M ANAGEMENT OF AUDIT PRACTICE QUESTIONS AND ANSWERS

QUESTION 1

Your firm audits H-Pound Ltd., a recognized East Africa’s premier engineering construction and infrastructure company that undertakes construction contracts which include roads, bridges, warehouses, factories and offices. H-Pound Ltd.customers include governments and businesses. Recent cut-backs in local government expenditure have resulted in fewer contracts being started this year than budgeted.

The statement of accounting policy for construction contracts in 1-1-Pound financial statements provides as follows:

“Revenue is recognised using the percentage of completion method, calculated on the basis of costs incurred as a percentage of expected costs.

“Anticipated losses are provided for in full as soon as the possibility of loss is forecast”. Direct costs attributed to specific: contracts include:

  • Architect’s design costs, legal fees and engineering assistance.
  • Material issued to site.
  • Site supervision (apportioned foreman’s salaries).
  • Site labour costs (allocated from the payroll and subcontractors invoices  Costs of hiring suitable building and leasing plant and equipment.
  • Depreciation of plant, equipment and vehicles.
  • Transportation costs of resources such as materials between sites.  Insurance and telephone.

Indirect expenses incurred H-Pound Ltd.’s head office which relates to construction activities are attributed to the project at 70% of direct costs.

Last year, your firm qualified the auditor’s report due to lack of evidence to support the client’s schedule of estimated costs to completion.

During the year, a quantity surveyor joined the client’s management team to undertake the following:

  1. Supervise monthly physical counts at the major construction sites.
  2. Monitor costs to date against the monthly rolling budget.
  3. Prepare year-end schedules contract of total cost of completion (that is direct costs incurred to the balance sheet date, attributable overheads and estimated costs to completion).

You are satisfied that the quantity surveyor is appropriately qualified and experienced. Required:

Explain the principal audit risks to be considered when placing the approach to the final audit for the year ending 30 September 2015. – 

  • Recognition of revenue from construction contracts on a completion .method.
  • Revenue can be recognised too early before work is done.
  • Provision of anticipated losses, has it factored inflation?
  • Apportionment of indirect costs: how do we arrive at fixed overheads or is it done arbitrarily?
  • Accounting policies used to depreciate the assets
  • Qualification of report previous auditors means that the opening balance of the accounts are misstated hence substantive procedures need to be done to determine the correctness of the balances.

Explain the nature and extent of reliance which you should seek to place on the work of the quantity surveyor.

  • The Q. surveyor is an employee of the entity therefore he can make the measurements to be favourable to the company hence chances of misstatements.
  • Actual stock take could pose a challenge (chances of manipulation of measurement of unused materials).
  • Labour costs have no precise way of measurement.

Involving work of an expert

  • Independency /objectivity of the expert
  • Skills of competence considering the level of training, license, and relationship to professional body.
  • Scope of work, terms of reference
  • Standards used in measurement and acceptability in the industry.
  • Assumptions used in measurement.
  • Reputation and experience of previous performance.

QUESTION 2

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 instalrnents: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 a drilling machine operator whose arm was severely injured when a machine supplied lkulu Ltd malfunctioned. The Chief Executive officer (CEO) of Ikulu Ltd. has advised you that the claim Roka Limited is being ignored as it is generally known that Roka Limited has a poor safety record and that the accident was their fault. Two orders which were placed 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 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 the auditors.

Required:

Citing relevant International ‘financial Reporting and Auditing Standards, analyze the principal audit risks to be considered when planning the final audit of Ikulu Ltd. for the year ended 31 December 2014.

(You may assume that the amounts indicated are material in the context of the financial statements),

  1. Revenue recognition – timing

The company raises sales invoices in three stages. There is the risk of a breach of !AS 18, Revenue, which demands that revenue should only be recognised once the seller has performed its contractual obligations. This right does not necessarily correspond to amounts falling due for payment in accordance with an invoice schedule agreed with a customer as part of a contract. Ikulu Ltd. appears to receive, payment from its customers in advance of performing any obligation, as the stage 1 invoice is raised when an order is confirmed, thus before any work has actually taken place. This creates the potential for revenue to be recogniSed too early, in advance of any performance of contractual obligation, when a payment is received in advance of performance, a liability should be recognised equal to the amount received, representing the obligation under the contract:. Therefore, a significant risk is that revenue is overstated and liabilities understated.

  1. Disputed receivables

The amount owed from Mukoma Ltd. is a material amount. The risk is that the receivable is overstated if no impairment of the disputed receivable is recognised.

  1. Legal claim

The claim should be investigated Ikulti Ltd. The opinion of the Chief Executive Officer that the claim will not result in any financial consequence for lkulu Ltd. is naive and flippant. The recurring high level of warranty provision implies that machinery faults are fairly common and therefore the accident could be the result of a defective machine being supplied to Roka Limited. The risk is that 110 provision is created for the potential damages under IAS 37, provision, contingent liabilities and contingent assets, if the likelihood of paying damages is considered probable. Alternatively, if the likelihood of damages being paid is considered possible, then a disclosure note should be made in the financial statements describing the nature and the possible financial effect of the contingent liability.

  1. A further risk is that any legal fees associated with the claim have not been accrued within the financial statements. As the claim has arisen during the year, the expense must be included in this years’ income statement, even if the claim is still ongoing at the year end.

The fact that the legal claim is being ignored may cast doubts on the overall integrity of senior management and on the integrity of the financial statements. Management representations should be approached with a degree of a professional skepticism during the audit.

  1. Roka Limited has cancelled two orders. If the amounts are still outstanding at the year end it is highly likely that Roka Limited will not pay the invoiced amounts, and thus receivables are overstated. If the stage 1 payments have already been made, then Roka Limited may claim a refund, in which case a provision should be made to repay the amount or a contingent liability disclosed in a note to the financial statements,
  2. Roka Limited is one of only five major customers and losing this customer could have future going concern implications for Ikulu Ltd, ifa new source of revenue cannot be found to replace the lost income from Roka Ltd. lithe legal claim becomes public knowledge and Ikulu Ltd. is .found to have supplied faulty machinery, then it will be difficult to attract new customer.

A case of this nature could bring had publicity to Ikulu Ltd., a potential going concern issue, if it results in any of the five customers terminating orders with Ikulu Ltd. The auditors should plan to extend the going concern work programmes to incorporate the issues noted above.

  1. Warranty provision

The warranty provision is material. The basis of charging could be understated to avoid charging the increase in the provision as an expense through the income statement. This is of special concern as the CEO estimates the warranty provision.

 

QUESTION 3

You were recently employed XYZ and associates Ltd. at the level of audit senior. XYZ and associates Ltd. is a reputable audit firm that has ensured a disciplined approach to client acceptance. which has in turn contributed to its sustainable growth and long-term profitability.

Peter Ngeno. your manager, has assigned you the task of performing a background check on ABC Ltd., a prospective client. The manager has informed you that ABC Ltd. is a public company that has rapidly expanded over the past five years. Currently ABC Ltd. has presence in many parts of the world

Required:

Assess five areas you would consider when performing a background check on ABC Ltd.

  • Company’s management – Performing a background check on key members of the company’s management. This might include a survey of bankruptcy proceedings judgements, tax liens, credit records, regulatory and licensing actions and criminal records. You should also verify their ‘prior employment history, credentials and current and past businesses ownership,
  • Public records – You should conduct a review of the entity’s public records including financial ratings, for an audit or attest engagement.
  • Interviews of selected employees performing tax and accounting functions to assess their perception of the company’s control environment and the entity record keeping practices.
  • A detailed review of previous, financial statements including the reasons for any delays in, issuance or-restatements:
  • ABC Ltd. being publicly held and having rapidly expanded their history of changes in CPA firms should also be checked. Depending on the results of his investigation, you should consider contacting more than one predecessor firm for additional information.
  • It would also be important to conduct a detailed, review of previous tax returns, recent tax return audit results and other pending tax issues

QUESTION 4

Explain the meaning of the term ‘Enterprise risk management’.

  • This is a process designed to identify potential events that might affect the organisation. It is also a process designed to manage risk to be within the organisations risk appetite.

The process eventually aims to provide achievement of the organization’s objectives,

Discuss the elements of an enterprise risk management integrated framework as developed the Committee of Sponsoring Organisations (COSO) in 2004.

Objective setting

Enterprise risk management (ERM) ensures management has a process in place to set objectives and that objectives support and align with the entity’s mission and are consistent with its risk appetite.

Event identification

Internal or external events that may affect achievement of an entity’s objective must be identified, distinguishing between risks and opportunities.

Internal environment

Includes the organisation nature, how risk is reviewed and addressed employer, integrity, ethical values and the underlying environment.

Risk assessment

Risks are analysed, considering risk and impact, as a basis for determining how they should be managed.

Risks are assessed on an inherent and residual basis,

Risk response

Management selects risk responses – avoiding, accepting, reducing or sharing risk. Management develops a set of actions to align risks with risk tolerance and risk appetite.

Control activities

Policies and procedures are set and implemented to help ensure the risk responses are carried out.

Information and communication

Relevant information is identified, captured and communicated in a form and time frame enabling people carry out their responsibilities.

Effective communication is multi-directional flowing down, across and upwards.

Monitoring

The entire ERM is monitored and modifications made as necessary. Monitoring is realised ongoing management activities, separate evaluations or both.

 

QUESTION 5

Consider the following client situation’s.

You are required to indicate in each case whether the engagement should be treated as a high or low risk engagement and which account balances and/or audit issues should receive the most attention.

