Additional practice questions

Test your understanding 1 – Confidentiality

Client confidentiality underpins the relationship between Chartered Certified Accountants in practice and their clients. It is a core element of ACCA’s Code of Ethics.

Required:

Explain the circumstances in which external auditors are permitted or required to disclose information relating to their clients to third parties without the knowledge or consent of the client. (4 marks)

A waste disposal company has breached tax regulations, environmental regulations and health and safety regulations. The auditor has been approached by the tax authorities, the government body supervising the award of licences to such companies and a trade union representative. All of them have asked the auditor to provide them with information about the company. The auditor has also been approached by the police. They are investigating a suspected fraud perpetrated by the managing director of the company and they wish to ask the auditor certain questions about him.

Describe how the auditor should respond to these types of request. (6 marks)

(Total: 10 marks)

Test your understanding 2 – Ethical threats

You are a manager in the audit firm of JT & Co and this is your first time you have worked on one of the firm’s established clients, Pink Co. The main activity of Pink Co is providing investment advice to individuals regarding saving for retirement, purchase of shares and securities and investing in tax efficient savings schemes. Pink Co is a listed company regulated by the relevant financial services authority.

You have been asked to start the audit planning for Pink Co, by Mrs Goodall, a partner in JT & Co. Mrs Goodall has been the engagement partner for Pink Co, for the previous seven years and so has a sound knowledge of the client. Mrs Goodall has informed you that she would like her son Simon to be part of the audit team this year; Simon is currently studying for his first set of papers for his ACCA qualification. Mrs Goodall also informs you that Mr Supper, the audit senior, received investment advice from Pink Co during the year and intends to do the same next year.

In an initial meeting with the finance director of Pink Co, you learn that the audit team will not be entertained on Pink Co’s yacht this year as this could appear to be an attempt to influence the audit opinion. Instead, he has arranged a day at the horse races costing less than two fifths of the expense of using the yacht and hopes this will be acceptable.

JT & Co have done some consulting work previously and the invoice is still outstanding.

Required:

Identify and explain the threats to independence in relation to the audit of Pink Co by JT & Co. For each threat, recommend how the threat can be managed.

(10 marks)

Test your understanding 3 – Analytical risk assessment

With reference to ISA 520 Analytical Procedures explain:

what is meant by the term ‘analytical procedures’

(1 mark)

the different types of analytical procedures available to the auditor

(3 marks)

the situations in the audit when analytical procedures are used.

(3 marks)

Tribe Co sells bathrooms from 15 retail outlets. Sales are made to individuals, with income being in the form of cash and debit cards. All items purchased are delivered to the customer using Tribe’s own delivery vans as most bathrooms are too big for individuals to transport in their own motor vehicles. The directors of Tribe indicate that the company has had a difficult year, but are pleased to present some acceptable results to the members.

The statement of profit or loss for the last two financial years are shown below:

Statement of profit or loss
	31 March 20X4	31 March 20X3
	$000	$000
Revenue	11,223	9,546
Cost of sales	(5,280)	(6,380)
	––––––	––––––
Operating expenses	5,943	3,166
Operating expenses
Administration	(1,853)	(1,980)
Selling and distribution	(1,472)	(1,034)
Interest payable	(152)	(158)
Investment income	218	–
	––––––	––––––
	2,684	(6)
	––––––	––––––
Statement of financial position extract
	––––––	––––––
Cash and bank	380	(1,425)
	––––––	––––––

Required:

As part of your risk assessment procedures for Tribe Co, identify and provide a possible explanation for unusual changes in the statement of profit or loss.

(8 marks)

(Total: 15 marks)

Test your understanding 4 – Audit risk

You are an audit senior in Staple and Co and you are commencing the planning of the audit of Smoothbrush Paints Co for the year ending

31 August 20X0. Smoothbrush Paints Co is a paint manufacturer and has been trading for over 50 years. It operates from one central site which includes the production facility, warehouse and administration offices.

Smoothbrush sells all of its goods to large home improvement stores, with 60% being to one large chain store Homewares. The company has a one year contract to be the sole supplier of paint to Homewares. It secured the contract through significantly reducing prices and offering a four-month credit period, the company’s normal credit period is one month.

Goods in/purchases

In recent years, Smoothbrush has reduced the level of goods directly manufactured and instead started to import paint from South Asia. Approximately 60% is imported and 40% manufactured. Within the production facility is a large amount of old plant and equipment that is now redundant and has minimal scrap value. Purchase orders for overseas paint are made six months in advance and goods can be in transit for up to two months. Smoothbrush accounts for the inventory when it receives the goods.

To avoid the disruption of a year-end inventory count, Smoothbrush has this year introduced a continuous/perpetual inventory counting system. The warehouse has been divided into 12 areas and these are each to be counted once over the year. At the year-end it is proposed that the inventory will be based on the underlying records. Traditionally Smoothbrush has maintained an inventory allowance based on 1% of the inventory value, but management feels that as inventory is being reviewed more regularly it no longer needs this allowance.

Finance Director

In May 20X0 Smoothbrush had a dispute with its finance director (FD) and he immediately left the company. The company has temporarily asked the financial controller to take over the role while they recruit a permanent replacement. The old FD has notified Smoothbrush that he intends to sue for unfair dismissal. The company is not proposing to make any provision or disclosure for this, as they are confident the claim has no merit.

Required:

Explain the audit risks identified at the planning stage of the audit of Smoothbrush Paints Co.

(8 marks)

Discuss the importance of assessing risks at the planning stage of an audit.

(6 marks)

Describe THREE substantive procedures the auditor of Smoothbrush Paints Co should perform at the year-end in confirming each of the following:

The valuation of inventory

The completeness of provisions or contingent liabilities. (6 marks)

(Total: 20 marks)

Additional practice questions

Test your understanding 5 – Fraud

Fraud and error present risks to an entity. Both internal and external auditors are required to deal with risks to the entity. However, the responsibilities of internal and external auditors in relation to the risk of fraud and error differ.

Required:

Explain how the internal audit function helps an entity deal with the risk of fraud and error.

(5 marks)

Explain the responsibilities of external auditors in respect of the risk of fraud and error in an audit of financial statements.

(5 marks)

Stone Holidays is an independent travel agency. It takes commission on holidays sold to customers through its chain of high street shops. Staff are partly paid on a commission basis. Well-established tour operators run the holidays that Stone Holidays sells. The networked reservations system through which holidays are booked and the computerised accounting system are both well-established systems used by many independent travel agencies.

Payments by customers, including deposits, are accepted in cash and by debit and credit card. Stone Holidays is legally required to pay an amount of money (based on its total sales for the year) into a central fund maintained to compensate customers if the agency should cease operations.

Describe the nature of the risks to which Stone Holidays is subject arising from fraud and error.

(5 marks)

(Total: 15 marks)

Test your understanding 6 – Quality control

You are the partner responsible for quality control within your firm. You are reviewing the findings from a recent post-issuance (cold) review performed by your firm’s compliance department. The following issues were identified on a number of audits:

Client A

A review of working papers found that some working papers had not been signed off by the team member that had completed the work. Some working papers were not dated and some did not have a signature confirming they had been reviewed.

Client B

A mandatory procedure included in the audit plan which required a written representation letter to be obtained, had not been completed.

A comment had been added by the audit manager stating that there were no issues requiring a written representation from management.

Client C

An audit test over purchases required a sample of 30 invoices to be tested. 27 had been tested and found to be recorded accurately and completely. 3 invoices could not be found. No further invoices were identified for testing and a conclusion was drawn based on the 27 items tested.

Client D

The audit of a material provision was performed by the audit junior as the audit manager was too busy finishing off work for the previous client on which they had been working.

Client E

The planning section of the file has not been completed. The audit procedures performed were copied over from the previous year’s file and the same approach and sample sizes have been used to conduct this year’s audit.

Required:

Describe the quality control issues arising from each of the findings.

(10 marks)

Test your understanding 7 – Controls

You are carrying out the audit of the purchases system of Spondon Furniture. The company has revenue of $10 million and all the shares are owned by Mr and Mrs Fisher, who are non-executive directors and are not involved in the day-to-day running of the company.

The bookkeeper maintains all the accounting records and prepares the annual financial statements.

The company uses a standard computerised accounting package.

You have determined that the purchases system operates as follows:

When materials are required for production, the production manager sends a handwritten note to the buying manager. For orders of other items, the department manager or managing director sends handwritten notes to the buying manager. The buying manager finds a suitable supplier and raises a purchase order. The purchase order is signed by the managing director. Purchase orders are not issued for all goods and services received by the company.

Materials for production are received by the goods received department, who issue a goods received note (GRN), and send a copy to the bookkeeper. There is no system for recording receipt of other goods and services.

The bookkeeper receives the purchase invoice and matches it with the goods received note and purchase order (if available). The managing director authorises the invoice for posting to the purchase ledger.

The bookkeeper analyses the invoice into relevant nominal ledger account codes and then posts it.

At the end of each month, the bookkeeper prepares a list of payables to be paid. This is approved by the managing director.

The bookkeeper prepares the cheques and remittances and posts the cheques to the purchase ledger and cashbook.

The managing director signs the cheques and the bookkeeper sends the cheques and remittances to the payables.

Mr and Mrs Fisher are aware that there may be weaknesses in the above system and have asked for advice.

