Audit And Assurance Question And Answers Bank

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN FI\J(,I AN0 Aldl) M'/\l i

AUDIT AND ASSURANCE QUESTION BANI<

For exams in 2007 and 2008

AUDIT AND ASSURANCE ACA Professional Stage Application Level

The Institute of Chartered Accountants in England and Wales (ICAEW) AsTF77Eld-lEGd1ng professional accountancy body, the Institute of Chartered Accountants in England and Wales (ICAEW) provides leadership and practical support to over 128,000 members in more than 140 countries, working with government, regulators and industry in order to ensure the highest professional standards are maintained. Our members provide financial knowledge and guidance based on the highest technical and ethical standards.' They are trained to challenge 'people and organisations to think and act differently, to provide clarity and rigour , and so help create and sustain prosperity. The ICAEW ensures these skills are constantly developed, recognised and valued. Because of us, people can do business with confidence. For more information on ICAEW qualifications visit www.icaew.com or phone

+44 (0)1908 248 040

The Institute of Chartered Accountants in England and Wales Learning 8 Professional Development Chartered Accountants' Hall PO Box 433 Moorgate Place London EC2P 2BJ United Kingdom Tel: +44 (0)1908 248 040

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ISBN 978-1-84152-501-3

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Audit and Assurance The lnstitute of Chartered Accountants in England and Wales Professional Stage ISBN: 978- 1-84152-501-3 First edition 2007 All rights reserved. N o part of this publication may be reproduced or transmitted in any form or by any means or stored in any retrieval system, electronic, mechanical, photocopying, recording or otherwise without prior permission of the publisher. British Library Cataloguing-in-Publication Data A catalogue record for this book has been applied for from the British Library Printed in Great Britain by W M Print 45-47 Frederick St. Walsall West Midlands WS2 9NE

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Your learning materials are printed on paper sourced from sustainable, managed forests.

O The lnstitute of Chartered Accountants in England and Wales

Legal, ethical and current issues I 2

Short form questions

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Criticisms of auditors

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Alpha pic

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Mart plc

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Gardenvale Ltd

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Beeches Technologies plc

Mac Ltd

Accepting and managing engagements 8

Short form questions

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Sleeper Ltd

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Gemini plc

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Hairsay Ltd

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Wrapper Ltd

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Waverley Ltd

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Wavenden Ltd

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Benson plc

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Healey Ltd

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Planning assurance engagements Short form questions Santander Ltd Apparel Ltd Holly plc Garments Ltd Curson Ltd Builda Ltd LUSCOLtd

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Wrapak Ltd Electra Ltd WHAT Pubgames Ltd Nosh Ltd Medical Diagnostics Ltd

THE INSTITUTE OF CHARTERED ACCOUNTANTS

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Sporticus Ltd

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Atlantis Ltd

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Pallas Ltd

Concluding and reporting o n assurance engagements Short form questions Anagram plc Garb Ltd Plumb Ltd Delux Hotels Ltd Salmonoid Ltd Betta Networks plc Audit report phrases

CCEP Ltd Vista plc lronco Ltd

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Your exam will consist of Part one

- 6 short form questions (worth between 2 and 4 marks each)

20 marks

Part two

- 3 questions (2 worth around 20 marks and I worth around 40 marks)

80 marks

Time available

2.5 hours

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Short form qrrestions .

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The ICAEW has issued professional ethical guidance. The fundamental principles form part of this (2 marks) guidance. What do the principles cover and at whom are they aimed?

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If the regular fees from a client company o r group of companies constitute a substantial proportion of the fee income of an audit firm, a self-interest threat is likely t o arise so as to impair objectivity.

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Set out the safeguards a firm should use to recognise this threat and the procedures available t o offset ~t. (2 marks)

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You are the auditor of Harmony Ltd of which the share capital is owned 40% each by David Dennis and his wife, Diana, and 20% by Edward Endersby, i t s three directors. David and Edward have fallen out with each other after an argument during a round of golf. You have now been requested by Edward t o provide him with details of reimbursement of expenses t o David and Diana for the last financial year. You are working on the audit and all the company's books and records are in your office.

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State, with reasons, how you would respond t o Edward's request.

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(2 marks)

You are planning the audit of Sportsresults-a-minute.com. You have ascertained that the company has overdue fees of f 15,000, being the previous year's audit fee. Explain the threat t o your firm's independence and state the action your firm should take in respect of (3 marks) this matter.

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A partner in a firm of chartered accountants has been approached t o accept appointments as auditor of two separate companies. (I) (2)

Jenkins Ltd, in which his adult son is a 10% shareholder Davidson Ltd, of which his brother-in-law is a director

State whether i t would be a&eptable for the partner t o accept each of these appointments, and why. (2 marks)

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENCLbND AND WALES

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Section I: Legal, ethical and current issues

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Your client has asked why the audit report your firm has issued on i t s f~nancialstatements talks about 'true and fair' rather than 'correct' given that you had spent two weeks on site reviewing all its accounting records. Explain why this type of opinion has been given on the financial statements.

(2 marks)

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Describe and explain the concept of assurance.

(2 marks)

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A fraud has recently been discovered, involving the chief buyer in the purchasing department of Rodney Ltd and a purchase ledger clerk in the accounts department over a period of two years. The managing director of Rodney Ltd has written t o the company's auditors claiming that they had a responsibility t o detect frauds during the course of their audits, and requesting an explanation as t o how they could have missed it.

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What points should the auditors make in response t o the managing director?

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(2 marks)

Dimension Ltd is a software company providing e-commerce solutions t o business. I t was incorporated on I April 20W8 and revenue has doubled each year. Rapid expansion is expected t o continue for the next few years. This growth requires heavy investment in working capital, particularly work in progress and receivables, and the company will be seeking a substantial increase in the borrowing facility from its bankers when the present facility is due for annual review in September 20X I. The increase in revenue in the year ended 3 1 March 20x1 has taken the company over the exemption threshold, and i t is obliged to have a statutory audit for the first time. List the benefits that the company may obtain from the statutory audit.

(2 marks)

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There is an ongoing debate surrounding the regulation of auditors and whether the profession should regulate itself o r be subject t o independent regulation. What are the main arguments in favour of independent regulation of auditors?

(3 marks)

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The 'expectation gap' is the possible difference between an auditor's actual responsibilities and those assumed by readers of an audit report.

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What are the main misunderstandings in respect of the audit made by lay users of accounts!

(3 marks)

12

You have been invited $0 tender for the audit of Data plc, a company that owns and operates 35 , hotels in the South West of England. You have not previously acted for Data plc, but you are the current auditors of Lodge Ltd, a company that owns and operates hotels in 30 out of the 35 towns in which Data plc operates. The hotels operated by each company offer similar facilities t o each other at a similar price.

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Identify and explain the principal ethical issue that you may need t o consider when deciding whether or not t o tender for the audit of Data plc, and state the procedures you may need t o implement in event that your tender was successful.

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QUESTloN BANK

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You are the auditor of Royale Limited, a manufacturer of fireworks. Following a disappointing last three months of trading, the company has requested an extension t o its overdraft facility from its bankers. The bank has in turn asked your firm t o provide a report on the company's working capital, focusing on the recoverability of trade receivables and inventory. Explain the benefits and limitations t o both the bank and Royale Limited of obtaining the working

(4 marks)

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Briefly describe what you understand by the terms 'reasonable assurance' and 'limited assurance'.

(2 marks)

s of pronouncement issued by the International Auditing and Assurance Standards Board (3 marks) n what kind of engagement each of these is relevant.

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One of your clients. Selhurst Ltd, is a small company which is not legally required to have a statutory audit. Explain the benefits of a statutory audit for a small company such as Selhurst Ltd.

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(3 marks)

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State three types of threat t o an auditor's objectivity and independence identified by the APB9sEthical Standards. For each give an example of how the threat might arise for an auditor. (3 marks)

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In the past few years the cash flow position of your firm has altered considerably. After a relatively stable period your firm found itself in a bad financial position. One of your fellow partners discussed this problem with a major client during a golfing weeltend. As a result the client offered your firm a low interest loan. Fortunately, the position changed and your firm never took up the client's offer. N o w your firm is financially sound and would be in a position to make a reciprocal offer t o the client, should he need it. Why are practice loans tolfrom clients prohibited under the APB's Ethical Standards?

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(I mark)

Mrs Wallace is the audit partner in her firm for Racdale Ltd. She has just been appointed a trustee of the Racdale Family Trust, which owns 20% of the shares in Racdale Ltd. She replaces the family solicitor who has just retired. In addition, Mr Netwater, the audit manager for Racdale Ltd, has given one month's notice that he will be leaving the firm t o become finance director of the company. State the threats t o independence that these situations pose, and the safeguards that the firm should (3 marks) employ t o maintain objectivity. ., -.

20 State what you should do if you identify money-laundering activities during the course of an audit. ( I mark)

THE INSTITUTE OF CHARTERED ACCOUNTANTS

Section I : Legal, ethical and cut-I-ent issues 21

The following is an extract from an independent accountant's unmodified report on a profit forecast: 'Based on our examination of the evidence supporting the assumptions, nothing has come t o our attention which causes us t o believe that these assumptions do not provide a reasonable basis for the forecast.' Describe the level of assurance provided by this statement and explain how and why i t differs froin the level of, assurance provided by an audit report on annual historical financial statements. (4 ~narlts)

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Your firm acts as auditor- to Colun~busLtd, a retail car dealer. During the course of your audit for the yeat- ended 30 June 20x5, you discover that the company's sales managel-,assisted by the accounts clerlc has deliberately falsified details of the value of vehicles sold in order to increase his morlcl.ily bonus payments. Set out your responsibilities in respect of the above matter and contrast these with the responsibilities (3 ~ ~ ~ a r l t s ) of the management of Columbus. .

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Stater~lentssets out pi-ocedures that ISA 250 Consideratiorl of Laws and Regulations in arl Audit of Fina~~cial the auditor must follow in order t o help him identify those instances of non-co~npliancewhich should be considered when auditing financial statements. What additional procedures should be pet-formed in the LIK and what differences are there in the UI< in respect of when instances of non-compliance must be communicated to management without delay! ( 2 mar-lcs) ...

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The auditors of Trigger Ltd have become aware during the course of their audit that the company has been guilty of a set-ious breach of the law. This non-compliance has no direct effect on the financial statements.

( 2 marks)

List the steps the auditors might have to take in these circumstances. ........

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Sharpe Ltd is a public relations company providing targeted mailings for its clients from i t s detailed comprehensive database. It is subject to the provisions of the Data Protection Act. Identify the risks to which the company would be exposed from non-compliance with the Act, and the implications for the audit of the financial statements. ( 3 marks) ---.----..--.----.... .... ... .. .......... --.......... ."-......................

Mac btd Your firm acts as external auditor for Mac Ltd, a company whose principal business activity is the manufacture and export of high quality raincoats. Due t o changes in the statutory audit exemption thresholds, Mac Ltd i s no longer required by law t o have an audit of its financial statements for the year ended 28 February 20x5. The directors of Mac Ltd have asked you t o expla~nwhy your firm is trying to persuade them to continue t o have an audit even though i t is no longer required by law. They believe that it would be more useful if your firm provided a report on the profit and cash flow forecasts prepared by the directors. . .

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN FYCIINII I\Yi, \V4115

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List the advantages to the directors and shal-eholders of Mac Ltd of continuing to have a f~ll,~audit under the Companies Act when exempt from the statutory audit. ( 6 marks)

(b) In respect of a report on profit and cash flow fol-ecasts, set out the nature and the level of the assurance which may be given in such a report and explain how and why i t differs from the level of assurance provided by an audit report. ( 9 marks)

( 1 5 marks)

Following high profile corporate failures, auditors have been criticised by various interested pat-ties in connection with (I)

Their responsibility for the detection of fraud

( 2 ) The provision of non-audit services to their audit clients (3)

The period of time for which they can act as auditors for a client.

Requiremerit Outline the current regulatory and professional requirements in respect of the matters identified in ( I ) to (3) above and state how they might be further changed by the UK regulatory bodies. Set out the case for and against changes t o the current regulatory and professional requirements. ( 1 5 marks)

4 Alpha plc Alpha plc, a listed company, operates a policy of putting its audit and related services out to tender every five years. Following submissions frorn a number of firms of accountants, the audit committee of Alpha plc recommended that your firm be appointed t o provide the following services.

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The statutory audit of the annual financial statements.

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An independent review of the interim financial information which will be circulated to shareholders together with your firm's independent review report. The independent review will be restricted to making enquiries of management, applying analytical procedures to the financial information and assessing whether the accounting policies and presentation have been consistently applied unless otherwise disclosed.

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Consultancy services in respect of the implernentation of a new financial information technology system.

Your firm has not previously acted for Alpha plc but does act as auditor for one of its major competitors. Requirements (a)

Identify and explain the professional and ethical issues that should have been identified by your firm in relation to the provision of the services, outlined above, to Alpha plc and outline the safeguards that should be in place in order to address these issues. ( 14 marks)

(b)

Comment on the level of assurance provided by the report on the interim financial information, and explain how and why it diff6rs from the level of assurance provided by the statutory audit report on ( 6 marlcs) the annual financial statements.

(20 marks)

THE INSTITUTE OF CHARTERED ACCOUNT@TS 0.1 EICLAND 4ND U'AlES

Section I : Legal, ethical and CLII-rent issues

You worlc for a firm of aud~toi-swhich has seven offices throughout England and Wales. The firm's largest client in terms of fee income i s Mart plc, a company which has grown steadily through a mixture of organic growth and acquisition of companies in the same industry sector. Your firm has acted fol- this client since i t s incorporation 20 years ago and, in addition t o the statutory audit, provides a range of non-audit services, including tax planning (for the company and i t s individual dil-ectors) and consultancy worlc in respect of Mart plc's acquisition policy. Earliet- this year- the finance director of Mart plc retired and was succeeded by a former member of your fil-m's staff who had managed the audit of Mart pic for the preceding four years.

(a)

Discuss the ethical and p~.ofessionalissues raised by the situation described above and identify the measures which sliould be implemented by your firm in order t o mitigate any threats t o objectivity ( I 0 marks) which might arise.

(b)

Set out the implications for audit firms and their clients if the provision of all non-audit services t o (6 marks) audit clients is banned and mandatory periodic rotation of audit firms is introduced.

( 1 6 marks)

Gardenvale Ltd is a company which operates a chain of garden centres specialising in the retailing of high quality garden p r o d ~ ~ cand t s the pt-ovision of landscaping services. Following information from one of the employees, it was discovered that the financial controllel- had used company cheques and bank transfers t o pay for goods and services for his own use. Although the amounts involved were immaterial in the context of the financial statements, it transpit-ed that this had been going o n for several years. The managing director i s considering whether the company's auditors were negligent. H e has requested that your firrn under-taltes a detailed independent review of Gardenvale Ltd's purchase and payments system in 01-det-to establish any shortcomings in its policies and procedures, so that they can be rectified.

(a)

Distinguish between the responsibilities of the management and the statutory auditor of a limited company for the prevention and the detection of fraud and outline how these responsibilities are discharged. (6 marks)

(b)

Prepare a list of questions in respect of internal control procedures, answers t o which would establish whether ther-e are any shot-tcomings in Gardenvale Ltd's purchase and payments system. ( I I marks)

( 1 7 marks)

You are currently planning the audit of Beeches Technologies plc and i t s subsidiaries for the year ending 30 September 20x7. Beeches Technologies plc heads an international group which sells computer software and related sel-vices. Spftware is developed in the UK and sold throughout the world by the group's numerous overseas subsidiaries. These subsidiaries act as agents for the parent company, selling software and providing support on its behalf. They receive a commission equal t o their costs plus a 5% margin. The c o s t s incurred by the subsidiaries typically comprise: b

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Payroll costs and associated expenses for sales, technical and administrative staff Sales commissions Establishment costs for the local office Depreciation Miscellaneous expenses t h'

b b

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THE INSTITU1E Of CHARTERED ACCOUNTANTS IN [\CI

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QUEVION BANK At 30 September 20x6, Beeches Technologies plc had 24 overseas subsidiaries, a t which audit work was performed as follows: Full audit by your firm Limited review by your firm N o worlt

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No new subsidiaries are expected t o be established before 30 September 20x7 With the exception of the two largest subsidiaries (at which your firm performs a full audit), all of the subsidiaries are of similar size. The costs of each smaller subsidiary represent approximately 0.5% of the group's total cost base. Where a full local audit is not required, the subsidiaries are visited on a rotational basis, each subsidiary being visited at least once every three years. You called the group financial controller of Beeches Technologies plc in order to arrange a planning meeting. She informed you that she has just returned from investigating a fi-aud at the group subsidiary in Madrid, a location where your firm performed limited review procedures two years ago and no work in the prior year. The financial controller in Madrid misappropriated the equivalent of f 150,000 over a three-year period by using company cheques and bank transfers t o pay his own personal expenses. These were reported as company expenses in the profit and loss account submitted to Beeches Technologies pic. Whilst the amount involved is not material to the group as a whole, it is very significant t o the local subsidiary. The group financial controller told you that the group finance director has expressed concern that the audit work performed did not uncover the fraud and has aslted for a meeting with the audit partner t o discuss this. You have arranged a meeting for this Friday.

(a)

Prepare the following schedules to assist the audit partner in his preparations for Friday's meeting: (i)

A l i s t of questions you believe the audit partner should aslt in order to ensure that he has significant information about the fraud t o assess its impact on the audit for the year ending 30 September 20x7. (8 marlts)

(ii)

A summary of the most important contl-01s you would expect the group t o have in place t o , prevent and detect the misappropriation of funds by subsidiary employees. ( 1 0 marks)

(b) Using the Beeches Technologies fraud as an example, compare and contrast the responsibility of the auditor in respect of fraud with the expectation of company directors and the general public in this ( 1 4 marks) area. Your answer should refer t o any duty the auditor has to report fraud.

(32 marks)

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Section I : Legal, ethical and cul-rent issues

7 HE INSTITUTE OF CHARTERED

QUEST I O N BANK

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What information should be included o n every wot-king papel- originated by audit team members? ( 2 marks)

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An accountancy firm has previously used the services of an independent provider t o conduct cold reviews of i t s completed audit engagements. However, the partners have decided t o undertake inhouse all aspects of monitoring the quality of audits carried out. Set out the objectives of conducting cold reviews which the in-house system must achieve. ( 2 marks)

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An audit partner has consulted a colleague o n a question of judgement concerning the audit of his client. Explain the important features in respect of this matter that the working paper recording the (3 marks) consultation should contain.

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What are the three main considerations for an auditor when considering the acceptance and continuance of client relationships and specific audit engagements? (2 marks) ............

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List the principal items t o be agreed in an engagement letter between an assurance firm and a person commissioning an assurance engagement. ( 2 marks)

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A prospective auditor is required t o write t o the client's existing auditor t o seek information which could influence his decision as t o whether he may accept the auditor appointment. Give examples of relevant matters which could be within this letter and which would influence the prospective auditor's decision t o accept the audit appointment. ( 2 marks)

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Certain rights are confellred on an auditor by the Companies Acts when a company proposes t o remove him from office. State the rights the auditor has in these circumstances.

( 2 marks)

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Section 2: Accepting 2nd ri>ntlaging engagements

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Tlie cut-rent auditors of Meldrew Ltd will not be proposed for re-appointment at the annual general meeting to be held 01112 October 20x9. The directors were extremely unhappy at the additional disclosures in tlie financial statements for the year ended 3 1 December 20x8 concerning the status of the company as a going concel-n. The auditors had insisted upon these before they would express an ~rnqualifiedopinion, As a I-es~rltyour fil-ni has been aslted to accept appointment as auditors of Meldrew Ltd. All the shareliolde~-sof tlie company are directot-s. Set out the matters your fit-m ought t o consider and the procedures to follow before i t should accept appointment as auditors. (4 marks) . . .

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An audit partner has consulted a colleague regarding a question of judgement concerning the audit of his client. The audit partnet- has prepared a worl
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A niatcll-e student lias recently joined you~-firm on a training contract. She has told you that in her previous job, she was allowed to wot-I
(3 marks)

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List six functions of an audit colnmittee. .

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(a) Your audit firm has recently been invited to accept appointment as external auditor to Sleeper Limited, a company that owns and opel-ates a nunibel- of mobile phone stores within a 50-mile radius in the North West of England. You have not pi-eviocrslyacted for Sleeper Limited, but your firm is auditor to Zelig Limited. a conipany which also operates mobile phone stores in many of the same locations as Sleeper ! . Limited. Yocrl- audit firm has a total of seven partners located in three offices which are situated in major cities within the UK. The current auditors of Sleeper Limited have received notice from the company's directors that they are not to be re-appointed as auditors at the company's forthcoming Annual General Meeting. The management has given no reason for this course of action, although the auditors suspect that it i s because they insisted on modifying tlie audit I-epo!-t for the previous accounting year, despite substantial pressure from management to issue an unmodified audit report. The modification to the previous year's audit report was in respect of inventory. It was discovered during the audit that the year end inventory quantities at t w o of the company's stores had been falsely inflated by the managers of both stores in order t o cover up a substantial theft of mobile phones immediately prior t o the year end. There were no satisfactory audit procedures that could be carried out t o substantiate the existence of the physical quantities of inventory at the year end.

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II Hairsay facilitiec are lad! Followit rnisappt the rela and pro The mat has rzql

QUES'I'ION BANK

(a)

Identify and explain the professional ethical issues which you might need t o consider in deciding whether o r n o t t o accept appointment as external auditor t o Sleeper Limited. Recommend the possible safeguards that could be p u t in place t o resolve these issues. (6 m a r k s )

(b) Set o u t the responsibilities and rights, including those under the LIK Companies Acts, o f the current auditors o f Sleeper Limited in relation t o the proposed change in professional appointment.

(3 m a r k s ) (c)

Set o u t the respective duties o f b o t h the management and external auditors o f Sleeper Limited in relation t o the prevention and detection o f fraud, and outline h o w these duties are discharged.

(6 m a r k s ) (d)

List the financial statement assertions, other than existence, which are relevant t o the audit o f inventory and, for each one listed, outline one relevant audit procedure t o test that assertion in respect o f Sleeper Limited. (6 m a r k s )

(21 m a r k s )

Described below are situations that have arisen in companies which are external audit clients o f your firm. (I)

During the year ended 3 1 May 2 0 x 2 your firm commenced a five-year contract t o provide internal audit services f o r Gemini plc. O v e r the course o f the year the internal audit team carried o u t a risk assessment exercise and an evaluation o f the internal control systems supported by tests o f control.

(2)

Leo Starr, the managing director and sole shareholder o f Taurus Ltd. received an offer f r o m Sagittarius plc, also an audit client, f o r the entire share capital o f Taurus Ltd. Leo Starr has agreed in principle t o sell his shares t o Sagittarius plc. The purchase consideration is likely t o consist o f an initial cash payment based o n the n e t assets o f Taurus L t d as at 3 I August 2 0 x 2 , and a deferred cash payment contingent o n the operating profit growing by an average o f 5% over the next t w o years. Leo Starr and the management o f Sagittarius plc have requested, independently, that your firm acts as advisors in respect o f the negotiations and provides an assurance r e p o r t o n the calculation o f the amount o f the net assets at 3 1 August 2 0 x 2 .

