm‘s reputation.

 

 

  • Right to access books of account and vouchers of the business at all times.
  • Right to call for information and explanation which he/she considers necessary for purpose of forming an opinion.
  • Right to attend the AGM regardless of whether accounts are a subject of discussion or not. iv) Right to make a presentation at the AGM if:

 

  • They were received too late for the company to send them to each shareholder to whom notice of the AGM was sent.
  • A wrong impression was given to share holders by the Board of Directors about him.
  • There is any material he wishes to add to his report, which came to his knowledge after the report had been dispatched but before the AGM. This does not include the right to make up for negligence earlier made in his

report.

  • Right to indemnity
  •  Right to visit branches

Right to information and explanation relating to activities of branches as far as they  affect the company affairs. viii)  Right to remuneration ix)  Right to lien-hold on to his report until his fees are paid. x) Right to legal and technical advice.

 

QUESTION THREE

 

An internal control system is designed to provide reasonable assurance that all the control objectives are being achieved.

 

Required:

What purpose does an internal control system serve in an organization? (6 marks)  Identify and briefly explain the three key elements of a good internal control system. (6 marks)  Identify and briefly explain any four inherent limitations of an internal control system.

(8 marks)

(Total: 20 marks)

QUESTION

THREE a)

  • In an organization, an internal control system enhances the efficient and orderly running of activities and operations to satisfy the needs of stakeholders.
  • It ensures adherence to management policies. These policies provide a good framework within which the internal control system operates.
  • Helps in the safeguarding of company‘s assets. Using physical controls such as lock and key and documentation e.g. fixed asset register, the company‘s assets can be

safeguarded from unauthorized individuals.

  • An internal control system assists in the prevention and detection of fraud and error.
  • It enhances accuracy and completeness of accounting records vi) Ensures timely preparation of reliable financial information.

 

 

Internal control system as discussed by ISA consist the following elements on components: –

  • The control environment:: is the overall attitude, awareness and actions of directors and management regarding the internal control system and its, importance in the
  • Risk assessment process: this is risk management in the entity which is a component             of inherent, control and detection risks i.e.

AR = IR X CR X DR

  • Information system i.e. financial reporting which entails reporting of timely, accurate and complete information.
  • Control procedures which are those policies and procedures in addition to the control environment which management has established to achieve the entity‘s

specific objectives.

  • Monitoring of controls: intend to see that I.C.S is operating as intended and whether any modifications are necessary e.g. supervision, evaluation etc.
  • Most internal controls tend to be directed at routine transactions rather than nonroutine transactions.
  • The possibility of circumvention at internal controls through the collusion of a member  of management or an employee with parties outside the entity.
  • There‘s also possibility of a person responsible for exercising an internal control could abuse that responsibility e.g. management.
  • There is the possibility that procedures that constitute an internal control system may become inadequate due to changes in conditions, and compliance with procedures may  also deteriorate.
  • Lack of management support for the control systems due to their requirement that the  cost of an internal control does not exceed the expected benefits to be derived.

There is potential for human error due to carelessness, distraction, mistake of judgement and the misunderstanding of instructions.

 

QUESTION FOUR

 

You are in charge of a group of audit trainees who have just been employed by your audit firm. This is the audit trainees‘ first assignment and they are aware that they are supposed to prepare audit working papers but they do not know how to do so or what information they should include in the audit working paper.‘

 

Required:

  • Explain the importance of audit working papers. (4 marks)
  • Provide the audit trainees with guidelines on how they should prepare audit working

papers.                                                                                            (4 marks)

  • Identify the type of information that the audit trainees should include in the audit working papers.       (8 marks)
  • List any four advantages of standardized audit working papers. (4 marks)

(Total: 20 marks)

QUESTION FOUR

 

  • Guidance regarding preparation of working papers and their importance fall under ISA 230: Documentation. Working papers basically refers to material prepared by and for, or obtained and retained by the auditor in connection with the performance of the audit. Can be in the form of paper, film, electronic media or other media. These are important for the following reasons:

 

 

  • They assist in the planning of the audit. Current year‘s working papers will be used to plan subsequent years‘ audit.
  • They assist in the supervision and review of the audit work. Audit assistants will use the working papers as evidence of work done.
  • They assist incoming auditors to assess the position of the new client before they begin their actual audit work.
  • Working papers record the evidence resulting from the audit work performed to support the auditor‘s opinion.
  • In the event of litigation against the auditor, the working papers will serve as evidence to prove work done by both an employee of an audit firm and the firm
  • Working papers minimize duplication of audit effort because whatever is done is documented and cannot be repeated.
  • They are also useful in determining audit fees payable by the client as they indicate what has been done by whom and how long it took, all of which serve as a basis for
  • In the event of catastrophe, working papers will serve as material to support a plea for compensation by the insurance company.