Explain the control deficiencies in Spondon’s purchases system and suggest improvements to overcome the deficiencies.

(10 marks)

Test your understanding 8 – Inventory count

DinZee Co assembles fridges, microwaves, washing machines and other similar domestic appliances from parts procured from a large number of suppliers. As part of the interim audit work two weeks prior to the company year-end, you are testing the procurement and purchases systems and attending the inventory count.

On the day of the inventory count, you attended depot nine at DinZee.

You observed the following activities:

Pre -numbered count sheets were being issued to client staff carrying out the count. The count sheets showed the inventory ledger balances for checking against physical inventory.

All count staff were drawn from the inventory warehouse and were counting in teams of two.

Three counting teams were allocated to each area of the stores to count, although the teams were allowed to decide which pair of staff counted which inventory within each area. Staff were warned that they had to remember which inventory had been counted.

Information was recorded on the count sheets in pencil so amendments could be made easily as required.

Any inventory not located on the pre-numbered inventory sheets was recorded on separate inventory sheets which were numbered by staff as they were used.

At the end of the count, all count sheets were collected and the numeric sequence of the sheets checked. The sheets were not signed.

Required:

Describe FOUR audit procedures that an auditor will normally perform prior to attending the client’s premises on the day of the inventory count.

(4 marks)

Identify the deficiencies in the control system for counting inventory, explain why it is a deficiency and state how each deficiency can be overcome.

(12 marks)

State the aim of a test of control and the aim of a substantive procedure and in respect of your attendance at DinZee Co’s inventory count, state one test of control and one substantive procedure that you should perform.

(4 marks)

(Total: 20 marks)

Test your understanding 9 – Evidence and procedures

You are the auditor of BearsWorld, a company which manufactures and sells small cuddly toys by mail order. The company is managed by

Mr Kyto although due to other business commitments Mr Kyto only visits the office once a week. BearsWorld employs two assistants. One assistant maintains the payables ledger, orders inventory and pays suppliers. The other assistant receives customer orders and despatches cuddly toys. Mr Kyto authorises important transactions such as wages and large orders.

At any time, about 100 different types of cuddly toys are available for sale. All sales are paid for at the time of ordering. Customers pay using credit cards and occasionally by sending cash. Revenue is over

$5.2 million.

You are planning the audit of BearsWorld and are considering using some of the procedures for gathering audit evidence recommended by ISA 500 Audit Evidence as follows:

Analytical procedures

Inquiry

Inspection

Observation

Required:

For each of the above procedures in relation to the audit of

Bearsworld:

Explain its use in gathering audit evidence.

Describe one example how it could be used.

Explain the benefits of each procedure.

Explain the limitations of each procedure.

(20 marks)

Test your understanding 10 – Procedures

Describe FIVE types of procedures for obtaining audit evidence; and

For each type of procedure, describe an example relevant to the audit of BANK balances.

Note: The total marks will be split equally between each part.

(Total: 10 marks)

Test your understanding 11 – Audit risk NFP

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

(4 marks)

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 10% of income in any year.

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

Cash collected by volunteers asking the public for donations in shopping areas.

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:

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

(12 marks)

Explain why the control environment may be weak at the charity EuKaRe.

(4 marks)

(Total: 20 marks)

Test your understanding 12 – NFP audit

Ajio is a charity whose constitution requires that it raises funds for educational projects. These projects seek to educate children and support teachers in certain countries. Charities in the country from which Ajio operates have recently become subject to new audit and accounting regulations. Charity income consists of cash collections at fundraising events, telephone appeals, and bequests (money left to the charity by deceased persons). The charity is small and the trustees do not consider that the charity can afford to employ a qualified accountant. The charity employs a part-time bookkeeper and relies on volunteers for fundraising. Your firm has been appointed as accountants and auditors to this charity. Accounts have been prepared in the past by a volunteer who is a recently retired Chartered Certified Accountant but these accounts have not been audited.

Required:

Explain the audit risks associated with the audit of Ajio.

(4 marks)

Describe the audit procedures to be performed on income and expenditure from fund raising events.

(6 marks)

Note: You are not required to deal with the detail of accounting for charities in either part of the question.

(Total: 10 marks)

Test your understanding 13 – Subsequent events

Grains 4U Co (Grains) manufactures breakfast cereals and has three factories, four warehouses and three distribution depots spread across North America. The audit for the year ended 31 December 20X5 is almost complete and the financial statements and auditor’s report are due to be signed shortly. Profit before taxation is $7.9 million. The following events have occurred subsequent to the year-end and no amendments or disclosures have been made in the financial statements.

Event 1 – Fire

On 15 February 20X6, a fire occurred at the largest of the distribution depots. The fire resulted in extensive damage to 40% of the company’s vehicles used for dispatching goods to customers, however, there have been no significant delays to customer deliveries. The company estimates the level of damage to the vehicles to be in excess of $650,000. Only a minimal level of inventory, approximately $25,000, was damaged. Grain’s insurance company has started to investigate the fire to assess the likelihood and level of payment, however, there are concerns the fire was started deliberately, and if true, would invalidate any insurance cover.

(5 marks)

Event 2 – Inventory

On 18 February 20X6, it was discovered that a large batch of Grain’s new cereal brand ‘Loopy Green Loops’ held in inventory at the year end was defective, as the cereal contained too much green food colouring. To date no sales of this new cereal have been made. The cost of the defective batch of inventory is $915,000 and the defects cannot be corrected. However, the scrapped cereal can be utilised as a raw material for an alternative cereal brand at a value of $50,000.

(5 marks)

Required:

For each of the two subsequent events described above:

Based on the information provided, explain whether the financial statements require amendment, and

Describe audit procedures which should now be performed in order to form a conclusion on any required amendment.

(Total: 10 marks)

Test your understanding 14 – Written representations

Explain the purpose of a written representation.

(3 marks)

You are the manager in charge of the audit of Crighton-Ward, a public limited liability company which manufactures specialist cars and other motor vehicles for use in films. Audited revenue is $140 million with profit before tax of $7.5 million.

All audit work up to, but not including, the obtaining of written representations has been completed. A review of the audit file has disclosed the following outstanding points:

Lion’s Roar

The company is facing a potential legal claim from the Lion’s Roar company in respect of a defective vehicle that was supplied for one of their films. Lion’s Roar maintains that the vehicle built was not strong enough while the directors of Crighton-Ward argue that the specification was not sufficiently detailed. Dropping a vehicle 50 metres into a river and expecting it to continue to remain in working condition would be unusual, but this is what Lion’s Roar expected.

Solicitors are unable to determine liability at the present time.

A claim for $4 million being the cost of a replacement vehicle and lost production time has been received by Crighton-Ward from Lions’ Roar. The directors’ opinion is that the claim is not justified. Depreciation

Depreciation of specialist production equipment has been included in the financial statements at the amount of 10% per annum using the reducing balance method. The treatment is consistent with prior accounting periods (which received an unmodified auditor’s report) and other companies in the same industry. Sales of old equipment show negligible profit or loss on sale. The audit senior, who is new to the audit, feels that depreciation is being undercharged in the financial statements.

Required:

Discuss whether or not a paragraph is required in the written representation for each of the above matters.

(4 marks)

A suggested format for the written representation has been sent by the auditors to the directors of Crighton-Ward. The directors have stated that they will not sign the written representation this year on the grounds that they believe the additional evidence that it provides is not required by the auditor.

Required:

Discuss the actions the auditor may take as a result of the decision made by the directors not to sign the written representation.

(3 marks)

(Total: 10 marks)

Test your understanding 15 – Auditors’ reports

You are currently reviewing the working papers of several audit assignments recently carried out by your audit firm. Each of the audit engagements is nearing completion, but certain matters have recently come to light which may affect your audit opinion on each of the assignments. In each case the year-end of the company is 30 September 20X2.

Jones (Profit before tax $150,000)

On 3 October 20X2 a letter was received informing the company that a customer, who owed the company $30,000 as at the year-end had been declared bankrupt on 30 September. At the time of the audit it was expected that unsecured creditors, such as Jones, would receive nothing in respect of this debt. The directors refuse to change the financial statements to provide for the loss, on the grounds that the notification was not received by the statement of financial position date.

Total debts shown in the statement of financial position amounted to

$700,000. (5 marks)

(b) Roberts (Profit before tax $500,000)
On 31 July 20X2 a customer sued the company for personal
damages arising from a defect in one of its products. Shortly before
the year-end the company made an out-of-court settlement with the
customer of $10,000, although this agreement is not reflected in the
financial statements. Further, the matter subsequently became
known to the press and was extensively reported. The company’s
legal advisers have now informed you that further claims have been
received following the publicity, although they are unable to place a
figure on the potential liability arising. The company has referred to
the claims in a note to the financial statements stating that no
provision has been made because the claims are not expected to be
material.	(5 marks)

Additional practice questions

Griffiths (Profit before tax $250,000)

The audit work revealed that a trade investment stated in the statement of financial position at $500,000 has suffered a permanent fall in value of $300,000. The company has refused to put an impairment charge through for it on the grounds that other investments (not held for resale) have risen in value and are stated at amounts considerably below their realisable values.