  1. Mepesa Ltd. is a public limited company and has engaged your audit firm to conduct the audit for the year ended 31 December 2013. This is the second year of engagement for your firm. In the previous year, you noted that the client required a lot of assistance with general book keeping. You also noted that their accounting personnel were relatively inexperienced. In the current year, the client has issued a large number of stock options. Haraka Ltd. and Upesi Ltd. are some of Mepesa Ltd.’s suppliers. These suppliers have been paid in shares rather than in cash
  2. Usafi Ltd. is a private limited company that your firm has audited for the past four years. The accounting personnel of Usafi Ltd. have been with the company for a number of years and are very competent. Each year there are very few journal entries passed the company, but nothing significant. Usafi Ltd. is in wholesale business and receives large quantities of its products from a major supplier in Asia. All its transactions are in United States (US) dollars. In the current year, Usafi Ltd. is involved in a dispute with the government over tariffs.

 Audit risk

  • In this client situation the audit risk is high i.e. related party transactions,  The audit should focus on equity shares.
  • The audit should also focus on share options.
  • The audit should also focus on liquidity of entity.
  • It should focus on self-review threats

 In this client situation the audit risk is low The audit should focus on;-

  • Accounts receivable
  • Commitments/ tariffs disputed
  • Contingencies existing e.g disputes with government over tariffs.
  • Gain or losses on foreign exchange

 

QUESTION 6

The auditor may decide not to send a new audit engagement letter or other written agreement each period. However, there are certain factors that may make it appropriate to revise the terms of audit engagements or to remind the entity of existing terms.

With reference to the above statement, elaborate on eight factors that might persuade the auditor to revise the terms of audit engagement.

  • Any indication that the entity misunderstands the objective and scope of the audit. – Any revised or special terms of the audit engagement e.g fees –      A significant change in ownership /states of the business.
  • A significant change in nature or size of the entity’s business.
  • A change in legal or regulatory requirements.
  • A change in the financial reporting framework adopted in preparation of financial statements.
  • A change in other reporting requirements.
  • Change in technology e.g complex systems installed
  • Additional services, taxations, consultancy

QUESTION 7

As the audit assistant of B Ltd., you would like to limit your examination of account balance tests. Describe the control objectives that you would expect the accounting control system to achieve.

As the lead auditor in the audit planning process of T Ltd., you wish to consider audit risk at the financial statement level.

  • Whether all transactions are recorded.
  • Whether recorded transactions are real.
  • Whether all recorded transactions are properly valued.
  • Whether all transactions are recorded timely.
  • Whether all transactions are properly posted.
  • Whether all transactions are properly classified and disclosed.

Highlight five factors that you would consider in the determination of audit risk at financial statement level.

  • Integrity of management.
  • Management experience, knowledge and changes during the period
  •  Unusual pressures on the management
  • Nature of entity’s business.
  • Factors affecting the industry in which the entity operates.

QUESTION 8

Jeed Ltd. a listed company is an oil producer with interests in North Africa, West Africa and East Africa. Latest interim reports show the following:

 

 

 

 

 

  31 December 2012 30 June 2012 31 December 2011
  Sh.”million” Sh.”million” Sh.”million”
Revenue 22,000 18,300 37,500
Profit before tax 5,500 4,200 7,500
Total assets 95,900 92,300 88,400
Earnings per share (basic)(Sh.) 1.82 2.07 3.53

 

 

In October 2012, the company was awarded a five year licence the Kenyan Government to explore for oil in Northern Kenya. The licence was granted at no cost to iced Ltd. However, the management of Jeed Ltd. has decided to recognise the licence at an estimated fair value of Sh.30 million.

The most significant of Jeed Ltd.’s tangible non-current assets are its 17 oil rigs (2011-2022). Each rig is composed of numerous items including a platform, buildings thereon and drilling equipment. The useful life of each platform is assessed annually on factors such as weather conditions and period over which it is estimated that oil will be extracted. Platforms are depreciated on a straight line basis over 15 to 40 yeas.

A provision for the present valuF of the expected decommissioning of an oil rig is recognised in full at the commencement of oil production. One of the rigs in West Africa was extensively damaged in March 2013. Jeed Ltd.’s management believes the rig is beyond economic repair and there will be no alternative but to abandon it. This suggestion has brought angry protests from conservationists. In January 2013, iced Ltd. entered into an agreement to share in the future economic benefits of an extensive oil pipeline.

You are the manager responsible for the audit of .feed Ltd. Last year, your firm modified its auditor’s report due to lack of evidence to support management’s schedule of proven and probable oil reserves to be recoverable from known reserves.

Required:

  1. Discuss the audit risks to be addressed when planning the final audit of Jeed Ltd. for the year ended 31 March 2013.
  • As Teed Ltd. is a limited company there will be pressure on its management to meet expectations of users in particular shareholders and analysts there increasing inherent risks.
  • The oil industry is a volatile market, this increases the going concern risk.
  • jeed Ltd, operates in different regions with exposure to economic instability, currency devaluation and inflation. Increased disclosure risk arises as lAS 1 presentation of financial statements requires that key assumptions concerning the future of such sources of estimation uncertainty be disclosed.
  • The fall in the basic EPS (as compared with the first six months of the previous half year) may increase management bias to overstate performance in the second half of the year

Inherent-Assertion level

The grant of a license may be valued at either cost or fair value as per 1AS 20 Accounting for Government Grants and Disclosure of Governmental Assistance. However, valuation other than at cost if inherently risky as fair value may be estimated -management.

  • The license is an intangible asset. If recognised other than at cost it should be amortised on a straight line basis over five years as per lAS 38.
  • Item replacements of drilling equipment’s should be recognised as items of property, plant and equipment band the replaced items as disposal in accordance with IAS 16. Constituent items of each rig should be depreciated over their useful lives.
  • If management is properly reassessing the useful life of each rig annually then this should be reflected in the change, from time to time, of a number of years over which each rig is depreciated.
  • Although the treatment of decommissioning provisions appears to be correct as per IAS 16 and IAS 37 abandoning the damaged rigs calls into question Jeed’s recognition of such provisions. In absence of a legal or constructive obligation, there is no liability to be PI-

ON

  • The abandoned rig may be overstated, depreciation should cease and rig be tested for impairment. In particular decommissioning provision should be revised against the undepreciated balance included in cost.
  • Actual or contingent liabilities may arise if iced is exposed to fines or penalties as a result of abandoning the rig (IAS 37). As the rig was damaged before year end provision should be made as at year end unless they cannot be reliably measured.
  • The oil pipeline is a jointly controlled asset that should be accounted for to reflect the economic substance as per 1AS 31..leed should recognise its share of assets, liabilities and expenditure incurred and any income from the rate of its share of the oil output.
  • The prior year modification would have been qualified – except for! If there is a similar lack of evidence in the current year the auditor’s report should be similarly qualified. Even if the correct position as at 31 March 2013, is determinable, the audit opinion at that date should be modified in respect of the impact if any, on the operating position and comparative, unless the opening oil reserves position has since been ascertained and can be corrected with a prior period adjustment.
  1. Describe the principal audit work to be performed in respect of the useful lives of iced Ltd.’s rig platforms.
  • Review of management’s annual assessment of the useful life of each rig at 31 March 2013, and corroboration of any information that has led to change in estimates.
  • Consider the management is past experience and expertise in estimating useful lives. For example, if all lines initially assessed as short are subsequently lengthened. Review of industry producers comparative as published in the annual reports of other oil producers.
  • Comparison of actual maintenance costs against budgeted to confirm that the investment needed in maintenance, to achieve expected life expectancy is being made.
  • Comparison of actual output (oil extracted) against budgeted. If actual output is less than the budgeted economic life of the platform may be shorter because there is less oil to be extracted than originally surveyed or vice versa.
  • A review of the results of management impairment testing of each rig • Recalculation of cash flow projections discounted at a suitable pre tax rate.
  • Review the working papers of geologist or quantity surveyor employed .feed supporting estimations of reserves used in the determination of useful life of rigs.

QUESTION 9

According to International Standard on Auditing (ISA) 210: Agreeing the terms of Audit Engagements; the form and content of the audit engagement letter may vary for each entity. Nonetheless, the standard provides guidance on the matters an audit engagement letter may make reference to.

Explain the matters highlighted ISA 210 to which an audit engagement letter might make reference

  • Audit methodology to be adopted.
  • Professional regulations that govern the audit.
  • The form of report that can be issued.
  • The timing of representation to be obtained from management.
  • The extent of the audit.

 

QUESTION 10

  1. a) Tamu Juice Ltd. is a well-established soft drinks manufacturer which has twelve cafeteria; within the cenrral business district.

The company has appointed your firm as their auditors for the year ending 31 December 2012.

The company distributes its products through dealers. The dealers distribute the company’s products together with products belonging to other companies.

Tarim Juice Ltd. faces stiff competition and therefore spends significant amounts on advertising and other promotional expenses. Advertising expenses are reimbursed to dealers according to the company’s policy. These expenses are recorded in the financial statements under selling and distribution expenses. This expense category includes 1,400 transactions which range from Sh.600,000 to Sh.2 000,000.

Jackson Kalimba is the audit senior in charge of your audit team. lie has decided to gather evidence using audit sampling verifying one transaction out of every ten transactions under selling and distribution expenses. All samples selected are worth Sh.80,000 and above.

The internal audit reports for the second quarter of the year indicated that there were many irregularities in the advertising expense, which were reimbursed to the dealers.

The audit report revealed the following irregularities.

  • 1 The copy of advertisements made the dealer (which was reimbursed the company) in the local newspaper advertised the dealer as a distributor of Tamu Juice products and other products.
  • Some of the expenses reimbursed were not supported Documentary evidence

Required:

Discuss the appropriateness and sufficiency of the audit sampling used-Jackson Kalimba

  1. Risk assessment.

Ile should first have to assess the risk of material misstatement. If it indicates high level of audit risk he will have to ensure that the sampling is sufficient to take care of the risk.