(a)

Describe the purpose o f quality control measures in respect o f the provision o f assurance and advisory services. (6 m a r k s )

(b)

Discuss the ethical and professional issues raised by the situations described above, and identify the quality c o n t r o l measures your firm should implement in o r d e r t o mitigate any threats t o objectivity (I 2 marks) which might arise f r o m the provision o f the services described above.

(1 8 marks)

Hairsay Ltd is a company which operates six hairdressing salons. T h e company does n o t grant credit facilities and customers pay b y cash, cheque o r debit o r credit card. All branches have tills in which takings are lodged, and receipts are issued when requested by customers. Following a tip-off by one o f the employees, the managing director discovered that another employee was misappropriating cash takings by pocketing cash received f r o m customers and deliberately failing t o record the related transactions. Although thd amounts involved w e r e immaterial in the context o f the cash sales and profit figures, it transpired that this had been going o n f o r several years. The managing director has expressed concern that the company's auditors did not.discover this fraud ahd has requested that your firm undertakes an independent review o f the company's cas handling procedures.

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THE INSTITUTE OF CHARTERED ACCOUNTANTS II,

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Section 2: Accepting and managing engagements

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H e is wol.ried that other cash handling il-I-egulal-ities may be occurri~igand is anxious t o have a system in place which will PI-event any misappropt-iation of cash takings.

(a)

Outline the mattel-s t o be included in he letter of engagement which your firm should send t o the management of Hairsay Ltd prior t o comlnencing the independent review of the company's cash (5 marks) handling procedures.

(b)

Using Hairsay Ltd's fraud as an example. compare and contrast the responsibilities o f the auditors in (5 marks) respect of fraud with the expectations of the managing director.

(c)

Prepare a checlclist of questions which you would aslc in order t o establish whether there are any shortcomings in Hail-say Ltd's policies and PI-ocedures which increase the risk of misappropriation of (6 marks) cash.

( 1 6 marks)

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I 2 ' Wrapper &td Your firm, which has six partners, has been invited by M r Paclcer, the managing director and majority shareholder of Wrapper Ltd, t o accept appointment as auditor of the company and also provide assistance with the preparation of the financial statements and the corporation tax computation. The principal activity of WI-apper Ltd is the production of paper carrier bags, serviettes, coffee cups and lids which are sold t o customers operating in the fast food sector. Wrapper Ltd was incorporated on I October 20x4 and the financial statements will cover the 15 month period t o 3 1 December 20x5. Although the conlpany's revenue and assets are below the thresholds for statutory audit purposes, the company's bankers require the annual accounts t o be subjected t o a full audit. M r Packer started the business using a combination of money inherited from his grandfather and a bank loan. The loan agreement includes a covenant specifying that the company's debt equity ratio should not exceed parity (ie I : I). The accounting records are compi~terisedand the' ;ompany uses software which was developed by I T Systems Ltd, a company owned by MI- Pacltel-'s brother. The software has been customised t o integrate inventory control with receivables and payables. I T Systems Ltd also provides support for the company's computer systems. The accounting recot-ds are maintained by Mrs Carlton, assisted by Mrs Biggs who works one day a weelc and is I-esponsible for payl-oll processing.

(a)

State, with reasons, the matters t o be considered and pr-ocedures t o be performed prior t o your firm accepting and commencing the audit of Wrapper Ltd for the period ending 3 1 December 20x5. (8 marks)

(b)

Identify, from the information provided above, the factors which should be taken into account when assessing the risk of misstatement in the financial statements of Wrapper Ltd and explain why such factors should be talcen into account when conducting the audit. ( I 0 marks)

,

( 1 8 marks)

The auditors of Waverley ~ t d f i a v eI-esigned following a disagreement with the directors. The audit report on the financial statements for the year ended 3 1 March 20x3 was qualified on the grounds that they did n o t comply with accounting standa1:ds in some material respects. Subsequently the directors have engaged your firm t o review the accounting policies adopted by the company and t o investigate the application of the accounting policies in the financial statements for the year ended 3 1 March 20x3. Your firm is required t o report on the appropriateness o ~ i h e policies adopted and the extent t o which they were pl-operly applied in the financial statements. $: 1, 1'

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14

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN INGLhNO 4hll'Whl l S

QUESTION BANK Requirements (a)

Contrast this assurance engagement with the statutory audit of the annual financial statements with respect to the scope of the work you would undertake and the report you would issue. (II marks)

(b)

If, after presenting the report, your firm were requested to accept appointment as auditors of Waverley Ltd, identify the matters it should consider and the procedures i t should follow before it accepts the appointment. (7 marks)

( 1 8 marks)

Wavenden Ltd Your firm has been asked by the directors of two companies t o accept appointment as auditors. (I) The directors of Wavenden Ltd have become dissatisfied with the service of the existing auditor, mainly due t o the lack of urgency that he appears to display in his dealings with the company. He has been notified of their wish to replace him and has been asked for his resignation. This has not been received and the directors now wish to remove him from office.

(2) Stockwood Ltd has grown during the year ending 30 September 20x1 and its revenue will, for the first time, trigger the necessity for a statutory audit. Profit before tax for the year will be around £ 70,000. The financial statements for the year ended 30 September 20x0 showed inventories of £25,000. Inventories at cost were f50,OOO. A review of obsolescence was not performed but, on the recommendation of the company's accountants, the cost was written down by 50% on the grounds of prudence. The directors admit that obsolete inventories rarely exceed 10%. but there are no satisfactory audit procedures that could be adopted t o confirm the true figure at that date. Requirements (a)

Set out the steps that both Wavenden Ltd and your firm should follow in order t o complete the ( 1 3 marks) process of the appointment of your firm as its auditors.

(b)

In respect of the issue over inventory reach a conclusion on whether you would modify your audit report on Stockwood Ltd for the year ending 30 September 20X I, on the basis that no other matters arise which affect the opinion. You should give reasons for your conclusion and describe aqy additional statements which would need t o be made in the equivalent UK audit report. (8 marks) (21 marks)

Benson plc Benson plc is a medium sized entity, managed by its owners who bought it out from a large plc six years ago. The share capital is owned by four directors. One of the original directors, Andrew Fisher, has recently passed away and his shares and his place on the board have been taken up by his son, John Fisher A large loan from the bank which helped t o finance the management buy out was paid off in the previous period. This year, the directors have negotiated another loan from the bank t o help finance an expansion into Europe. You work for a firm of chartered accountants called Andrews, Baker and C o (ABC). ABC became involved with Benson at the time of th'e buy out when they provided advice t o two of the (current) directors. They have been involved with the busi~essever since, acting in the capacity of tax advisers, management consultants, and personal tax advisers for all the directors. They have also been involved in some special projects for Benson, taking part in an investigation due t o a suspected fraud t w o years after the MBO, and putting together projections and budgets for the potential expansion into Europe. ABC were invited to tender initially for the audit, but their tender had the highest fee, and Mr Fisher senior, who was the managing director at the time, strongly believed that an audit,was a statutory necqssity which the company should obtain as cheaply as possible. The audit was given t o a smaller firm of auditoi-s, XYZ, but ABC were engaged to provide what Mr Fisher always termed, 'the useful stuff - w o p h paying for'. h

$ ' THE INSTITUTE OF CHARTERED ACCOUNTANTS RI M M D A M ) WALES

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Section 2: Accepting and managing engagements

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The fee income from Benson has been considerable over the years. Two years ago, when the.work was done o n the expansion, it represented 20% of the income of the firm for that year. The increase in size of the business since the expansion has led t o the current auditors, XYZ, resigning. Rather than going through another tender, the directors have decided t o offer the audit to their business advisers, ABC, as they believe that it provides synergy to combine the t w o roles, and that synergy may result in a lower overall cost t o the company o f accountancy and related services. ABC have accepted the audit work. The first audit is due t o start in three weeks' time. A t a recent board meeting, attended by the partner who has been in charge o f the work provided t o Benson, and his colleague, who has been appointed as the audit engagement partner, the directors discussed plans t o float the company on the Stock Exchange in the foreseeable future.

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Explain the current ethical and legal considerations in connection with accepting appointment as an (8 marks) auditor.

(b)

Discuss whether the conduct o f ABC has been ethical in its dealings with Benson plc during the course of their relationship, and how Benson's prospective listing might change the ethical situation. (15marks)

(c)

Outline the effect a listing would have o n the audit o f Benson.

(d)

ABC have appointed an audit engagement partner who has not previously been involved with the client t o the audit of Benson. What other quality control procedures and policies should ABC have in (8 marks) place in relation t o the audit of Benson t o safeguard audit quality?

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(33 marks)

Healey Ltd

16

Your firm has been invited by M r Allard, the managing director of Healey Ltd, t o accept appointment as auditor o f the company. M r Ailard owns 5 1 % o f the shares of the company and the remaining 49% is owned by IYr Morgan, the sales director. The present firm of auditors will n o t be re-appointed when its term of office expires as M r Allard is dissatisfied with the cost o f its services. In addition, M r Allard has requested that your firm takes o n the following work. (I)

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Advises both parties on the purchase consideration in respect of the sale of M r Morgan's shares in Healey Ltd; M r Morgan plans t o retire and has agreed in principle t o sell his shares t o M r Allard.

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( 2 ) Advises o n an on-going basis in respect of M r Allard's plans t o expand ~ e a l e yLtd's operations by the acquisition o f other businesses; this will involve investigations and reports on businesses identified by M r Allard. Requirements (a)

(i)

State the matters, other than independence, that you would consider and the procedures you would perform in deciding o n the suitability of Healey Ltd as an audit client for your firm. (8 marks)

(ii)

Explain the six general threats t o independence identified by ethical standards.

(iii) State, with reasons, the specific threats to the auditor's objectivity which may arise providing the additional services outlined above, and describe the safeguards which may offset (7 marks) such threats. (b)

Outline the potential liabilhy of the firm in respect of the three services requested by M r Allard, including suggestions related t o how the firm might restrict its liability in respect of the services , provided. (1 5 marks)

, (c)

Identify four quality control policies o r procedures the firm could implement t o ensure that the independence and quality o f the audit was n o t impaired. (4 marks)

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,(40 marks) 16

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN E N G L A N D A N D WALIS

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QUESTION BANK

Short form questions In the context of ISA 600 Using the Work of Another Auditor, state what i s meant by the terms "principal auditor" and "other auditor". (2 marks)

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Your firm is the principal auditor of Narberth Group plc. The financial statements of one of the components which will be included in the financial statements of Narberth Group plc has been audited by another firm of auditors who have modified their audit report on the component's financial statements. State the matters that should be considered, in respect of the above issue, by the principal auditor when reporting on the financial statements of Narberth Group plc. (2 marks)

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The risk that the financial statements aremmaterially misstated can be broken down into ditection risk, inherent risk, control risk and audit risk.

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Explain what information an auditor uses to evaluate each of these components of risk during the planning of an audit. (2 marks)

4

The external auditor of Thorpe Ltd has assessed the internal audit department of the company, and concluded that its organisational status and the scope of its function are satisfactory. As a result he has decided to make use of the department's work which is relevant to him to reduce the extent of his audit procedures. On what other matters must he assure himself, and how should he obtain this assurance, in order t o reduce his own work? (3 marks)

THE INSTITUTE OF CHARTERED ACCOUNTANTS H LNUUO *H)

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Section 3: Planning assurance engagements 5

a

Drusus Ltd has a f~nancialyear end 3 1 March 20x7 and it formed an internal audit department in September 20x6. This new department wasbeaded by the co2any's sen@ management accountant, and his deputy was thengromoted management accountant. '-

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You have performed an assessment of the department and are satisfied with all aspects of its organisational status, scope of operations, technical competence and professional care. Since its formation the internal audit department has completed the following work.

(1)

Documentation of the new purchases system which was introduced on I April 20x6.

(2)

Tests of control on the purchases system from I October 20x6.

(3)

Preparation of a report in February 20x7 on significant weaknesses revealed by the tests of control. Its recommendations were implemented in full in March 20x7.

(4)

Preparation of detailed reports for the board of directors on the monthly management accounts since July 20x6.

To what extent might you be able t o make use of this work during your audit, and what effect would i t (4 marks) have on the selection and scope of tests in the areas concerned?

j6

An auditor is planning the audit of Cardigan Ltd for the year ending 3 1 December 20x1. List the factors that will determine the balance between tests of control, analytical procedures and (4 marks) other substantive procedures t o be included in the audit plan.

7

After obtaining a general understanding of the legal and regulatory framework applicable t o the entity and the industry and how the entity i s complying with that framework in accordance with ISA 250, what further audit procedures should the auditor perform t o help him identify those instances of non4 compliance which should be considered when preparing financial statements? .

What additional procedures should be performed in the UK?

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(3 marks). '

Why do auditors carry out preliminary analytical procedures at the planning stage of an audit?

( I mark)

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9

One of your existing audit clients has recently acquired a subsidiary company,Jade Limited, and has appointed you as its auditor. Jade Limited is a developer of computer games software, an industry with which neither you nor your firm is familiar. From what sources would you obtain knowledge about Jade Limited and the industry in which it operates? (3 marks)

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18

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

QUEUION BAP 10

In the draft accounts of Gough Ltd, the gross proflt percentage (ie gross profit as a % of sales) has fallen from 44% in the prevlous year t o 39% in the current year. The following information has been obtained. (I)

Closing inventories have been understated due t o the omlsslon of some items from the physical inventory count.

(2) Revenue has declined because the company has not reduced its prices t o combat cut-price competition. (3)

Purchases have increased due t o a large receipt of raw mater~alson the last day of the year.

Describe what effect each of these matters would have on the gross profit percentage, and whether it helps t o explaln the fall. (3 marks) -- - - - - - -- - -- -- - ---. -

Your firm has recently acquired a new audlt client, which has an internal audit department. The department has conducted a rolling programme of tests of financial controls over all areas affecting the financial statements, and you seek t o rely on its work t o reduce the extent of the audit procedures you will carry out.

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On what aspects of the Internal audlt department and its work will you need t o satisQ yourself in order t o be able t o place the necessary reliance? (2 marks)

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You have conducted analytical procedures on the draft accounts of Blunt Ltd for the year ended 3 1 October 20x1. T w o of your findings are as follows. (I)

The gross profit margin has decreased from 29% for the previous year t o 23% for this year.

(2)

The current ratio has decreased from 1.6 at the previous year end t o 1.2 at this year end.

The directors had expected a decrease in both these measures but not by as much as shown above. Indicate what errors might be incorporated within the draft accounts t o produce these unexpected variations, and in which areas you would carry out extra audit work in order t o reach a conclusion.

(3 marks)

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Auditors should have a sufficient knowledge of the business o f the entity t o be audited. What sources of information would assist the auditor in identifying related parties?

14

(2 marks)

During the course of the audit of your client Sloth plc you notice a balance within receivables entitled 'advances against directors' expenses'. The company's managing director, who is familiar with the concept o f materiality, has questioned your need t o audit this balance, which at the year end stands at f 12,500. The company's retained profit for the year is f 1.3m. r

Prepare brief notes t o the managing director explaining your audit approach in respect of this item.

(2 marks)

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN E W L N kND WAUS

!

Section 3: Planning assurance engagements 15

Your client, Neral Ltd, is a family owned and run haulage business. The managing director's brother runs a manufacturing business, Jaron Ltd, which uses Neral Ltd for its distribution requirements. You are planning the audit o f Neral Ltd. Identify the audit risks in respect of this relationship between (3 marks) the t w o companies and state how you would plan t o address these risks.

J 16

During the planning meeting for the audit of Omag plc, the client informed the audit team that M r Vada, the managing director, is being investigated by the local council for fraudulently trying t o obtain a residents' parking permit for business premises. Explain what impact this would have on the a u d i ~ approach. (3 marks)

17

You are planning the audit o f Berlini Ltd, a manufacturer o f air conditioning units, for the year ending 30 September 20x0. The company requires the financial statements t o be signed by 3 1 October 20x0. The finance director has supplied you with copies of the company's monthly management accounts for the first eleven months of the financial year. Explain how you would seek t o make use of these management accounts in your audit planning, and (4 marks) what factors might limit their usefulness.

18

Woodruff Ltd is currently involved in a large scale construction project t o develop part of the waterfront in a medium-sized Gloucestershire town. A review of the current risk factors has highlighted three key issues.

(I)

A number of the subcontractors it plans t o use may not complete the work within the specified timescale. I

(2) Although not within a flood plain area, the development will be at risk from flooding. (3)

Although the benefits from the project will be significant, Woodruff Ltd is concerned about the funding required and is unhappy about the overall level of risk it will have t o face.

What risk control strategies could Woodruff Ltd use t o deal with the above issues?

19

A t your planning meeting with the finance director o f Dent Ltd, you are informed that the chief accountant has been formally reprimanded for authorising payment of the servicing bill for his wife's car. The matter was discovered by accident. The amount was only f 8 0 and no further action was taken. Explain the effect this might have on your audit planning.

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(3 marks)

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

(2 marks)

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QUESTION BANK Grim Ltd has had an internal audit department of six persons for several years. Previously you have been able t o reduce your audit work by placing reliance on its work. During the last three months of the year ended 30 November 20x9 four of the personnel, including the department head and deputy head, left the company and replacements were recruited. ; Before the departures the department had conducted tests of the control systems in all areas for the f i r s t nine months of the financial year. Since the appointment of the new members of the department, it has conducted an overall review of the strength of the system of control as recorded in the procedures manual, and reported t o the board on recommendations for improvements. Describe the effect these matters might have on the reliance you place on the work of the internal audit department for the year ended 30 November 20x9. (3 marks)

Set out the principal audit objectives t o be satisfied by tests of control of a company's system.

(2 marks)

Your firm has acquired a new audit client. From the information that you gained in order t o present your audit proposal, you are hopeful that internal controls are strong and you will be able t o place reliance on them t o reduce your substantive procedures. List the steps you should follow before you are in a position t o determine the combination of tests of control and substantive procedures for the audit plan. f ,.\.L 1 ,,.. -:,+-I m ~ra d (3 marks)

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When planning t o use the work of experts and in assessing the results of the work of experts, t o what matters should the auditor pay attention? (3 marks)

24

Struction Ltd designs and constructs conservatory extensions for domestic homes, operating throughout the United Kingdom. It has administrative and works premises in Devon, and employs a network of local subcontract building companies for all work on site. Identify the risks from i t s customers t o which Struction Ltd is exposed from this method of operation. (3 marks)

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Your firm has recently acquired a new audit client, Dilbert Ltd. and you have been assigned t o draft the audit plan. The audit manager has briefed you on the firm's knowledge of the business that he has compiled from visits t o the company, discussions with management and the previous auditors, and from industry and other sources. Set out which components of the audit strategy or plan would be influenced by this information. (3 marks)

THE INSTITUTE OF CHARTERED ACCOUNTANTS N M(;UND I H ) WNES

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Section 3: Planning assurance engagements

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26

Springtime Ltd is a human resources consultancy company providing specialist advice t o large businesses on employment issues. What would you consider to be the material information streams (accounting cycles) that would need t o be documented by the auditors in their recording of the company's accounting and internal control systems? (2 marks)

27

You have planned the audit of Craig Ltd for the year ended 3 1 March 20x2 based on the year end management accounts. The week before the audit work is due t o start the chief accountant informs you that the directors are concerned by the likely amount of corporation tax on the profits shown, and provides you with a schedule of 60 journal entries and the resulting draft financial statements. The effect of the journal entries is t o reduce gross profit by 20%, net profit by 65%, and net assets by 15%. Explain how this information will affect the nature, timing and extent of the audit procedures in your (4 marks) audit plan.

28

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During the planning of the audit of Milten Textiles Ltd, the financial controller asked t o have a quiet word with you. She tells you that she suspects the payroll clerk is defrauding the company, as she is regularly going on exotic holidays, buying new cars and spending substantial sums of money on home improvements. There is only one payroll clerk who manages the single monthly payroll run. What would be the impact on your audit approach in respect of the information provided by the financial controller? (3 marks)

1 29

You have completed the tests of control in your audit. The only deviations found were that there was no evidence that one particular control had been operated in three cases out of 25 tested. Explain what considerations will determine whether you are able t o reduce the substantive (2 marks) procedures in the area of this control.

30

A t the audit planning meeting for the year ended 28 February 20x4 with the finance director of Malbec Ltd, you ascertained that payroll processing, which had been outsourced for a numbkr of years, was brought back in-house in December 20x3. Management was not satisfied with the performance of the service provider and repudiated the contract. The service provider had been responsible for making payments t o the employees and the monthly remittances t o H M Revenue & Customs. Two of Malbec Ltd's accounts clerks have been trained in payroll processing. Identify the audit risks in respect of the above matter for the year ended 28 ~ e b r u ' a 20x4 r~ and state how you would addrep these risks. (4 marks)

22

THE INSTITUTE OF CHARTERED ACCOUNTANTS IH E N G L A N D A N D \VALES

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QUESTION BANK

Your firm has recently been appointed as auditor to Santander Ltd, a company whose principal business activity is the manufacture and installation of children's playground equipment. .You are planning the company's audit for the year ending 3 1 October 20x5. Your audit manager has arranged a planning meeting next week with the company's finance director. Your audit manager has given you the following extracts from the company's management accounts for the ten months to 3 1 August 20x5 and the comparative period to 3 1 August 20x4. He has asked you to provide him with notes based on this information to assist him in his meeting:

(I) Operating results

,

10 months to

I 0 months to

3 1 August 20x5

3 1 August 20x4

PO00 17,228 10,854 6,374 3,207 3,167

Cost of sales

, (2) Balance sheet extracts As at

As at

3 1 August 20x5

3 1 August 20x4

Trade receivables

The company's principal customers historically have been local government authorities and schools based in the UK. The company has, however, within the past twelve months expanded i t s customer nd house developers based in South America. Previously the company felt these customers were in economies which were too politically unstable to trade with. Business in these countries is conducted both in f sterling and in the local currency.

'

Due to increases in the number of personal injury cla~ms,legislation was Introduced in the LIK on I January 20x5 which requires the use by Santander Ltd of softer materials in the construction of its e new materials are approximately 30% more expensive t o Santander Ltd than t they replace. The introduction of the new legislation had a twelve month lead-in period, but the company's managing director announced in February 20x5 that in order to tion, all new playground installations were to use the new material with immediate effect. -

Requirements (a)

State the reasons why it is important for auditors to carry out audit planning.

(3 marks)

s of information that are available to an auditor when planning an audit. r (4 marks)

anager outlining the areas that he needs to discuss with the finance director g meeting and, for each area identified, briefly state the potential audit risk. ( 1 6 marks) <

(23 marks)

9

THE INSTITUTE

S F CHARTERED ,@pUNTANTS NE?slMaANIWLLLI

I j

Section 3: Planning assurance engagements

19 Apparel btd You are planning the audit of Apparel Ltd for the year ended 30 November 20x5. The principal activity of the company is the retailing and wholesaling of outdoor clothing, footwear and equipment. All goods are sold under one of the company's t w o brands:

-

b

The Comfy brand which targets the everyday consumer offering family orientated products at mid market prices; and

b

The Elite brand which targets the specialist market for the serious outdoor consumer offering more technical clothing, footwear and equipment at a higher price.

Apparel Ltd sources its products from suppliers based in Europe and, more recently, China. The company sells its products through its own retail outlets and also wholesales t o independent retailers. In February 20x5, the company completed the implementation of a new dynamic warehouse management system. The implementation commenced in 2 0 x 4 and was introduced in stages t o avoid any disruption t o the business. You are preparing for your planning meeting with the finance director and have obtained, in advance of the meeting, a copy of the draft financial statements for the year ended 30 November 20x5. Following your preliminary review, you have identified the following extracts from the financial statements as matters of significance t o discuss with management.