(5 marks)

Evans (Profit before tax $100,000)

This client is a construction company, currently building a warehouse on its own premises and using some of its own workforce. The labour cost has been included in the cost of the non-current asset in the statement of financial position at a value of $10,000. During the audit it was discovered that the direct labour cost records for the early part of the year have been accidentally destroyed.

(5 marks)

Required:

Discuss each of the cases outlined above, referring to materiality considerations and, where appropriate, relevant accounting principles and appropriate accounting standards. Explain the audit reporting implications in each case.

(Total: 20 marks)

Test your understanding 16 – Corporate Governance 1

You are an audit manager of Satsuma & Co and have been assigned to the audit of Tangerine Tech Co (Tangerine), a company which is planning to list on a stock exchange within six months. The listing rules of the stock exchange require compliance with corporate governance principles, and the directors are unsure whether they are following best practice in relation to this. They have asked the audit engagement partner for their view on this matter.

Tangerine’s board comprises six executive directors, a non-executive chairman and three other non-executive directors (NEDs). The chairman and one of the NEDs are former executive directors of Tangerine and on reaching retirement age were asked to take on non-executive roles. The company has established an audit committee, and all NEDs are members including the chairman who chairs the committee. All four members of the audit committee were previously involved in sales or production related roles.

All of the directors have been members of the board for at least four years. As the chairman does not have an executive role, he has sole responsibility for liaising with the shareholders and answering any of their questions. The company has not established an internal audit function to monitor internal controls.

Required:

Using the information above:

Describe FIVE corporate governance weaknesses faced by Tangerine Tech Co and provide a recommendation to address each weakness to ensure compliance with corporate governance principles.

(Total: 10 marks)

Test your understanding 17 – Corporate Governance 2

What is meant by corporate governance?

(2 marks)

Why are external auditors interested in corporate governance? (2 marks)
Who should make up a typical audit committee?

(1 mark)

What is the audit committee’s role?

(5 marks)

Why would a company need an audit committee if it has a good relationship with its external auditors?

(2 marks)

A company has identified one of its major risks as loss of key staff.

Explain:

– What they should do as a result of this?

– How they might reduce or even eliminate the risk?

– Why the auditor is interested in this, given that it is not a direct financial risk?

(3 marks)

(Total: 15 marks)

Additional practice questions

Test your understanding 18 – Internal audit

Flylo is an airline. The company owns some of its fleet of aircraft. Other aircraft are leased from third parties. Flylo has an internal audit function that has recently been expanded. Your firm is the external auditor of Flylo. Your firm has been asked to investigate the extent to which it may be able to rely on the work of internal audit in the following areas:

Sales and ticketing

Fleet acquisition and maintenance

Trade payables and long-term debt financing (borrowings).

Required:

Explain why the work of the internal auditors, in the three areas noted above, is likely to be useful to you as the external auditor.

(6 marks)

Explain the matters that should be considered by the external auditor when evaluating the internal audit function and whether reliance can be placed on their work.

(4 marks)

(Total: 10 marks)

Test your understanding answers

Test your understanding 1 – Confidentiality

Disclosure of information relating to clients to third parties

– Auditors are permitted or required to disclose information about their clients to third parties without their knowledge or consent in very limited circumstances.

– Generally, auditors can be required to, or are permitted to, disclose information to certain regulatory bodies, including certain specialist units under legislation. Examples include legislation covering financial services companies such as banks, money laundering and investigation of serious fraud or tax evasion.

– Auditors may disclose information where they are personally involved in litigation, including litigation that involves the recovery of fees from clients, or where they are subject to disciplinary proceedings brought by ACCA or other, similar professional bodies.

– Auditors are permitted to disclose information where they consider it to be in the ‘public interest’ or in the interests of national security. Factors to take into account include the seriousness of the matter, the likelihood of repetition and the extent to which the public is involved.

Response to requests

– Auditors must not disclose information without the consent of the client or unless the necessary statutory documentation is provided by the person(s) requesting the information.

– Unless the auditor has reason to believe that there is a statutory duty not to inform the client that an approach has been made, the client should first be approached to see if consent can be obtained, and to see if the client is aware of the investigations. The auditor should ensure that the client is aware of the fact the voluntary disclosure may work in the client’s favour. If the client refuses, the auditor should inform the client if the auditor has a statutory duty of disclosure.

– Auditors should take legal advice in all of the cases described.

– Where the auditor is made aware of potential actions against the client that may have an effect on the financial statements, the auditor must consider the effect on the auditor’s report. If the client is aware of the investigation, the auditor will be able to seek audit evidence to support any necessary provisions or disclosures in the financial statements.

– The auditors should consider whether the suspected fraud relating to the managing director relates to the company and affects the financial statements.

– Auditors will be in a very difficult situation if they become aware of an action that may materially affect the financial statements, but where the client is not, and where auditors are under a statutory duty not to inform the client. This situation will not be improved by the resignation of auditors as they may be obliged to make a statement on resignation. Legal advice is essential in such circumstances.

– Tax authorities normally have powers to ask clients to disclose

information voluntarily. Such voluntary disclosure is often looked on favourably by the tax authorities and the courts. Tax authorities normally also have statutory powers to demand information from both clients and auditors. The same is generally true of environmental and health and safety inspectors.

– The power of the police to demand information is sometimes less clear and auditors and clients should take care to ensure that the appropriate authorities are in place. Those sections of the police investigating serious frauds usually have more powers than the general police.

– It is unlikely that trade union representatives have any statutory powers to demand information.

Test your understanding 2 – Ethical threats

Threat	Managing the threat

Mrs Goodall has been the	Mrs Goodall should be rotated
engagement partner for the last	from the engagement team.
seven years. This creates a	It may be possible to allow
familiarity threat.	It may be possible to allow
familiarity threat.	Mrs Goodall to continue as
	Mrs Goodall to continue as
Mrs Goodall may be too trusting of	engagement partner for one
or too close to the client to be able	further year in order to safeguard
to make objective decisions due to	audit quality.
this long association.	Audit committee approval must be
	Audit committee approval must be
	obtained in order to allow this and
	an independent partner review of
	the audit files for Pink Co should
	be arranged.





		There may be the impression of lack of	To demonstrate complete
		independence as Simon is related to the	independence, Simon
		engagement partner. Simon could be	should not be part of any
		tempted not to identify errors in case this	audit or assurance team for
		prejudiced his Mum’s relationship with	which Mrs Goodall is
		the client.	partner.
		In addition, if Mrs Goodall was reviewing
		Simon’s work, she may not review it as
		thoroughly as the other audit staff due to
		their relationship.
		As long as Mr Supper paid a full fee to	Mr Supper should be asked
		Pink Co for the investment advice (i.e. it	not to use the services of
		is on normal commercial terms) there is	Pink Co again unless this is
		no ethical threat as investment advice is	first agreed with the
		in the normal course of business for	engagement partner.
		Pink Co.
		However, if Mr Supper received a
		discount on the services or preferential
		rates, as a benefit of being part of the
		audit team, this would create a self-
		interest threat.
		Mr Supper may feel he has to overlook
		issues identified during the audit
		because of the preferential treatment.
		The audit team has been offered a day	The day out should not be
		at the horse races at the end of the audit	accepted. The rationale for
		which creates a self-interest threat.	accepting hospitality in
		Unless the value is trivial and	previous years should be
		Unless the value is trivial and	investigated.
		inconsequential, hospitality is not	investigated.
		allowed. The fact that the horse race day
		costs less than the yacht expense is
		irrelevant.
		The auditors may feel indebted to the
		client and therefore overlook issues
		identified during the audit.
		There are outstanding fees creating a	Payment for work should be
		self-interest threat. JT & Co may be	arranged before the audit is
		reluctant to identify misstatements for	commenced, or a payment
		fear of not getting paid.	plan agreed.
		In addition, outstanding fees may be
		considered to be a loan. Loans to clients
		are not permitted.

Test your understanding 3 – Analytical risk assessment

(i) Explanation of analytical procedures

‘Analytical procedures’ means the evaluation of financial and other information and the review of plausible relationships in that information. The review also includes identifying fluctuations and relationships that do not appear consistent with other relevant information or results.

Types of analytical procedures Analytical procedures can be used as:

– Comparison of comparable information to prior periods to

identify unusual changes or fluctuations in amounts.

– Comparison of actual or anticipated results of the entity with budgets and/or forecasts, or the expectations of the auditor in order to determine the potential accuracy of those results.

– Comparison to industry information either for the industry as a whole or by comparison to entities of similar size to the client to determine whether receivable days, for example, are reasonable.

Use of analytical procedures

Risk assessment procedures

Analytical procedures are used at the beginning of the audit to help the auditor obtain an understanding of the entity and assess the risk of material misstatement. Audit procedures can then be directed to these risky areas.

Analytical procedures as substantive procedures Analytical procedures can be used as substantive procedures in determining the risk of material misstatement at the assertion level during work on the statement of profit or loss and statement of financial position.

Analytical procedures in the overall review at the end of the audit

Analytical procedures help the auditor at the end of the audit in forming an overall conclusion as to whether the financial statements as a whole are consistent with the auditor’s understanding of the entity.

Net profit

Overall, Tribe’s result has changed from a net loss to a net profit. Given that revenue has only increased by 17% and that expenses, at least administration expenses, appear low, then there is the possibility that expenditure may be understated.