  1. Efficiency and effectiveness of the internal control systems.

Audit sampling technique work out well where the ICS is assessed to be strong and efficient. In this case Tamu Ltd internal audit report indicates irregularities in the internal controls. This means the auditor may not apply sampling method.

  1. The level of materiality.

For activities where the level of materiality is high the auditor has to increase the sample size to cover a wide sample of entries and ensure the quality of evidence is high.

  1. Previous audit experience.

The use of sampling method depends on the auditor’s previous expense relating to the occurrence of misstatement in certain areas of the operations. In this case even though there is no evidence of the auditors experience the internal audit report indicates irregularities, hence all the transactions have to be examined in order to detect the irregularities.

  1. Awareness of the enterprise business and the industry

If the auditor is aware of the enterprise business and the industry in which it operates, he may be aware of areas in which the chances of material misstatement can occur. The auditors are aware that the dealer whose expenses are reimbursed uses the expenses to advertise the product which do not belong to the company. Therefore the auditors sample must be large enough to detect the occurrence of such misstatement.

  1. Audit procedures findings.

The auditors have to verify the audit evidence using the sampling size he had fixed. If evidence shows that there are money irregularities, the auditor (Mr. Jackson) will have to increase the size of audit sample or look for more reliable audit evidence. This may need looking at dealer’s correspondence files to verify whether-the company has faced the ‘- problems with expense reimbursement to the dealers.

  1. The source and reliability of evidence

The sample size will depend on the source and reliability of audit evidence. Written evidence from external sources are stronger than oral evidence or internally generated evidence. Therefore the size of audit sample will be small if it is supported a written external evidence:

QUESTION 11

Commercial Bank (MCB) Ltd. is a large and well established bank with eight branches in the country of domicile. Your audit firm was re-appointed the auditors of the bank for the year ended 31 October 2012. George Bwire is the audit manager in charge of the audit of MCB Ltd.

The interim audit for the year ended 31 October 2012 commenced on 1 April 2012. During the interim audit the auditors noted that MCB Ltd. had gradually changed its accounting system from a manual system to a computerized system as follows:

  • Four branches were fully computerized.
  • Two branches were in the process of being fully computerized.  Two branches operated a manual system.

George Bwire assessed the bank risk as follows:

  1. The four branches which were fully computerized were less risky because the internal control system in place was working as intended. In addition the employees of these branches were computer literate.
  2. The two branches which were in the process of being computerized in the current year were more risky. This was because the internal control system of these branches had changed substantially and therefore needed greater focus. In addition the computerized environment was new to the employees and they needed training in the operations of the cornpurerised system.
  3. The two branches which were operating a manual system were less risky. This was due to the fact that there were no changes_ in the internal control system and the working environment. Further, George Bwire had knowledge of the operations of these branches.

George Bwire completed the interim audit on 30 April 2012 and is now planning tor the final audit of the financial year ended 31 October 2012. On the basis of previous years’ experience, he has decided that the level of materiality will remain at Sh,1,000,000 the same as that of the previous year.

George Bwire has however, noticed the following:

  • The bank has introduced internet banking and tele-banking.
  • The bank has opened a new branch.
  • The two branches which were operating manually at the time of the interim audit had been fully computerised.
  • New legislation related to anti-money laundering has been enacted in the country which requires all banks to have an anti-money laundering program in place and auditors to report on such transactions.
  • Loans and deposits of the bank have increased 20% which is a substantial change compared to the last year.

Required:

Assess the audit risks posed the changes in mwananchi Commercial Bank (MCB) Ltd. and their possible impact on the level of materiality

Events that may have an impact on risk and materiality assumed at the planning-stage; –

  1. Starting of new operation.

Internet banking and tele-banking will result in a significant risk such as exposure to the internee risk such as the viral attack, hacking and loss of sensitive information. The auditor should therefore assess such risk and the effectiveness of internal control system (ICS).

  1. The substantial increase in loans and deposits 20% may also change the materiality levels because of the increased risk of potential bad debts on the loans granted.
  2. Computerisation of the rethaining two branches.

Initially the auditor assessed the risk of two branches which were not computerised to be low because of the ICS existing and his previous knowledge of these systems. However following the computerisation of the branches the risks have increased because the ICS have changed substantially.

  1. Opening up of a new branch.

By opening up a new branch the bank will be exposed to new risk e.g. additional funds required for running the branch, competition from the existing competitors, new employees who may lack experience and the risk of the bad debts due to increased loans. The auditor should therefore change his audit plan significantly on the review of ICS. The auditor may face the detection risk due to the limited evidence since he doesn’t have experience or knowledge of operation.

  1. Enforcement of the new legislation on money laundering.

This has increased the auditor’s responsibility in terms of reporting. This may increase the level of audit risk. The auditor will therefore need to check whether the bank has implemented an anti- laundering program and whether it has a system of identifying and reporting such activities. The auditor may need to lower the materiality level from Shs 100,000 if the bank has put in place laundry system.

  1. Draft financial statement.

As a result of significant increase in operations the materiality may need to be changed: The auditor should review the financial statements and apply analytical review procedures to assess the risk accordingly.

 

QUESTION 12

Discuss the audit risk that auditors face in the course of the audit of financial statements of entities with material assets stated at fair values instead of historical costs.

  1. Audit risks USA 320)

Audit risk refers to the risk that the auditors will express an inappropriate audit opinion when the financial statements are materially misstated.

Audit risks awing the auditor when material assets are stated at fair values instead of historical costs include:

  • Inherent risk is the susceptibility of an assertion to a misstatement that could be material, either individually or when aggregated with other misstatements, assuming that there are no related controls.
  • Control risk is the risk that a misstatement that could occur in an assertion and that could be material either individually or when aggregated with other misstatements, will not be prevented or detected and corrected on a timely basis the entity’s internal control. Control risk is a function of the effectiveness of the design and operation of internal control in achieving the entity’s objectives relevant to the preparation of the entity’s financial statements.
  • Detection risk is the risk that the auditor will not detect a material misstatement that exists in an assertion that could be material either individually or when aggregated with other misstatements. Detection risk is a function of the effectiveness of an audit procedure and its application the auditor.

 

QUESTION 13

Chai Bora Ltd. is a tea growing and processing company. In addition to producing its own raw tea leaves, the company buys raw tea from farmers in the neighbouring environs:

As the manager in charge of the external audit of the company for the year ended 31 December 2001 you gathered the following facts about the company’s operation:

  • The company has its own free nurseries whose tea seedlings are raised for establishing new plantations. In addition, there are blue gum tree nurseries for establishing wood fuel plantations for factory boilers,
  • The tea grown the company and that from out growers is weighed and graded for quality compliance. It is then processed at the factory.
  • Processed tea is graded and kept in a large store in readiness for sale. Thereafter the tea is either exported or sold locally at the factory retail shop situated near the factory gate and other local outlets.
  • The company has rented five shops in different towns to boost local sales. Each of the shops is a profit centre and has a shop manager. All cash collections from each shop are banked daily in the main bank account of the company.

The company’s turnover for the year amounted to Sh.400 million of which Sh.360 million were export sales. All exports are zero rated with respect to Value Added Tax (VAT). The company claimed

VAT refunds estimated at Sh 1 2 million each quarter in the year 2010. Your firm certified the claims as required the tax authorities.

Tea for export is sold brokers at the auction who later transfer the sales proceeds electronically to the bank account of the company usually in US dollars.

The company maintains a US dollar account and a shilling account. Dollars are from time to time converted to shillings using negotiated rates.

Required:

Evaluate the risks posed to you as the auditors of Chai Bora Ltd. In expressing your audit opinion and outline the measures you would take to minimise the risks in the course of your audit.

 

Risks posed to the auditor

 

1.     Biological assets

Since Tea and blue gun trees are biological assets the auditor may be faced with challenges like determining costs incurred to date, economic value matureIrees, market value etc.

 

2.     Collusion between bank staff and company employees in relation to exchange rate negotiations

 

 

3.     Since the grading system is manual, it may lead to human error and abuse.

Measures to minimize the risk

 

1.     The auditor may check the industry practice regarding the assets.

 

 

 

 

 

2.     The auditor should check the reasonableness of exchange rates; he should do so confirming the exchange rates from relevant authorities such as banks.

3.     Enter into discussion with management on safeguards against possibility of .failure of the system.

4.     The is the risk that brokers can manipulate prices realised at the auction.

 

5.     Determination of closing stocks in each of the five shops as well as stocks in transit

4.     Confirm that all charges the broker are in line with industry practice and legal provisions.

 

5.     Check Sales receipts, deposit slips and stock take sheets for validity

 

QUESTION 14

Your firm, PLC & Associates Certified Public Accountants have recently been appointed the auditors of Plastic Manufacturing Limited (PML). The Company manufactures jugs and other kitchen ware and has a workforce of 100 employees.

The products are predominantly sold to local retailers and distributed countrywide. The company has a small accounting unit which consists of the chief accountant, Mr.Mwendapole and an accounts clerk Miss Kazungu the Chief Accountant reports directly to the managing director and the major shareholder Mr.Makanyaga.

The company uses a simple personal computer based accounting system. Miss Kazungu enters invoices into the computer and maintains the manual cash book. Mr.Mwendapole is in charge of preparing management accounts on a monthly basis and the payroll, which is approved monthly Mr.Makanyaga controls purchasing and sales although he has a personal assistant who performs the paperwork in liaison with Miss Kazungu.