Income statement Years ended 3 0 November 20x5 20x4 Draji Actual £000 £000 Revenue O w n retail outlets Wholesale

Cost of sales Gross profit Operating expenses Profit from operations

Balance sheet

As at 30 November 20x5 20x4 Draff Actual £000 £000

Current assets Inventories Trade receivables (wholesale business) Current liabilities Trade payables

Requirements (a)

In respect of the $formation provided above, prepare planning notes o n matters which you wish t o discuss with management. Your notes should refer t o the results of your analytical procedures. ( 1 6 marks)

(b) As part o f the completion stage of an audit, the auditor will carry out a review of the financial statements. State the conclusions that the auditor should be in a position t o reach as a result o f this (4 marks) review. 8

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(20 marks) I I

t 24

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALLS

QUESTION BANK

You have recently been appointed auditol- t o Holly plc ('Holly') and are in the process of planning the audit for the year ending 30 Apt-il 20x6. Holly owns and operates a chain of 50 high street coffee shops located throughout tlie UK, and a ful-thel- 20 located in the rest of Europe. Holly's main expenses ar-e tlie cost of coffee sold, PI-eniises costs, tlie cost of leasing the coffeemaking machines, and staffing the shops. Holly meets these costs centrally, with all permanent staff salaries paid monthly by direct bank tl-ansfet-. Each shop is I-un o n a day-to-day basis by a shop manager, who is responsible for sourcing any food sold and other consumable goods locally and taking on any casual staff ' needed t o cover peak pel-iods. Both these expenses are generally met using cash from the till. The company made the decision to soul-ce goods locally both t o encourage local management autonomy and t o support the local economies where each shop is based. Shop managers have bonus incentives linlted t o the annual profit of theit- shop. Holly has I-ecently set up its own internal audit department, having previously outsourced this function to their previous auditors. Several of tlie senior posts within the department were created by transferring established long-serving staff members from Holly's main finance department.

.

(a)

Outline the factors clint need to t)c talten into account by an external auditor when evaluating an (5 marks) internal audit function and its work.

(b)

Identify, with reasons. from the situation outlined above, circumstances that should be taken into ( I 2 marks) account when ptanning the external audit of Holly.

( 1 7 marks)

You are planning the audit of Garments Ltd for the year ending 30 june 20X I. Historically, the principal and wholesaling o f fashion clothing, on a credit basis, t o retailers. activity has been the ~nanufactut-e However, early in 20x0, the company diversified into I-etailing and opened t w o retail outlets selling fashion clothing t o the general public. N o credit facilities are granted t o customers of the retail outlets. During your planning meeting witli tlie finance dit-ector, the following matters were highlighted as the major changes since the last audit. Expansion of retailing operations

As a result of the success of the retailing business, the company expanded its operations and opened ten additional retail outlets during the year ending 30 June 20X I . The management accounts indicate that the retail operations will amount t o at least 20% of the company's revenue for the year ending 30 June 20X I. Increase in overdraft facility

The overdraft facility was increased t o help t o fund the expansion. The company is currently trading at its overdraft limit as a result of tlie increased volume of business. The directors are seeking t o increase the facility and are negotiating witli tlie company's bankers. New computer system

During the year the company replaced its computer system in order t o accommodate the retailing activities. It installed a central cornputel- at head office linked t o terminals at its warehouses and retail outlets. The software is an integrated standard package, which includes an inventory control system. modified by the supplier t o the company's I-equirements.

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Identify, from the cil-cunistances described above, the audit risks, and for each risk (i)

List the factors which have led you t o ide,ntify that risk

(ii)

Outline the audit WOI-Ityou would perfol-tn in that I-isk area. 1Ht I N 5 I I I U l t OF CHARTERED ACCOUN I A N I S ,h,k,,,\

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Section 3: Planning assur-ance engagements

The management of Curson Ltd, a retailer of domestic appliances, has requested that your firm assists with a I-IS\< assesstiient exercise, as it is seeking assurance that there are adequate controls in place t o minimise exposul-e t o the I-islts t o which its retailing operation is exposed. The company operates a number of stores throughout the UK and sells a wide variety of products, ranging from inexpensive appliances t o high value items, such as television and video equipment. The company has a policy, of providing a higher level of personal service and advice t o its customers than available from its competitors, and aims t o reflect this in the remuneration of its employees. In addition, the company operates a policy of flexible opening hours, whereby store managers have discretion t o determine opening hours t o suit local demand. The till systems in each store are networked devices which also perform inventory control and ordering functions, and have additional linlted devices for validating cheque guarantee cards and creditldebit cards in I-espect o f non-cash transactions. The product lines are competitively priced and it is company policy t o lteep a f ~ l lrange l of inventories so that it can provide any of its products within twenty four hours. Once inventol-y has reached its re-order level, a purchase order is automatically generated and transmitted t o the ;~pp~.ovcd silppliel-. Suppliers deliver the goods t o the company's central warehouse for distribution t o the stores by the company's own fleet o f vehicles.

T l r ~company uses a rnlxture of leas~ngand outr~ghtpurchase t o fund its property, plant and equipment. Its pl-emlses at-e all leased, but all other property, plant and equipment is purchased. It replaces 20% o f its veh~clesevery year

Identify the risks t o which the retailing operations of Curson Ltd are exposed and, for each risk, outline the conti-ol pl.oced~~l-es wtiich should be in operation in order t o minimise exposure t o those risks. (22 marks)

You are in cli;~~-ge of the audit of Builda Ltd for the year ending 30June 20x3 and are responsible for preparing the progl-amme of worlt t o be undertaken by the audit staff. Builda Ltd i s a small building company which specialises in the building of new houses. It has 24 employees and nol-nially builds between 25 and 30 houses a year. All employees are salaried, and the payroll is processed by the business services section of your firm. Employees' salaries are paid directly by electronic [vansfel- into their bank accounts each month. Your firm also prepares the annual statutory accounts from [lie boolts and I-ecords maintained by the company. All the shares in the company are owned by Eddy Brick, the managing director, who is actively involved in rilnnlng [he company. He draws a salary from the business and awards himself a bonus once profits have been determined. The company has a history of increasing retained earnings as Eddy Brick is very prudent, and his reniunel-ation is modest compared t o compa'ny profits. The company has no borrowings and surplus cash i s invesced on the money market. The company owns a small amount of non-current assets comprising plant and equipment and m o t o r veh~cles. Inventories are the largest asset in the balance sheet comprising undeveloped land and w o r k in progress, which represents houses at various stages o f completion at the balance sheet date. The land was purchased several years ago and is included in the balance sheet at cost. Costing records are n o t maintained and the worl; in progress is based on Eddy Brick's and his site manager's estimate of direct costs and overheads based on the stage of completion of each house as at the balance sheet date.

QUESTION BANK The company accounts for the sale o f a property only when notified by its lawyers that contracts have been exchanged. Receivables represent amounts owed by

b

Customers for completions o f sales

b

The local authority for deposits paid, by Builda Ltd, which are released once access roads t o the sites are completed

b

H M Revenue & Customs for V A T

The company is normally in a VAT repayment situation as the sale of new houses is zero rated for V A T ,purposes, but the company is allowed t o reclaim V A T on its purchases and expenses, and consequently submits monthly VAT returns. Payables represent amounts owed t o trade suppliers and H M Revenue & Customs in respect of payroll deductions, and deposits from customers which have been paid t o Builda Ltd via its lawyers. Eddy Brick is keen t o maintain good relationships with the company's suppliers and t o pay them on time. There is no purchase ledger, but Eddy maintains a file of unpaid invoices which he reviews on a daily basis. H e pays an invoice as soon as he receives the supplier's delivery note from the site manager indicating that the materials have been delivered to, and accepted on, the building site. There are no cash transactions as all payments are made by cheque, and Eddy Brick is the only cheque signatory. Receipts and payments are recorded in an analysed cash book which is prepared, on a monthly basis, by a freelance accountant, who also undertakes monthly bank reconciliations. Receipts and payments are recorded from details on the completion statements from the company's lawyers, remittances from H M Revenue & Customs, and cheque stubs. The accountant also prepares a day book, in respect o f the purchases and expenses invoices, in order t o analyse the V A T t o support the V A T returns which he completes on a monthly basis. The company is subject t o periodic inspections by H M Revenue & Customs in respect of VAT and recent inspections have not identified any problems.

Requirements (a)

Identify, from the circumstances outlined above, the factors which indicate low inherent risk in respect of the audit o f Builda Ltd and, for each factor identified, explain why it contributes t o low inherent (8 marks) risk.

(b)

Outline the audit w o r k which you would direct the audit staff t o undertake in respect o f the key balance sheet and income statement items during the audit o t Builda Ltd. (I I marks)

( 1 9 marks) iic

Lusco Ltd Your firm has recently been appointed auditor of Lusco Ltd (Lusco). The company operates a chain of 30 UK based retail stores, selling luxury Italian ladies' clothing and accessories. The company operates a central U K based warehouse from which it supplies all 30 stores with inventory. The company sources its inventory from a small number o f major fashion wholesalers based in Italy. The majority of inventory items are previous year's designs, which the wholesalers supply t o Lusco at discounted prices. Lusco places all its orders centrally three times a year, coinciding with the Spring, Summer, and Winter seasons. All transactions are conducted in euros and payment is due in full on arrival of the goods in the UK. osts

Most o f the company's sales are conducted by cash, cheque, o r credit card. In order t o remain competitive with other major high street retailers, the company offers a returns policy t o its customers which allows goods t o be returned t o the store for any reason with a full refund offered. Goods returned under this policy are then sold on in bulk through the trade, sometimes at less than their original cost t o Lusco. The company's employees include monthly paid head office staff and store managers and a weekly paid core number of other store staff. In addition the company employs a number of casual staff in peak periods. Permanent staff are paid by weeklylmonthly direct bank transfer, and casual staff in cash.

Q

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

27

Section 3: Planning assurance engagements <.

26

Lusco's managing d~t-ectol-,aged 60, is also the company's main shareholder. H e adopts a very hands-on approach t o tlie business; lie is involved in all major decisions and rarely delegates. H e is k n o w n for his lavish lifestyle and in order t o finance this he seeks each year t o g r o w the business and improve upon the previous year's profitability.

I'

.

I,

!

,;. 5

The company has recently acquired new offices adjacent t o its central warehouse. T h e purchase was financed by large bank bol-rowings under t e r m loans, which call for annual capital repayments.

(a)

(b)

(c)

Describe the different elements o f audit risk and explain why the auditor needs t o consider risk when (4 m a r k s ) conducting an audit.

I..

Identify, f r o m tlie circumstances outlined above, the factors which indicate high audit risk i n respect o f the audit o f Lcrsco Ltd and, f o r each factor identified, explain why i t contributes t o high audit risk. (I0 m a r k s )

I

I. I,

You at activit) followl

Revenr C o s t 0,

1 !:

LF

O u t l ~ n ethe ~ n t e r n acontrols l w h ~ c hLusco L t d should put In place t o ensure the complete r e c o r d ~ n gof sales and safe custody o f cash. (6 m a r k s )

1

Gross 1 Adminir Profit fr Finance

You are responsible for the audit o f Wrapak L t d f o r the year ended 3 1 July 2 0 x 4 . T h e principal activity of Wrapak L t d is the provision o f a specialist packaging service f o r companies in t h e cosmetic industry. T h e niajority of WI-apak Ltd's customers are blue chip companies b u t recently the customer base has broadened t o include small and medium sized companies. Customers ship their PI-oducts t o W r a p a k Ltd, and o n arrival warehouse personnel enter details o f each consignment of goods received i n t o Wrapak Ltd's computer system. The system is updated t o r e c o r d the completion o f the packaging process and the subsequent despatch o f each consignment t o t h e customer. O n confirmation o f despatch, the system generates the invoice which is printed o u t i n the accounts office. All invoices are reviewed and authorised by Anna, the accountant, prior t o mailing t o customers. A t the end o f each week the system generates a list o f consignments which have been completed b u t n o t yet dispatched.

a

: g

Extract ASSETS Non-cu Currelli '

\

f Anna is also responsible for ledger processing and sending monthly statements t o customers. A t the end of each m o n t h she tries t o find the time t o chase slow payers as identified o n the aged receivables analysis. N o o t h e r credit control procedures are undertaken.

c

As a result o f the increased level o f activity, the company moved its operations t o larger freehold premises in May 2 0 x 4 . T h e acquisition was funded by a bank loan repayable i n monthly instalments over I 0 years. The loan is secured o n the premises.

EQUITY Capital ; Non-cur

A comparison o f the draft accounts for the year ended 3 1 July 2 0 x 4 w i t h t h e previous year indicates a significant deterioration i n the cash position despite an increase i n profitability. The preliminary analytical review also identified that w o r k completed b u t n o t yet invoiced and trade receivables increased a t s ~ g n ~ f ~ c a nhigher tly rates than the rate o f increase in revenue. H-t~trr: t.ttlt,rli

(a)

(b)

I3 Current

B C T C

-

Identify, f r o m the i n f o r m a t ~ o nprovided above, factors which may have contributed t o Wrapak Ltd's cash f l o w problems, and recommend policies and procedures t o be implemented i n o r d e r t o improve cash flow. (I 2 marks)

!

Outline the audit procedures you w o u l d undertake i n o r d e r t o ensure that the loan has been properly accounted f o r in the financial statements f o r the year ended 3 1 July 2 0 x 4 . (6 m a r k s )

i

( 1 8 marks)

r (a). . Iden!

i

i I

why (b)

In r e woul

(c)

ldenr state

QUESTIONBANK

!

Electra Ltd You are preparing for your audit planning meeting with the finance director of Electra Ltd, whose principal activity is electrical contracting under fixed-pr-ice short-term contracts. You have been provided with the following information in respect of the years ended 3 1 March 20x2 and 20x3. Extracts from the income statement Draft 2 0 x 3

f '000

Actual 20x2

f '000

f '000

17.407

Revenue Cost of sales Opening work in progress Materials used Wages and salaries Closing work in progress

f '000 15.873

Gross profit Administrative expenses Profit from operations Finance cost (Loss)/profit before tax Extracts from the balance sheet Draft 2 0 x 3

ASSETS Non-current assets Current assets Work in progress Receivables Cash and cash equivalents

f '000

..

f '000 1,006

Act~lal2 0 x 2

f '000

f '000 939

EQUITY AND LIABILITIES Capital and reserves Non-current liabilities Bank loan Current liabilities Bank loan Overdraft Trade payables Other payables

Requirements (a)

Identify, from the information provided above, the matters which give cause for concern, and explain why they give cause for concern. (7 marks)

(b) In respect of the issues raised in (a), identify the matters after the balance sheet date to which you (6 marks) would direct your attention. (c) Identify the forms of audit report modification which may arise from the concerns raised above, and state the circumstances in which they are appropriate. (6 marks)

( 1 9 marks)

THE INSTITUT t OF CHART €RED ACCOUNTANr s ih t\'I,AN,>

bh'l ULLI'.

Section 3: Planning assurance eligagcnlelits

Welfare and Help for the Aged TI-ust ( W H A T ) is a riot-fol--PI-ofit company limited by guarantee. It has I-ecently commenced operating from a commi~nitycentre in your locality by providing facilities for the wellbeing of seniol- c i t i z e ~ ~ s .

a u d ~clear t financial st

W H A T c receives income fl-om t l ~ efollowing soul-ces.

Req11irc.11

(I

)

At the bric

Donations under deeds of covenant (contl-actual agl-eelnents t o donate a s'pecified amount for a specified n~rlnbel-of years) entered into by ind~vidirals

( 2 ) Postal donations of cheques and cash

(a)

Ideni~

(b)

Prodi

(c)

(3)

DOOI--to-doorcollections by volunteel-s w i t h boxes, and worl
Some unde~

(4)

O t l i e ~donations . (sevet-al mini-buses liave been given, either new o r second hand, by large businesses)

dent^

(5)

Grants fl-0111local a u t l i o r ~ t ~ e s

(6)

Sales of I-efl-estinients at the colnmunlty centre

(7)

A val-lety of fu~ld-l.a~s~ng c v e ~ o~.ganlscd ~s by volirnta~-y1ielpe1-s

Nosh L.

The directors have appoirited you1 firm as ai~ditol-s. PI-ior to your wo~.lcon tlie audit the dil-ectol-s liave asked your advice, by way o f an additional engagement, on the internal contl-01s which should be in place over the company's income;

: i

Your f ~ r mI ch~lledfooc name and t are package d ~ r e c t o ran

1

(a)

Briefly explain how this engagement differs from your engagement as statutory auditor, and set o u t the (5 marks) approach that should be followed fot- any assurance engagement. ,

(b)

Describe the controls over- the above income which you would expect W H A T t o operate. For (4) ( 1 5 marks) above you shocrld describe the contl-01s over the donated assets.

(20 marks)

't

1i /

You are a member of tlie audit team for Pubgames Ltd, a company which manufactures electronic quiz machines for use in pubs and clubs. The a u d ~ manager t has informed you that o n the current audit your responsibility will be trade payables. The following schedule has been prepared by the client.

I

'\ i

The previor Charles Tuc H e ,was imp new compu advisory sel similar busir O n review11 The finance goods whict exceeded sa

Requirenlc (a)

(i)

f TI-ade payables Overseas suppliel-s Ferganto plc Others G R N l (goods rece~vedb c ~nt o t invoiced)

175.000 380,000 1 10,000 72,000

I

(ii)

I

I f

(2)

'O

During the current year the clet-lc w h o was responsible f o r overseas suppliers retired due t o ill health. She was n o t replaced as the company needs t o cut costs, and her w o r k has been shared o u t around the rest o f the accounts department. Fel-ganto plc is the sole supplier of high quality sheet steel which is used by pubgames Ltd t o build the casings for the quiz machines. In the past Ferganto has always refused t o confirm o r give a year end balance. In addition, during the current year Ferganto has introduced a reservation o f title clause on .. all invoices t o Pubgaliies.

(3)

'Othel-s' I-elates t o 21-ound 100- 150 small suppliel-s which produce specialist electrical cpmponents.

(4)

'GRNI' relates t o goods received PI-101t o the year end but where n o invoices have yet been entered in the purchase ledgel. The f~gut-e1s c o ~ ~ s ~ d e ~ -highela b l y than last year because of problems i; the

EJ

lHtINSI1111IL OF CHARTERED

nccOUNTyN"

:

Sf

(b)

Preparc and auc proced

(c)

Compa differer

j

Having reviewed last year's audit files and discussed matters with the client, you have noted the following. (I)

LI 01

(i)

At

(i~) 0

!

(111) , 0 be (d)

Set o u t

3

QUESTION BANK

computer system, which meant that no purchase invoices could be processed in the week immediately following the year end. At the briefing meeting for the audit the manager explained that the client had set a very tight deadline for audit clearance. This is because it is currently negotiating a merger with one of its competitors, and the financial statements are needed before final completion. Requirements

(4 m a r k s )

(a) Identify the main audit risks for payables specific t o Pubgames Ltd.

(I0 m a r k s )

(b) Produce an outline audit approach t o payables for submission t o the manager.

(c) Some audit firms use directional testing as part of their audit approach, with payables being tested for understatement. ldentify and explain the specific audit techniques which could be used t o try t o identify understatement errors in the payables cycle. (3 m a r k s )

( 1 7 marks)

Nosh Ltd Your firm has recently been appointed auditor of Nosh Ltd, whose principal activity is the preparation of chilled foods for the catering trade and supel-markets. Products are sold under the company's own brand name and that of a national supermarket chain with which it has a one-year renewable contract. The foods are packaged in plastic trays purchased from Plasco Ltd, a company in which Charles Tuck, the managing director and majority shareholder of Nosh Ltd, has a controlling interest. The previous auditors, from whom you have obtained professional clearance, were not re-appointed as Charles Tuck felt that your firm had the appropriate resources t o assist with plans t o develop the business. He was impressed with the professional advice the company had received from your firm in respect of the new computer system which was introduced during the year. The terms of engagement also include tax and advisory services. These services are t o include advice o n expanding the business by the acquisition of similar businesses and funding the expansion. On reviewing the management accounts you ascertain that revenue and margins have improved significantly. The finance director informs you that this has resulted from a significant increase in the sales of own brand goods which have higher margins, and the successful launch of a new gourmet range which has already exceeded sales targets. In addition, the company's export market has grown. Requiremerits (a) (i) (ii)

List, with reasons, the information you would require in order t o carry out analytical procedures on the draft financial statements of Nosh for the first audit. Set out the limitations of using analytical procedures at the planning stages of this audit. ( I0 m a r k s )

(b) Prepare a file note which, from the circumstances identified above, identifies any professional issues and audit risks and the factors which have led you t o identify those issues and risks and outlines the procedures t o be undertaken in order t o address the professional issues and audit risks identified. (1 7 marks) (c) Compare the purposes and characteristics (including the different levels of assurance provided) of the different forms of assurance p r ~ v i d e dby (i)

Audit reports under the Companies Act

(ii)

Other reports under legislation o r regulation

(iii) Other reports where the scope of the w o r k and of the report t o be provided are agreed (9 marks) between the t w o parties involved.

(4 m a r k s )

(d) Set out the benefits t o Nosh Ltd of having an audit.

4

a

(40 m a r k s ) "

f

Section 3: Planning assirl-ance engagements

,

You al-e an audit senlot- in tlie firm of West & Company. You have just Iieard that, following the resignation of anotliel- seniol-. you have been assigned t o the audit of Medical Diagnostics Ltd (MDL) for the year ended 3 1 Octobe~.20x3. You have I-eceived an initial briefing from the partner, Geoff West, who has provided you with t11c following information: Medical Diagnostics Ltd (MDL) supplies colnputerised diagnostic systems t o hospitals and general p~.actitioners.It lias iIi~.een ~ a i nstveams of revenue: I

The initial equipment sale

2

Engineering project wol-I<, billed on a 'time and matel-ials' basis

3

Ongoing suppol-t for which the customer pays an annual fee.

I

t

The ma L~mited agreeml MI

b

On

iI

dvl TI1 ne thc

b

1

r eI

'I

The company was established 5 years ago by its present managing director, Andrew Young. H e owns 75% of the 01-dinat-y slial-e capital, the remaining 25% being owned by the company's financial director, Bill Tyson

j

b

i

I

Medica

1

rev en^ Equipnj lnstallal Suppor

Th

The company has grown rapidly and now has 35 employees - 4 engaged in research and development, 7 in sales. 5 in assembly. 15 in technical support and 4 in administrative functions. W i t h the exception of final assembly and testing, all of the company's manufacturing is performed by subcontractors. R e c e n t results

Revenue Gross margin Operating expenses Operating profit

Year ended 3 1 October 20x2 f '000 8.540 3,450 (40%) 1,985 1.465

I I months to 3 0 September 2 OX3 f '000 10,064 3.704 (37%) 2,130 1.574

Forecast for year ending 3 1 October 20x3 f '000 1 1,200 4,140 (37%) 2,350 1,790

I i

Cost 0 Materi; lnventc Subcon Assemt Enginec Other

Historically, tile company has experienced little seasonality in either sales 01- profitability. However, Octobel- 20x3 is expected t o be a particularly good month with a large number of orders on hand for delivery p1.e yeat- elid.