Revenue – increase 17%

According to the directors, Tribe has had a difficult year. Reasons for the increase in revenue must be ascertained as the change does not conform to the directors’ comments. It is possible that the industry as a whole, has been growing allowing Tribe to produce this good result. Alternatively, incorrect revenue recognition may have been applied.

Cost of sales – fall 17%

A fall in cost of sales is unusual given that revenue has increased significantly. This may have been caused by an incorrect inventory valuation and the use of different (cheaper) suppliers which may cause problems with faulty goods in the next year.

Gross profit (GP) – increase 88%

This is a significant increase with the GP% changing from 33% last year to 53% this year. Identifying reasons for this change will need to focus initially on the change in revenue and cost of sales.

Administration – fall 6%

A fall is unusual given that revenue is increasing and so an increase in administration to support those sales would be expected. Expenditure may be understated, or there has been a decrease in the number of administration staff.

Selling and distribution – increase 42%

This increase does not appear to be in line with the increase in revenue as selling and distribution would be expected to increase in line with revenue. There may be misallocation of expenses from administration or the age of Tribe’s delivery vans is increasing resulting in additional service costs.

Investment income – new this year

This is expected given the cash surplus in the year, although the amount is still very high indicating possible errors in the amount or other income generating assets not disclosed on the statement of financial position extract.

Interest payable – small fall

Given that Tribe has a considerable cash surplus this year, continuing to pay interest is surprising. The amount may be overstated.

Reasons for the lack of fall in interest payment e.g. loans that cannot be repaid early, must be determined. If the interest is associated with the overdraft that was in the SFP last year, this may have only been paid off just before the year-end.

Test your understanding 4 – Audit risk

Audit risks Inventory valuation

Smoothbrush supplies 60% of its goods to Homewares at a significantly reduced selling price. Inventory may be overvalued if the net realisable value is lower than cost.

Receivables

Smoothbrush has extended its credit terms to Homewares from one month to four months. There is an increased risk as balances outstanding become older that they may be irrecoverable resulting in overstatement of receivables.

Plant and equipment

The production facility has a large amount of unused plant and equipment. This plant and equipment should be stated at the lower of its carrying value and recoverable amount, which may be at scrap value depending on its age and condition. Plant and equipment may be overvalued.

Cut-off

Smoothbrush imports goods from South Asia and the paint can be in transit for up to two months. The company accounts for goods when they receive them. Therefore at the year-end only goods that have been received into the warehouse should be included in the inventory balance and a respective payables balance recognised. Cut-off of purchases and inventory may not be accurate.

Inventory system

A new inventory system was introduced in the year. This could result in inventory balances being misstated if the records and new system have not initially been set up correctly.

Inventory allowance

Smoothbrush previously maintained an inventory allowance of 1%, however, this year it has decided to remove this. Unless all slow-moving/obsolete items are identified at the year-end and their value adjusted, there is a risk that the overall value of inventory may be overstated.

Legal action

The company’s finance director (FD) has left and is intending to sue Smoothbrush for unfair dismissal. However, the company does not intend to make any provision or disclosure for any potential payment to the FD. Provisions or contingent liability disclosures may not be complete.

Lack of FD

Inherent risk is higher due to the changes in the finance department. The financial controller has been appointed as temporary FD and this lack of experience could result in increased risk of errors arising in the financial statement. In addition, the previous FD is not available to help with the audit.

Perpetual inventory system

Inventory may be misstated if the perpetual inventory counts are not complete and accurate. The inventory counts should cover all of the inventory lines but if any of the warehouses are not counted then this will need to be done at the year- end. In addition, inventory adjustments arising from the counts must be verified and updated by an appropriate member of the finance team to ensure the records are accurate.

Importance of assessing risks

– Assessing engagement risk at the planning stage will ensure that attention is focused early on the areas most likely to cause material misstatements.

– A thorough risk assessment will also help the auditor to fully understand the entity, which enables an effective audit to be performed. Any unusual transactions or balances would also be identified early, so that these could be addressed in a timely manner.

– As auditors adopt a risk based audit approach, these risks need to be assessed early in order for the audit strategy and detailed work programmes to be developed.

– Assessing risks early should also result in an efficient audit. The team will only focus their time and effort on key areas as opposed to balances or transactions that might be immaterial or unlikely to contain errors.

– Assessing risk early should ensure that the most appropriate team is selected with more experienced staff allocated to higher risk areas and high risk balances.

– A thorough risk analysis should ultimately reduce the risk of an inappropriate audit opinion being given. The audit would have focused on the main risk areas and hence any material misstatements should have been identified.

– It should enable the auditor to have a good understanding of the risks of fraud, money laundering, etc. Assessing risk should enable the auditor to assess whether the client is a going concern.

Substantive procedures to confirm valuation of inventory

– Select a representative sample of goods in inventory at the year-end, agree the cost per the records to a recent purchase invoice and ensure that the cost is correctly stated in the inventory records.

– Select a sample of inventory from the inventory listing and review post year-end sales invoices to ascertain if NRV is above cost or if an adjustment is required.

– For a sample of manufactured items obtain cost sheets and confirm:

– raw material costs to recent purchase invoices

– labour costs to time sheets or wage records

– overheads allocated are of a production nature.

– Review aged inventory reports and identify any slow-moving goods. Discuss with management why these items have not been written down.

– Compare the level/value of aged product lines to the total inventory value to assess whether the allowance for slow-moving goods of 1% should be reinstated.

– Review the inventory records to identify the level of adjustments made throughout the year for damaged/obsolete items. If significant, consider whether the year-end records require further adjustments and discuss with management whether any further write downs/allowance may be required.

– Follow up on any damaged/obsolete items noted by the auditor at the inventory counts attended, to ensure that the inventory records have been updated correctly.

– Perform a review of the average inventory days for the current year and compare to prior year. Discuss any significant variations with management.

– Compare the gross margin for current year with prior year. Fluctuations in gross margin could be due to inventory valuation issues. Discuss significant variations in the margin with management.

Substantive procedures to confirm completeness of provisions or contingent liabilities

– Discuss with management the nature of the dispute between Smoothbrush and the former finance director (FD), to ensure that a full understanding of the issue is obtained and to assess whether an obligation exists.

– Review any correspondence with the former FD to assess if a reliable estimate of any potential payments can be made.

– Review correspondence with the company’s lawyers to obtain their views as to the probability of the FD’s claim being successful.

– Review board minutes and any company correspondence to assess whether there is any evidence to support the former FD’s claims of unfair dismissal.

– Obtain a written representation from the directors of Smoothbrush confirming their view that the former FD’s chances of a successful claim are remote, and hence no provision or contingent liability is required.

Test your understanding 5 – Fraud

Internal audit function: risk of fraud and error

Internal audit can help management manage risks in relation to fraud and error, and exercise proper stewardship by:

– Commenting on the process used by management to identify and classify the specific fraud and error risks to which the entity is subject (and in some cases helping management develop and implement that process).

– Periodically auditing or reviewing systems or operations to determine whether the risks of fraud and error are being effectively managed.

– Where deficiencies are identified which provides opportunity for fraud and error, making recommendations for improvements.

– Monitoring the incidence of fraud and error and investigating serious cases.

In practice, the work of internal audit often focuses on the adequacy and effectiveness of internal control procedures for the prevention, detection and reporting of fraud and error. Routine internal controls (such as the controls over computer systems and the production of routine financial information) and non-routine controls (such as controls over year-end adjustments to the financial statements) are relevant.

It should be recognised however that many significant frauds bypass normal internal control systems and that in the case of management fraud in particular, much higher level controls (those relating to the high level governance of the entity) need to be reviewed by internal audit in order to establish the nature of the risks, and to manage them effectively.

External auditors: fraud and error in an audit of financial statements

– External auditors are required by ISA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements to consider the risks of material misstatements in the financial statements due to fraud. Their audit procedures will then be based on that risk assessment.

– Regardless of the risk assessment, auditors are required to be alert to the possibility of fraud throughout the audit and maintain an attitude of professional scepticism, notwithstanding the auditors’ past experience of the honesty and integrity of management and those charged with governance.

– Members of the engagement team should discuss the susceptibility of the entity’s financial statements to material misstatements due to fraud.

– Auditors should make enquiries of management regarding management’s assessment of fraud risk, its process for dealing with risk, and its communications with those charged with governance and employees. They should enquire of those charged with governance about the oversight process.

– Auditors should also enquire of management and those charged with governance about any suspected or actual instance of fraud.

– Auditors should consider fraud risk factors, unusual or unexpected relationships, and assess the risk of misstatements due to fraud, identifying any significant risks. Auditors should evaluate the design of relevant internal controls, and determine whether they have been implemented.

– Auditors should determine an overall response to the assessed risk of material misstatements due to fraud and develop appropriate audit procedures, including testing certain journal entries, reviewing estimates for bias, and obtaining an understanding of the business rationale of significant transactions outside the normal course of business.

– Appropriate written representations should be obtained from management confirming they have informed the auditor of all known or suspected frauds.

– External auditors are only concerned with risks that might cause material error in the financial statements. External auditors might therefore pay less attention than internal auditors to small frauds (and errors), although they must always consider whether evidence of single instances of fraud (or error) are indicative of more systematic problems.

– It is accepted that because of the hidden nature of fraud, an audit properly conducted in accordance with ISAs might not detect a material misstatement in the financial statements arising from fraud. In practice, routine errors are much easier to detect than frauds.