The previous auditors did not offer themselves for re-election due to dispute with Mr.Makanyaga, but have stated that they are not aware of any ethical reason which bars your firm from undertaking the audit. They have passed ove‘r some relevant working papers to your firm and have met with you to give some background information on the audit. One of the things

 

they mentioned about the audit was that they have always assessed the internal controls of PMI as poor. Required:

Discuss the term “audit failure” and it’s probable causes.

  • It refers to a situation where the auditor issues an erroneous audit opinion as the result of an underlying failure to comply with the requirements of generally accepted auditing standards.

Audit failure frequently related to inadequate industry expertise.

  • The causes of audit failure include:-

Failure to-

  • Understand the entity’s business model.
  • Understand changes in the entity’s operating environment.
  • Fully understand the nature the business purpose of transactions.
  • Perform appropriate client acceptance/continuance procedures.
  • Reconsider prior year judgment or assumptions.
  • Involve specialists.
  • Be sufficiently firm with the client,
  • Corroborate explanations given client.
  • Consult on issues and judgments.:
  • Appropriately consider corporate governance.  Arrange realistic deadlines:
  • With respect to PML identify and briefly explain three types of each of the following risks:

 Audit risks 

Audit risk

This is the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a measure of how reliable the information used in the accounting system is that, how much reliance can be put on it. The higher the audit risk, the more evidence must be gathered in order for the auditor to obtain sufficient assurance as a basis for expressing an opinion on the financial statements. Audit risk has three main components.

Business risks

  • Inherent risk-this is the susceptibility of an account balance of class of transactions to misstatements that could be material, individually or when aggregated with

misstatements ill other balances or classes, assuming that there were no related internal controls.

  • Control risk- This is the risk 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 corrected on a timely basis accounting and internal control systems.
  • Detection risk-risk that an auditor’s substantive procedures will not detect a misstatement that exists in an account balance or class or transactions that could be material individually or when aggregated with misstatements in other balances or classes.
  1. ii) Business risks

They result from significant conditions, events, circumstances or actions that could adversely affect the entity’s ability to achieve its objectives and execute its strategies. Even though such risks are likely to eventually have an impact on an entity’s financial statements, not every business risk will translate directly in a risk of a material misstatement in the financial statements, which is often referred to as audit risks. There are 3 categories of business risk.

  • Financial risk- this is the risk that the firm will not be able to meet its short term maturing obligations as a when they fall due.
  • Operational risk- these are risks arising with regard to operations for instance, the risk that a major supplier will lie longer be able to supply the company with the key raw materials.
  • Compliance risk- Risk that arises from non-compliance with laws and regulations under which the business operates for example, environmental issues.

 

QUESTION 15

You are the audit manager at Shabir & Associates, a firm of Certified Public Accountants. One of tile clients assigned to you as the audit partner is Zep Engineering Ltd, a company engaged in oil and gas exploration. The audit partner has indicated that Zep Engineering Ltd could be a high risk company with respect to social and environment obligations.

Required:

Identify four possible areas that might lead to the risk of material misstatements in the financial statements of Zep Engineering Ltd.

  • The classification of assets in accordance with the requirements of lAS 16 and IFRS 6.
  • Oil and gas valuation: Valuation of oil and gas in accordance with lAS 2
  • Valuation of tile property and equipment that firm uses during, exploration as provided for under IAS 16 property, land and equipment and 1 FRS
  • The provisions made the company, contingent liabilities and contingent assets. This may lead to possible litigation as a result of environmental degradation.

 

QUESTION 16

Your client, Island Ltd. manufactures machines for use in coal extraction. Your audit firm was appointed as the auditors of the company in June 2009.This is your first audit engagement Island Ltd. .

You are planning the audit of the financial statements for the year ended 31 October 3009.The draft financial statements show revenue of Sh.125 million (2008 – Sh 103 million). The reported profit before tax is Sh 5.6 million (2008 – Sh5.1 million) while total assets are reported as Sh.95 million (2008 – Sh.90 million).

Island Ltd. has five main customers who pay for supplies in three instalments; 50 % on confirmation of order,25 °10 on delivery and 25% on the installation of machinery. It takes, on average, six months from the time of confirmation of an order to the installation of machinery. You have established the following:

  1. There is an outstanding amount of Sh.2.85 million from Jack Mine Ltd.jack Mine Ltd. has disputed payment of the amount due, claiming the machinery installed was not operating efficiently.
  2. One customer, Wyne Ltd. claimed for damages for injuries suffered their employee when a machine malfunctioned in August 2009.The company has a poor safety record. Island Ltd. has informed Wyne Ltd. that they would not pay for the damages claimed the company. Subsequently, Wyne Ltd. has cancelled two orders placed in October 2009.
  3. Work in progress is valued at Sh.8.5 million as at 31 October 2009.A physical inventory count was carried out on 17 October 2009.The company’s chief engineer estimated the stage of completion of each machine on 17 October 2009.
  4. One of the major components used in manufacturing the machinery for coal extraction is sourced from an overseas supplier, Locks Ltd. and is invoiced in Euros. There is a trade payable of Sh.1.5 million owed to Lock Ltd. as at 31 October 2009.
  5. All machine are supplied with a warrant; of one year. An allowance of Sh 2.5 million (2008 – Sh 2.4 million) in respect of warranties is recognised in the statement of financial position as at 31 October 2009. The Chief executive as Island Ltd.,Ms.Kate Collins estimates the cast of repairing defective machinery reported customers which is used as the basis for making the allowance in the financial statements.
  6. Kate Collins owns 60 % of the shares of Island Ltd. She also owns 55 % of the shares in Pacific Ltd. The premises where the head offices if Islannd Ltd. are situated are owned Pacific Ltd.Ms.Kate Collins is considering selling part of her shareholding in February 2010 and would like the audit completed 15 January 2010.

Required:

Discuss the audit risks and any other matters to be considered when planning the final audit of Island Ltd. for the year ended 31 October 2009.

Audit Risks

Audit risk refers to the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a measure of how reliable the information used in the evidence must gathered .in order for the auditor to obtain sufficient assurance as a basis for expressing all opinion on the financial statements.

  1. The management should install an internal control system to detect material errors and correct them. In this case management should implement controls around receivables, work in progress and inventory to ensure that any materials errors are detected before they make it to the financial statements.
  2. Some material errors may fail to be detected the controls and others may completely by-pass the controls. The value of inventory depends on the valuation the chief engineer of the firm, who despite all the controls may under or overstate the value of inventory to suit the management intentions.
  • The auditor is expected to carry out audit procedures to provide reasonable assurance that material errors will be detected and removed from the financial statements. Despite the audit procedures and the controls, there will be the possibility that some misstatements will be undetected. The management makes provisions for warranties based on estimates of the costs incurred in repairing the machines.

Matters to be considered when planning for the final audit

ISA 210 provides that when planning and performing audit procedures and in evaluating and reporting the result, auditors should consider the risk of material misstatements in the financial statements resulting in fraud. The auditor must assess the risk that a material fraud or error has occurred,

  1. Knowledge of the business (ISA 310)

The auditor should obtain a proper understanding of the business to enable the auditor identity and understand the events, transactions and practices in which in the auditor’s judgment may have a significant effect on the financial statements or the auditor’s report. The auditor needs to obtain sufficient understanding of the firm’s clients, the nature of operations of the firm, the industry within which the industry operates.

  1. Materiality (ISA 310)

The auditor needs to obtain an understanding of all material items that may affect the reporting in the financial statements and the auditor’s report and their impact to the business. The auditor should assess the impact of bad debts and damaged inventory and their overall impact to the financial statements.

  1. Going concern (ISA 570)

The auditor should obtain all information regarding matters that affect the going concern of the firm. The auditor should assess the impact of the defaulting customers and the effect of cancellation of orders already placed. The auditor should also take into consideration other- factors affecting the existence of the firm in the foreseeable future.

 

Explain the audit procedure that could be used in verifying the allowance for warranties included in the statement of financial position as at 3! October 2009.

  • Obtain a detailed listing of the receivables-and a listing of all repairs that have been carried out in the current year and in the previous years.
  • Obtain the assumptions made management in the coming up with the provisions and assess then r reasonableness.
  • Compute the previous year’s provision and re-compute the current years and compare with the management’s provisions.
  • Discuss with management about the provisions they have made and reconcile any differences that may arise and the need to change the provisions where necessary.
  • Compare management’s provisions in the previous years and the current year and establish whether the assumptions have been applied consistently over the years.
  • In case there are any inconsistencies, the same should be resolved with management and adequate explanations provided to that effect.

 

QUESTION 17

(a) Business and audit risk i) Business risk

They result from significant conditions, events, circumstances, or actions that could adversely affect the entity’s ability to achieve its objectives and execute its strategies. Even though such risks are likely to eventually have an impact on an entity’s financial statements, not every business risk will translate directly in a risk of a material misstatement in the financial statements. For example, the fact that an engineering firm has difficulty finding sufficient engineers is clearly a business risk, without being an obvious direct link to an audit risk. ii)       Audit Risk

It is risk that the auditor gives an inappropriate audit opinion vhen the financial statements arc materially misstated. It is a measure of how much reliable the information used the accounting system is. The higher the audit risk, the more evidence must be gathered in order for the auditor to obtain sufficient assurance as a basis for expressing an opinion on the financial statements. Audit risk has three components.

  1. Inherent risk (IR): It is 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.
  2. Control risk (CR.) Risk that a misstatement that could occur in an account balance or class of transactions and that could be material- individually or when aggregation with other misstatements in order balance or classes will not be prevented or detected and corrected on a timely basis accounting and internal control systems.
  • Detection risk (DR): Risk that an auditor’s substantive procedures will not be detect a misstatement that exist in an account balance or class of transactions that could be material, individually or when aggregated with misstatements in other balances or classes.