 

  • The working papers should have a good index to facilitate referencing and cross-

referencing.

 

  • They should be as complete as possible. The working papers should include the auditor‘s reasoning on all significant matters which require the exercise of judgement, together with the auditor conclusion thereon. A competent auditor

reviewing the papers should arrive at the same conclusion.

  • In the event of difficulties, audit trainees should use the mnemonic facts as they know them at the time the conclusions were reached. –  Any symbols used by the trainees ought to be clearly explained.
  • The audit working papers need to be updated periodically for evidence to be relevant. -Audit working papers should be well secured.

 

 

  • Information concerning the legal and organizational structure of the entity.
  • Extracts of copies of important legal documents, agreements and minutes.
  • Information concerning the industry, economic environment and legislative environment within which the entity operates.
  • Evidence of the planning process including audit programmes and any changes thereto.
  • Evidence of auditor‘s understanding of the accounting and internal control system.
  • Evidence of inherent and control risk assessments and any revisions thereof.
  • Evidence of auditor‘s consideration of the work of internal auditing and conclusions
  • Analyses of transactions and balances.
  • Analyses of significant ratios and trends.
  • A record of the nature, timing and extent of audit procedures performed and the results of such procedures.
  • An indication as to who performed the audit procedures and when they were
  • Letters of representation received from the entity.
  • Conclusions reached by the auditor concerning significant aspects of the audit.
  • Copies of the financial statements and auditor‘s report. Financial statements of previous years are also necessary. 15. Copies of bank mandates and specimen signatures.

 

 

  • Standardised audit working papers enhance efficiency in the manner in which they are prepared and reviewed.
  • They enhance training of audit assistance by following laid out audit programmes. iii) They are also useful in the delegation of work to audit staff. iv)       They provide a means to control the quality of audit work.

                        Easy to use and follow out since they provide no room for judgement

 

QUESTION FIVE

 

Bafu Ltd., a private limited company, manufactures a wide range of bathroom fittings. These fittings are made from steel components which are chromed in small vats. The steel components are sourced from outside suppliers. The year end stock mainly consists of these steel components and finished items. As at 31 October 2004, the total stock was valued at

 

 

 

 

Sh. 6,048,000 out of total assets of Sh. 19,200,000. This stock figure was obtained by a physical count as at 31 October 2004, and valuation by reference to purchase invoices and manufacturing cost estimates.

 

Required:

With reference to each of the matters listed below, state the work you would do to  conclude whether the amount attributed to stock is fairly stated.

  • Quantities (5 marks)
  • Identification of stock items (3 marks)
  • Condition of stock items (2 marks)
  • Cut-off procedures (5 marks)
  • Valuation of stock (5 marks)

 

(2 marks)

(2 marks)

(2 marks)

(2 marks)

(Total: 20 marks)

QUESTION FIVE

 

a) Quantities
•         Obtain copies of count sheets used at the stock take.

•         Ensure the stock sheet include the specific date when stock count was actually

carried out.

           Check whether there were any post-count adjustments made to quantities of

stock recorded in the count sheets.

 Ensure no repetitions of stock counts. This would be done by making sure no stock item appears more than once in any count sheet, hence count sheets

should be indexed as well.

             Check with management in case there are some items of stock in the count

sheets that are not physically present in the store at the time of audit test.

   Verify that steel components were not mistakenly counted as finished items.

b)

 

Identification of stock items

                 Comparing stock items in the stock sheets with the items of stock in the

shelves/store.

       Verifying that stock items‘ description in the stock sheet match the actual stock

item (as per given code) in the store.

       Ensure there is a clear distinction between finished units and steel components

and that work-in-progress, if any is clearly identified.

 Verify that stock-in-transit is not included in stock count since it‘s not present at the store. This is recorded in purchases journal.

c)

 

Condition of Stock Item

             Verify that stock whose value is given is in good condition i.e. there are no

defects of any sort.

      Ensure that items identified as damaged or obsolete during the count have been

treated as such.

 Obtain details of damaged/obsolete stock and the extent of damage as taken during the stock take.

d)

 

Cut-off Procedures

 Verify that the value of stock as given is not inclusive of previous year‘s closing stock. This would entail ascertaining the value of opening stock (if any) and

subtracting from this, the value of units produced in the current year.

          Check that no sales figure for finished goods (awaiting collection) is included

into stock.

 Ensure that steel components ordered for, but not yet delivered (in-transit) from the suppliers, are recorded in the purchases journal in the appropriate

period, and not as part of closing stock.

 From the duplicate book of stores ledger cards, obtain the last few (may be five) stores receipt forms recorded immediately before year end and trace to invoice

to ensure the invoice is dated before year end.

   Verify that own material is not included as stock.