– Where auditors encounter suspicions or actual instances of fraud (or error), they must consider the effect on the financial statements, which will usually involve further investigations.

– They should also consider the need to report to management and those charged with governance.

– Where serious frauds (or errors) are encountered, auditors need also to consider the effect on the going concern status of the entity, and the possible need to report externally to third parties, either in the public interest or for regulatory reasons. Many entities in the financial services sector are subject to this type of regulatory reporting and many countries have legislation relating to the reporting of money laundering activities, for example.

Nature of risks arising from fraud and error: Stone Holidays

– Stone Holidays is subject to all of the risks of error arising from the use of computer systems. If programmed controls do not operate properly, for example, the information produced may be incomplete or incorrect.

– Inadequate controls also give rise to the risk of fraud by those who understand the system and are able to manipulate it in order to hide the misappropriation of assets such as receipts from customers.

– All networked systems are also subject to the risk of error because of the possibility of the loss or corruption of data in transit. They are also subject to the risk of fraud where the transmission of data is not securely encrypted.

– All entities that employ staff who handle company assets (such as receipts from customers) are subject to the risk that staff may make mistakes (error) or that they may misappropriate those assets (fraud) and then seek to hide the error or fraud by falsifying the records.

– Stone Holidays is subject to problems arising from the risk of fraud perpetrated by customers using stolen credit or debit cards or even cash. Whilst credit card companies may be liable for such frauds, attempts to use stolen cards can cause considerable inconvenience.

– There is a risk of fraud perpetrated by senior management who might seek to lower the amount of money payable to the central fund (and the company’s tax liability) by falsifying the company’s sales figures, particularly if a large proportion of holidays are paid for in cash.

– There is a risk that staff may seek to maximise the commission they are paid by entering false transactions into the computer system that are then reversed after the commission has been paid.

Test your understanding 6 – Quality control Client A

Failure to sign off a working paper makes it difficult to identify the person responsible for the work in case of any query. If the working papers had been reviewed the reviewer should have identified this issue and investigated who had performed the work and asked them to sign the working papers.

Completion dates of audit work are essential in order to identify the information that would have been available to the auditor at the time the procedures were completed. With the passage of time more information can come to light which would change the conclusion. If the working papers had been reviewed the reviewer should have identified this issue and asked the preparer to date the working papers.

Review of the working papers is an important quality control procedure. Every team member’s work should be reviewed by someone more senior to ensure it has been performed properly and to the appropriate standard. If a review has not been performed there could be material misstatements that have not been detected during the audit which could result in an inappropriate auditor’s report being issued.

The comment on the file stating that there are no matters requiring written representation would indicate that the audit manager does not understand the professional standards that should be followed during an audit, specifically the requirements of ISA 580 Written Representations.

Client B

Written representations are required by ISA 580. By not obtaining a written representation the audit firm does not have sufficient appropriate evidence to support the audit opinion.

Written representations should include matters such as the management confirming they have prepared financial statements that give a true and fair view and that they have provided the auditor with all of the information required for the audit.

The audit partner should not have signed the auditor’s report without the written representation being on file.

Client C

A sample of 30 was chosen for a purchases test yet only 27 were tested and a conclusion drawn from those items.

Sample sizes are chosen to ensure sufficient appropriate evidence has been obtained. As only 27 items were tested instead of 30, sufficient appropriate evidence has not been obtained in this instance.

The three missing invoices could be evidence of a wider control deficiency or a material fraud. Further investigation should have been performed to discover the reason for the missing invoices.

The issue may indicate a lack of supervision if the audit team member was unsure how to proceed after discovering the issue.

The issue would also indicate a lack of review as the matter was not identified during the review process.

Client D

Provisions are inherently risky as they are often determined by the judgment of management. As such they should be audited by someone with suitable experience and judgment.

An audit junior should not have performed this task. Tasks should be allocated to team members of appropriate experience and competence. Junior members of staff are usually allocated lower risk areas which require little experience and judgment. More senior members of the team should be assigned the riskier areas of the audit.

It is stated that the audit manager was too busy to perform the audit of the provision due to other client work. This may indicate that the workload of staff is not manageable. Audit quality could have been affected on both clients as work may be rushed to get it completed which may result in material misstatements going undetected.

Client E

Planning is an important and compulsory part of the audit process.

ISA 300 Planning an Audit of Financial Statements requires the audit to be planned in order to ensure that the audit is performed in an efficient and effective manner and an appropriate audit approach is taken which addresses the risks of the audit.

The auditor should not simply copy last year’s procedures and approach as this may not be appropriate for this year’s circumstances.

By failing to plan the audit properly, ISA 300 has not been complied with and therefore the audit has not been performed in accordance with professional standards.

General points

The quality control issues identified raise doubts over the performance of several audits conducted by the firm.

If it is discovered that an inappropriate auditor’s report was issued in any of these cases the firm could face action by the ACCA and by the client.

Any action taken against the firm could damage their reputation as well as result in a loss of clients and financial penalties.

The firm’s policies and procedures should be communicated again to staff to remind them of the requirements and the importance of them.

Further training is recommended to ensure staff are aware of how to comply with the requirements.

Disciplinary action may be necessary in respect of staff who have been found to be deliberately disregarding company policy.

Test your understanding 7 – Controls

Deficiency Recommendation

(1 mark) (1 mark)

Hand written orders with no sequential numbering.

Orders could be placed for goods not required resulting in overspending which will reduce profit. Alternatively, orders could be lost and not placed leading to potential stock outs. This will mean customer orders cannot be fulfilled leading to customer dissatisfaction.

Orders should be

sequentially pre-

numbered.

A sequence check should be performed on a regular basis to ensure completeness.

Orders should be authorised by a manager before being placed to ensure the goods are required.

Purchase orders are not issued for all goods and services.

Goods/services could be purchased that are not legitimate. This will increase costs for the company.

Purchase orders should be required for all goods. For services, a budget should be set and quotes obtained. Purchase orders should be authorised by someone other than the person requesting the goods to ensure they are for business use.

No system for recording receipt of other goods and services. Failure to record goods received could lead to over-ordering as inventory levels will be inaccurate.

This will result in additional cost for the company and poor cash flow management.

Goods received are not checked against the purchase order.

Goods could be received that have not been ordered. Incorrect quantities could be received. This will lead to production delays if the wrong goods have been received and delays in fulfilling customer orders leading to customer dissatisfaction.

There is no review of the bookkeeper’s work e.g. posting of invoices into the nominal ledger.

Errors could go undetected resulting in suppliers being paid incorrect amounts. This will affect the company’s relationship with the supplier affecting credit terms or discounts received.

A list of payables is given to the managing director without supporting documentation.

The managing director will not know if payables are valid or correct therefore could be paying incorrect amounts resulting in poor cash flow management.

There is a lack of segregation of duties as the managing director authorises invoices, approves payment and signs cheques.

Fraud could occur and go undetected as the managing director could create a fictitious purchase invoice to support a payment to himself. This will cause loss for the company.

A goods received note should be completed and used to update the inventory records on a daily basis.

Agree the GRN to the purchase order to ensure the correct goods are being delivered.

A review of the nominal ledger postings by a manager should be performed on a regular basis.

The managing director should also review source documents before signing the list to ensure payments are for a valid business use.

Segregate duties by sharing the responsibility with another manager.

Test your understanding 8 – Inventory

Audit procedures prior to inventory count attendance

– Review prior year working papers to identify any issues encountered which the auditor should be prepared for this year.

– Obtain inventory count instructions from the client to ascertain whether appropriate controls and procedures will be in place during the count.

– Enquire with management whether there have been any control issues relating to inventory during the year.

– Enquire of the client whether any inventory is held at third parties and assess whether attendance is required at those sites.

Deficiencies in counting inventory

Deficiency	Explanation	How to overcome
		deficiency:
Inventory sheets	Count teams will focus on	Count sheets should
stated the	finding that number of items	not state the quantity
quantity of items	making undercounting of	of items so as not to
expected to be	inventory more likely –	pre-judge how many
found in the	teams stop counting when	units will be found.
store	‘correct’ number of items
	found.

Count staff were	Count staff are also	Count teams should
all drawn from	responsible for the	include staff who are
the stores	inventory. There could be a	not responsible for
	temptation to hide errors or	inventory to provide
	missing inventory that they	independence in the
	have removed from the	count.
	store illegally.
Count teams	There is a danger that	Each team should be
allowed to	teams will either omit	given a precise area
decide which	inventory from the count or	of the store to count.
areas to count	even count inventory twice
	due to lack of precise
	instructions on where to
	count.

Count sheets	Lack of signature makes it	All count sheets
were not signed	difficult to raise queries	should be signed to
by the staff	regarding items counted	confirm who actually
carrying out the	because the actual staff	carried out the count
count	carrying out the count are	of individual items.
	not known.

Inventory not	As above, there is a danger	Inventory should be
marked to	that inventory will be either	marked in some way
indicate it has	omitted or included twice in	to show that it has
been counted	the count.	been counted to avoid
		this error.

Recording	Recording in pencil means	Count sheets should
information on	that the count sheets could	be completed in ink.
the count sheets	be amended after the count
in pencil	has taken place, not just
	during the count. The
	inventory balances will then
	be incorrectly recorded.