 

QUESTION 18

You have been appointed the auditor of Chapa Kazi Ltd., a limited liability company. The company has 150 employees and deals in the manufacture of household goods including glasses.

The glassware is sold predominantly to a large distributor and retail store in an affluent market. The glassware sold to the distributor and retail store in the affluent market are designed to the store’s specification and cannot be sold to anyone else.

Chapa Kazi Ltd. also sells household goods to a number of retailers operating in the low income market segment. The accounting function of Chapa Kazi Ltd. consists of the chief Accountant, Mr.Mhasibu, who reports directly to the managing director who is also the major shareholder Mr. Egeza and an accounts assistant Mr.K.arani.

There is a simple personal computer (PC) based accounting system. Mr.Karani enters invoices into the computer and maintains the manual cash book Mr.Mhasibu is in charge of preparing the management accounts on a monthly basis and the payroll which is approved monthly Mr.

Egeza. Mr. Mhasibu also manages the tax affairs of the company and the tax affairs of Mr. Egeza.

Mr. Egeza controls purchasing and sales, although he has an assistant who produces the paperwork and liaises with Mr.Karani the accounts assistant from time to time on matters relating to accounts payable.

Arising from disputes between the previous auditors and Mr. Egeza, the auditors did not offer themselves for re-election .Mr. Egeza has requested your firm of auditors 10 undertake the audit of Chapa Kazi Ltd. for the current financial year ending 31 December 2009.

You have met the previous auditors who have provided YOLI with some background information on their audit of Chapa Kazi Ltd. The auditors also provided you with their working papers and inform you that they are not aware of any ethical reason which may prevent your firm from accepting the audit appointment

However, the previous auditors have disclosed that they have always assessed the internal control systems of Chapa Kazi Ltd. as ineffectVie to be relied upon in their previous audits.

Required:

Describe the key audit risks and business risks of Chapa Kazi Ltd.

Audit risks and business risks

  • Audit risks (AR= IR x DR x CR)

This is the risk that the auditor-gives an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a measure of how reliable the information used in the accounting system is, that is, how much reliance can be put on it. The higher the andit risk, the more evidence must begathered in order for the auditor to obtain sufficient assurance as a basis for expressing an opinion on the financial statements. Audit risk has three main components.

  1. Inherent risk – this is the susceptibility of an account balance or class of transactions to misstatements that could be materials individually or when aggregated with misstatements in other balances or classes assuming that there were no related internal controls.
  2. Control risk – this is the 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 corrected on a timely basis accounting and internal control systems.
  • Detection risk – risk that all auditor’s substantive procedures will not detect a misstatement that exists in an account balance or class of transactions that could be material individually or when aggregated with misstatements in other balances or classes.

The key audit risks include;

  1. Poor accounting system

Simple accounting system which the company uses comprises a simple computer and the staff at the accounting department who maintain the books manually. There is a risk that material misstatements may be done since there are no checks and balances in the accounting system.

This in effect makes it hard for the auditor to detect fraud or material misstatements.

  1. Unclear, job description

Responsibilities of staff at the department overlap each other. Employees team up in different jobs meaning that there are no clear job descriptions. Employees can use such confusion as an avenue to perpetuate fraud.

Business Risk

There are 3 categories of business risk namely: –

  • Financial risk – this is the risk that the firm will not be able to meet its short term maturing obligations as and when they fall due.
  • Operation risk – These are risks arising with regard to operations for instance, the risk that a major suppliers will no longer be able to supply the company with the key raw materials.
  • Compliance risk – risk that arises from non-compliance with laws and regulations under which the business operates for example, environmental issues.
  1. Specialized goods

The firm deals in specialized stuff that is sold to the affluent market only. This poses a risk to the firm in case the goods do not find any customers and hence the firm may be holding too much high value non-moving stock which is detrimental to the firm.

  1. Inefficient internal controls

Inefficient internal controls and are not able to detect frauds or other misstatements. The firm’s internal controls do not clearly provide procedures and checks and balances to ensure that there is minimal chance for a fraud to be carried out. There is therefore need for the auditors to carry out more effective substantive procedures.

 

QUESTION 19

The activities of the Pesa Mingi Business Group (PMBG) comprise retailing of general merchandise and luxury goods. PMBG has developed an internal audit function over many years. In the recent past, employee turnover in the internal audit department has risen, with high performing employees moving to other-departments and less successful employees leaving the company:

The external audirors, Weru & Co. have suggested that PMBG outsources its internal audit function to experienced auditors. Your firm, Mulzin & Co. has been invited to tender for the. provision of the internal audit services to PMBG for three years up to 31 December 2011.The appointment will include an evaluation of organisation risk, financial compliance., information technology controls, systems audit and fraud investigation. • •

As the prospective assignment manager in Mulzin & co. you have been asked to identify the principal matters to be presented in your firm’s written submission for the tender. The invitation to tender indicates that written submissions will be used as a means of shortlisting candidates to make a detailed presentation to PMBG’s Audit rind Risk Management Committee.

You have obtained the following information from PMBG:

  1. The Audit Risk Management Committee receives annual reports from the head of internal audit on the controls over operational, financial and compliance risks.
  2. PMBG has a comprehensive system of budgetary controls including monthly performance reviews of both financial and non-financial indicators. 3. Financial extracts

 

  Six months to 30 June 2009 Year to 31 December 2008
  Draft Actual
  Sh ‘million’ Sh ‘million’
Revenue 387 751
Profit before tax 46 83

 

 

  1. A substantial proportion of PMBG’s revenue is generated through retail outlets in departmental stores and shopping centres. Many of tile rents payable for these premises are contingent on revenues earned the retail outlets.

Required:

Briefly describe potential advantages and disadvantages to PMBG of outsourcing its internal audit function.

Internal audit can also be defined as an independent appraisal function within a firm for the review of systems of control and the quality of performance, as a service to the organization. It objectively examines, evaluates and reports on the adequacy of internal controls as a contribution to the proper, economic, efficient and effective use of resources. internal audit should be carried out independent personnel of the firm or outsourced from other firms. (ISSA 610 Using the work of an internal auditor).

Potential advantages and disadvantages of outsourcing internal audit functions are briefly described as follows:

  1.  Advantages of outsourcing the internal audit function

 

  • Skills required for only a short time each year can be provided without incurring excessive cost of maintaining an in-house expertise.
  • Internal audit staff can be used from a broader source of expertise, for example, professional firms that may specialize in particular types of organizations.
  • With a professional outsourced department, less management time is required on internal audit, for example, in appraisals, training and development.
  • There is greater focus on cost and efficiency of the internal audit functions.
  • It reduces the risk of high turnover or loss of staff from the internal audit department.
  • External sources are useful for providing specialist, experienced skills such as IT, than an in-house department may find difficult to recruit or retain.

Disadvantages of outsourcing

 

  • There is the risk of lack of knowledge or awareness of the organization objectives, culture or business.
  • An outsourced department may not be able to provide the same flexibility or ready staff available particularly where problems arise since they do not have a permanent presence.
  • Standards or service may fall once the contract has been secured and the previous team disbanded.
  • There is risk of blurring ropes between internal and external audits, resulting in les creditability for both.
  • In as much as external staff may be well experienced, there is still no way to confirm that they will guarantee quality. This can be left to speculation.
  • Conflict of interest may arise if the outsourced internal audit service is provided the external auditors.

Describe the principal matters that should be included in your firm’s submission to provide internal audit services to PMBG.

  • Responsibilities of the internal audit staff and the management
    • This section will seek to make clear the responsibilities of both parties in relation to the internal audit function. The roles and responsibilities of both parties should be expl icitly stated and understood both parties. This section will seek to stress the fact that the internal audit function will run independently and should be allowed unrestricted access to any documents and records that the auditors might require in carrying out their duties.
    • Management should also provide channels that allow the external auditors to go directly to the audit committee where need arises.
  • Scope of work
    • This will indicate the various areas that the external auditors will seek to examine during the exercise, the nature of work to be done, the extent of audit procedures the impact of Stich procedures and any other work to be done beside what is explicitly required.
  • Reporting responsibilities
    • The internal audit function would be useless if the reports issued and the recommendations made are not implemented. This sectionwill provide management with information about the nature of reports to expect and the implementation programs to be issued alongside the reports. –
  •  Professional fees
  • This section will seek to elaborate on how the professional fees will be calculated on work done and the terms of payment including the mode of payment to be issued alongside the reports.
  •  Other services
  • This section will highlight any other services that may be offered the firm alongside the internal audit function and their impact on the internal audit function in case they are offered together.

Explain the possible impact of PMBG outsourcing its internal audit functions to Mulzin & Co. on the audit of the financial statements Weru & Co.

Express on audit of opinion is the sole responsibility of the external auditor. Reliance on the work of internal auditors does not reduce this responsibility the auditor may rely on the work of Muslin only after confirming.

  •  The work was done auditors having adequate technical training and proficiency. ii) The work was properly documented, reviewed and supervised: iii) Adequate audit evidence has been obtained to enable the internal auditors draw reasonable conclusions.
  • Conclusions reached are appropriate in those circumstances and any reports prepared the auditors are consistent with the results of the work performed.
  • Any exceptions, or unusual matters disclosed the auditors.
  • Any potential risks to the audit are minimized.
  • Weru & co. may expect the internal auditors to uncover most of the frauds and errors that may be perpetuated within the organization and may therefore reduce their procedures when it comes to frauds and other materials misstatements in the financial statements.
  • The overall audit of the financial statements Weru & Co. may be done even a notch higher because of the existence of two audit firms working on similar projects together leading to even a more conclusive opinion on the audit of financial statements.