Gross I

The following I-evenue recognition policies have been agreed with the company in previous years: (i)

Revenue on equipment sales is recognised on delivery, providing the supply contract is for standard equipment. Whet-e tlie supply contt-act is for equipment which requires significant customisation or integt-ntioll wltli existing cirstomcr systelns, no revenue is I-ecognised until the customer has signed an acceptance certificate.

( ~ i ) For each equipment supply contract, there is normally a separate installation contract covering worlc done by the company's engineers t o install the equipment, perform site testing and train the customers' staff in ~ t suse. Revenue from these services is recognised as the worlc is performed. (iii) Most customers also enter into a support and maintenance contract with MDL. An annual fee entitles them t o 24 haul. telephone support, quarterly testinglcalibration, repair w o r k as and when necessary and the loan of equipment if their own equipment needs t o be removed for repairs. Fees for this set-vice are invoiced annually in advance and the revenue is spread evenly over the period t o which it I-elates. MDL uses a spreadsheet t o record support invoices and t o calculate the revenue deferral at each month end. (iv) The company holds inventories of standard machines, spare parts and sub-assemblies. I t also has significant wot.l< in progress, being machines in the process of manufacture, customised machines which have been lnanufactured but not accepted by the customer and the time spent t o date on installing, Integrating and testing such machines.

IHF I N 5 I I l U l t OF CHARTERED ALCOLN IAN I S ,k., : ,..,, .,,.\I:',

,,

,

I

!

0~ei~2.t Sales st Sales e, Adminl Establrs Office ( Researc Other

Profit ( Taxatic Profit (

QUESTION BANK The managing director has successfully negotiated the sale of the entire share capital of Medical Diagnostics Limited to a public company in a similar field of business. The ltey terms of the sale and purchase agreement, that has been signed, are as follows: )

MDL will receive initial cash consideration of f 7 million, with further cash considel-ation of f 4 million on 3 1 January 20x7, providing that the operating profit of Medical Diagnostics Limited grows by an average of 5% per annum over the next t w o years ending 3 1 October 20x5.

)

The initial consideration of f 7 million is based on net assets at 3 1 October 20x3 of f 1.2 million. If the net assets in the final audited accounts for the year ended 3 1 October 20x3 are less than f 1.2 million then the initial payment will be reduced by an amount equal t o the difference between the final reported net assets and f 1.2 million. 'There is no corl-esponding ilpwat-d adjustment.

)

The audited accounts must be available by 3 1 December 20x3.

Medical Diagnostics L i m i t e d Management A c c o u n t s

3 1 O c t o b e r 20x3 Morltl~ Actual f'000

Yeor to date Actual f '000

Year to date Budget f '000

Revenue Equipment sales Installation, training 2nd other servlces Support Cost of sales Material purchases Inventory provisions Subcontract manufacture Assembly staff Engineering staff Other

Gross margin Operating expenses Sales staff Sales expenses Administrative staff Establishment costs Office equipment, stationery etc Research and development Other

Profit (loss) before taxation Taxation Profit (loss) after taxation

IHE INSIIIUTt OF CHARTERED ACCOUNTANTS Ih IhCllliD

1UD 'Whl l S

Section 3: Planning nssul.nnce engagements Balance S h e e t Movement 111 month Actual f '000

3 1 October 20x3 Actual f '000 672

(65)

Non-cul-l-ent assets

3 1 October 20x3 Budget f '000 720

1

(a)

iI

WI (1)

(11)

i

Inventory Trade I-eceivables PI-epayments Cash

(b)

Set

(c)

Go1 (1)

TI-ade payables Defel-red ~-evenue ACCI-uals COI-pol-ation tax payable Other taxes

N e t assets

(190)

1,204

-1,750

(a)

Review MDL's 3 1 October 2 0 x 3 management accounts and identify. with explanation, any areas which you believe wa1.1-antfurther investigation. ( 1 3 marks)

(b)

Set o u t any Ikey audit I-isks which you have identified f r o m the information provided by the partner. For each r-islk identified, you should briefly cover the nature o f the risk and explain why you consider'it Icey t o the M D L audit. D o NOT set o u t the audit w o r k you would perform. (20 marks) .

(c)

>

Set o u t the audit w o r k you would perform in the area o f revenue recognition.

:

i

1 "

Atlantis L number ( Features

(1)

,

(9 marks)

(42 marks)

39

1

I

COll

(2) sale Wh(

t

Your cl~ent.Spot-ttcus Ltd, lins 40 spol-ts shops and operates I 0 leisure centres around the Midlands. You t the year ending 30 September 20x9. are the senlor In charge o f the a u d ~for In PI-evlous years substantwe procedul-es have been reduced as a result of your assessment o f control risk as l o w T h ~ sassessment has been suppol-ted by evidence obta~nedby tests of control. A t tlie start of the year. in October 20x8, the company established an internal audit department. The new departnient is independent of the accounting function and is responsible directly t o David Campbell, the finance dil-ectol-.

All1 fro11

cust

i 1

i

t o tl the

(3) Due

d~sct man

I

f

(4)

Aftc a wc

(b)

lden tkie

i

i

The head o f che department, Petel- Adarns, a chartered accountant, was promoted from his previous position of assistant chief accountant. A n unqualified accountant with information technology experience was recruited externally, and the staffing was completed by the internal transfer of a payroll clerk. S~ncei t s fol-mat~onthe depat,-tment has evaluated and re-documented the internal control systems In all areas. I t has also pel fo~.niedtesting of the control procedures In the sales and cash handling system throughout tlie flnanc~alyearAll of the WOI-king papers In respect of the worlc of the department will be provided t o you for the audit. Additionally, before the time the audit is scheduled t o begin in November 20x9, the department is planning t o perform deta~ledtesting o f the control procedures in the purchases system during the whole year. David Campbell has aslced ~ O L tI o expla~nthe extent t o which you will be able t o make use of the dapar-tment's WOI-I
I H t iNSIIIUlt OF CHARTERED ACCOUN I A N l S

,<, ,",, 8

,v

, .,I

c

<

i

QUESTION BANK

(a)

Write a fol-ma1 letrel- t o Davld Campbell setting out (i)

The factors that could limit your ability t o use the WOI-Itof the ilitc~.nala i ~ d i tdepal-tment in yourfinal assessment of control risk ( I 0 marlts)

(ii)

The effect on your audit and the extent t o which you may ~nalteuse of tlie WOI-I
(b) Set out the advantages t o a conlpany of establishing an effective internal audit function.

(4 m a r k s )

(c) Compare the responsibilities of management. internal auditors and external auditors in relation t o (i)

The design and operation of systems and controls

(ii)

The reliability of management information

(iii) The prevention and detection of fraud (iv) Company compliance with laws and regulations (v)

Money laundering

( 1 3 marks) (35 m a r k s )

Atlantis L,&t:i Atlantis Ltd is a long standing client of the firm. I t is a suppliel- of Ikitchenware and bathroomware from a number of outlets which compl-ise s1iow1-oomsand stores. All sales are made on credit. Features of the sales system of the business include the following (I)

All processing of accounting information i s pelformed centrally at head office from returns submitted from the bl-anches. The only system maintained at each branch is inventory control on a personal computer. A full physical count is carried o u t at each branch at the year end.

(2) Sales orders are supplied from the branch concerned when inventory

IS available at that branch. When this is not the case, inventory may be transferred from another branch o r delivered t o the customer direct fl-om the other branch. Inventory movement dockets are sent by the second branch to the originating branch when inventory i s transferred between branches. Sales are accounted for by the branch talking the order.

(3) Due t o the competitive natul-e of the business, branch managers have considel-able discretion t o offer discounts from list price, within specified parametel-s. Part of the remuneration package of branch managers is dependent on the revenue of their branch.

(4) After delivery of the goods, PI-oforma sales invoices are submitted t o head office from the branches 01.1 a weekly basis, and are pr-ocessed and sent t o customers during the following weelk.

(a)

Explain the importance for audit purposes of obtaining an undel-standing of the business, setting o u t appropriate sources of infol-mation about Atlantis and identifying the procedures the audit team would use t o obtain the information. ( I0 m a r k s )

(b)

Identify the potential risks t o Atlantis Ltd arising from the above matters and, for each risk, describe the possible consequences of the risk t o the company. ( I I marl<$)

(c)

Propose and justify an audit approach for revenue at Atlantis Ltd, setting o u t the substantive audit work you would pel-form in the areas of inventory quantities, revenue and trade receivables t o address the rislts. ( 14 m a r k s ) (35 m a r k s )

Section 3: Planning assurance engagements

You have recently been appointed as auditor t o Pallas Ltd ('Pallaz'). Yo'u are currently in the process of planning i t s audit for the yeat- ending 3 1 October 2 0 x 6 prior t o your meeting next week with the company's finance director. The company's principal activity is the hiring out of specialist camera equipment. Further information . Pallas owns approximately 5,000 items of camera equipment which it hires out t o independent film and television production companies for periods ranging from one day t o six months. The individual pieces of equipment vary in their original cost t o Pallas from £200 t o £25,000, the average value being £2,000. A t any given point in time, 75% of these items of equipment are out o n hire with customers. Customers are responsible for insuring the equipment whilst o n hire, and they are charged by Pallas for any lost o r damaged items. Customers place their orders either by telephone, by email, o r through one of the company's sale agents. Equipment o n hire is then either sent o u t by courier o r collected by the customer from Pallas's warehouse. A t the end of the period of hire, customers are invoiced in full for the relevant hire charge.

Pallas sources much of its equipment directly from the manufacturers in Germany and Japan, for which Pallas is invoiced in the appropriate local currency. Pallas calculates depreciation o n a five-year straight line basis for all its camera equipment. Pallas employs a number of sales agents who are responsible for visiting existing and potential customers with a view t o generating business. Each sales agent has the authority t o offer discounts of up t o 35% off the Pallas catalogue hire rate. These sales agents are also responsible for chasing overdue trade receivables from customers. During the year Pallas introduced new custom-written specialist software which deals with the booking in and out of items on hire, and the invoicing of customers. Due t o an incompatibility between the t w o types of software, the information held on the old system had t o be manually transferred t o the new. This was done over the first weekend of August 20x6, prior t o the live launch of the new system. Pallas operates an incentive scheme under which the executive directors are entitled t o a bonus based on the pre-tax profit of the company. The bonus is payable one month after the audited accounts are available.

(a)

From the information provided above, identify and explain the potential audit risks in respect of Pallas, and indicate the matters you would discuss at the forthcoming meeting with the company's finance (1 4 marks) director.

(b)

Describe the internal controls that Pallas should implement t o prevent the following:

(c)

(i)

Loss of non-current assets

(ii)

Non-recoverability of trade receivables.

(8 m a r k s )

Comment on the differences between an audit of a non-specialised profit oriented entity such as Pallas Ltd and the audit of: (i)

Caring Hands UK Ltd, a registered chanty

(11) Publ~csector

entitles,

(8 m a r k s )

such as a county counc~land a cen'tral government department. ( I 0 marks) (40 m a r k s )

IHE I N S l l l U l E OF CHARTERED ACCOUN IANTS 1N k \ C L

I N 0 4UIl iY,\IC\

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QUESTION BANK

I

Your firm is the a u d ~ t o rof Swanky Cars Garages Ltd, a medium-sized chain of garages. The following points have arisen from your audit. (I)

Mechanics in t w o of the garages are known t o worlc at weekends - there is a possibility that they may be using the company's premises t o service friends' cars.

(2) The garages have been I-evalued this yeat- resulting in an unrealised surplus of £45,000.

(3) Some cx-s taken in part exchange are scrapped immediately. There is n o evidence of any cash being received. State, for each of the above, whether they should be referred t o in the r e p o r t t o management o r the letter of repl-ese~itation01- both. W h e r e you believe they should be referred to, give reasons.

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The new auditor of a company has concluded that a material amount in the preceding year's financial statements was included within an incorrect current asset heading. The audit opinion was unqualified.

(2 marks)

Explain the auditor's I-esponsibilities in relation t o the current year's audit report. -

I

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You have just completed the audit of Bitterne Ltd. One major expense has been disclosed in the income statement under distribution expenses, but you feel that i t should be included in cost of sales. As a result you are of the opinion that the gross profit figure has been materially overstated. You are satisfied with all other aspects of the financial statements. What forni should your auditors' r e p o r t take, and why?

4

,

(2 marks)

The directors of Howlcins Ltd have prepared the financial statements on the going concern basis, although there is a significant doubt about the company's ability t o continue as a going concern. What effects will this situation have o n your audit report if the, uncertainty over going concern is (i)

Fully disclosed in the financial statements

(ii)

N o t disclosed in the firfancial statements?

--

"-

-

-

- -- -----

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----

(3 m a r k s )

THE INSTITUTE ACCOUNTANTS IN ELICLAND AND W A I I S

Section 4: Concluding and ~.eportingon assurance engagements A UK audit report contains the following sentence.

5

'In forming our opinion we also evaluated the overall adequacy of the presentation of information in the financial statements.' Expla~nthe meanlng and pul-pose of this statement. --"

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(2 marks)

-------

You are the auditor of Fenditton plc, a listed company with two UK subsidiaries. During your review of the wot-Icing papers and draft annual report for the year ended 3 1 July 20x4 you note the following niatter.

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The chairman's statement in the annual report indicates that the groi~p'sprofit has trebled in the year to 3 1 july 20x4, without explaining that the principal reason for this is the exceptional profit on the sale of a trade name 'Butler's Beauties' for f 5 million. The name had not previously been recognised in the financial statements. State the action that you would take, in respect of the above and how affected if the matter- remains unchanged. .

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report would be (4 m a r k s )

Thc

...................................

As part of the completion stages of ari audit, the auditor should carry out a review of the financial statements.

7

During the year ended 3 1 August 20x2 Worboys Ltd, an outdoot- leisure retailing chain, switched purchases of tents and waterproof clothing from Leakproof Products Ltd to another supplier. Two months later. Leal<proof Products Ltd went into liquidation.

8

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(2 marks)

What conclus~onsshould the aud~torbe In a posltlon to form as a result of this review? -- - - -

13

Th'e fro11 part1

The liquidators of the company have issued a claim against Worboys Ltd for breach of implied contract and conseqirential losses. N o amount has yet been put on the claim, but lawyers advise that it could be substantial and, although they are confident of a successful defence, also advise that the case could go against Worboys Ltd. This would have a serious effect on the company.

In tli mtc

1

Describe the effects this situation will have on the audit report of Worboys Ltd if the matter is (i)

Fully disclosed in the financial statements

(ii)

N o t disclosed in the financial statements.

. . . . . . . . . . . . .

(3 marks)

...................................................................................................

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14

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The i and cons1 I 1

9

During the audit of Morgan Ltd audit tests indicated that company policy requiring purchase orders t o be placed only by the company's buying department was not adhered to in 10% of the transactions examined.

State descl (i)

In respect of the above breach in company policy, draft extracts suitable for inclusion in the auditor's management letter, which set out the possible consequences and the recommendations that you would make. (4 marks) ................................................................

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10 Your firm has recently been appointed as auditor t o Donner Lcd for the year ending 3 1 October 20x5. This is the first year of audit for Donnel- Ltd as it fell below the statutory audit exenlption lirn~ts for the year ended 3 1 October 20x4, which was the colnpariy's first period of trading. State che matters t o be cons~deredIn respect of the openlng balances of Donnet- Ltd -- --

II

(3 m a r k s )

During your post balance sheet evencs review of a second division football club. you found out chat the club has just been relegated co the third division. This means that I-evenires for the following season are likely t o be considerably lower than [he current season.

(3 marks)

Explain what additional procedul-es you would ca1.1-yo i ~ cin ~.especcof this mactet.. ....

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12 You have carried out a receivables circularisation as part of your audit of Charnley Lcd for the yearended 3 1 October 20x0. The following disagreements have been revealed. (I)

A customer disagreed the balance because it had sent a cheque on 27 October 20x0

(2) A customel- had been promised a credit note against an invoice dated 5 October 2 0 x 0 because the wrong price had been charged, but this had not yet been issued. What further information will you require in order t o conclude on the results of this test, and why will ( 3 marks) you require this information? ..

................................................

. . .

. .

..........................

13 The directors of t w o companies, Fletcher Ltd and Dervish Ltd, have each prevented their auditors from carrying out procedures considered necessary t o verify the amount of inventories held by third parties of £250,000. In the audit of Fletcher Ltd materiality has been set at £200.000. and in [he audit of Dervish Ltd materiality has been set at £ 15,000. State the effect this matter will have on the audit report of each company. including any additional effects in the UK. (3 m a r k s )

The directors of Denzil Ltd are preparing the financial statements for the year ended 3 1 May 20x1, and have approached the auditors for advice because they are unsure whether the company can be considered a going concern.

14

'

State the importance of the going concern concept in the preparation of financial statements, and describe the effect on the financial statements if the company (i)

Is considered a going concern, although there are significant doirbts about this

(ii)

Is not cons~dereda golng concern. " -

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Section 4: Conclud~ngand I-cpovting o n assul-ance engagements 15

Your firm has been engaged t o conduct a non-statutory audit o f the year end accounts of the U K branch of Finch Inc, an American company, and t o provide an assurance report as near t o a statutory audit I-eport as yocr are able. Set out the maln differences between the assurance report you will provlde and a statutory audit I-eport (2 marks) *

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W i t h regard t o auditors' indepen,dence and their listed company audit clients, what action should UK auditors take a t least annually? W h a t other additional requirement is there in the UK according t o ISA 260? (3 marks)

resl, recc yeat

Expl

17

DUI-~ngthe coul-se of the a u d ~ of t Beacon Ltd for the year ended 30 November 2 0 x 2 you discovered that o n 25 January 2 0 x 3 a I-ecelver was appo~ntedat Gamlec Ltd, a major customer o f Beacon Ltd. The balance due from Gamlec Ltd at 30 November 2 0 x 2 was f 150.000.

Arlagr

ldentlfy the matters t o which you would ~ I I - e cyour t attention after the balance sheet date. (3 marks) . . " . ----"

18

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The directors of Pinot plc have included the following note in the accounts for the year ended 3 I December- 20x3. 'The company reached agreement with its lenders, in October 20x3, t o extend the maturities o f its debt facilities until September 20x4, waive all existing covenant breaches and reduce interest costs. All pi-econditions contained in the facilities agreement have n o w been satisfied. The company is wol-king o n initiatives t o significantly reduce its current debt levels and is t o explore opportunities t o raise further funds by September 20x4. Based o n progress t o date, the directors remain confident that the company will be successful in achieving its strategy. While there can be n o cert?inty, the dil-ectors believe that the adoption of the going concern basis is appropriate in the preparation o f the financial statements. If adoption o f the going concern basis was n o t appropriate, adjustments would be required t o write down assets t o their I-ecoverable value, t o reclassify non-current assets as current assets and t o provide for any further liabilities that might arise.' Describe, with reasons, the possible effects of this note o n the audit report for the year ended 3 I December 2 0 x 3 . (4 marks)

Yo11are r m Anagram

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The bulk , asked yorl managenif During it!, entered 1 1 chips t o a of five yen part been contract :# Increased The sales amounts. but the 2 1 thlrd of tl Anagram hold~ngo f

(a) 19

Assurance firms may be engaged t o prepare a I-epol-t on the financial statements and other information presented by organisations which are required t o report under special legislation o r regulations. Give four examples of such 01-ganisations,and indicate why they might be subject t o such special I-epol-ts. (2 marks)

20

You have carried o u t a receivables circularisation as part of your audit of Trump Ltd for the year ended 3 1 December 20x2. It was revealed that a customer disagreed with the balance because it had sent a cheque on 23 December 20x2. W h a t further information would you require in order t o conclude o n the result o f this test, and why will you require this infol-mation? ( I mark)

(b)

List r stat11 ,

Set c. orde, issue

Garb I You are tl the design. . ! J ;

40

r H E INS l ITU l E OF CHARTERED ACCOUN l A N T S I h I \ < I i\l> V \ \ " \ I ' >

QUESTIGN B A N K

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Siskin L t d conducts all its sales o n a cash basis. The managing directol- and majority shareholder o f Siskin L t d has provided a w r i t t e n representation in respect o f the completeness o f cash sales. What a d d ~ t ~ o nniatters al w o u l d you cons~del-In detel-mtn~ngwhether o r n o t you would rely o n this representat~on? (3 marks)

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22 During the audit o f Poplal- L t d fol- the yeat- ended 3 1 January 20x3 you have been assigned the responsibility o f checking the cash at bank figure in the balance sheet. W h i l e checlting the bank reconciliation y o u discovered that receipts f r o m customers, listed as outstanding lodgements at the year end, w e r e cleared through the bank o n 14 February 20x3. Explaln why t h ~ smattel- should be ~nvest~gated further

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You are the senior in charge o f tlie audit o f Anagram plc ('Anagram') f o r tlie year ended 30 June 20x5. Anagram is a manufacturer o f silicon chips and wafers. The bulk of the audit fieldwol-lc In respect o f this client was completed last week, and the audit managel' has asked you t o pull the file together so that she can attend the final clearance meeting w i t h the client's management. During the caul-se of tlie audit, particulal- attention was paid t o a major sales contl-act that Anagram entered into during the year. T h e contract is f o r the supply o f a substantial numbel- o f custom-made silicon chips to ajapanese component manufacturer. In o r d e r t o service this contract, which has an initial duration of five years, Anagram has invested heavily in new specialist plant and equipment. This investment has in part been financed by substantial n e w bank loans and an extension t o the company's overdraft facility. 7-he contract also gives the customel- a 60 day credit t e r m o n all purchases f r o m Anagram, and this has in t u r n increased Anagram's worlting capital requirements. The sales contract stipulates that the customel- is t o purchase the p r o d u c t f r o m Anagram in fixed monthly amounts, referred t o in the contract as 'call-downs'. The call-down f o r March 20x5 w e n t ahead as planned, but the amount o f p r o d u c t called-down f o r April, May, and June 20x5 represented approximately only onethird of the amount originally stipulated in the sales contract. The lead-time f o r r a w materials purchased by Anagram is t w o months and therefore the above shortfall in sales has resulted in a significant increase in the holding of raw materials and finished goods inventories f o r Anagram a t the year end.

I

I

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(a)

List the principal components that you would expect t o see in an audit completion memorandum f o r a (4 marks) statutory audit conducted under the UK Cornponies Acts.

(b)

Set out the matters t o which you w o u l d direct attention during y o u r subsequent events review i n order t o reach a satisfactory conclusion o n the accounting treatment and disclosure in respect o f the (7 marks) issues raised above.

(c)

State with reasons h o w each o f the issues raised above might cause y o u t o modify your audit r e p o r t in (7 marks) respect of Anagram.

( 1 8 marks)

You are the external auditor of Garb L t d f o r the year ended 30 September 20X I. Its principal activity is the design, manufacture and sale o f clothing.

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The conlpany made a loss in the year ended 30 September 20X I, but the profit forecast indicates a return to PI-ofitability in the year ending 30 September 20x2. The loss was due t o redundancy and restructuring costs following the loss of its major customer, a national retailer, t o whom i t supplied clothing under the I-etailer's brand name. The company is now focusing on its own branded goods which have been sold; historically, a t a higher margin. There are plans t o develop i t s overseas market and t o expand the customer base for its I-ecently launched corporatewear products, and contracts have recently been agreed with sevel-al new overseas customers. The company has also negotiated a new contract with a major supplier, which has resulted in reduced prices in return for committed monthly purchases.