Count sheets for	It is possible that the	All inventory sheets,
inventory not on	additional inventory sheets	including those for
the pre-	could be lost as there is no	‘extra’ inventory,
numbered count	overall control of the sheets	should be pre-
sheets were only	actually being used. Sheets	numbered.
numbered when	may not be numbered by
used	the teams, again giving rise
	to the possibility of loss.

Tests of controls and substantive procedures

The aim of a test of control is to check that an audit client’s internal control systems are operating effectively.

Example: Observe the count teams ensuring that they are counting in accordance with the client’s inventory count instructions.

The aim of a substantive procedure is to ensure that there are no material errors at the assertion level in the client’s financial statements.

Example: Record the condition of items of inventory to ensure that the valuation of those items is appropriate on the final inventory listing.

Test your understanding 9 – Evidence and procedures Audit procedures

Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and non-financial data.

Inquiry means to seek relevant information from sources, both financial and non-financial, either inside or outside the company being audited. Evidence may be obtained orally or in writing.

Inspection is the examination of records, documents and tangible assets.

Observation involves looking at a process or procedure as it is being performed to ensure that the process actually works as documented.

Recalculation means the checking of the mathematical accuracy of documents or records.

Analytical procedures

Compare revenue year on year to try to identify whether income has been understated, possibly by cash being taken prior to banking. There is no control over the opening of post so cash could be withdrawn by one assistant, and the deficit made up by a fraud on customers.

Inquiry

Obtain statements from suppliers to check the completeness of liabilities at the end of the year. As there is no control over purchases, invoices could have been misplaced resulting in a lower purchases and trade payables figure.

Inspection

The assets of the company, namely cuddly toys in inventory at the end of the year, can be inspected to ensure the inventory exists and that the toys are saleable in their current condition.

Observation

Procedures such as the opening of the post and recording of customer orders can be observed to ensure that all orders are recorded in the sales day book and cash book.

Recalculation

Recalculating the cash book to confirm that the total amount of cash recorded is accurate and can be included in the revenue figure (cash receipts should equal revenue as there are no receivables).

Analytical procedures

This method of collecting evidence will be useful in BearsWorld because it will help to identify unusual changes in income and expenditure. As BearsWorld is a relatively small company, monitoring gross profit will show relatively small changes in sales margin or purchasing costs. Decisions by Mr Kyto to amend margins can therefore be traced into the actual sales made.

Enquiry

Enquiry evidence will be very useful in the audit of BearsWorld, especially where this is derived from third parties. Third party evidence is generally more reliable than client originated evidence as there is a decreased likelihood of bias. Trade payables can therefore be verified using supplier statement reconciliations.

A review of any customer complaints file (if these letters are kept) will also help to identify any orders that have not been despatched. Inspection

Inspection of documents within BearsWorld will be useful, particularly regarding checking whether expenses are bona fide. All purchase invoices, for example, should be addressed to BearsWorld and relate to purchases expected from that company, e.g. cuddly toys for resale, office expenses, etc.

Observation

Observation may be useful because it will show how the assistants perform their work and whether there are any obvious deficiencies in the processes of the company.

Recalculation

Recalculation evidence is very useful for checking additions on invoices, balancing of control accounts, etc. This means that the arithmetical accuracy of the books and records in BearsWorld can be confirmed.

Analytical procedures

The technique may be limited in its application because it will not detect errors or omissions made consistently year on year. If either assistant is defrauding the company (for example by removing cash) each year, then analytical procedures will not detect this. Analytical procedures will also not detect misstatements which cancel each other out, i.e. one misstatement may overstate the balance but another may understate the balance. The auditor would not detect these misstatements using analytical procedures. Enquiry

External inquiry evidence will be less useful in the audit of sales and receivables because there are no receivables as goods are paid for prior to despatch. Internal evidence will be available from Mr Kyto and the assistant, however the lack of segregation of duties means that this may not be so reliable.

Inspection

Inspection of documents can be time consuming. However, given the poor internal control system within BearsWorld, the auditor may have no choice but to use this method of gathering evidence.

The fact that an invoice is addressed to the company does not confirm completeness of recording so inspection of the cash book for unusual payments verified by checking the purchase invoice will also be required. Additional substantive testing would also be required due to poor controls.

Observation

Observation tests will be of limited usefulness because the assistants may act differently when an auditor is present. The same problem will apply to any observation checking carried out by

Mr Kyto. Recalculation

The main weakness of recalculation checking is that calculations can only be carried out on figures that have been recorded. If there are any omissions then checks cannot be carried out.

Test your understanding 10 – Procedures Inspection

Inspection involves examining records or documents, whether internal or external, in paper form, electronic form, or other media, or a physical examination of an asset.

Inspect the bank reconciliation for any outstanding lodgements and agree to the pre year-end cash book, post year-end bank statement and also to paying-in-book pre year-end.

Observation

Observation consists of looking at a process or procedure being performed by others.

Observe the process for the opening of mail and logging of any cheques received from customers to ensure adequate segregation of duties.

Analytical procedures

Analytical procedures consist of evaluations of financial information through analysis of plausible relationships among both financial and non – financial data. Analytical procedures also encompass such investigation as is necessary of identified fluctuations or relationships which are inconsistent with other relevant information or which differ from expected values by a significant amount.

Review the year-end bank balance against prior year to identify any significant fluctuations as these could be evidence of window dressing and discuss with management.

Inquiry

Inquiry consists of seeking information from knowledgeable persons, both financial and non-financial, within the entity or outside the entity.

Inquire of management as to whether the company has opened/closed any bank accounts during the period.

Recalculation

Recalculation consists of checking the mathematical accuracy of documents or records. Recalculation may be performed manually or electronically.

Recalculate the additions in the year-end cash book to confirm accuracy of the amount.

External confirmation

An external confirmation represents audit evidence obtained by the auditor as a direct written response to the auditor from a third party, in paper form, electronic form or by other medium.

Obtain a standard bank confirmation from each bank the company has undertaken banking transactions with during the year.

Re-performance

Re-performance involves the auditor’s independent execution of procedures or controls which were originally performed as part of the entity’s internal control.

Re-perform the year-end bank reconciliation to ensure the process was undertaken accurately.

Test your understanding 11 – Audit risk NFP

Audit risk

Audit risk is the risk that an auditor gives an inappropriate opinion on the financial statements being audited.

Inherent risk is the susceptibility of an assertion to a misstatement that could be material individually or when aggregated with misstatements, before considering any related controls.

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

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

Inherent risks and effect on audit approach

Area of inherent risk	Effect on audit approach
Income is from voluntary	Review forecasts and enquire
donations only. It will be difficult	with the trustees and
to estimate future income.	management of the charity how
There is a risk that disclosure of	their fundraising plans for the
going concern issues is not	future.
adequate in the financial	Obtain written representation
statements.	from the trustees that they
	believe the charity can continue
	in existence for the foreseeable
	future.
Risk to completeness of income	Assess what controls exist over
as cash donations may be	cash donations (if any).
stolen in the absence of any	Test the controls in place.
controls. No invoices will be	There may need to be a
raised and therefore there will	There may need to be a
raised and therefore there will	modified opinion due to lack of
be no evidence of the income	modified opinion due to lack of
be no evidence of the income	sufficient appropriate evidence.
received.	sufficient appropriate evidence.
received.
There is a risk that the funds	Inspect the constitution of the
are not spent in accordance	charity to understand its aims.
with the aims of the charity	Review a breakdown of
(regularity audit).	expenditure to ensure it is in line
	with the constitution.
The taxation rules are quite	Consult with a tax expert or audit
complex for the charity resulting	staff with relevant knowledge to
in a risk to the reasonableness	assess the tax rules and
of the tax accrual at the year-	recalculate the tax charge and
end.	liability to ensure arithmetical
	accuracy.
According to the constitution of	Inspect the constitution of the
the charity, only 10% of	charity to understand its aims.
expenditure can be on	Review the breakdown of other
administration. There is a risk	types of expenditure to identify
that administration costs are	any admin costs incorrectly
misstated to ensure this	classified if the 10% limit has
restriction is met.	been exceeded.
Some donations are made for	Obtain supporting
an intended purpose. There is a	documentation for any donations
risk that these restricted funds	and agree the expenditure to the
are disclosed as such in the	terms of the donation. Any
financial statements.	discrepancies should be
	reported to management.

Weak control environment Lack of segregation of duties

There is normally a limited number of staff working in the charity meaning that a full system of internal control including segregation of duties cannot be implemented.

Volunteer staff

Many staff are volunteers and so will only work at the charity on an occasional basis. Controls will be performed by different staff on different days making the system potentially unreliable.

Lack of qualified staff

As staff are mainly volunteers they may not have professional qualifications or experience to implement or maintain good control systems.

No internal audit department

Any control system will not be monitored effectively, mainly due to the lack of any internal audit department. The charity will not have the funds or experience to establish internal audit.

Attitude of the trustees

Where trustees are not professionally trained or have little time to devote to the charity, there may be a perception that controls are not important. The overall control environment may therefore be weak as other charity workers may not appreciate the importance of maintaining good controls.

Test your understanding 12 – NFP audit

Audit risks

– Charities can be viewed as inherently risky because they are often managed by non-professionals and are susceptible to fraud, although many charities and the volunteers that run them are people of the highest integrity who take a great deal of care over their work.