 

QUESTION 20

You are the audit supervisor On the audit of RS Ltd., a company listed on the Nairobi Stock Exchange. RS Ltd. sells building materials, plumbing supplies and ceramic tiles through its home improvements retail outlets.

The results of operations and the financial position of RS Ltd. for the previous financial year as well as the current financial year are summarized as follows:

 

 

 

  Actual Year ended 31 December 2003

Sh. Million

Budget Year ended 31 December 2003

Sh. Million

Turnover 11,480 13,780
Profit before interest and tax 1,270 1,500
Profit before tax 920 1,200
Profit after tax 630 800
Ordinary shareholders’ funds 3,240 3,640
Total assets 5,500 6,000

 

You are currently planning the audit for the year end 31 December 2004. The following matters have come to your attention during your review of last year’s working papers and the most recent management accounts and during discussions with the financial director of RS Ltd.

  1. MPH Ltd., the holding company of RS Ltd. is in financial difficult. MPH Ltd. holds 50% of the ordinary shares in issue.
  2. RS Ltd. also has retail outlets in Tanzania, Uganda, Ethiopia and Sudan.
  3. The managing director of RS Ltd., Mr. Peter Rush, has acquired an interest in a national car hire business. It appears from discussions with the financial director of RS Ltd. are encouraged to use this car hire company at all times. Car hire expenditure is a material component of the operating costs of RS Ltd.
  4. The RS Ltd.’s pension fund has a large surplus. During the current financial year, the company has temporarily suspended its contributions to the pension fund.
  5. RS Ltd. made a loan to Mr. Peter Rush to purchase shares in the company. The financial director intends to obtain repayment of the loan before the financial year end and to re- advance the funds from the RS Ltd. share trust.
  6. RS Ltd. is currently involved in a dispute. A customer is alleging that certain building supplies purchased from the company were sub-standard and the customer is claiming damages of Sh.50 million. RS Ltd. has rejected this claim. A preliminary trial date has been set for February 2005.

During a discussion with Mr. Peter Rush he offered to supply, free of charge, the bathroom tiles and plumbing materials for the house you are in the process of building.

Required:

  1. Outline the potential audit risks apparent from the above matters and state briefly the audit procedures necessary to address the risks you have identified. Detailed audit programme steps are not required. You simply need to set out each of the issues that will need to be covered your audit procedures.
  2. Indicate what matters you need to consider, what steps you should take before responding to the offer from Mr. Peter Rush. In addition, state what you believe to be the appropriate response to Mr. Peter Rush.

 

Potential Risk Audit Procedures
Financial reporting risk Review the transactions between MPH and RS
Foreign operations risk Review currency exchange rates.
Exchange risk Reviewthe translation exercise
Related party transactions misrepresentation resulting in details and disclosures are appropriate Request for a letter of representation showing
Pension fund not being able to pay benefits Review the basis on which the surplus was determined. Consult actuaries
Inadequate provisions to boost profits Review cut off procedures forsales and purchases

 

QUESTION 21

You have been the auditor of Nairobi Super Furniture Ltd. for the last ten years. The company manufactures furniture for the local and export markets. The shares in Nairobi Super Furniture Ltd. whose year end is 31 December changed hands during the year, resulting in 74% of the shares now being owned a company in Vienna (Austria).

The directors of Nairobi Super Furniture Ltd. have informed you that the audited financial statements must be delivered to the holding company in Vienna 15 January 2004 for consolidation purposes. The year end of the holding company in Vienna is’ also 31 December.

You are currently planning your audit.

Required:

State the actions to be taken to perform the assignment within the time restriction. Discuss this in terms of

  • Steps to be taken the client
  • Steps to be taken the auditor

For the assignment to be completed in the specified time restriction the client will take the following steps:

  • Ensure that all employees affected the audit are aware
  • The books of account should be up-to-date so that the auditor will not be delayed
  • An interim audit should be undertaken to ensure that work that can be done early is done.
  • The following key audit tasks will be undertaken during the interim audit. (b) Steps to be taken the auditor
  • Adherence to deadlines in the audit process
  • Use more experience staff
  • Perform most of the work during the internal audit
  • Group accounting issues should be dealt with early in the process
  • Quality assurance procedures should be adhered to

 

QUESTION 22

You are the audit manager on the audit of Super Furniture Ltd a company which manufactures office and household furniture. The financial year-end of the company is 30 June 2002 and you took charge of the audit assignment on 20 august 2002 after the resignation of the previous audit manager.

The following are extracts from the audit-planning memorandum.

  • Shareholdings

Currently all shares are held the directors. A takeover offer has been received from Dominant Furniture Ltd, a listed company to buy 51 % of the equity shares in Super Furniture Ltd. Negotiations are still under way.

  • Materiality

The materiality level has been set at Sh 1.5 million.

While reviewing the audit working papers for the year ended 30 June 2002, you find the following notes prepared the senior in charge of the audit.

 

  2002 2001
  Sh. 000 Sh. 000
1.   Sundry accruals 3,774 5,028
2.   Provision of leave pay 1800 6,180
3.   Provision for major maintenance 7954 12,000
4.   Provision for legal costs 480
5.   Provision for losses on insurance claims 1,050
6.   Provision for credit notes 750 750
7.   Provision for management and provisions 1,800 2,245_
Total sundry accruals and provisions 16,558 27,253

Notes

  1. Sundry accruals

For a full list of accruals see working paper H2.1. Supporting documentation has been seen for all accrued amounts over Sh 60,000 totaling Sh.2, 565.000 (68%). All accruals are for normal expenses of the company and appears to be reasonable.

  1. Provision for leave pay

This amount agrees with the total leave pay due as reflected on the printout from the salaries system. We have reviewed the controls in the salaries system, including the computerized leave records and have tested the controls through compliance testing. No weaknesses or exceptions have been found.

The reason for the lower Orovision is that the company has changed its leave policy. From 30 April 2002, only management may carry forward leave due to them from one year to the next. I have discussed and confirmed the new policy with Mr. Chege the financial director.

  1. Provision for major maintenance

The only movement on this account during the year has been maintenance expenses of Sh 4,046,000 debited against the account. 1 have seen supporting documentation for expenses totaling Sh 850,000 being 21% of Sh 4,046,000.

  1. Provision for legal costs

This amount has not been incurred at the year-end and concerns the estimated legal costs for the company’s defense of a claim for damages against it an ex-employee. The employee was retrenched in January 2002. As the court case started in September 2002, this is an over provision (carried forward to the list of immaterial errors.

  1. Provision for credit notes

This provision is maintained at Sh 750,000 and is for possible credit notes after the year-end relating to invoices issued before the year-end. As the average monthly credit notes amount to approximately Sh 720,000 the provision is considered to be sufficient.

  1. Provision for management bonuses

All managers are entitled to a bonus based on criteria which are determined a year in advance at their annual performance review interview. Mr. chege refused to give me a list of bonus amounts or the letters setting out the bonus criteria, as the amounts have not been finalized and are still confidential.

The provision appears to be reasonable when expressed a as percentage of turnover 0.45% (2002) compared to 0.47% (2001)

You are required to:

  • Define inherent risk and indicate in respect of the line item “sundry accruals and provisions” what effect the proposed turnover has on:
    1. Your assessment of the inherent risk
    2. Your audit approach
  • Draft review notes to the senior in charge of the audit on any five of the seven items making up the balance of sundry accruals and provisions. In each case you should indicate
    1. Whether you are satisfied with the basis of calculation and the accounting principles applied.
    2. What additional audit work, if any, needs to be performed?

 

ANSWER

Inherent risk is the susceptibility of an account balance or class of transactions to material misstatement, either individually or when aggregated with misstatements in other balances or classes of transactions irrespective of related internal controls.

Therefore, inherent risk is the risk that items will be misstated due to characteristics of those items, such as the fact they are estimates or that they are important items in the accounts.

  1. As an audit manager, I will use my own professional judgment and all the available knowledge/information to assess inherent risk.
  2. As regards the takeover, I will consider whether the provisions managers’ assessment of inherent risk is reasonable regarding the sundry accruals and provisions. If there was information that was not available to the profits manager and is now available, for example provision for management bonuses, I will consider the impact of this information on his assessment of inherent risk. If a lot of information is not available (e.g. as regards provision) this would increase the level of inherent risk.
  3. My audit approach would be determined the extent of reliance that I would be able to place on the work carried out the previous audit manager. If I am satisfied with his approach, I may continue with it and arrive at a conclusion or I would have to carry out my own tests_

Even if I place reliance on the previous audit manager’s work. I would still have to carry out some substantive procedures and comp re my results with those of the previous manager. If they agree, I would be persuaded to place reliance on his work.

(b)

  1. Accruals have been verified inspecting supporting documentation of (60% of the value of accruals) accruals over Sh.60, 000. Thus, this is not representative of the accruals figure and further tests need to be done on the other 40% on a test basis. If analytical procedures are carried out, and the 2001 and 2002 figure are compared. it will be seen that there was a significant drop. This could be an indicator that some accruals have been left out. Thus further work should be done to test for completeness of accruals
  2. The reason given Mr. Chege does not seem to be reasonable for the decrease in provision. This is because, even if the employees may not carry forward the leave, they are entitled to their leave pay. Thus, I will ensure that the provision takes into account the unpaid leave pay for the other employees.
  3. lAS 37 prohibits, companies from creating a provision for maintenance expenses on the grounds that these expenses are avoidable. Thus, this provision needs to be realized to the profit and loss account by: –

DR provision for maintenance

CR profit and loss accounts.

  1. I would consider the reasonableness of the estimated costs. If it is an overprovision then I would require the directors to write off the overprovision and set up only the required amount, as prudence would dictate.
  2. This provision is not justified. This is because credit notes are accounted for in the period in which they arise and not necessarily the period in which the sales were made. Thus. I

need to discuss with the directors the need to reverse this provision by: –

DR provision for credit notes, CR profit and loss account.