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During the year ended 30 September 20X I the company suffered severe negative cash flow but managed to stay within the overdraft facility by delaying payments to trade payables and HM Revenue & Customs. The company has a bank loan which is due for repayment in March 20x2 and is negotiating with its bankers for a replacement loan required to repay the present loan.

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Expla~nwhat IS meant by the golng concern concept and why the auditor should consider whether a (5 marks) company IS a golng concern.

(b)

Identify the matters to be considered when reviewing the profit and cash flow forecasts prepared by (9marks) the conlpany, in order to assess whether the company is a going concern.

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Discuss the implications for the audit report of Garb Ltd in respect of the financial statements for the year ended 30 September 20x1, if the negotiations for the replacement loan are not completed by the time the audit report is signed. (4 marks)

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You are in charge of the audit of Plumb Ltd for the year ended 30 September 20x5. The principa1,activity is the PI-ovision of plumbing and central heating services under fixed-price short-term contracts. The majority of the company's business is conducted on a sub-contract basis for construction companies many of which use Plumb Ltd on a regular basis. It is common practice in this industry sector for construction companies to pay 95% of the contract value on completion with the 5% balance being retained by the customer for six months as security against problems with the work undertaken. Plumb Lcd also has retail outlets through which it sells consumables used in the plumbing trade. However, management is currently negotiating the sale of the retail operation and plans t o use the proceeds t o repay a loan falling due in February 20x6. Following the disposal of the retail operation, Plumb Ltd will continue to buy consumables used in its contract work from the existing suppliers but in smaller quantities. . Plumb Ltd made an operating loss for the year ended 30 September 20x5. This is mainly due t o a substantial provision for rectification work relating t o a contract for Builda plc, one of Plun;b Ltd's major customers. The contract was completed in early September 20x5 but failed t o meet the customer's specification. Furthermore, in October 20x5, Plumb Ltd received notification that Builda pic had lodged a claim against the company for substantial compensation for alleged damage t o the customer's business. N o provision has been made for this compensation as the directors of Plumb Ltd have instructed the company's legal advisors t o fight the claim. The company is currently trading at its overdraft limit and the directors have been negotiating with the company's banl<ers,in order to increase its borrowings. 'The directors have prepared profit and cash flow forecasts for the three years ending 30 September 20x8 in support of the request for funding. The company's bankers require this information to be reviewed by independent accountants and the board of directol-s has requested that your firm undertalces this review.

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(a)

In I-elat~ont o the aud~tof the f~nanc~al statements, ~dent~fy from the information provided above, the (6 marks) matters whlch give cause for concern and explaln why they glve cause for concern.

(b)

ldent~fythe d~fferenttypes of audit report mod~ftcationwhich may arise from a going concern 'problem ,b and state the c~rcumstancesin which they are appropriate. (6 marks) T t i t INSTliUTE

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l - s would consider when reviewing Identify from the infol-mation provided above, the spccif~c~ ~ n t t c you the assumptions underlying the incorne and expend~tirte included in rllc pl-ofit forecast and the receipts and payments included in the casli flow fo~.ecast. (8 m a r k s )

(20 marks)

Delux Hotels b. ;,: Your firm is the auditor of Delux Hotels Ltd, which owns and Inanages a chai~lof hotels. The hotel systems are run on networked computers and the accounting function is centl-alised at head office which is responsible, amongst ocher- matters, for capital expenditure. The following significant points have been identified during the audit. ( I ) R o o m lettings

- corporate customers

Staff have granted discounts in excess of authonsed levels iri 40% of the ti-ansactions examined Formal credit limits are set for about 50% of cot-pol-ate customel-s with credit accounts, and audit tests indicated that about 20% of custolnel-s with formal credit limits have exceeded those limits for more than six months.

(2) Property, p l a n t a n d e q u i p m e n t Company policy, which was t o obtain three quotes for cap~talexpenditure in excess of £5,000, was not adhered t o on t w o occasions.

(3) C o m p u t e r s y s t e m File servers holding business-CI-itical data and systems ar-e n o t sited in secure locations. The changing of passwords is at the discl-etion of staff 11iernbe1.s

(a)

Set out, in a manner suitable for- inclusion in a report t o management, the possible consequences arising from the wealmesses identified above and the I-eco~nmendationsto remedy those weal
( 18 marks)

(b) When communicating audit matters t o those charged with governance, describe the attributes (5 m a r k s ) required for such communication to be effective. (c)

Set outwhat additional matters ar-e I-epol-ted in the UI< t o those chal-ged with govel-nance. (3 m a r k s )

Salrnonoid Ltd specialises in the pi-oduction and sale of rainbow trout. I t has three divisions all opel-ating from one site located in Ha~npshil-e. Division I Fish c u l t u r e a n d supply d fresh water from bore holes. W h e n Up to 300,000 fish of differing sizes are Ikept in cages s ~ ~ p p l i ewith inventories are at their 1n5ximum levels PI-oblems have been encountel-ed with parasites and a fungus. causing fish t o lose weight and condition. Chemicals have been used as control agents with limited success. Division 2 Fish f o o d s To ensure rapid growth the fish are fed six times a day with high protein fish pellets. A minimum inventory of eight tonnes is held at any time in airtight silos. Aftel- three months the pellets start t o deteriorate in quality in spite of the stol-age conditions, and if Ikept for t o o long actually become poisonous. ..i

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Section 4: Concludiiig and I-epol-ting on assurance engagements

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In recent yeat-s the demand for freshly prepared trout has grown, and the company now sells to the major supel-rnarl<etchams. The prepared flsh are blast frozen, and despatched monthly in refr~gerated 101-1-~es The ~nsut-ancepol~cycoverlng these inventories i s about to be renewed.

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Salmonold Ltd's revenue has stab~l~sed at €9 mill~onper annum generating 14% net profit. To grow further I[ needs to secure an addlt~onalslte, and an excellent location has been identified. The dil-ectol-sof Salmonoid Ltd have approached their bank, the Sterndale Bank, t o ask for a €5 million loan t o fund the purchase. The bank is not averse to the proposition, but is nervous that 48% of the company's assets are represented by inventories (fish and feed pellets). If the net realisable value were t o fall dl-amatically Salmonoid Ltd's credit rating would deteriorate, and the bank's head office would question the' appl-opt-iatenessof the loan. Consequently the bank has commissioned Bingt & Co t o report on the accuracy of the current inventory values of Salmonoid Ltd, and their sensitivity t o future eventualities. $\$,;;j?2a:

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State the nmln features of your final assurance report on Inventory values andbriefly explain the ( 1 4 marks) slgn~f~cance of each.

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(b)

Compare the purposes and character~stics(including the levels of assurance provided) of the different fol-nis of assurance PI-ov~dedby A u d ~ reports t under the Companies Act

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(iii) Other reports where the scope of the worl< and of the report t o be provided are agreed between the two parties involved. (8 marks)

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(22 marks) I

Described below are situations which have arisen in three audit clients of your firm. The year end in each case is 3 1 January 20x3. B e t t a Networl<s plc Betta Netwol-l<s plc is a company in the telecoms sector which builds and operates national fibre optic networl<s. During the year the company incurred costs of €8.5 million in respect of repairs and maintenance to its networks. These costs have been capitalised and included in non-current assets. The directors refuse t o make any adjustments in respect of this matter. The PI-e-tax profit of Betta Networl<s plc for the year ended 31 January 20x3 is €7.2 million. Rayton Ltd Inventories at the yeat- end include €240,000 in respect of the cost of items which had been returned by a customer because they were not in accordance with the customer's specification. The directors insist on including the items at cost, as the company has an agreement t o sell them t o another customer for € 320,000, following the modification of the items at an additional cost of f 140,000. The pre-tax profit of Rayton Ltd for the year ended 3 1 January 20x3 is €2.4 million. Viva Ltd In September 20x2 Mary Benton was paid f60,000 for services in respect ofinterior design work atviva . Ltd's head office. Mary Benton is the wife of the managing director and majority shareholder of ~ i v a ' l t d . The managing director refuses t o disclose details of the transaction in the notes t o the accounts betause of t. its sensitive nature. '

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QUESTION BANK The pre-tax profit of Viva Ltd for the year ended 3 1 January 20x3 is f 10.4 million. Requirements

'(a)

Describe the role of the concept of materiality in the conduct of an audit and explain why i t can be a difficult area for auditors. (8 marks)

(b) In respect of the situations outlined above, reach a conclusion on whether or not you would modify each audit report. Give reasons for your conclusions and describe the potential effect, if any, on each (9 marks) audit report.

( 1 7 marks)

41 Audit report phrases The following audit report has appeared in published accounts.

Independent auditors' report to the shareholders of Cain Ltd We have audited the financial statements of Cain Ltd for the year ended 3 1 December 20x1 comprise.. ... . These financial statements have been prepared under the accounting policies set out therein. This report is made solely to the company's members, as a body, in accordance with Section 235 of the Companies Act 1985. Our audit work has been undertaken so that we might state to the company's members those matters we are required to state to them in an auditor's report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the Gompany and the company's members as a body, for our audit work, for this report, or for the opinio,n we have formed.

Respective responsibilities of directors and auditors The directors' responsibility for preparing the Annual Report and the financial statements in accordarice with applicable law and United Kingdom Accounting Standards is set out in the Statement of Directors' Responsibilities. Our responsibility is to audit the financial statements in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland). We report to you our opinion as t o whether the financial statements give a true and fair view and are properly prepared in accordance with the Companies Act 1985. W e also report to you whether, in our opinion information given in the Directors' Report is consistent with the financial statements. In addition we report to you if, in our opinion, the company has not kept proper accounting records, if we have not received all the information and explanations we require for our audit, or if information specified by law regarding directors' remuneration and transactions with the company is not disclosed. We read other information contained in the Annual Report, and consider whether i t is consistent with the audited financial statements. This other information comprises only the Directors' Report and the Chairman's Statement. W e consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the financial statements. Our responsibilities do not extend to any other information.

Basis of opinion We conducted our audit in accordance with International Standards on Auditing (LIK and Ireland) issued by the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant t o the amounts and disclosures in the financial statements. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the financial statements, and of whether the accounting policies are appropriate t o the company's circumstances, consistently applied and adequately disclosed.

,

We planned and performed our audit so as t o obtain all the information and explanations which we,. considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud o r other irregularity or. 3 ,

"

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN r w , I n ~ [ > AYD W L I ~ S

Section 4: Concluding and I-epo~.tingon ass[ll-anrc cl)gagellic.nrs

d

err-01-. In forming o u r opinion we also evaluated the overall presentation of information in thefinancial statements.

Opinion In 0111- opinion the financial statements give ;Ltlue and fail- view in accordance with United Kingdom Generally Accepted Accounting PI-actice of the state of the company's affairs as at 3 1 December 2 0 x 1 and of its profit for the year then el~ded.The financial statements have been properly prepared in accordance with the C o r n p o ~ i ~ eAct s 1985. The infol-niation given in the Dil-PCLOI-S' Report i s consistent with the financial statements. Able & C o

(a)

Explain the meaning of and the purpose of including each of the phrases underlined above.

( 1 3 marks) (b)

Descl-ibe the objectives of requiring unqualified audit reports t o be published in a standard form.

(4 marks)

( 1 7 marks)

Described below al-e situations that have arisen in three audit clients of your firm.

Cardiff Corporate Engine Parts Ltd (CCEP) CCEP manufactul-es engine parts. Revenue for the year ended 3 1 December 20x3 was f 2 0 0 million, and net profit was f 17 million. H M Revenue & Customs has launched an enquiry that is still underway. It is n o t possible t o ascertain at this stage if a tax liability will arise in this company. The directors have disclosed the enquiry in a note t o the accounts. They have also indicated a willingness t o make any further disclosures that you recommend. A tax specialist has advised you that the possible.range o f outcomes in respect of additional tax liabilities is between a zero liability and a f 2 0 m i l l ~ o nliability but, because o f the complexity o f the issues. she i s unable t o forecast the outcome.

Prime Volunteers Ltd

- a charity

Prime Volunteers Ltd has accl-ued f 170,000 for the purchase of a freehold property and recorded this liability within accruals in payables falling due within one year, and a corresponding expense in building costs in the income and expenditure account. The charity has n o t yet identified a property t o purchase and has not entered into a contract t o purchase a property. The draft financial statements f o r the year t o 3 1 March 2 0 x 4 currently show an excess of i n c o r n ~ o v e expenditure r of £700. he trustees of the charity refuse t o adjust the financial statements because they believe disclosure of a large surplus would inhibit their ability t o raise funds in the future.

Worldwide Ltd Worldwide Ltd exports a significant amount of its products and has a major distribution centre in an overseas country, which is at war with a neighboul-ing country. D u e t o the imposition o f travel restrictions i t was not possible f?r your firm t o attend the year end inventory count. The inventory at the overseas distribution centre at 3 2 0 x 4 represented 60% o f Worldwide ~ t d ' sinventory.

arch

(a)

Explain the reasons and benefits of auditors (i)

Completing a d~sclosul-echecltlist

(ii)

Carrying out a final analytical review

when they are conducting final checks or) the financial statements

74: l h j i i : d i ~ OF CHARTERED ACCOUN rANTS !k r \ C ' . > V ; > . > V 3 > $ , . V r <

QUESTION B A N K

(b) In respect of CCEP, set out the mattel-s you would consider as part of a going concern review.

(6 marks) (c) For each of the situations above, reach a conclusion on whether 01.not you would qualify the audit report. Give reasons for each conclusion and describe the effect on each audit report. Refer t o any additional reporting responsibilities arising in the UK. (1 0 marks) (20 m a r k s )

Vista plc Described below are situations which have arisen in five audit clients of your firm. The year end in each case is 30 September 20x2. Vista plc Vista plc, a supplier of retail display equipment, has included in its income statement immediately below profit after tax, an exceptional loss o f f 3.7 million o n the sale of a trade investment. This accounting treatment is not in accordance with accounting standards, which require the loss t o be taken into account in arriving at the profit o r loss before taxation. The pre-tax profit of Vista plc for the year ended 30 September 20x2 is f694,OOO. Expo Ltd Expo Ltd exports a significant amount of its products, and has a major distribution centre in an overseas country in which there has been a military coup. As a result of travel restrictions imposed by the military junta, it was not possible for your firm t o attend the year end physical inventory count. The inventories at the overseas distribution centre at 30 September 20x2 represented 75% of Expo Ltd's inventories. Pharm plc Pharm plc, a company engaged in the manufacture of pharmaceutical products, has extensive interests in an overseas country which requires pharmaceutical products t o be registered. The regulatory situation in that country is undergoing considerable change and Pharm plc does not expect t o obtain drug registration as quickly as originally anticipated. However, after carrying out the appropriate review, the directors have decided that Pharm plc has enough resources t o continue for the next 12 months. Additional funding will be required from that point, and the directors believe that this can be achieved by a further: issue of shares within the next 12 months. The directors have included a note to the accounts explaining the situation Mog plc Mog plc manufactures light fittings. Certain of its finished inventory lines are out of fashion and have a net realisable value which is f35.000 lower than their original cost. However, the directors have argued that,, overall, the net realisable value of the entire inventories exceeds original cost and that fashions may well change over the next few years such that the company can ultimately sell these lines above their current net realisable value. The pre-tax profits of Mog plc for the year ended 30 September 20x6 were f900,OOO. N e t assets and inventories on 30 September 20x6 totalled f I 0 million and f 4 million respectively.

Hubbard Ltd Hubbard Ltd is a family company which makes and sells medical syringes. The company's factory is ultramodern and conforms t o the appropriate hygiene standards. All of Hubbard Ltd's syringes are supplied sterilised and individually wrapped. Shortly before its year end the company's solicitors notified the company of an action being brought by a patient who had contracted gangrene in his right arm following a routine influenza injection. The patient is claiming that the syringe used by his doctor was contaminated. This patient will probably have t o have his arm amputated. The company's s o l i ~ j t o r sbeliive that the case will not come t o court for several months, if n o t years. In addition,they mention that the patient is also , . suing the doctor who administered the inlection. The patient concerned IS pressing for at least €500,000 in 1

8

.

,

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ICCI 4ND AV11 W 1 1 5

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Section 4: Concluding and I-eporting o n assurance engagements damages, an amount which i s material t o the financial statements. The directors of Hubbard Ltd do not intend to provide for the claim in this year's financial statements. However, a reference t o the action will be made in the notes t o the accounts.

(a)

i

'The loglcal extenston of audit deregulation would be t o allow shareholders in all companies of whatever size, llsted o r otherwlse, t o choose whether t o have an audlt. If the audlt were no longer a statutory requlrement, shareholders could decide for themselves what klnd of audlt sults thelr company and the commercial terms on which it is undertaken. This would solve the problems of value for money, expectation gap and independence at a stroke' Discuss the issues raised by this quotation and consider, reaching a conclusion, the advantages and ( 1 2 marks) disadvantages of there being a legal requirement for an audit.

(b)

List the conditions of the Companies Acts which have t o be satisfied in the UK before an unmodified (5 m a r k s ) audit report on annual financial statements can be issued.

(c)

In respect of the situations outlined above, reach a conclusion on whether o r not you would modify each ac~dltrepol.t. Give reasons for your conclusions and describe the potential effects on each audit I-epol-t. (20 m a r k s )

You are preparing for your audit planning meeting with the finance director of lronco Ltd, a company whose pi-incipal activity is the production of iron castings made t o customers' specifications. Although the company's revenue and assets are below the thresholds for statutory audit purposes, the company's bankers require the annual accounts t o be subjected t o a full audit. The company's revenue fell by 10% during the year ended 3 1 October 2 0 x 4 due t o the loss of a major customer, and as a result the company made an operating loss. However, the directors are forecasting a return t o profitability for the year ending 3 1 October 2 0 x 5 as they are currently negotiating contracts w ~ t h new customers. The draft balance sheet as at 3 1 October 2 0 x 4 indicates net assets of f 148,850, but current liabilities exceeded current assets by f 180,733. Details of current assets and liabilities as at 3 1 October 2 0 x 4 and 2 0 x 3 are set out below. Draft 20x4

Actual 20x3

f

f

( 1 80,733)

fl83,826)

Current assets Inventories Trade receivables Other receivables Current liabilities Borrowings Trade payables Other payables Taxation

N e t current liabilities

The company IS up t o date with VAT payments t o HM Revenue & Customs but has fallen behind wlth its payments in respect of payroll taxes. ',

.

THE INSTI IUTE OF CHARTERED ACCOUNTAN7 S Ih thC.1 4NI> 4UI\

15

,

', '

Requirements

(a)

Set out the benefits, other than the maintenance of its borrowing facility, t o the company and its management of having a full audit. '(4 m a r k s )

(b) '(i)

(c)

List ten indicators of going concern problems given in ISA 570.

(ii)

Explain the auditors' responsibilities in respect of going concern (including reporting ( 1 5 marks) responsibilities).

(i)

Identify, from the information pt-ovided above. t1icmattc1-swl;icti give cause for concern and explain why they give cause for concel-n.

(ii)

In respect of the issues raised in (i), identify the matters t o which you would direct youl. attention during the post balance sheet review.

(iii) Identify the different types of audit report which may arise fl-otn the concerns raised above and state the circumstances in which they are appropt-iate. ( I 9 marks)

(38 m a r k s )

IHE INSlITUIL

or CHARTERED ACCOUN IANTS I&

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Section 4: Concluding and reporting on assurance engagements

THE INSTITUTE OF CHARTERED ACCOUNTANTS
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ANSWER BANK

I

2

Fundamental principles o f ICAEW b

Framed in broad and general terms, the principles constitute basic advice on professional behaviour

b

Aimed at all members of the profession whether in practice o r not

Safeguards r e fees T o recognise t h r e a t b

Before acceptinglretaining audit, consider whether total fees represent 2 10% annual fee income (or 2 5% for listed companylpublic interest company)

b

Regularly review situation as client profile changes

T o offset t h r e a t b

b

3

Considel whether firm could be open t o criticism and either -

Refuse appointment, o r

-

Introduce safeguards, including independent review and disclosure t o ethics partner and those charged with governance

Must refuse assignment if total fees regularly exceed 15% of annual fee income (or 10% for listed company)

Reimbursement expenses b b

Professionally dangerous t o become involved in internal wrangle Encourage Edward t o resolve dispute

Otherwise b b b

4

Ask other directors for permission t o give information t o Edward Refuse request if pet-mission not given Duty of confidentiality prevents disclosure

Overdue fees b

Overdue fees constitute a self-interest threat t o independence (ES4)

b

Issue of unqualified report this year may increase chance of collecting overdue fees

b

Ideally arrange for settlement of the overdue fees

b

If not settled anfl fees are -

Significant In dispute

consider resigning from the engagement b

If do n o t resign apply appropriate safeguards (eg second partner review)

b

And notify ethics partner

L C THk INSrll U I L OF CHARTERED ACCOUNlAN1 S ~h~h<,lnrivnu.) WIIS

Sect~onI . Legal, e t l \ ~ 11 c a ~ l dcui ! ent ~ssucs

5

Safegua~ds

( I ) Yes

( 2 ) Yes

Despite family relationship ES2 only specifically bans immediate family members from owning shares. A n adult son is a close family member but not an immediate family member

b

Safeguards would be required

b

Brother-~n-lawnot def~nedas immediate o r close family member by ES2

b

Safeguards would be required

' T r u e arid fair' r a t h e r t h a n ' c o r r e c t '

6

7

8

9

)

All t~.ansactionscould not have been reviewed

)

Audit i s designed t o ensul-e that accounts are free from material misstatement

)

Sampling is used to identify a repl-esentative number from each population, but still a risk that I ~ C OI.C'C~ I 1te11isw o i ~ l dnot be chosen

b

To spec~fycorrect an aiid~r~ n e ~ n b eofl -staff would need to be present when each transaction was generated

b

Audic is not merely co~isideringentries in accounting records, but also consideration of systems and controls over- transactions to ensure these have been recorded fully and accurately

b

Judgement involved in the use of accounting policies and estimates

C o n c e p t o f assurance b

In an assurance engagement an assurance firm is engaged t o express a conclusion designed t o enhance the degree of confidence o f the intended users other than the responsible party about the outcome of the evaluation o r measurement of a subject matter (eg financial o r operational infol-mation, systems o r behaviour) against criteria.

b

The conclirsion i s an expression of assurance, o r comfort, about the subject matter which has been examined

b

Degree of con~fol-tgiven depends on amount of worl< performed by the assurance firm

b

It may be I-easonable assurance o r limited assurance

b

The greater the examination of the supporting evidence, the greater the degree of assurance provided

Points r e fraud

b

Duty is t o report on financial statements

b

N o responsibility as such t o detect fraud

b

An audit conducted in accordance with lSAs obtains reasonable assurance that the financial statements are free from material misstatement whether caused by fraud o r e r r o r

b

~ u d i t o kmay n o t find material frauds

b

Frauds involving collusion harder t o detect

b

Responsibility set out in engagement letter

b

Management is responsible for implementing and monitoring the system of control

B e n e f i t s of s t a t u t o r y a u d i t b b b

54

b

Independent confirmation of profits earnedlnet assets Assurance of compliance with Companies Acts Recommendations on systems via management letter I ).ItIN\ I I I U I h OF (:HAI?l FRED ACCOUN I A N l S