 

 

Valuation of Stock

 

  • Check that the stock sheets used during the count are the ones used as the basis of valuation.
  • Compare valuation sheets with copies of stock count sheets to ensure that no

alterations were made or if so, this is reflected in valuation.

  • Ensure costs allocated do not exceed net realizable value.
  • Ensure costs allocated do not exceed net realizable value
  • Ensure items    treated as         damaged/obsolete          in valuation       really are damaged/obsolete.
  • Check calculation of scrap on Net Realisable value and compare this with cost

           in respect of damaged/obsolete stock.

  • Check for consistency in valuation method.

 

QUESTION SIX

 

Briefly explain the following terms as used in auditing:

Vouching audit

Inherent risk.

Control risk

In depth audit tests.

 

  • Explain the assurances that an auditor seeks to obtain in the audit of tangible fixed assets. (6 marks)
  • Suggest six control measures that would help reduce the control risk associated with             tangible fixed assets.       (6 marks)

(Total: 20 marks)

QUESTION SIX

 

  • A voucher is a documentary evidence of a transaction as recorded in the books of account e.g. receipt, invoice etc. Vouching is the process of examining a voucher with the view of proving whether it has been properly authorized, recorded and that the amount is reasonable. Vouching audit thus means the examination of vouchers with the view of proving the true and fair view of the client‘s financial position of the business as at the balance sheet date. It‘s applied when the auditor feels that the internal controls of the client is not promising.

 

  • Inherent Risk

This is part of the audit risk and is basically defined as the susceptibility of an account balance or class of transactions to misstatements that could be material, individually or when aggregated with misstatements in other balances or classes, assuming that there were no related internal controls.

 

  • Control Risk

Also part of audit risk and is defined as a risk that a misstatement that could occur in an account balance or class of transactions and that could be material individually or when aggregated with misstatements in other balances or classes, will not be prevented or detected and collected on a timely basis by the accounting and internal control systems.

 

  • In depth Audit Tests

These tests are aimed at justifying the figures in the books of account, and  eventually, in the final accounts themselves. The tests are designed for 2 purposes:

  • Support the figures in the account and
  • Where errors exist, to assess their effect in monetary terms.

 

Before embarking on these tests, it‘s essential to consider whether any errors produced by weak systems could lead to material differences.

 

  • Ownership: The auditor needs to verify that there was authority issued for the purchaseof an asset by the company.
  • Cost: The auditor should verify the cost as given by comparing it with manufacturer
  • Valuation: This assurance will be acquired by ensuring appropriate depreciation has beencharged, so that valuation at year end is reasonable.

 

  • Existance: By physically inspecting the assets, noting down their details.
  • Presentation and Disclosure: Here the auditor analysis the classification of the assets,noting distinction between leased assets (if any) and fully owned assets as

disclosed in the Balance Sheet.

  • In the event of disposal, the auditor should verify issuance of authority to dispose,reasonability of disposal price and correct recording.
  • Check receipt of the disposal price and proper recording in the records.

 

  • Purchase of a tangible fixed asset should be authorized by one person.
  • Once acquired, there should be limited access to the asset i.e. only authorized personnelcan gain access or use the equipment.
  • Ensure asset is kept in good condition, repaired if needed and consistent depreciationmethods applied. – Ensure any transaction with respect to acquisition, disposal or modification of an asset  isfully/completely recorded.
  • Periodic comparison of recorded assets with existing assets.
  • Ensure financial reporting frameworks and guidelines are followed in the disclosure andpresentation of assets.

QUESTION SEVEN

  • What is an audit peer review?      (2 marks)
    • State and briefly explain the objectives of an audit peer review (6 marks)

 

  • You are the auditors of Mount Elgon Ltd. You are carrying out a review of the accounts for the financial year ended 31 October 2004 with a view of signing

the audit report. During this review, you have noted the following matters:

  • No depreciation has been provided on plant and machinery for the financial year ended 31 October 2004. This is because the directors of Mount Elgon Ltd.

feel that the value of the plant and machinery is in excess of the amount at  which it is stated in the financial statements.

  • Some sections of the company‘s stocktaking records were accidentally destroyed. Consequently, the value attributed to stocks as at 31 October 2004 is only an estimation by the directors of Mount Elgon Ltd.

 

Required:

What would be your audit opinion with regard to the matter referred to in

(1) above?                                                                     (6 marks)

  • Draft an audit report expressing your specific reservations with regard to (2)

above                                                                           (6 marks)

(Total: 20 marks)

QUESTION SEVEN

 

Peer Review

This is a review of an audit firm‘s systems, procedures, and audit standards generally, conducted by another firm of comparable site and reputation. It‘s a review of a firm‘s complete set up by another firm and should be considered occasionally.