  1. Chege’s argument that the list of director’s bonus is confidential is not acceptable. This is because according to Companies Act, the auditor has a statutory right of access to all books and records of the company. Thus, I would demand from him such a list, which I would use to determine the reasonableness of the provisions. If he refuses to give the list would seek other evidence.

if not available, I will have to consider whether lack of the list consisting a limitation in the scope of my work and if so, I would give a qualified opinion i.e. a disclaimer.

 

QUESTION 23

Twenty Second Century Ltd, a large company was founded and controlled Mr. J.Presscot. The principal business of the company was to develop derelict land in city and town centers into office accommodation. In 1999, Kenya Revenue Authority became suspicious of the nature of the operations being carried out the company and an investigation into its affairs commenced. The resultant report stated that the company’s internal controls were weak and non-existent in many cases. The investigators found payments to unknown persons, and fictious consultancy firms. In addition Mr. Prescott had maintained a secret expense account that was used to disburse funds to himself. The board of directors of Tvienty Second Century Ltd did not know of the existence of this account. This expense account was maintained the partner firm of accountants responsible for the audit of the company. The auditors were heavily criticized in the report of the investigators.

The firm of auditors A to Z & Co. had an aggressive marketing strategy and had increased its audit fees 1 00% in two years. The audit firm had accepted the appointment in I 997 after the previous auditors had been dismissed. The audit report for the year ended 1996 had been heavily qualified the previous auditors on the grounds of poor internal control and lack of audit evidence.

Mr. J.Presscot has approached several firms of auditors in order to ascertain whether they would qualify the audit report given the present systems of control in Twenty Second Century ltd. A to Z & co itd has stated that it was unlikely they would qualify their report. They realized that Mr. J. Prescott was “opinion shopping” but were prepared to give an opinion in order to attract the client to the firm.

Twenty Second Century Ltd was subsequently put under receivership and liquidation and A to Z & Co were sued for negligence the largest loan creditor, its bankers.

Required:

Describe the procedures, which an audit firm should carry out before accepting a client with potentially high audit risk such as Twenty Second Century ltd

  1. It should be obvious to any prospective auditor that the management of Twenty Second Century Ltd could lack integrity, given the circumstances of the previous auditors dismissal and the `opinion shopping’ procedures adopted them. Thus, the quality control procedures adopted the prospective firm would include the determination of the client’s integrity.

The quality control procedures therefore which should be adopted a firm of auditors when accepting a new client with potentially high audit risk such as Twenty Second Century Ltd are as follows:

  1. Request the client’s permission to communicate with the previous auditor. If permission is refused, the auditor should decline the nomination.
  2. On receipt of permission, the previous auditor should be requested to furnish all information which would enable the prospective auditor to decide whether he is prepared to accept nomination. In the case of Twenty Second Century Ltd, the prospective audit firm may enquire of any reason that the firm might have to question the integrity of the prospective clien’ts management.

Further information would be required about the reasons for the audit qualifications and the dismissal of the previous auditors.

  1. Enquire informally of the client’s business associates whether they feel that the management of the company is competent and trustworthy.
  2. Contact the regulatory authority with responsibility for overseeing the sector, if this is applicable, in order to see if any disciplinary measures have been taken against the company.
  3. Make a preliminary assessment of audit risk. This would be undertaken discussing business and economic matters with the client, and making a preliminary assessment of the internal control structure of the client. In the case of Twenty Second Century Ltd, the previous auditors had qualified the audit report because of poor internal controls and lack of audit evidence. Thus, it would be important for the audit firm to make a preliminary visit to the prospective client in order to gain first hand experience of the management and the accounting system.
  4. Assess whether the audit firm has the required expertise to carry out the audit. The audit of land developers is quite specialized and experience in the sector is important if the audit is one of high audit risk.
  5. Evaluate the costs and benefits of acceptance of the client.- The risk of potential legal liability and loss of public image may make the appointment relatively unattractive.

Discuss the ethical problems raised the maintenance of the secret expense account for Mr. J.Presscot the audit partner.

  1. There are several ethical issues involved in the maintenance of a secret expense account for the company the audit partner. First, the audit partner has not behaved with integrity and objectivity. Integrity implies not Merely honesty but truthfulness. He has not been open with the board of directors of the company because he concealed the secret expense account from them. Secondly, the audit firm would not be seen, to be independent even though in dealing with the transactions in this secret expense account he may have possessed a true mental state of independence. Third parties would doubt the partner’s independence irrespective of whether or not the partner acted independently. Objectivity can only be assured if the partner was, and was seen to be independent. Thirdly, in the case of a large public company, a practice should not participate in the maintenance of the accounting records.

The auditor should not assume a role equivalent to that of an employee of a client.The key consideration in this case is the fact that J.Prescott and the audit partners kept the expense account secret from the management of the company. it would appear to an observer that the two persons were colluding in order to at best, conceal information and at worst defraud the company. From a third party, viewpoint the auditor would not be seen to be independent and it would render the audit opinion somewhat less meaningful.

Suggest measures that audit firms might introduce to try and minimize the practice of “opinion shopping” the prospective audit clients.

  1. In recent years, many companies, who have disagreed with their auditors over an item in their financial statements, have asked another audit Firm for their view on the matter and if the

view is sympathetic, then the company invariably has changed its auditors. This practice of ‘opinion shopping’ could be minimized adopting the following procedures:

  • Where an auditor is dismissed, the company could be required to -file a statement to that effect with the Registrar of Companies stating any disagreements with the former audit firm.
  • The audit firm who succeeds the former auditors could be required to disclose also to the Registrar and/or in the first audit report whether or not it agrees with the former audit firm.

The above points could deter companies from attempting to find audit firms who are prepared to express a more flexible attitude to accounting issues

  • Where an audit firm is approached a non-client to give a technical opinion on a matter, it is important that the firm has a clear and comprehensive understanding of the issue prior to giving an opinion.

The audit firm should correspond with the non-clients own audit firm in order to obtain all the information at hand. If it appears that the non-client is ‘opinion shopping’ then the audit firm should consider its ethical position and possibly refuse to give an opinion.

  • Existing legalization gives auditors the right to present their case to the members against removal either verbally at a general meeting or in writing prior to their removal. Similarly where an auditor resigns from his office, he may make a statement regarding the circumstances of his resignation which must be sent to the registrar and ever person entitled to receive a copy of the financial statements. However, auditors seldom publicize their point of view when being dismissed for fear of being branded ‘controversial’. However, if audit firms were prepared to publicize their viewpoint more forcibly the adverse publicity might dissuade company directors from finding a more co-operative audit firm. Also the prospective auditors would possibly be dissuaded from accepting the appointment, if greater publicity was given the circumstances behind the previous auditors dismissal.

Explain how audit firms can reduce the risk of litigation and its effects upon the audit practice

 

  1. Audit firms can reduce the risk of litigation and its effects upon the audit practice b adopting the following procedures:
    • Ensuring that all audit engagements follow Auditing Standards.
    • Establishing quality control procedures and practice standards of the highest quality.
    • Adopting rigorous client acceptance procedures.
    • Ensuring adequate professional indemnity insurance.
    • Developing a positive litigation strategy. Audit firms often have actions brought against them, which would fail in a court of law. Historically some firms have made nominal `out of court’ settlements in order to avoid publicity but others have refused to deal with this type of lawsuit in this manner choosing to go to court and allegedly this has discouraged potential plaintiffs.

 

QUESTION 24

State the objective of the statutory audit and explain how carrying out the audit in accordance with ISAs helps the auditor to achieve that objective.

The objective of the statutory audit is to obtain reasonable assurance about whether the financial statements are free from material misstatement, thereenabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework (such as IFRSs).

There is an International Standard on Auditing that deals with the overall audit objectives (ISA 200), but in, addition each individual ISA has its own objective designed to aid in the achievement of the overall stated above.

Therefore, in most cases fully understanding and complying with the ISAs relevant to the audit will result in the auditor achieving each applicable ISA’s objective and the overall objective.

To ensure objectives are met, ISA 200 states that the auditor must go beyond the requirements in a particular ISA if it is considered necessary to meet the objective.

The way in the audit is approached is very important, so ISA 200 stresses that in order to achieve the overall objective, auditors also need to plan and perform the audit with professional scepticism and apply professional judgment

  • ISA 315 Identifying and assessing the risks of material misstatement through understanding the entity and its environment sets out matters that should be documented during the planning stage of an audit,

Required

List six matters that should be documented during audit planning.

  • Discussion amongst the audit team about the susceptibility of the Financial statements to material misstatements
  • Key elements of the understanding gained of the entity
  • Identified and assessed risks of material misstatement
  • Significant risks identified and related controls evaluated
  • Overall responses to address the risks of material misstatement
  • Nature, extent and timing of further audit procedures linked to the assessed risks at the assertion level
  • Where reliance is to be placed on the effectiveness of controls from previous audits, conclusions on how this is appropriate
  • ISA 230 Audit documentation provides guidance to auditors in respect of audit working papers.

Required;-

List six factors which affect the form and content of audit working papers.

  • The size and complexity of the entity
  • The nature of the audit procedures to be performed
  • The identified risks of material misstatement
  • The significance of the audit evidence obtained
  • The nature and extent of exceptions identified
  • The need to document a conclusion or basis for a conclusion not readily determinable from documentation of work performed or audit evidence obtained
  • The audit methodology arid tools used

 

QUESTION 25

  • Explain the term °audit risk’ and the three elements of risk that contribute to total audit risk.

is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risk of material misstatement and the risk that the auditor will not detect such misstatement (detection risk). The risk of material misstatement has two components: inherent risk and control risk. Audit risk can be summarized the following equation:

Audit risk — Inherent risk x Control risk x Detection risk

Inherent risk is the susceptibility of an assertion to a misstatement that could be material, individually or when aggregated with other misstatements assuming that there were no related internal controls.