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ANSWER BANK Added credibility of accounts will assist negotiations with bank Reliable financial information for business decisions

b b

10 Arguments f o r i n d e p e n d e n t r e g u l a t i o n

b b b b

Public perception - self-regulation seen as cosy Institutes cannot be both trade assoc~ationand regulator Independence must be seen t o be central t o process for acceptability lndependent regulation means public accountability and transparancy Input of public Interest from outside profession

)

I I Expectation gap m i s u n d e r s t a n d i n g s b b b ) )

I2

Responsibility for preparing accounts lies with auditor Auditor's duty is t o detect fraud Auditors check all transactions Auditor certifies accounts in report as being correct Unqualified report guarantees going concern

Principal ethical issue Confidentiality ) )

b

Data and Lodge may perceive threat of disclosure/use of information Conflict of interest for audit firm Difficult t o act in best interest of both clients

Procedures )

b )

b )

b

Ensure staff are aware of confidentiality issues Staff t o certify they are aware o f procedures Obtain informed consent of both clientslinform both clients Use different partners and teams lndependent review of arrangements for ensuring confidentiality maintained Information barriers in place (Chinese walls)

13 Benefits T o t h e bank )

b )

Reduces uncertainty as t o reliability o f the information/increases credibility Reduces the risk of management biaslindependent Enables bank t o determine risk in advancing more money t o Royale

T o Royale

b

Enables them t o obtain the overdraft which may not be possible without the report

Limitations T o t h e bank

I I

I

I

1

I4

b

N o t all receivable and inventory balances will be looked at by your firm

)

Possibility of collusion o r misrepresentation

b

Evidence likely t o be persuasive rather than conclusive/assurance n o t absolute - reasonable o r limited level of aeurance depending on scope of work

b

Report may not highlight full extent of problemllack of sufficient information

b

Inherent limitations o f accounting systemlintegrity of data

Reasonable assurance

b

Objective i s a reduction in assurance engagement risk t o an acceptably low level in the circumstances

b

Conclusion expressed positively

THE INSTITUTL OF CHARTERED ACCOUNTANTS h IW,LAND ANDWALl\

55

Section I : Legal. e t l i ~ c a land cul-I-ent issues High level of assul-ance

b

'In o u r opiiiion. . . . . . . . ..'/TI-ue and fair 1

N o r absolute level of assurance

L i m i t e d assurance

r

Oblective is a I-edirctlon in assurance engagement I-islc t o a level that is acceptable i n the c~~.cumstances but wliere the risk is greater than for a reasonable assurance engagement C o n c l ~ ~ s i oexpressed ri negatively 'Nothing has come t o o u r attention.. . . . ..'

b

15

16

IAASB pronouncements b

Ilite~.nauonalStandards o n Auditing (ISAs) - applicable t o audit engagements

b

Intel-national Standards o n Review Engagements (ISREs) -applicable t o review engagements

b

Intel-nar~onalStandards o n Assurance Engagements (ISAEs) which are n o t audits 01-reviews

P

Intel-national Standards o n Related Services (ISRSs) - applicable to, o t h e r non-assurance engagements

b

I n t e ~ m t i o n aStandards l o n Quality C o n t r o l (ISQCs) - applicable t o all engagements carried o u t i ~ n d e lany - of the IAASB's standards

- applicable

t o assurance engagements

Benefits o f statutory audit b

Can assist management in financial reporting process - eg advice r e h o w t o maintain accounting I-ecords and prepare financial statements

b

Helps instil better discipline o f maintaining accounting data o n an ongoing basis

b

A u d i t opinion may give financial statements extra credibility w i t h outside parties (eg bankers)

b

External auditor (EA) can pass o n experiencelknowledge t o help directors discharge statutory/fiduciary duties (eg advice o n safeguarding assets)

b

EA advice on internal controls can assist in reducing risk profile o f company (eg advice o n forecasting techniques)

b

EA may help improve company efficiencylperformance (eg advice o n better inventory c o n t r o l systems)

b

M o r e reliable financial information will result in m o r e informed business decisions

17

18

b

Self-interest

b

Fear o f losing the clientlfee dependency

b

Self-review

b

Provision o f n o n audit services such as tax and accountancy w o r k

b

Intimidation,

b

Pressure n o t t o qualify r e p o r t by dominating personality a t the client

..............

Practice loans - w h y p r o h i b i t e d b

Loan f r o m - w o u l d make practice financially dependent o n client independence as firm w o u l d feel obligated t o the client

b

Loan t o

a u d ~ t o could r avoid qualifying because o f concerns about recoverability

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+ could jeopardise

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1

ANSWER BANK 19 Threats t o independence a n d safeguards M,rs W a l l a c e b

Self-interest thl-eat

b

Trustee intel-est held by a pel-son in a position t o influence the audit is only allowed by ES2 where -

-

)

MI-s Wallace not a beneficiary of the trust The financial interest held by the ti-ust in Racdale Ltd is not material t o the trust Trust is not able t o exercise significant influence over Racdale Ltd Mrs Wallace does not have significant influence over investment decisions made by the trust

Therefore transfer audit I-esponsibility t o another partner

Mr Netwater

20

b

Familiaritylself-interestlintimidation threat

b

Should be removed immediately from audit role

b

Review of the audit wol-I< pel-formed by MI- Netwater in the current and, where appropriate, most recent audit

b

Firm should reassess composition of audit team

Money laundering b b b

21

Report t o nominated officerlmoney laundering reporting officer in your firm Report t o SOCA Avoid tipping off

Accountant's r e p o r t o n p r o f i t forecast Comment b

Negative assurance which is limited assurance

H o w it differs b

Audit provides high level of assurance which is reasonablelnot absolute assurance

b

Opinion expressed in positive terms -

Give a ti-ue and fail- viewlproperly prepared in accordance with Companies Actldirectors' report consistent

W h y it differs

22

b

Financial statements are based on fact as well as judgement

b

Persuasive evidence available

b

Often the delay between balance sheet date and audit report means that even items such as provisionslestimates can be substantiated

b

Scope of work on forecasts is limited as forecasts at-e based on assumptions about the future and as such are subject t o uncertaility

Responsibilities A u d i t o r responsibilities b

N o I-esponsibility t o prevent fraud

b

Responsibility t o detect material misstatements in the financial statements whether due t o fraud o r error

b

Must design audit procedures t o obtain reasonable assurance that financial statements are free from material misstatement whether caused by fraud o r error

b

Must make report t o relevant authority under money laundering regulations

b

Must not tip-off sales manager THE INSTITUTE OF CHARTERED ACCOUNTANTS IN tNCLlND AND W A i t S

Section I : Legal, ethical and current issues M a r l a g e r ~ ~ eresponsibilities nt Responsible for preventing fraud Responsible for detecting fraud Must implement system of internal control suitable for the business and monitor such systems Responsible for safeguarding the assets of the company

b b )

b

23

I S A 250

- additional procedures in U K

b

Obtain a general understanding of procedures followed t o ensure compliance with relevant legal fl-amewot-I<

b

Enquire of management whether they are on notice of any possible instances of non-compliance

)

Written representations t o include actual o r contingent consequences of the non-compliance

Differences r e w h e n should c o m m u n i c a t e w i t h o u t delay ISA 250 says when intentional and material UK (ISA 250 para 33- I ) - when material or believed t o be intentional

b

b

24

Steps r e non-compliance b

Fully docunlent findings

b

Discuss with directors

b

Fo~.mallyrepot-t findings t o directors

b

If directors involved, report t o audit committee or take legal advice

b

Report to appt-opriate 3rd party authority Where statutory duty (eg money laundering, arms export controls) 01in public interest

--

)

25

Resign. as last resort and make statement of circurnstances on resignation

Non-compliance w i t h D a t a P r o t e c t i o n A c t Risks b b

b b

Civil liab~litiesto victims of non-compliance Statutot-y fines and penalties Loss of reputation for security and integrity Loss of licence t o operatelforced closure

A u d i t implications b b

Possibility of unrecorded liabilities or undisclosed contingent liabilities Going concern implications

Marks (a)

Benefits (each) Maximum (b) Nature of assurance Level of assurance provided by forecast How it differs Why it differs Available Maximum Total marks available ............................................

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ANSWER BANK (a)

Benefits of audit b

The credibility o f financial infot-mation would be enhanced.

b

Enhances the value o f accounts f o r business valuation purposes in the event o f a sale.

b

Authorities such as HPI Revenue & Customs can have mot-e faith in the figures.

b

Avoids the future cost o f extra WOI-lc by the auditor- when audit exemption limits are exceeded.

b

Avoids a potential future qualification over the oper~inginventot-y figure.

b

Makes it easier t o raise finance.

b

May act as a deterrent t o fl-audlmanagenient abusing assetsireduce I-isle o f management bias.

b

More reliable information results in m o r e infornIcd dccisions.

b

Provides managetnent/shareholders w i t h assul-ance that the f~nanc~al statements are true and fairlprepared in accordance w i t h accounting standards.

b

By-products o f the audit such as identification o f wka~enessesand recon~mendationsshould reduce rislc and inipl-ove pel-fol-mnncc (nlanagement Icttcl-)

b

Imposes discipline o n management and accounts staff if they k n o w that the figures will be subject t o third party scrutiny, and therefore encout-ages best practice.

b

Gives management comfol-t that they are conlplying w ~ t htlie~t.PI-ofessional responsibilitieslthe 1 Act. accounts conlply w i t h the Con~pon~es

(b) Report on forecasts Nature of the assurance b

Forecasts have been prepared in line w ~ t hstated assumptions and are prepared in accordance with the relevant financial reporting frameworlc

b

The accounting policies used are consistent w i t h the annual financial statements

Level of assurance The level o f assurance would be limited and the conclusion w o u l d be expressed negatively ie "Based on our examination o f the evidence suppol-ting the assumptions, nothing has come t o our attention which causes us t o believe that these assumptions d o n o t provide a reasonable basis f o r the forecast".

How it differs i

An audit provides reasonable assurance which is a high level o f assurance and is expressed positively ie 'in our opinion the financial statements give a true and fail- view'.

! In a reasonable assurance engagement, the level of risk is reduced t o an acceptably l o w level in the circumstances. In a limited assurance engagement the risk is reduced t o a level that is acceptable in the circumstances, but is greater than f o r a reasonable assurance engagement.

Why it differs Financial statements are a combination o f histot-~calfact and judgement which often involves estimates. However even where there are estimates some c o m f o r t can be derived f r o m events after t h e balance sheet date.

j

Forecasts are estimates which are subject t o uncertainty.

THE INS IITUT E OF CHARTERED ACCOUNTANTS Ih tljCLAN0 IYDU'AL[S

Section!: Legal, ethical and current issues

Marks (I)

(2)

(3)

Responsibility for detecting fraud Current situation H o w it might be changed Case for change Case against change

Maximum available Provision of non-audit services Current situation H o w it might be changed Case for change Case against change Maximum available Period of time for which auditors can act for a client Current situation H o w it might be changed Case for change Case against change

Maximum available General Confidence and credibility

(I)

Responsibility for the detection of fraud Current regulatory and professional requirements

Auditors are not responsible for the detection of all fraud - it is management's responsibility t o detect fraud. The auditors' responsibility is discharged by planning, performing and evaluating their work so that they obtain reasonable assurance that the financial statements are free from material misstatements due t o fraud. Possible changes

The auditors' responsibility for the detection of fraud could be extended by requiring them t o perform specific (limited scope) procedures.

,

Case for change

This would narrow the expectation gap in respect of the auditors' duty in relation t~ fraud dbtection and this higher priority would be a greater deterrent t o fraud. Case against change

It would result in ~ncreasedcosts owing t o additional w o r k and also increased cost of professional indemnity Insurance due t o extended exposure t o litigation. P

I t may also n o t be feasiblelpracticable due t o the inherent limitations of an audit.

8 THE INSTITUTE OF CHARTERED ACCOUNlANTS Ih $\LLhNO

iU0 W\IL\

ANSWER B A N K

Provision o f n o n - a u d i t services to a u d i t c l i e n t s

;

Current regulatory and professional r e q u i r e m e n t s Some non-audit services are permitted as long as objectivity would not be perceived to be impaired and safeguards are in place. However

b b b

Fee levels must be appropriate Accounts must n o t be prepared for listed companies Auditors must advise only and n o t make management decisions

and certain non-audit services have effectively been banned by the APB's Ethical Standards (ESs), for example

b

Internal audit services where heavy reliance would subsequently be placed o n the w o r k of internal audit

b

Valuations which have a material effect o n the financial statements and involve a significant degree of judgment.

Possible f u r t h e r changes The provision of all non-audit services could be banned. Case for c h a n g e This would negate the threats t o objectivity, in particular

b b b

Fear of losing fee Reluctance t o r e p o r t adversely o n o w n firm's w o r k Insufficient rigorous checking of colleagues' work.

It would discourage lowballing - the practice of quoting a low audit fee in order t o attract more lucrative consultancy work. The use of a different firm may provide a different perspectivelskill sets. Case against c h a n g e Such action could I-esult in b

b b b

A lower quality o f services (the auditor would n o t be in possession of the whole picture) Increased costs due t o a lack o f pooling o f bacl
It may also impair the ability of firms b

To recruit high calibre personnel w h o value the broad-based training provided by firms undertaking a variety of services

b

To audit tax and computer systems

b

To draw upon the wider intellectual capital which currently exists in firms.

Period of t i m e for w h i c h a u d i t o r s c a n a c t for a c l i e n t C u r r e n t r e g u l a t o r y a n d professional r e q u i r e m e n t s Auditors are appointed f r o m the conclusion of the A G M t o the conclusion of the next A G M with n o limit on the number o f reappointments. There are professional requirements in ES3 which d o n o t allow the engagement partner o r other key employees t o act for a continuous period of

b 1 b

More than five years (listed clients) More than ten years (non-listed clients) unless reasons for continuing are documented and facts communicated t o those charged with governance More than seven years (key audit partners for listed clients).

THE INSTITUTE OF CHARTERED ACCOUN l A N T S IN INGLINO &ND WALES

Section I: Legal, ethical and cul-rent issues Possible further changes Fixed-term appointmentslniandatory rotation (of audit firms, as opposed t o audit partners) could be introduced. Case for change There i s currently a risk of familiaritylcomplacency - auditors who get too close t o their clients may lose their independence, objectivity, scepticism and become complacent. Rotation stimulates the auditors' courage and independence because there is no expectation of a longterm relationship and hence they do not fear dismissal. Case against change Recurring fil-st-time audits are likely to ) )

Be disruptive t o clients (process of selectionlanswering questions, etc) Result in increased costs (introducing new auditors is costly t o the client as the team builds detailed knowledge of the client, its business and the ltey issues in its financial statements).

However, the understanding and experience of long-term complex issues where the auditors' expertise is needed most is lost o n rotation. Rotation can discourage auditors from specialising t o the required depth, thus limiting the choice of available altei-natives. However, there would be increased risk due t o first time audits, as auditors may miss things due t o their lack of experience with a particular client. General If users perceive auditors t o be free from influence they will have more confidence in the audit process and financial information will have greater credibility.

.....

i iie !:r:~i,iuci~ of :.ic;r\-:ludic serviccs was tile best ;:.nswec-ecl part of the qtlesriol.i, and the detectioi?o i I!! ~ d ,.,, c ri.e 'casr we;\ ;:r:s\h;c?t-ed par-t. l i ~ i.elation LO the detecrion of finitd. the ir>or;tcornrncn oir>issior~s wet-e t ~ i cli!vt-t; LC:, cor>ii(jerthe: expectitcior.1gap 2nd t t ~ eiricre;tsed'exposur-e co Iitigcitiorl rllac v ~ o i I d~ C L U I T ) ~ ; I ! I ~ ::li c.?x:i.i.!slc:?s% ~ ! i : j i t ~S' i :-esp:.)rlsrbility iirld its lil
,*.

-

<,..

i t . z i : ~ i . 4 ~,tgi:ifiiari!: n~.:nit)et.of cantliclntes were nllable to dist.inguis!i between audit film I-otrrtion Ifil.iii
.:if

Z I I ~ ;!:i.:!t

THE I N S T I T U T t OF CHARTERED ACCOUNTANTS Ih lUGl AND i U i ) iWAlt5

ANSWER BANK

5;

C..

1..

8: :. . Alpha pls ('.: I"

6:

$. ,.,

a.

- , !Y<, ( 1

r

--

...,.. .

.....

7

Marks

...: (a) ..

.

Listed company implications Integrity o f management/money laundering Identification and explanation of self interest threat ldentification and explanat~onof self revlew threat Conflict of interest and conf~dent~ality Safeguards - general Safeguards - consultancy services Safeguards - competltolarks available . Maximum

: :! :i .

f:', ,. .,

" ,,

8'

*

1

?A + ! ,. (I,

pj : k-:

I%

-

1 71/2

b)

Level of assurance How it differs Why it differs Marks available Maximum Total marks available

i' 9:

(a)

6 20

Professional a n d e t h i c a l issues a n d safeguards Issues

B

A listed company poses a greater threat as there is Increased risk due t o greater public interest.

@

Any question marks over the lntegrlty of management can mean potent~alfor money laundering and

*,fraud.

.8':

3.t

'11both audit and non-audit services are provided, the following issues anre.

ci

g:::; ,

.

)

A self-interestlfee dependency threat arises. Because of the fear of losing a large client, the

@-?;-' r!',:b,

auditor may be tempted t o turn a blind eye and issue an unqualified report when a qualified one

,,+,

should be issued.

$.<. g. <.I

a kY.7 !

b

:.,

A self-review threat arises when assessing the adequacy of internal controls over the new financial information system, as the auditor may be reluctant t o report

7 .;

5

-

Problems related t o the new system

-

Errors subsequently identifled in i n t e r ~ maccounts.

?

)

A management threat arlses In respect of the w o r k o n the system.

f!: .

b

ES5 does not allow the audit firm t o undertake w o r k on designing, providing o r implementing IT systems for an audit client where

,il.

i!

".,

-

The systems are a significant part of the accounting systemlsignificant t o the production of the financial statements, o r

-

For the purposes of the IT services the audit firm would undertake part of the role of management.

Because the firm also acts for a major competitor, the following Issues arise. )

Ei ,

Acting for a competitor may result in a conflict of interest such that the auditor may not be able • t o act in the best interests of both parties.

THElNSTllUTE OF CHARTERED ACCOUNTAN 15 IN IPIGLhND &YO W,\LlI

'

63

Sect~onI : Legal, erh~caland cul-rent ~ssires The auditor will have ~ccessto confidential information which is not in the public domajn - this infot-mation must be pt.otecced.

b

Safeguards General b

Obtain professional clearance from the rptiring auditors.

a

Separate engagement letters must clearly set out management and auditor responsibilities for each assignment, the scope of worlc, the content of the reports and the level of assurance provided. b

Ensure that fees do not exceed the recommended threshold (10% for listed company).

b

Confirm in writing t o those charged with governance that appropriate safeguards are in place.

b

Independent partner review of the audit.

Consultancy services (if i t i s acceptable to act at all) b

'Informed ~nanagelnent'is designated by Alpha plc.

b

Management must acl<nowledgein writing that they take responsibility for the overall system of internal control.

b

Rigorous review of the system by the audit team.

b

The audit firm must not make o r appear to make management decisions.

b

Separate teams and partners.

Competitor b b

The cit-cumstances should have been disclosed t o the client. Informed consent of both clients must be obtained. Chinese wallslinformation barriers established. Staff t o certify they are aware of these procedures. Separate teams and partners.

b b b

(b)

Mi

tb)

Irr P k,

The report on the interim financial information Level of assurance provided

Im P

The I-eport on the interim financial information will provide limited assurance.

, i

A conclusion will be expressed in negative terms, ie 'we are not aware of any material modifications that should have been made to the financial information

. . . I .

Max

Total qvail;

H o w i t differs from the level of assurance provided by the statutory audit report An audit provides a high level (but not absolute) assurance. The opinion is expressed in positive terms. ie 'give a true and fair view'and . . . have been properly prepared in accordance with the Cornponies Act 1985'.

Why it differs The wot-lc involved in an audit is more rigorous.

..

,),!

A review excludes

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Tests of contt-01s Tests of detail Going concern review.

b b

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ANSWER BANK ?,

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!:or Many :a~~diclnrcsi15cc:I the safegun1.d of ,CIIIII~SC: ~..i/i:;'i~:?.i!:,::: i:,>ji!;i:!:!ly :I~I,! 2'. 2:.- appreciate that this safeguard i s only appl-opriarc wl?cl-e ~cilfidentialityi c 1:;: ::!::::?;!iii.A s!gl~~ii<.ar!r !!ui?lgt.!. C

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Fees threats and safeguards Long association - threats and safeguards Add~tionalserv~ces- threats and safe~uards Conflict o f interest

2

Former employee - threats and safeguards

g... kJ:

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(b)

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Maximum available I m p l i c a t i o n s f o r firms b N o n audit services

2

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2

b b

2% 2%

b

N o n audit services Mandatory rotation

9

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Max~mumava~lable

g:

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r(a)

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Ethical and p r o f e s s i o n a l issues a n d m e a s u r e s t o b e i m p l e m e n t e d t o m i t i g a t e a n y t h r e a t s t o objectivity

b The fact that this client generates the

b

largest fee Income and addit~onalservices are p r o v ~ d e dgives rlse t o a fee dependencytself-interest threat. ---b Fear of losing such a large fee may influence

Regular review should be performed t o ensure that regular fees are b e l o w recommended thresholdslthe firm's o w n threshold

b

Per ES4 regular fees must n o t exceed 10%

b Acting for a client f o r 20 years gives rise to

b

Periodic r o t a t i o n o f senior staff.

$b:1:, ,

,

familiarityltrustlcomplacency threats.

rHE INST11UTE OF CHARTERED ACCOUNTANTS IN LKCLAND AVD W A I C I

Section I : Legal, ethical and cut-rent issues

b

The auditors may be over-~nfluencedby the pel-sonality and qualities of the directors and management, and consequently too sympathetic towards them

b

The audit01 s may become too trusttng of management repl-esentat~onsso as to be insufficiently r~gorousin testing them because they are too fam~liarwith the issue.

b

The provision of additional services also gives rise t o A self-review threat - the auditors may be reluctant t o challenge adversely the outcome of a previous engagement or report on colleagues' worlc

-

-

A management threat (I-e tax planning)

b

Per ES4, if Mart plc is a listed company, engagement partners are required t o be rotated after five years, extended to seven years for key audit partnerslsenior staff.

b

The use of different teams with separate reporting lines.

b

Independent partner review of the audit.

b

'Informed management' t o be designated by Mart plc. ,

b

N o management decisionslrole t o be taltenlpel-ceived to be taken.

- Possible lowballing - a low audit fee may be set in order to retain lucrative consultancy work. b

Valuation services (which may form part of the consultancy work) are not pel-mitted by ES5 where the valuation would both -

Involve a significant degree of judgment, and

-

Have a material impact on the financial statements.

b

There IS a conflict of interest by acting for individual directors and the company - the firm may be tempted t o favour one party at the expense of the other

b

Use of different personnel t o act for the individual directors.

b

A former employee having joined the client

b

Assess the composition of the audit team in the light of this (may need t o remove team members who havelhad a close association with this ex-employee).

b

Quality control procedures should be in place to ensure a healthy professional scepticism at all times.

in the last two years gives rise t o - A familiarity threat (too much reliance

on representations of former employee) - A former self-interest threat (as

manager this person may have been too sympathetic) -

(b)

Intimidation threat.