– Charities are also at risk of being in violation of their constitutions which is important where funds are raised from public or private donors who may object strongly if funds are not applied in the manner expected. Other charities and regulatory bodies supervising charities may also object.

– Most small charities have a high level of control risk because formal internal controls are expensive and are not often in place. This means that donations are susceptible to misappropriation. Charities rely on the trustworthiness of volunteers.

– Ajio is a new client and as a result detection risk is higher due to a lack of cumulative knowledge and experience.

Audit procedures: fundraising events

– Attend a fundraising event and observe the procedures employed in collecting, counting, banking and recording the cash. This will help provide audit evidence that funds have not been misappropriated and that all income from such events has been recorded. Sealed boxes or tins that are opened in the presence of two volunteers are often used for these purposes.

– Perform cash counts at the events to provide evidence that cash has been counted correctly and that there is no collusion between volunteers to misappropriate funds.

– Examine bank paying-in slips, bank statements and bank reconciliations and ensure that these agree with records made at events. This also provides evidence as to the completeness of income.

– Examine the records of expenditure for fundraising events (hire of equipment, entertainers, purchase of refreshments, etc.) and ensure that these have been properly authorised (where appropriate) and that receipts have been obtained for all expenditure. This provides evidence as to the completeness and accuracy of expenditure.

– Review the income and expenditure of fundraising events against any budgets that have been prepared and investigate any significant discrepancies.

– Ensure that all necessary licences (such as public entertainment licences) have been obtained by the trustees for such events in order to ensure that no action is likely to be taken against the charity or volunteers.

– Obtain representations from the trustees to the effect that there are no outstanding unrecorded liabilities for such events for completeness of expenditure and liabilities.

Test your understanding 13 – Subsequent events Event 1 – Fire

This event occurred after the reporting period and is not an event which provides evidence of a condition at the year-end and hence this is a non-adjusting event.

Normally as the company is insured, only uninsured losses suffered by Grains 4U Co (Grains) would need to be accounted for, which in the normal course of events would be an immaterial amount. However, the insurance company is investigating, as there is a possibility the fire was started deliberately, and this would invalidate the insurance policy.

If this is the case, the total damaged assets of $675,000 (650 + 25) would be material as they represent 8.5% (675/7,900) of profit before tax.

Therefore as a material non-adjusting event, the assets should not be written down to their scrap value in the current year financial statements. However, the directors should include a disclosure note detailing the fire and the total value of assets which may be impacted due to the possibility of a lack of an insurance settlement.

Procedures

Obtain a schedule showing the damaged property, plant and equipment and agree the net book value to the non-current assets register to confirm the total value of affected assets.

Obtain a breakdown of the inventory stored at the distribution centre on 15 February 20X6 and compare to earlier records or despatch documents to ascertain the likely level of inventory at the time of the fire.

Additional practice questions

Review any correspondence from the insurance company confirming the amount of the claim, and the current status of their investigation into the fire and any likely payments to assess the extent of any uninsured amounts.

Discuss with the directors whether they will disclose the effect of the fire in the financial statements.

Event 2 – Inventory

Grains has identified that inventory at the year-end with a cost of $915,000 is defective. This information was obtained after the year-end but provides further evidence of the net realisable value of inventory at the year-end and hence is an adjusting event.

The inventory of $915,000 must be written down to its net realisable value of $50,000.

The write down of $865,000 (915 – 50) is material as it represents 10.9% (865/7,900) of profit before tax.

Hence, the directors should amend the financial statements by writing down the inventory to $50,000.

Procedures

Discuss the matter with the directors and enquire if they are prepared to write down the cost of the inventory to net realisable value.

Review the board minutes to assess whether this event was the only case of defective inventory as there could potentially be other inventory which requires writing down.

Obtain a schedule showing the defective inventory and agree to supporting production documentation that it was produced prior to 31 December, as otherwise it would not require a write down at the year end.

Discuss with management how they have assessed the scrap value of $50,000 and agree this amount to any supporting documentation to confirm the value.

Test your understanding 14 – Written representations

Written representations are a form of audit evidence. They are written by the company’s directors and sent to the auditor, just before the auditor’s report is signed.

Written representations are required for two reasons:

– For the directors to acknowledge their collective responsibility for the preparation of the financial statements and to confirm that they have approved those statements.

– To confirm any matters which are material to the financial statements where representations are crucial to obtaining sufficient and appropriate audit evidence.

In the latter situation, other forms of audit evidence are normally limited because knowledge of the facts is confined to management and the matter is one of judgment or opinion.

Obtaining written representations does not mean that other evidence does not have to be obtained. Audit evidence will still be collected and the representation will support that evidence. Any contradiction between sources of evidence should be investigated.

Lion’s Roar

It is appropriate to include the claim in the written representation.

The amount of the claim is material being 50% of profit before taxation.

There is also a lack of definitive supporting evidence for the claim. The two main pieces of evidence available are the claim from Lion’s Roar itself and the legal advice from Crighton Ward’s solicitors. However, any claim amount cannot be accurately determined because the dispute has not been settled.

The directors have stated that they believe the claim not to be justified, which is one possible outcome of the dispute. However, in order to obtain sufficient evidence to show how the treatment of the potential claim was decided for the financial statements, the auditor must obtain this opinion in writing.

Depreciation

Including the point in the written representation is inappropriate because the auditor appears to have obtained sufficient evidence to confirm the accounting treatment.

The lack of profit or loss on sale confirms that the depreciation charge is appropriate. Large profits would indicate over-depreciation and large losses would indicate under-depreciation. The amount also meets industry standards confirming that Crighton-Ward’s accounting policy is acceptable.

Lack of written representation

– Discuss the situation with the directors to try and resolve the issue that the directors have raised. Ascertain exact reasons why the directors will not sign the letter.

– Explain the need for the written representation again and note that the requirement to obtain a written representation letter was included in the engagement letter.

– Consider whether amendments can be made to the letter to incorporate the directors’ concerns that will still provide the auditor with appropriate and sufficient audit evidence.

– Explain that if the auditor does not receive sufficient and appropriate audit evidence, then the auditor’s report will have to be modified due to an inability to obtain sufficient appropriate evidence.

Test your understanding 15 – Auditor’s report

Jones Materiality

The receivable of $30,000 represents 20% of profit and more than 4% of receivables therefore is material.

Relevant accounting principles

The bankruptcy of the customer provides evidence of a condition existing at the statement of financial position date. It should therefore be treated as an adjusting event in accordance with

IAS 10 Events After the Reporting Period. The receivable should be written off in full in the financial statements at 30 September 20X2. The company has overstated receivables and profit by $30,000. Impact on the auditor’s report

– The financial statements are materially misstated.

– The matter is material but not pervasive.

– A qualified opinion should be issued with the ‘except for’ wording.

– The ‘Basis for Opinion’ section will be amended to a ‘Basis for Qualified Opinion’ to explain the reason for the qualified opinion.

– Tutorial note: If the company is listed the Key Audit Matters section will reference the Basis for Qualified Opinion.

Roberts Materiality

The amount of $10,000 represents only 2% of the stated profit before tax and therefore is not material.

The potential losses may be more significant than the figure of $10,000 since other claims are now pending. The auditor may conclude that the whole legal matter is potentially material.

Relevant accounting principles

There is uncertainty with regard to the outcome of the pending claims and the potential liability which may arise as a result of the product defect. The appropriate accounting treatment will depend on whether the chance of loss is probable, possible or remote. If it is probable a provision should be recognised. If it is possible a contingent liability should be disclosed. If it is remote the financial statements will not be affected. (IAS 37 Provisions, Contingent Liabilities and Contingent Assets).

Liabilities may be understated or contingent liabilities may not be adequately disclosed.

Impact on the auditor’s report

– Management has chosen to ignore both the actual loss (which is not individually material) and the potential loss (which may be material). If the auditor does not believe that the management’s view is acceptable, or does not think that the disclosure is adequate, the financial statements will be materially misstated.

– If the potential claims are considered material a qualified opinion with the ‘except for’ wording should be issued.

– If the auditor believes that the claims are likely to be successful and are likely to be substantial then an adverse opinion should be issued stating that the financial statements do not show a true and fair view.

– The ‘Basis for Opinion’ section will be amended to a ‘Basis for Qualified Opinion’ or ‘Basis for Adverse Opinion’ to explain the reason for the modified opinion.

– Tutorial note: If the company is listed the Key Audit Matters section will reference the Basis for Qualified/Adverse Opinion.

Griffiths Materiality

The fall in value is material and pervasive as the adjustment would have the effect of turning a profit before tax of $250,000 into a loss of $50,000.

Relevant accounting principles

Investments should be written down if they are impaired. A fall in the value of one asset must not be offset against an increase in the value of another asset. Each asset has to be considered separately.

As the company admits that a permanent fall in value has taken place it should write the value of the assets down otherwise assets will be overstated.

Impact on the auditor’s report

– The financial statements are materially misstated.

– The matter is material and pervasive.

– An adverse opinion should be issued stating that the financial statements do not show a true and fair view.

– The ‘Basis for Opinion’ section will be amended to a ‘Basis for Adverse Opinion’ to explain the reason for the adverse opinion.

– Tutorial note: If the company is listed the Key Audit Matters section will reference the Basis for Adverse Opinion.