Control risk is the risk that a misstatement that could occur in an assertion and that could be material, individually or when aggregated with other misstatements, will not be prevented or detected and corrected on a timely basis the entity’s internal control.

Detection risk is the ii.sk that the auditor’s procedures will not detect a misstatement that exists in an assertion that could be material, individually or when aggregated with other misstatements.

  • The EuKaRe charity was established in 1960. The charity’s aim is to provide support to children from disadvantaged backgrounds who wish to take part in sports such as tennis, badminton and football.

EuKaRe has a detailed constitution which explains how the charity’s income can be spent. The constitution also notes that administration expenditure cannot exceed 1 O% of income in any year.

The charity’s income is derived wholly from voluntary donations. Sources of donations include:

  1. Cash collected volunteers asking the public for donations in shopping areas,
  2. Cheques sent,to the charity’s head office,
  • Donations from generous individuals. Some of these donations have specific clauses attached to them indicating that the initial amount donated (capital) cannot be spent and that the income (interest) from the donation must be spent on specific activities, for example, provision of sports equipment.

The rules regarding the taxation of charities in the country EuKaRe is based are complicated, with only certain expenditure being allowable for taxation purposes and donations of capital being treated as income in some situations .

Required;

  1. Identify areas of inherent risk in the EuKaRe charity and explain the effect of each of these risks on the audit in approach.

Inherent risk areas Detailed constitution

The charity has a detailed constitution which sets out how money may be spent. This increases the inherent risk of the audit.

The auditors will need to spend time examining and becoming faMiliar with the constitution and design their audit procedures with this in mind.

Limit on administration expenditure

The constitution states that administration expenditure cannot exceed 10% of Income in any year. This increases inherent risk as management may be tempted to misstate income or administration expenditure so this limit is not breached.

Special attention will need to be devoted to income and expenditure to ensure that the 10% limit is not breached legitimately.

Uncertainty of future income

The charity relies wholly on voluntary donations for its income which means that it cannot be assured of receiving a minimum level of income from one year to the next. This increases the risk of it not being able to continue.

Page 150

The auditors must bear in mind whether the charity can continue as a going concern when carrying out their nimi review procedures, This will involve discussion with management and examination of budgetary information.

Cash donations

Some of the donations received will be in the form of cash collected from the public. There is a risk of misappropriation of cash as a result.

Controls over cash should be examined as this is an area open to misappropriation and theft. Donations from individuals

Some donations have clauses about how the money can be spent. This again increases inherent risk because money may be misspent without regard for the conditions in place.

Where donations have been received with clauses attached, the auditors will need to do detailed work to ensure the conditions have not been breached.

Taxation legislation

There are complex rules in place regarding the taxation of charities.

The audit team will need to familiarize itself with the taxation rules for charities to ensure that this area is correctly dealt with.

  1. Explain why the control environment may he weak at the charity EuKaRe.

The control environment at EuKaRe may be weak for a number of reasons.

The staff working at the charity may be volunteers who may not have accounts experience and who may also not work there full-time. There may also be a high staff turnover because of the nature of the work.

There may be a lack, of segregation of duties in place due to the number of staff working at the charity. This means that trustees may play a role in the day to day running of the charity and there is therefore a risk of override of any controls that are in place.

The charity may not have an internal audit department in place due to its size or the equivalent of an audit committee to monitor its effectiveness.

There may also be a lack of budgetary information being produced on a timely basis which increases the control risk from the auditor’s point of view.

 

QUESTION 26

  1. a) ISA 315 Identifying and assessing the risks of material misstatement through understanding the entity and its environment requires the auditor to perform risk assessment procedures which include obtaining an understanding of the entity and its environment, including its internal control.

Required

  • Explain the purpose of risk assessment procedures.

procedures are performed at the planning stage of an ‘audit to obtain an. understanding of the entity being audited and to identify any areas of concern which could result in material misstatements in the financial statements. They allow the auditor to assess the nature, timing and extent of audit procedures to be performed.

  • Outline the sources of audit evidence the auditor can use as part of risk assessment procedures.
  • Inquiries of management
  • Prior year financial statement
  • Current year management accounts and budgets
  • Analytical procedures
  • Observation and inspection
  1. b) Mal & Co, an audit firm, has seven partners. The firm has a number of audit clients in different industrial sectors, with a wide range of fee income.

An audit partner of Mal & Co has just delegated to you the planning work for the audit of Serenity Co. This company provides a range of mobile communication facilities and this will be the second year your firm has provided audit services.

You have just met with the financial controller of Serenity prior to agreeing the engagement letter for this year. The controller has informed you that Serenity has continued to grow quickly, with financial accounting; systems changing rapidly and appropriate control systems being difficult to maintain. Additional services in terms of review and implementation of control systems have been requested. An internal audit department; has recently been established and the controller wants you to ensure that external audit work is limited using this department.

You have also learnt that Serenity is to market a new type of mobile telephone, which Is able to intercept messages from law enforcement agencies. The legal status of this telephone is unclear at present and development is not being publicized.

The granting of the license to market the mobile telephone is dependent on the financial stability of Serenity, The financial controller has indicated that Mal & Co may be asked to provide a report to the mobile telephone licensing authority regarding Serenity’s cash flow forecast for the year ending December 20×7 to support the license application. .

Required

As part of your risk assessment procedures for the audit of Serenity Co for the year ending 31 December 20×6, identify and describe the issues to be considered when providing services to this client.

  1. c) When reporting on a cash flow forecast, explain the term ‘negative assurance and why this is used.

) Poor internal controls and rapid growth

The accounting systems of Serenity Go are changing rapidly and the control systems are difficult to maintain as the company continues to grow. This indicates that the internal controls are likely to be poor so control risk and the risk of material misstatements in the aecounts will be high. Therefore a fully substantive audit is likely and Mal-& Co must ensure it has enough time and resources to obtain sufficient audit evidence to support the figures in the financial statements.

Reliance on internal audit department

Serenity Co has only recently established its internal audit department so Mal & Co needs to be very careful in deciding whether It can place reliance on the work performed Internal audit and ultimately in a reduced external audit fee, as desired the financial controller. Additional time and work would be required to Assess Internal audit so an immediate reduction in the fee is very unlikely.

Additional services required

Serenity Co requires additional services of review and implementation of control systems but Mal & Co must consider whether it has sufficiently skilled resources to carry out this additional work as it Is a small firm with a number of clients in different sectors.

Fee income

The additional work required Serenity Co will result In increased fee income to Mal & Co. The audit firm must ensure that its fee income from this one client does not breach the guidelines set the ACCA’s Code of Ethics. These state that the fee income from an unlisted client should not exceed 15% of the firm’s total fees.

Self-review threat

The additional work required on the review and implementation of control systems at Serenity Co could result In the risk of self-review. Mal & Co must ensure it implements appropriate safeguards to mitigate this risk, such as separate teams to carry out tire review work and the external audit. • This may be difficult in a small audit firm. It would also be essential to ensure that the client makes all the management decisions in relation to the systems.

Legal status of new mobile

The legal status of the new mobile product is not known – it may be illegal:Any adverse publicity generated as a result will impact on Mal & Co as the auditors of the company. The audit firm needs to consider carefully whether it wants to be associated with Serenity Co. The fact that the company is planning to make a product of dubious legality raises questions about the integrity of the directors, arid the audit team should be cautious in relying on any written representations provided the directors.

Reliance on cash flow statement for license

The granting of the license to market the mobile is dependent on the financial stability of the company, Mal & Co may be asked to provide a report on the company’s cash flow statement for the following financial year. This need to be considered carefully – Mal & Co must ensure it has sufficient experienced resources for this work and determine what kind of assurance is required

Going concern assumption

The company is growing rapidly and is relying on the granting of a license for the new mobile, whose legal status is not known. These factors may indicate a possible going concern risk which should be monitored carefully.

  1. c)

‘Negative assurance’ refers to when an auditor gives an assurance that nothing has come to his or her attention which indicates that the financial statements have not been prepared according to the identified financial reporting framework. i.e. the auditor gives his or her assurance in the absence of any evidence to the contrary.

Negative assurance is given on review assignments such as the review of a company’s cash flow forecast.

A cash flow forecast relates to the future so is based upon assumptiOns that cannot be confirmed as accurate. The auditor cannot confirm positively that the statement is materially true and fair (or presented fairly in all material respects).

This is because the conditions assumed when preparing the cash flow statement may not turn out as expected and it is not possible to zain the level of evidence expected to express absolute or reasonable assurance.

 

QUESTION 27

  • ISA 320 materiality in planning and performing an audit provides guidance on the concept of materiality in planning and performing an audit.

Required;-

Define materiality and determine how the level of ateriality is assessed

Materiality for the financial statements as a whole (referred to from now on as ‘overall materiality’) and performance materiality must be determined for all audits.

In the context of the financial statements, a matter is material if its omission or misstatement would reasonably influence the economic decisions of users taken on the basis of the financial statements.

Performance materiality is a materiality level set the auditor for particular transactions, account balances and disclosures.

Ultimately, both overall and performance materiality are determined using the auditors judgment as to how the users will be affected misstatements for a particular area. However it is useful to use benchmarks as a starting point, such as 5% of profit before tax, or I% of total assets.

When setting performance materiality, the possibility of a number of misstatements with a low value aggregating to high overall value must be considered. This results in it being lower than overall material

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