- . ..

-- - - -- ---- - -

--

Implications for audit firms and their clients if the provision of all non-audit services to audit clients i s banned and mandatory periodic rotation of audit firms is introduced Audit firms Non-audit services Although a ban on the provision of non-audit services removes the threats t o objectivity, it may impair firms' ability to

b

Recruit high calibre personnel who value the broad-based training provided by firms undertaking a variety of services

b

Audit tax and computer systems

)

Draw upon the wider intellectual' capital which currently exists in firms.

THEINSIITUIE OF CHARTERED ACCOUN IAN I S th F\C,\ .',X!> \Vl, \V.\lt<

4, .

' .

ANSWERjBP

Rotation stimulates the auditors' courage, and independence because there is no expectation of a longterm relationship (ie they do not feat- dismissal). However, there will be increased risk due t o the number of first time audits as the auditors may miss things due t o their lack of experience with a pal-ticular client.

Their clients Non-audit services The use of a different firm may provide different pel-spectiveslsl
b b

A loss of conveniencelone-stop shop A lack of comfort from having all services provided by one trusted source.

b b

Be disruptive t o the client (process o f selectionlanswei-ing questions) Result in increased costs (introducing new auditors is costly t o the client as the team builds detailed knowledge of the client, its business and the Ikey issues in its financial statements).

Moreover, the accumulated cunlulative Imowledge and experience of long term complex issues where the auditors' expertise is needed most, i s lost on rotation. in~ [he required d e p ~ h chus . limitin2 the choice of Rotation can discour>g~> c i , r = r s frsm s c ~ c l > _ l i str, an:!z_; 5 ;:r--l; ,es 1: 1 - 5 : 5-1,

xaminer's con~rrlerlts

tiorl, rn;\ny did not identify thc ti)? dii-ecr:c-)rsns individuals

.

t ar-ld tho~rgl-:~ [h;~t.h e was ;jbuc.lt,:.! join, ii-lst~.>d cf ;!l!.e;idy I?;ivi~ij;j!:rirlr?(j, the cliet:t, 211(:1 conseqtlently indicated rl.~ati1i- siio!~ld be ~.el!l~ivcd fr-orn rl.!? ;iaeir. !e::rr,.

THE INSTITUTE O F CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

Section I: Legal, ethical and cur-rent issues

Marks (a)

Directors' responsibilities Auditor's responsibilities Discharged - directors Discharged - auditors Marks available Maximum

(b)

Each question Maximum Use of question format Maximum Total marks available

(a)

Distinction between the responsibilities of management and the statutory auditor for the prevention and detection of fraud and how these responsibilities are discharged Responsibilities The directors are responsible for the prevention and detection of fraud. The auditor has no responsibility for the prevention of fraud. However, the auditor is responsible for detecting material misstatements in the financial statements resulting from fraud.

How discharged The directors should implement a system of internal control.suitable for the size of the-entity and monitor that system of internal control. The auditors should plan, perform and evaluate their work so that they obtain reasonable assurance that the financial statements are free from material misstatements due t o fraud.

(b)

Questions re internal control procedures over purchase and payments system b

Is there segregation of duties between -

-

Authorisation of orders Processing of orders Suppliers' master file amendments Authorisation of invoices Processing of invoices Cheque, requisition Signing of cheques/transmission of details to bank Reconciliation of creditor accounts?

b

Are duties rotated (do all staff take holidays)?

b

Is access to supplier detailslrecords restricted, in particular -

-

Password protected, and Passwords changed periodically High level password required for amendments to standing data?

THE INSTI l U T E OF CHARTERED ACCOUNTANTS IN ENGL"NDn*lo whirs

ANSWER BANK Are amendments t o standing data -

-

Recorded on standard forms Authorised by responsible official Printed out and checked t o authorising document Periodic one-for-one checking of suppliers on master file with independent list?

Is a list of all approved suppliers maintained and reviewed on a periodic basis! Are purchase orders checked t o agreed supplier prices and approved! Are large purchases over a predetermined limit approved by senior management and limits placed on amounts! Are goods received checked t o purchase orders? )

Are GRNs sequentially numbered with regular review of sequence?

)

Are invoices matched t o GRNs prior t o being authorised?

)

Are prices, additions and calculations on invoices checked!

)

Are invoices authorised prior t o posting t o the ledgerlpayment!

)

Are batch totals used when entering invoices?

)

Are there periodic reconciliations of payables accounts t o suppliers' statements?

)

Is access restricted t o cashlcheque books, bank transfer facilities!

)

Are two signatures required on cheques over a specified limit!

b

Are bank reconciliations performed on a periodic basis?

)

Is there budgetary control o n a departmental basis?

)

Is there a purchase and payments procedures manual?

Examiner's cormrmerlts Answers to this question zchieved the highest average ~narl< on the W T scction. Answers t o part (a) generally tended to be stronger than answers t o par-t jb). Answers to part (a) were genelally good, with a significant number of candidates attaining rnaximurri ~na~.l<s. The point rtlost conitnonly overlooked was in respect of the directors' responsibility t o monitor the system of internal control. A significant nurrlber of candidates niisunderstood 'discharged' and wrote about how Weaker candidates wasted time writing about auditors should cornrnunicnte their re~~onsibilkies. directors' wider I-esporrsibilicies(clg pt-epal-ation of accounting records and financial statements) I-athcl- rtinn focusing on the prevcntioii and detection of fraud as 1-eqt.rired by the question. Tliose candidates who scored high marl<s on part (b) tended t o adopt an approach whereby they identified the rnaio~stages of a purchase and paytrlel.lts cycle and asked questions about the controls t o be exercised at each stage. The rnost conirnonly overlooked points were those relating t o access t o supplier details and amendments t o standing data. Weaker candidates confused the purchase and payments cycle with the sales and receipts cycle, and consequently listed irrelevant q\.rcstions. A minority of candidates did not use a question format and m e ~ e l ylisted internal controls, thereby missing out o n the question format mar-I<.

THE INSTITUTE Of CHARTERED ACCOUNTANTS IN IhCLAND AND WAICS

Section I : Legal, ethical and current issues

+

Marks (a)

(i)

(ii)

Each question Maxirnu~n Use of question format Maximum Controls over expenditure Controls over payroll Budgetary control Personnel controls Internal aud~t Marks available Maxi~iium

(b)

Auditor's responsibility Directors' expectations Public perception Beeches Technologies as an example Marks available Maximum Total marltr available

(a)

(i)

Questions to ask re fraud How was fraud discovered? (What group has done t o ensure full extent of fraud discovered? What breakdowns in control made fraud possible? -

Who authorised payments? Why not identified by review of subsidiary results? Any previous concerns about individual's behaviour? References for individual obtained and reviewed?

.

..

How was fraud perpetrated? How were fraudulent transactions hidden? What action is to be talcen t o recover monies from individual?

Is the conipany insured against fraud? What action has group taken t o preventiidentify other similar frauds? What controls put in place? Any specific review procedures t o look for other similar occurrences? Any other subsidiaries where have specific concerns? Consideration of collusion D o they have specific concerns about prior year audit teamlprocedures? What are management's expectations of audit visits t o overseas subsidiaries?

T H t INSTITUTE O F CHARTERED ACCOUNTANTS ?kI \< I A N 0

,'"

1 ,%,I, c

ANSWER B A N K

(ii) Expected controls Appropriate authorisation of expenditure

b

-

Group authorisation for significant or unusual expenditure Dual cheque signatories Review of supporting documentation by cheque signatories ' Appropriate authorisation of electronic funds transfers Control of passwot-dsfor electronic transfers Control of access t o bank account details on supplier masterfile Review of changes t o supplier masterfile details Segregation of duties between posting and payment (with explanation) Proper bank reconciliations Lines of communication for whistleblowing

b

Controls over access t o payroll data on computer

b

Review and authorisation of employee expense claims

b

Review of payroll masterfiles changes

b

Review of costs incurred against budget on a sufficiently detailed basis t o identify inappropriate expenditure -

-

Obtain and verify explanations for variances Review at group as well as local level Comparison to other subsidiaries Rationalisation of costs such as commission when compared t o sales Rationalisation of payroll costs compared t o headcount Items checked t o ensure business expenses

b

Rotation of staff between subsidiaries ,

b

Ensuring staff take holidays

b

Obtaining references for staff

)

Internal audit department reviews

(b) Discussion of expectations gap Auditor's responsibility

b

Aiming t o identify a material misstatement of the financial statements -

)

'Watchdog, not blood-hound'

b

N o responsibility t o seek out immaterial fraud Should report i t t o management once identified

Expectation that will raise management letter points where control weaknesses noted

b

This includes material fraud A material fraud would result in a qualification of the audit report

Much more lilcely t o identify such wealcnesses if controls based audit

N o obligation to prevent fraud

Directors' expectations b b )

b b b

Lot of focus on balue added Auditors 'promise' relevant management letters Also expect consistent quality and approach at different locations Often rely on auditors for monitoring they should do themselves Should ensure aware of locations which will not be visited Audit could be deterrent

t

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALE\

Section I: Legal, ethical and current issues Public perception b b b b b b

General perception that aud~twill find fraud Indeed often seen as primary purpose Implicit assumption that auditor has been negligent if fraud not found Implicit assumption that auditor should report discovered fraud to external agencies (would breach auditor's duty of confidentiality) Auditor typically blamed N o concept of materiality

Example o f Beeches Technologies plc b b b b

b b

72

Fraud was not material to group Therefore no requirement for group auditors to design audit processes which would be expected t o identify it Local entity did not require an audit Should lool< at what management letter points were raised in past re control over overseas subsidiaries Would expect controls based approach given number of small subsidiaries and geographical, spread Management unlil<elyto want t o pay for audit work which included visits t o all subsidiaries

THE INSTI r u 1 b OF CHARTERED ACCOUNTANTS 8h. ,,<,I

.\N,> .,,v> ,v.s,,

\

ANSWER BANK

t

Short form q~..ses:;~:i:.,aus I

Information t o b e included b b b b )

2

Name of preparerldate of preparation Name of reviewerldate of review Clientlyearltitle Objectives of testIworl< Conclusion

Objectives of cold reviews b

Confirm appropriateness of audit reports -

3

b

All audit partners subject t o review

b

Review process must be independent of audit partners reviewed

b

Action taken where deficiencies found

Working paper r e m a t t e r o f judgement

b b b b

b b

4

5

Facts known at time Criteria determining outcome of judgement Reasoning fot- conclusion Conclusion reached When and with whom the discussions tool< place Cross references t o other supporting documentation

Considerations b

The integrity of the principal owners, management and those charged with corporate governance

b

Whether the engagement team is competent and has necessary time and resources

b

Can the firm and engagement team comply with ethical requirements (eg independence,

Principal items b b b b b

6

Audits conducted in accordance with Auditing Standards Firm's procedures followed

The objective of the engagement The scope of the work t o be carried out by the assurance firm The form of the report t o be deliveredllevel of assurance The responsibilities of the various parties involved The fact that due to the limitations of the assurance process, assurance cannot be absolute

Professional enquiry

b b b b b

b

Unlawful acts o r defaults by the client Serious doubts re client's integrity Information required by auditor being deliberately withheld by client Client's reasons for change not in accordance with the facts Important differences of principle or practice behind the proposed chsnge .;. A 'statement of circumstances' t o be brought to attention of niemberslcre~tors

i

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THE INS1I TUTC OF CHARTERED ACCOUNTANTS IN rvf,~AND nu(, WA!

ri

Section 2: Accepting and managing engagements

..?

i

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7

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rilitcri.
15 not

of itself a reason for not .~cceptingnomination.

Rights on removal

Copy of notice of resolution proposing removal Representations in writing notified to members Attendance at general meeting Hearing at general meeting

b b b b

8

Before accepting appointment as auditors Matters to consider b

Whether the going concern issue likely to be present for future accounting periods

b

Whether the going concern disclosures made were warranted

b

Whether Meldrew will give permission t o contact incumbent auditors

b

Whether current auditors agree with reason given by Meldrew fornot wishing t o reappoint

b

Likely independence from Meldrew and therefore able t o carry out objective audit

b

Nature of Meldrew's business -

Whether any special expertise required Whether have necessary expertise

-

Timinglresource requirements to be able to perform audit competently

b

Procedures to follow b

Discuss with directors current going concern status

b

Review prior year's accounts re whether going concern disclosures were necessary

b

Request permission to contact incumbent auditors

b

If permission refused decline appointment

b

Write to incumbent auditors enquiring if any matters that affect appointment of firm as auditors

b

Review response received for any relevant matters. Are their reasons for non-appointment in accordance with those of Meldrew?

b

If significant matters which affect appointment with which firm does not feel it can deal, then do not accept engagement

b

If incumbent does not respond, telephone or fax t o request a response. If no response is fol-thcoming, send a recorded delivery letter stating that 'no matters' will be assumed unless advised otherwise, within a specified time

b

In absence of any response, consider refusing appointment

b

Review prior year accounts t o ascertain amount of work likely to be necessary, whether any technical expertise likely to be required and probable level of fee income

b

Compare estimated time required with current resources to ascertain whether sufficient staff available a t required times

r

b

9

-

Compare estimated level of fee income with current recurring fee income to ascertain whether ethical limits ( 1 0% and 15%) likely t o be breached

Why recorded b

Evidence in case partner's judgement is questioned subsequently ($g defence in litigation)

b

Pat-titularly by a t h ~ r dparty who may have the benef~tof hindsight ll

7 4

R

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN

i'4.I AN!) I U I ) WALC5

ISWER BANK

To demonstrate:

b

- The relevant facts that were Iknown at the tlme he reached his conclusion -That, based on the facts. the conclusion reached was reasonable b

Facilitates review

b

Requ~redby Auditing Standards

10 Reasons f o r r e v i e w Confirm worlk properly recorded In accordance w ~ t h

b

-

.

F~rm'sprocedures (qual~tycontrol) Engagement plan

b

Confi~:mall contentiousljudgemental areas have been h~ghl~ghted for consideration

b

Assurance work carries duty of care t o client

)

Audit worlk carries duty of care t o 3rd partieslprotection against litigation

b

Aud~tIS regulated actlvlty and governed by lSAs

I I Functions o f a n a u d i t c o m m i t t e e b

Monitor the integriti of financ~al~ n f o r m a t ~ o n

)

Oversee the company's ~nternalcontrol and risk management systems

b

Monitor and review the effectiveness of the company's auditors

b

Monitor the ~mplementationof agreed auditor recommendat~ons

)

Facilitate communication between internal and external auditors

)

Set performance indicators for internal and external auditors

b

Make r e c o m m e n d a t i o n s in relation t o the appointment. re-appointment and removal of external auditors

)

Approve the remuneration and terms of engagement of the aud~tors

)

Develop and ~mplementa policy on the engagement of the external auditor t o supply non-audit services

b

Review and monitor external auditors independence

b

Feedback t o main board (including annual report o n its activities)

)

Oversee investigation of suspected fraud and value for money initiatives

THE INSTlTUTb OF CHARTERED ACCOUNTANTS IN I K L A N D INTI WAl[l

Section 2: Accepting and managing engagements

Marks (a)

Confidentiality Conflict of interest Safeguards , Intimidation Safeguards Marlts available Maximum

(b)

Rights Responsibilities Marlts available Maximum

(c)

2 I% 3% 3

Management's responsibilities Auditors' I-esponsibilities Maximum

(d)

Assertions (each) Procedure per assertion (each) Maximum Total marlts available

(a)

Professional ethical issues Co.nfidentiality Sleeper and Zelig may perceive threat of disclosureluse of information

b

Conflict of interest May n o t act in the best interest of both clients

b

Safeguards Ensure staff are aware of confidentiality issues Staff confirm awareness in writing Obtain informed consent of both companies Use different partners and teams Chinese wallslstaff assigned from different offices Independent review of arrangements for ensuring confidentiality maintained

b b b b b

h

Intimidation by management1 fear of losing a client Auditor may be forced into giving inappropriate opinion through fear management may remove them

b

Safeguards

h

Firm's own procedures for accepting new clientsldo not accept if threat t o o high Flrm's annual review procedures/revrew of threat t o independence Overall control environment within the audit firm Notify your firm's audit compliance princ~palof p'otential threat

b b b

THE INSTITUTE OF CHARTERED ACCOUN I A N I S 3,

ir!norl nu^^ wnl r 5

a

(b) Rights May make written representations Request management c~rculatethese to members Right to attend general meetlng Right to speak at general meetlng

b b b b

Responsibilities

(c)

b

Obtain written permission from client to discuss its affairs with new auditor

b

Reply promptly to incoming auditor's communication

b

Statement of circumstances specifying whether o r not any circumstances should be brought to the attention of the members or creditors

Duties Management b

Directors are responsible for the prevention and detection of fraud

)

Directors should implement a system of internal control suitable for the size of the entitylsafeguard assets

)

Directors should monitor the system of internal control

Auditors )

Auditor has no responsibility for the prevention of fraud

)

Auditor is responsible for detecting material misstatements in the financial statements resulting from fraud

)

Aud~torsshould plan, perform and evaluate their worlc so that there is a reasonable expectatlon of detecting materlal misstatements

$,

..

(d) Assertions and procedures Valuation

... .

)

1.

f'

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.. .

)

Trace sample of mobile phone inventory to supplier invoice Examine after date sales t o ensure stated at lower of cost and net realisable value Discuss with managemendreview sales after date for slow moving o r obsolete inventory

? -

Rights and obligations

r?'

b )

Consider whether any inventory held for third parties o r on consignmendsale o r return bas~s Confirm inventory fully paid for and owned by client

Completeness t

)

b )

b

Carry out cut off testing Consider other locationlinventory held by third parties Attend year end Inventory count Test counts agreed t o inventory records

Presentation and disclosure b

Review financial Statements t o ensure inventory correctly disclosed

r:

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[;?his answer is the marking plan produced by the examiner. The examiner has co~lfirmedthat the style of $.thisanswer is appropriate for use by students in the examination. $.;I

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THE INSTITUTE OF CHARTERED ACCOUNTANTS IN [hCI bNI1 AVi, iAsAlr\

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M:I k s Purposes (each) Maximum

(a)

I

Internal audit services Identification and explanation of self-review threat Discussion of degree of reliance Quality control measures (2) Advisory services Explanation of conflict of interest Quality control measures Marks available Maximum Total rnayks available

(b)

(I)

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(a)

"

2% 2 5

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2% 5 17 12

18 "

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............................

-

. . ... .

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Purpose of quality control measures b

b

b

To ensure engagements are carried out in such a manner that -

They meet users' expectationslprovide a reliable service

-

The worl< undertaken is performed t o a high standardlprovides value for moneyl~nan efficient and cost-effective manner

-

The requirements of Monitoring UnitslAuditing Standards are satisfied

-

They enhance the reputation oflincreases confidence in the profession.

To protect the assurance provider against -

Negligence claims

-

Disciplinary procedures

To ensure that engagements are only accepted for services for which the firm has the necessary competencies

(b) Ethical and professional issues and quality control measures t o mitigate any threats t o objectivity (I)

Gemini plc Ethical and professional issues b

External auditors are entitled t o rely on the work of internal audit provided they are satisfied with the standard of work (in particular risk assessment and evaluation of internal controls) (ISA 6 10).

b

Where internal and external audit services are provided by the same firm, a self-review threat exists.

b

The external auditor may place t o o much reliance o n the work of internal audit and not rigorously test that work.

b

Internal audit may gear its work towards enabling external audit t o reduce its workload. Yf

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENC,,

.wrl

AVI'

i v . ~IS

Section 2 : Accepting and managing engagements b

Pel- ES5 the self-review threat will be unacceptably high where the auditors cannot perform the audit without placing significant reliance on the work performed o n the internal audit services engagement.

Quality c o n t r o l measures t o m i t i g a t e t h r e a t s t o objectivity

b

The engagement t o supply internal audit services should only have been accepted where The auditors would not place significant reliance on the internal audit work performed by the audit team, and

-

The audit firm would not undertake a management role as part of providing internal audit services.

b

If the auditor was not satisfied re the above the only adequate safeguard would be t o refuse the audit client's internal audit engagement.

b

The auditor cannot therefore rely on the outcomes of the internal audit services for statutory audit purposes in pervasive areas such as internal controls and risk assessment.

b

(2)

-

' Assuming that the appointment can be continued, specific safeguards might include -

The use of different partners and teams with.separate reporting lines

--

A review of the audit by a partner n o t involved in the audit engagement

-

The designation of 'informed management' by the audit client in respect of the internal audit set-vices.

T a u r u s L t d a n d Sagittarius p l c Ethical and pro$essional issues b

Conflict of interesdself-interest threat.

b

Can the one firm act in the best interests of all parties? (One party's gain is the other's loss.)

b

May be tempted t o favour one party over the other (in particular Sagittarius plc in order t o protect future interests).

Quality c o n t r o l measures t o m i t i g a t e threats t o ' o b j e ~ t i v i t ~ b

Use of different partners and staff with separate reporting lines.

b

Use of specialisdcompetent staff with experience in advisory matters.

b

If adequate safeguards cannot be put in place - advise one party only/ withdraw.

b

Disclosure t o clients of the circumstances.

b

Advise clients that they may wish t o seek alternative independent advice.

b

Obtain the informed consent of the clients.

b

Confidentiality is of paramount importance. Standing instructions and all other steps will be necessary t o prevent the transfer of confidential information.

b

Regular review of the situation by a senior partner o r compliance partner not personally involved with either client.

Examiner's co~a'armerats Answei-s t:o xi\;, ::;i~,;i:i!.,n i-i.ld eijc scc{::nd lowest average t.riaric or, [he W T section of the paper. Tliis was m;lir\ly (.iac to :-,:li:i,!.\;ti:5' f;i!iri- r:? ;;IIP\NC'I. I ~ C ?~ L I C S L ~ Oset I ~ i1.1 1j211.t (a).

Answers to pa!.! i a i ,,hic:~c cii~np\::oiilr-i~~g a s irlany candidarcs did not I-end the word '[~urpose'and instead lisccd nlj!ricr.oLis c:xar.i!i:ii?, c)f qu;l!ity ~ S S , . I ~ A ~ I C CI: ? I ( ~ o s !witIio~:t I ~ ~ ~ . aeternpting co explain why ehe lrieasurcs are ilecessn!-y. O f t!ioi;c: wl.!o d ~ dntldi-cis5 the purpose of q~i;tlitycoiitrol measures, many omitted to ~riention their role in the pi-otectiori of auditol-s from negligence claims and disciplir~a~~y'p~.oc~dul-es. !. .

THE INS1ITUTE OF CHARTERED ACCOUNTANTS IPI rh(,t AND ANIl WA! I\

ANSWER BANK

In part (b) tlic lnaj:.)~.ity of c ~ n t i i d a t ewer.c: able i.0 ii.!i.lfi/ rt:!;: r l i t ~ a r :ir;d > i;iicg~.~nl-ds in I-espccc of Gblectivity. Howe%:cr-.!liariy canciid?ces did not p~.oy)r~-ly !~t.~cier.st.;.u~if t / I clacicnsliip ~ bttwecn incel-rial nric! $67 external a~iditc;':;. M;iny :I~oug!ir chat. t.iie!.e sI!cnid bc r ~ oc.o!~rr:iu~?ii:nrloi.~ betvueen rliein ihcl-eby displaying n lack of knowledge of ISA 6 I 0 Cot:sMer~ngtile Wotk of Itirrt-t~oi Aiiiiit. "lI:e sras~dat-dstates that 'the internal pditors need t o be free t o colrlniunicace fully with the external auditol-s'.