 

  • Quality Control: peer review ensures a certain standard is achieved by an audit firm as a minimum, at least.
  • Independence: The reviewing firm wants to confirm that the audit farm was working  independent of its clients.
  • Staff performance: To review the performance of audit staff and to assist them in  improving their future performance.
  • Weaknesses: To identify areas of weaknesses in the firm‘s procedures or applications thereof and to suggest solutions.
  • Audit Opinion: To determine whether the scope and result of the audit work (audit evidence) is adequate to support the opinion as given in a particular audit.
  • Industrial comparison: Review of a number of specially selected audits by the peer reviewers to check consistency of audit approach and application of a particular statement of standard accounting practice.

By not providing for depreciation the management have gone against IAS 16 which require every non-current assets to be systematically depreciated over its useful life. If the directors think there is a change in the value of the plant and machinery, IAS 16 dictates that revaluation should be done by a competent and reputable person considering the market or fair value in an active market, then in the value have appreciated the carrying amount of the item should be changed to reflect the new value and depreciated over its useful life. Therefore the directors have no excuse for not depreciating the plant and machinery which have resulted in overstating the profit for the year and total assets of the company.

 

In an audit opinion I will qualify and include a ‗Expect for‘ paragraph by stating that the financial statements give a true and fair view except for the directors not depreciating plant and machinery.

 

 

 

AUDITOR‘S REPORT

 

Board of Directors,  Onyango &  Sons L.t.d.  P.O. Box 29842 Nairobi,City Square.

 

We were engaged to audit the accompanying balance sheet of Mount Elgon Ltd as of 31 October 2004, and the related statements of income, and cash flows for the year ended. These financial statements are the responsibility of the company‘s management.

 

We conduct our audit in accordance with International Standards on Auditing. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation.

 

In carrying out the audit, we were unable to observe accurate physical inventories and due to limitations placed on the scope of our work by the accident.

 

Because of the significance of the matters discussed in the preceding paragraph, we do not express an opinion on the financial statement:

 

Omondi, John

 

23 rd November 2004

P.O. Box 23497 NRB.

 

QUESTION EIGHT

 

  • State and briefly explain an auditor‘s responsibilities with regard to the detection of errors and frauds. (8 marks)
  • In the context of the audit of a computerized accounting system;

 

State and control objectives generally associated with the processing of data in a

computerized accounting environment.‘                                        (6 marks)

Identify the program controls which should be inbuilt in a computerized accounting (6 marks)                       (Total: 20 marks)

Auditors responsibility with regard to the prevention and detection of errors and frauds is as follows:             –

  • The auditor should remind directors of their responsibilities in prevention and detection of fraud and errors in the engagement letter or other communication and the need to have a system of internal control as a deterrent to errors and

irregularities.

  • Property plan, perform and evaluate his audit work so as to have a reasonable expectation of detecting material misstatements in the financial statements, whether

they are caused by fraud, other irregularities or errors.

  • Using professional scepticism in performing auditing to detect misstatement in the financial statements.
  • The auditor must obtain sufficient relevant reliable audit evidence to support his opinion. In regard to errors and irregularities he should have sufficient evidence that no material errors and irregularities have occurred or if they have occurred,


Revision Questions and Answers

then they have been either corrected and/or been properly disclosed in the financial              statements.

  • Conducting the audit using professional competence and exercising due care to protect the users of financial statements from fraud and error.
  • Other remedies include qualified report, disclaimer opinion, management letter etc if they get persistent frauds and errors in the accounts.

 

  • Personnel in charge of processing data are normally independent of those responsible for input and output, so as to maintain data integrity.
  • Processed data is destined to the transaction or master file and nowhere else. From  these files, their destinations can be verified.
  • Transactions, once processed cannot be processed again or duplicated or improperly

changed.

  • Processing errors should be identified and corrected on a timely basis to avoid future unnecessary cost to rectify magnified problems.
  • To ensure programs are not altered in any way, personnel in processing department should have no access to the programs.
  • There should be recovery procedures for use in the event of power failure so that

processing function is not left ‗hanging‘ as this creates room for manipulations.

  • Provision of offsite processing in the event of disaster.

 

  • Programmed sequence checking ensures the completeness of input in a timely Each item of input is verified as having been input into the system.  –   Programmed matching of input to a control file, containing details of expected input. – For accuracy, control techniques such as batch total will be used. This control alsoensures  completeness.
  • Programmed check digit verification wherein a check digit included in a referencenumber is arithmetically checked to ensure it bears the required relationship to the rest of the
  • Summary processing. This technique ensures completeness and accuracy i.e. incomputation such as involving depreciation, calculation based on total assets value is

compared with the sum of depreciation, calculation based on individual asset values.

 

    • Record counts and hash totals are techniques used to ensure the continued correctnessof master files and the standing data contained therein.
    • Programmed reasonableness checks (for input), including checking the logicalrelationship between two or more files.
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