Evans Materiality

The $10,000 represents 10% of profit before tax, and so would appear to be material.

Since the accounting records were only destroyed for the early part of the year, the auditor would still be able to confirm the calculations for the later part of the year. In these particular circumstances the auditor may consider that the amount of any error (which is likely to be considerably less than $10,000) is not material.

Relevant accounting principles

The company must include the cost of its own labour and materials in the construction of the warehouse, since these have been used to create a capital asset.

Impact on the auditor’s report

– There is a lack of sufficient appropriate evidence to support the treatment of the $10,000 labour costs therefore the auditor does not know whether the costs are materially misstated.

– Assuming that the extent of any potential misstatement is considered not material, an unmodified report and opinion will be issued stating that the financial statements give a true and fair view.

– If the possible misstatement is considered material, a qualified opinion with the ‘except for’ wording will be required.

– If modified, the ‘Basis for Opinion’ section will be amended to a ‘Basis for Qualified Opinion’ to explain the reason for the qualified opinion.

Tutorial note: If the company is listed the Key Audit Matters section will reference the Basis for Qualified Opinion.

Test your understanding 16 – Corporate governance 1

The board comprises six executives	At least half of the board
and only four non-executive directors	should be NEDs. Hence the
(NEDs). There should be an	board of Tangerine Tech Co
appropriate balance of executives and	(Tangerine) should consider
NEDs, to ensure that the board	recruiting and appointing
makes the correct objective decisions,	additional independent NEDs
which are in the best interest of the	to satisfy this requirement.
stakeholders of the company, and no
individual or group of individuals
dominates the board’s decision-
making.

One of the NEDs and the chairman	Only independent non-
are former executive directors of	executives with relevant
Tangerine who were asked to take on	experience and skills should
their existing roles following	be appointed to the board of
retirement. As former executive	Tangerine. A review should be
directors, they were previously	under taken of the
employed by the company and so	independence of all existing
may not bring the required level of	NEDs. Any who are not
independence and objective	independent should ideally be
judgement to the role as is necessary.	replaced or supplemented by
The independence of the other NEDs	independent NEDs.
cannot be assessed.


	The chairman, who is a NED, sits on	The chairman should cease to
	the audit committee as the chair. The	undertake the role of chair of
	audit committee is supposed to be	the audit committee. One of
	made up of independent NEDs. The	the newly appointed
	chairman can, for smaller companies,	independent NEDs should be
	sit on the committee provided that he	appointed to this role instead.
	is an independent non-executive,
	which is not the case for Tangerine.
	All four members of the audit	The company should ensure
	committee were previously involved in	when they recruit the new
	sales or production related roles. At	independent NEDs that at
	least one member of the audit	least one of them has the
	committee should have recent and	required recent and relevant
	relevant financial experience. None of	financial experience.
	the NEDs were former finance
	directors and so it is unlikely they
	possess the required financial
	experience.
	All of the directors have been	The directors should be
	members of the board for at least four	subject to re-election by the
	years. The shareholders should	shareholders at regular
	review on a regular basis that the	intervals not exceeding three
	composition of the board of directors	years. At the current year’s
	is appropriate, and that there is an	annual general meeting it
	appropriate re-election process in	should be proposed that a
	place to ensure this can be achieved.	number of the directors are
		subject to re-election. The
		remaining directors could then
		be subject to re-election next
		year.

	The chairman has sole responsibility	All members of the board
	for liaising with the shareholders and	should be involved in ensuring
	answering any of their questions.	that satisfactory dialogue
	However, this is a role which the	occurs with shareholders, for
	board as a whole should undertake.	example, all should attend
		meetings with shareholders
		such as the annual general
		meeting. The board should
		state in the annual report the
		steps they have taken to
		ensure that the members of
		the board, and in particular the
		non-executive directors,
		develop an understanding of
		the views of major
		shareholders about the
		company.

Currently Tangerine has not established an internal audit function. The audit committee should consider the effectiveness of internal controls and internal audit could support this role. Where there is no internal audit function, the audit committee is required to annually consider the need for one.

Further consideration should be given to establishing an internal audit function. Having an internal audit function will help the audit committee to discharge their responsibility for monitoring internal controls. However, the costs of establishing an internal audit function should be considered against the benefits.

Test your understanding 17 – Corporate governance 2

Corporate governance definition

The term corporate governance refers to the means by which a company is directed and controlled in the interests of all stakeholders. It will include consideration of:

– Directors’ responsibilities

– Composition of the board of directors

– Audit requirements (internal and external).

External auditors and corporate governance

If a company has good standards of corporate governance and is managed well in the interests of all stakeholders, the auditors are likely to conclude that control risk is lower and therefore audit risk is reduced. As a result of this they may be able to reduce the extent of the audit procedures they carry out.

The audit committee should take responsibility for ensuring the external auditor is independent and for monitoring and assessing the quality and effectiveness of the external audit.

The external auditor may have to report on whether the company is compliant with Corporate Governance requirements.

Composition of the audit committee

The audit committee should be made up of non-executive directors and include at least one person with recent and relevant financial experience.

Role of the audit committee

– Monitoring the integrity of the financial statements.

– Reviewing the company’s internal financial controls.

– Monitoring and reviewing the effectiveness of the internal audit function.

– If no internal audit function is in place, they should consider annually whether there is a need for one and make a recommendation to the board. The reasons for there being no internal audit function should be explained in the annual report.

– Making recommendations in relation to the appointment and

removal of the external auditor and their remuneration.

– Reviewing and monitoring the external auditor’s independence

and objectivity and the effectiveness of the audit process.

– Developing and implementing policy on the engagement of the external auditor to supply non-audit services.

Need for an audit committee

The existence of an audit committee will enhance the company’s corporate governance profile by:

– Improving public confidence

– Providing further support to directors

– Strengthening the independence of the external auditor

– Improving internal controls.

Risk management

The risk committee should discuss the issue and assess its seriousness in relation to its likelihood and potential impact. They should then decide what action is appropriate in order to manage the risk.

This risk might be reduced by:

– Ensuring favourable employment packages for such individuals

– Ensuring training for other staff assists in case of succession issues

– Ensure key tasks are not carried out by just one person.

The auditor must consider the possible impact of all significant risks as any of these could ultimately have financial consequences or going concern issues, hence impacting on the audit opinion.

Test your understanding 18 – Internal audit

Use of the work of the internal auditors by external auditors Sales and ticketing

– The sales function is likely to be integrated with the accounting and internal control system used to produce the figure in the financial statements for revenue, on which the external auditor reports and is therefore useful.

– The internal auditors’ work on the ticketing system relates to an operational area which does not have a direct impact on the financial statements. Ticketing may have an indirect effect because it is likely to be integrated with the sales system and there is likely to be some crossover between the controls over ticketing and controls over sales generally. The work of the internal auditors is therefore likely to be of some use to the external auditor.

Fleet acquisition and maintenance

– The internal auditors’ work on the fleet acquisition system is likely to be relevant to the external auditor because owned aircraft and leased aircraft will constitute a substantial element of statement of financial position assets and liabilities. The related depreciation and finance charges will be included in the statement of profit or loss.

– Much of the internal auditors’ work is likely to relate to ensuring that company policy has been complied with. Company policy will relate to the authorisation for and acquisition of aircraft and ensuring the appropriate accounting treatment is being used. The external auditor will want to ensure that the company’s policies are both appropriate and complied with.

– It is also possible that the internal auditors’ work may involve

some verification of the statement of profit and loss and statement of financial position figures. Given the likely materiality of the amounts involved, this work will also be of interest to the external auditor.

– It is possible that the internal auditors’ work may also relate to the quality of aircraft, and other operational aspects of fleet management. These issues may also be relevant to the external auditor, insofar as they relate to compliance with laws and regulations.

– Maintenance expenditure in the statement of profit or loss may be material and the work of the internal auditors is therefore of interest to external auditors. The internal auditors’ work is likely to relate to the authorisation and correct accounting for maintenance expenditure (capitalisation or expensing) which will affect the financial statements.

Trade payables and long term debt financing

– The extent of the external auditor’s interest in the internal auditors’ work on trade payables and long term financing will depend on the materiality of the amounts involved. Trade payables (for certain types of routine maintenance, and payables due to the service organisations, for example) may be material. Long term debt financing is very likely to be material as many airlines have substantial debt financing.

– Internal audit work on trade payables is likely to involve ensuring that routine internal controls are properly designed and are operating effectively. This will be relevant to the external auditor.

– There are substantial financial statement disclosures required for debt financing. The internal auditors’ assistance with ensuring that disclosures are properly made, as well as with ensuring that any covenants have been complied with and that the accounting for the financing is appropriate, may also be helpful to the external auditor.

Evaluating the internal audit function

– The firm will seek to ensure that there is an appropriate structure within the department itself, with appropriate reporting lines outside of the department, preferably reporting into the audit committee.

– The internal audit function has recently been expanded and there are likely to be changes in the way it is organised. The function should have operational independence within the organisation and formal terms of reference that encompass the recent changes made.

– The function should have a systematic and disciplined approach to its work including quality control procedures.

– Staff should be appropriately trained, experienced and qualified. The head of the internal audit department should preferably be professionally qualified.

(Visited 338 times, 1 visits today)

Written by MJ

Leave a Reply Cancel reply