I Hairsay Ltd

Marks Each matter Maximum (b) Auditor's responsibil~t~es Managing director's expectations Materiality Maximum (c) Each question Question format Maximum Total marks available

(a) ,

I.

(a)

I 6 16 --

Matters to be included in letter of engagement b b b )

b b b b b b

Confirmation of acceptance of the appointment Summary of the responsibilities of the directors and o f the assurance provider Disclaimer in respect of the limitations of internal control systems Scope of the engagemendwork t o be performedllimited t o review of cash handling procedures Form of report (not audit) Restriction o n circulation of report Fees and billing arrangements Timetable Complaints procedures Cap on liability

(b) Responsibilities r e fraud The auditors' responsibility is t o identify material misstatements in the financial statements. T o fulfil this responsibility auditors should plan, perform and evaluate their w o r k in order t o obtain reasonable assurance that the financial statements are free from material misstatements. There is no obligation o n auditors t o prevent fraud, although the audit may act as a deterrent. The managing director's perception that the auditors are responsible for discovering all fraud shows a lack of

b b

Appreciation of $he directors' own responsibility in respect of fraud Understanding of the concept of materiality.

Directors often rely on auditors for monitoring they should undertake themselves. ,'

I

Because the fraud was not material t o Hairsay Ltd there was therefore no requirement o n the auditors t o design audit processes which would be expected t o identify such a fraud.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN [NCLAND &NUW A I I S

Section 2: Accepting and managing engagements Checl<list o f questions

(c)

- r i s k o f m i s a p p r o p r i a t i o n o f cash

b

Does the company have a policy of obtaining references for staff?

b

Is there segregation of duties between Recording cash (restricted access) Banking cash Reconciling takings records t o bankings?

b

Is the appointments diary cross-referenced with takings records?

b

Are cancellations of appointments reviewed?

b

Are cash takings banked intact on a daily basis?

b

Are staff supervised?

b

D o all staff take holidays?

b

Are staff rotated?

b

Are independent cash counts undertaken o n a surprise basis?

b

Are till records reconciled t o bankings on a daily basis?

b

Are margins reviewed against budgetlsubject t o inter-branch comparisons?

i

v,,,is :cl~er.niiy very well .ir,swered. !:., ! :

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with a significant number writing down anything n~.~!nbe~of candidates raised che issue of trade w!?icli wel-c rlcr reievant t o the scenal-io. A significant number of candidates overlool<ed the

bas:r tcchr~iqclesof segregation of duties. supervision, staff rotation and reconciliation procedures.

Matter t o consider/procedure (each) Reason (each) Maxipum (b) Identification of factor (each) Explanation of why factor t o be taken into account (maximum for each) Maximum Total marks available

(a)

,"

THE INSTITUTE OF CHARTERED ACCOUNTANTS ~hI~C,LIND 4 w \ v & ~ r (

Y2

I Y2

2

'

ANSWER BANK

(a)

Matterslprocedures prior to acceptance of audit

Check adequacy of resources t o enable

b

-

W o r k t o be completed t o a high standard on a timely has~sluseof competent staff

-

Provision of taxlaccountancy services without coniprom~singindependence (ie. safegual-ds can be put in place) eg: b

Use of separate personnel t o perform accountancy and tax

b

Review by an independent partnerlsenior staff member with appropriate expertise if tax computation prepared by audit team

b

Review of the audit by an audit partner who is not involved in the audit engagement

Establishldocument existence of informed management

b

-

T o ensure auditor does not take management role

Consider relationshipslfamiliarity threat

b

-

I

T o ensure independencelobjectivity not impaired

Consider potential conflicts of interest (eg competing clients) -

T o ensure act in the best interest of clients

Consider integrity of client

b

-

T o reduce risk of misstatements due t o fraudlmisl-epl-esentation

Client identification procedures

b

-

T o reduce exposure t o money laundel-inglcomply with money laundering t-eq;it-elnents

Send letter of engagement

b

-

b

T o ensure cl~entunderstands nature and scope of the wol-lc t o be undertaltenlnarl-ow expectation gap

New client

b Start-up

b

Lack of prior y,ear figures

I

Lack of familiarity - may not identify events and transactions which have an impact on the financial statementslhigher detection rislt

b

Going concern risk

b

Doubtslmaterial uncertainty will require disclosure in the financial statements

b

Lack of golng concel-n status w ~ l require l financial statements t o be prepared o n a break up bas~s

b

Lack of comfortlcorroboration from use of analytical review procedures

b

Require more extensive use of tests of detail (substantwe tests)

b

Bank covenant

b

R~skthat profits may be overstated in order t o preserve the debt equity ratio

b

Trading w ~ t hIT Systems Ltd

b

Need t o ensure complete d~sclosureof related party transactions

W

THE INSTI [ U T E O F CHARTERED ACCOUN IANTS IP. I\<,I

111111&NO U'AlFt

Section 2: Accepting and managing engagements

)

Custornised accounting software

b

May not be reliable, resulting In errors

)

Lack of segregation of duties

b

Misstatements may not be prevented o r detected and corrected on a timely basislhigher control risk

b

Determine the audit approach which 1s likely t o be substantive based

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were bett.er at. ilde~!~.ii;.iiiz occ::il;!-es to bc. perfo~.rricdthan they were ;tt iderltifyirig tlie reac;cji\s.Mrlay cr, i-c.iari!>gco ;lcic.cl~lacyof l,esources, objectivity and integrity of :li~::r>i, ;~l::i.ii;crj;h c.:rlly a r\~ii-iority c o i ~ l dexplail~why this should be consider-cd. Many.cr!rltfitl:l~.c.\ tt~iswas n start i ~ and p wasted time writing at length about pr.ofcssiol-ial cie;l!.a~ir.r?. I ,:cc; n r lengrh abour fee dcpendency failing t o appl-eciate that a small company :uch 21s :i3t! q!~:s.ioiiwas r~nliltelyt o be a problem for a six-partner firm. Only a liiinoricy of . . , .. . ..,... ,-., ,fc!.r-edt o the concept of informed managenlent, conflicts of intel-est, client identification ?i,oct::;!::r.::'i .:i.i,:i engagerlierit letter. Given the high PI-ofile. in recent years, of accountants' responsibilit!cs iii ..~ .,. .,, .. ,! i::,.i;::yy I;!~II):!:.I-~II:J ,-,> ir wiis dis;:y)poir-!ting that client identification procedur-es did not fcacul-e !riot.(: i ; ,;:, -::-,:!:;: ; : i i;,;;did,3;:es' ar>swers, :

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ti:ii>c.ior~ ger>e~-:i!!y~ v e lanswert:d l with the niajoi-ity of candidates identifying the factors 'new c.lic:lr', 'bank covenanr'. 'trading with IT Systerns Ltd', 'customised accounting softwn~-e'and 'Inclc of segregation ot duties'. In general, candidates were better at identifying the factors than they were ac z..v,,1 ..,.> .~ . - , '<: why they $hould be collsidercd. A significant number of candidates missed the point on the ~:::i~ii>~it.c:r syitcr,.i .- tliey tlioi~gilt.incorrectly. that a conlputer system is less reliable than a rnanccal systelli ; ~ ~ . ~ : . ~ . :$ ~ , i cj . i ~ L j a .i>t!i.:;; ~i-!;!r ir was the custoniisation of the software that posed the risk. Statements S I J ~ : ~as ! ;\,!;

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1 1 - 1 ~INSrI ruTE OF CHARTERED ACCOUNTANTS
.AN:, >\t,!V,jll

\

ANSWER BANK

I Waverley L.td

Scope of work - assurance engagement Scope of work - audit Report - assurance engagement Report - audit Marks available Maximum (b) Professional clearance Client's response t o assurance report Eligibility under Companies Act Independence Resources and expertise Client identification and integrity Company search and filing Marks available Maximum Total marks available

(a)

2. $ (a) Contrast i

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Scope of work This assurance engagement )

W o r k carrled out in accordance with specific agreed terms.

b

Resultant work plan based on evidence required, restricted t o -

-

A review of accounting policies for compliance with accounting standards Testing that policies have been applied as stated A review of treatment and disclosure.

Statutory audit b

W o r k carried out in accordance with Companies Act Audit regulations Auditing standards

b

Audit plan based on risk assessment of material misstatement.

b

Detailed work will include -

-

Tests of control Substantive testing ~ 0 n s i d e r a t h -of t going concern Consideration o f subsequent events Obtaining of a lerter of repr-esenmtion from the directors.

Report t o be issued

This assurance engagement The report will be )

b

Addressed t o the directors Covering accounting policies only THCINSTIIUIC OF CHARTERED ACCOUNTANTS

85 '

2%

Section 2 : Accepting and managing engagements The fol-niat of the I-epol-t is wholly disc!-etionary but W i l l include che agreed scope of wot-I< W i l l be signed as accountants

b b

This is a private I-eport. Statutory audit This report is Addressed t o tlie niembel-s Giving an opinion o n the true and fail- view

b

b

The format is prescribed and the report will be signed as registered auditors. This report is in the public domain (although is likely t o include a disclaimer r e third parties in accordance with Institute guidance). M a t t e r s t o c o n s i d e r a n d p r o c e d u r e s t o f o l l o w b e f o r e a c c e p t i n g a p p o i n t m e n t as a u d i t o r s

(b)

b

Explain t o the client your professional duty t o communicate with the current auditors.

b

Ensur-e tlie client authorises them t o respond.

b

If the client refuses t o give such authorisation, the firm should n o t accept the appointment.,

b

W r i t e t o the current auditors for information which could influence the decision whether o r n o t t o accept appointment.

b

Discuss the client's response t o your assurance report.

b

If the client rejects conclusions, the firm should n o t accept appointment.

b

Confirm eligibility t o act under the Companies Act, ie n o partners o r staff are officers o r employees of the client.

b

Consider whether as auditor any threats t o objectivitylindependence exist, eg -

Undue dependence o n client (fee level) Closely connected (personal I-elationship) Beneficial o r mutual interest (shareholding) Conflict of interest.

-

b

Consider whether the firm is competent t o carry o u t the assignment (ie have sufficient resources and expel-tise).

b

Confirm the identity of the client under the money laundering rules.

b

Assess the integrity of management.

b

Gal-I-y o u t a company search.

b

Ensure the resolution of removal is filed with the Registrar of Companies.

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of carldi(j;ltcs strayed beyorld tl.le t-equirernencs, prgccdur.es: aftel- appointment in part (b). In part: (a) :..::I.!:. i l : .: :i:.ic:: :::.\ i:c:>(; :of *or/< 3yld the r e p o r t separately. In part (b) the most . . , . .,.<.;.< , ~ : ..- i . 3 i . : : ! 3 (:r: ii;:!;.r!<:iiri<:ti<.c issc;es at, [tie expense of other matters. :

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ANSWER BANK

I'

Wavenden Lrd

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Marks (a)

Steps undertaken by Wavenden Steps undertaken by audltor Marks available Maximum (b) ldent~ficationof llmltation on scope and reason Materiality and type of modiflcat~on Problems concerning openlng lnventorles only Reporting by exception Marks available Maximum Total marks ava~lable

(a)

Steps to complete the appointment of your firm as auditors

,

By Wavenden Ltd

. .,

,

b

Remove existing auditor by passing an ordinary resolution in general meeting. Such a resolution requires special notice of 28 days.

b

Send notice of the meeting to the existing auditor.

b

Circulate any written representations from the auditor with the notice t o the members unless i t is received too late o r is defamatory.

b

Grant the right of the auditor to attend and speak 3 the meeting.

b

Notify the Registrar of Companies within 14 days of removal, together with a statement of -----t circumstances from the auditor.

b

Appoint new auditor by ordinary

b

Authorise the prevjous auditor t o communicate with your firm.

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resolution (this also requires s~ecial notice). ..-I

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b

Undertake client ikti_fication -- procedures

b

Obtain permission from the directors t o communicate with the previous auditor.

b

If the directors yefuse, your firm should not accept appointment.

b

Write to the previous audltor asking for any professional reasons why the appointment should not be accepted.

b

If a letter elicits no response, try telephone, fax-or__registereddelivery.

b

If there i s no response at all, assume there are no reasons why the appointment cannot be accepted.

b

If the response casts doubt on the directors' integrity, do not accept appointment.

b

If an issue of conflicting viewpoints becomes apparent, dlscuss with the directors

b

Confirm that Wavenden Ltd is an appropriate client t o take on.

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The firm is eligible t o act under the Companies Act.

7 There a r e _ ~ o _ t h r e a t s _ t o ~ ~ j e ~ ~ v i t y l c oofn Interest. fl~cts -

The firm i s ccmpetent to undertake the assignment..

THE I N S I I T U ~ E OF CHARTERED ACCOUNlANTS ? IN

LNCLANU AQD WALi5

Section 2: Accepting and managing engagements

i

(b)

b

Obtain company search.

b

Obtain signed letter o f engagement.

A u d i t r e p o r t r e S t o c l < w o o d Ltd A limitation o n scope has arisen because the auditors were unable t o p e r f o r m procedures which would quantify the tl-ue figure. The matter is material, but n o t pervasive. Hence the audit I-epor-t should be qualified 'except for'. In accordance w i t h the Companies Act the auditor needs t o r e p b r t o n certain matters by exception only. I n this case the UK auditor w i l l need t o r e p o r t that, in respect of t h e limitation o n his w o r k relating t o opening inventories alone

b

H e has n o t obtained all the information and explanations that he considered necessary for the purpose o f his audit

b

H e was unable t o determine whether p r o p e r accounting records had been maintained.

Marks (a)

PI-ofessionally qualified t o act Adequate resources Client identification and references Professional clearance Legal requirements Marks ava~lable Maximum Consideration of situation p r i o r t o acceptance of audit (b) Importance o f independence, threats and safeguards Acceptance procedures Fee issue - non-listed v listed Marks available Maximum Combined Code o n Corpol-ate Governance (c) Auditors' responsibil~ty Maximum Documentation, direction, supervision and review issues (d) H o t review issues Monitoring procedures Marks available Maximum Total marks available

THE INSTITUTE OF CHARTERED

ACCOUNTANTS IN CIUGLAND AND W4LtS

ANSWER B A N K

Requirements r e l a t i n g t o a c c e p t i n g a u d i t a p p o i n t m e n t Ethical r e q u i r e m e n t s The auditor is required t o ensure that there is n o e t h i c a l b a r r i e r to his acceptiag appointment. Ensure professionally qualified to act

Consider whether dis ual~f~ed on legal or-ethicak~l_o~upds. In 3tet nis of ethics, the following issues are relevant:

b Does anyone in the audit firm own shares in Benson? b Is the nature of the relationship between the auditor and the client more personal than business? b Would the audit fee constitute t o o high a percentage of

gross practice income?

b Is there a conflict of interest with existing clients? All these issues would affect the independ_emeofthe audit firm. Ensure existing resources adequate

Consider

Undertake client, i d e n t i f i c a t i o n procedures

Ensure compliance with Money Laundering Regulations

Obtain references

Make independent enquiries if the directors are not personally known t o the audit firm.

Communicate w i t h o u t g o i n g auditors

b b b

/

Available time' Staff Technical expertise

Enquire whether there are reasons o r circumstances behind the change which the'new auditors ought t o Iknow. This i s also a courtesy t o the outgoing auditors.

Legal r e q u i r e m e n t s The auditor must also ensure that the outgoing auditor's removal correct manner, once they have accepted appointment.

01-

resignation was conducted in_the

-.

ABC's dealings w i t h B e n s o n ABC has had the following dealings with Benson and i t s directors.

b

Advice given during the management buy out

)

Taxation advice (company and directors)

)

Management consultancy

b

Special projects, comprising:

-

Fraud investigation Expansion, budgets and investigations

The question tells us that this has resulted in significant fee income for ABC. It mentions one statistic, that in the year of the ekpansion investigation, the fee income was 20% of the full office income. ABC have now been aslkedto provide audit services t o the company in addition t o the other services they provide. They have agreed t o take on the audit of the company. Standard o f c o n d u c t

Up until the point where ABC were asked t o become auditors of the firm for the second time, there were no ethical issues arising. Accountants are entitled t o provide any numbel- of services t o a client, unless one of the Services i s an assurance service t o which rules on independence apply. The services discussed above doanot

THE INSTITUTE OF CHARTERED ACCOUNIAN rs lh ENCIANU AND WnuS

Section 2 : Accepting and managing engagements constitute threat t o the independence of an assurance service. A firm of accountants may take on the combined roles of tax advice, management advice, and specialist investigations, with no independence issues. Independence The most recent step in the relationship between ABC and Benson is that the directors of Benson have aslted the firm t o provide audit services t o the company. However, audit is an assurance service and the independence of that service may be affected by the provision of other services. Codes of Ethical Conduct generally require that an a u d i t o r is, a n d i s seen t o be, independent. The auditor must be o b j e c t i v e in his dealing with audit clients. ES5 states that provision of a d d i t i o n a l services t o audit clients may result in objectivity being impaired. ICAEW rules also state that f e e i n c o m e derived from private company audit clients should not constitute more than 15% of their income. This is t o protect the independence of the audit firm, who might otherwise become financially dependent on the client, t o the point where they are no longer objective. In addition, fees of 10% of office income create a presumption of dependence. A p p l i c a t i o n t o A B C and B e n s o n p l c The fact that ABC already undertalte so much work for Benson represents a significant barrier t o them being able t o maintain objectivity on the audit. When aslted t o take on the audit, the partners should have considered whether it was appropriate t o take on the audit in addition to.the other work. 8

The question does not establish whether this has been done o r not. However, the firm has clearly talten some steps to preserve some independence for the audit service. The firm has appointed a different partner t o be audit engagement partner in addition t o the partner who has dealt with the client PI-eviously. This indicates that they have considered the issue and decided that there is no barrier to independence. Another key factor t o consider is the level of fees that the auditors gain from the client. This is because of the specific rule of the ICAEW that it should not exceed 15% of recurring gross practice income. The only references t o fees in the question are that the fee income from the client is high, and that in one year, when a special assignment was taken on, they represented 20% of the fee income. This does not necessarily mean that the fee income including the audit fee will be in excess of the 15% barrier, but it certainly suggests that it is possible. As a minimum, it suggests that it may no longer be appropriate t o undertalte the special assignments, and that a review of fee income will be required. It is impossible t o conclude precisely whether ABC were acting unethically in accepting the audit work. However. the indication is strong that the firm is not independent in relation t o the audit due t o the high level of other services, and the fees that they bring in. This is despite efforts which have been made t o preserve independence, notably appointing a different audit engagement partner. If Benson were t o float on a Stock Exchange, then the rules of independence would become more stringent. In such a case, fee income should n o t exceed 10% of total office income and the presumption of dependence level would drop t o 5%. Auditors of UK listed companies are entitled t o provide other services t o their clients (unlike their US counterparts, w h o are restricted in such provision by the Sarbanes-Oxley A c t 2002). However. maintaining independence from such companies is considered extremely important and it appears unlikely that ABC would be able t o justify that they were independent of Benson plc for the purposes of its audit. ~ e i itelisted, and hence, if it achieves a listing, they will have t o re-appraise their relationship with the client. (c)

Benson would be subjected t o the requirements of the Combined Code o n Corporate Governance. Auditors of listed companies are required t o review nine matters of the,Code t o ensure that the , . company has complied with them.

THt INSTlrUl t OF CHARTERED ACCOUNTANTS k L\CLANV

\Wl)

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ANSWER BANK

(d) Quality control procedures and policies The audit engagement partner 1s a ltey featut e 111 qual~tycontrol pi-ocesscs In relat~ont o ~ n d ~ v ~ d u a l audits. UK guidance on quality contl-ol foci~seso n t w o aspects of quality contl-01:

b b

General fit-ni-wide policies t o establish quality contl-ol at a firm level Specific quality control I-equil-etnentsfor ~rrdivldi~al audit assigntne~lt.s

We shall consider the latter in this answer. It is important for the audit engagement partner who has been appo~ntedt o both consider and document his considerations of the,ethical issues raised in the answer t o part (b), above. He must be assured that he i s independent with regard to the audit. Specifically with I-egal-d to the assignment, he must ensub-e that tl-~eaudit work is directed, supervised and reviewed in an appropriate Inanner. He may delegate much of these taslts t o an audit manager, who will be I-esponsible for i~ndel-taltirigplanning meetings with the audit team and liaising with them on site, pel-haps c~ndel-taltingan on site review of their wot.l<. However, the audit engagement pal-tnel- cannot delegate the I-espons~bilityfor dl-awing the audit conclusion, and must ensure that he has ireviewed the audit file to ensure that he draws the cot-I-ect conclusion, and that sufficient wol-It has been i~ndct-takento SLIP POI-^ that conclusion. The engagement partner must cons~del-the engagement I - ~ s l tattaching t o the assignment, and consider the need for a 'hot review' pi-iol- t o the issue of the audit opinion. If Benson does become listed, such a hot review will be essential. The audit engagement partner is I-esponsible in the first instance for ensuring that any disputes within the audit team arising over issues relating t o the Benson audit are resolved appropriately. The fit-ni should have clear guidelines as t o how such disputes should be resolved. Lastly, the firm should have a practice of monitoring audits undertaken for quality. It is likely that the audit of Benson should be monitot-ed by the firm team this year for several reasons:

b b

It is the first year of a new audit It is a sy)stantial client

It is a client which had significant ethical issues t o consider in relation t o accepting the audit, and therefore the audit (engagement) I-isl< is highel- on this audit than others.

THt I N S I I l U l t OF CHARTERED ACCOUNTAN r s Ih I \ d i h N D AUD W A l I S

tion 2: Accepting and managing engagements

Healey &;td

(a)

(i)

Adequacy of resources Ability of client t o pay fee Money Laundering Regulations Integrity of client Marks available Maximum (ii) ldentification of threat (each) ldentification and explanation of threat (each) Maximum (iii) Purchase consideration Conflict of interest Safeguards Ongoing advice ldentification and explanation of self interest threat Safeguards for self interest threat ldentification and explanation of self review threat Safeguards for self review threat ldentification and explanation of management threat Safeguards for management threat Current clients conflict of interest and safeguards Marks available Maximum Duty of care and negligence (b) Importance of quality control procedures Liability cap Use of disclaimers Use of contractslengagement lettersllegal advice Marks available Maximum (c) Direction, supervision and review Independent reviews Separate teams Maximum Total marks available

____ (a)

(i)

Suitability of Healey Ltd as an audit client Adequacy of resources

8%

b

Ensure that competent staff are available t o complete the job in the timescale

b

Ability td provide a professional service without detriment t o existing clients.

b

For the fee that has been agreed, whether a full service can be provided.

b

Whether the firm is familiar with the industry in which the client operates, an t o advise in key areas.

b

Will the client pay agreed fees?

THE INSTlTUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND W4LIS

uired.

competent

ANSWER BANK

Money Laundering Regulations Undertake client identification procedures.

Integrity of the client We would need to consider the integrity of the client by reference to the following.

b

Examining previous dealings with Healey Ltd.

b

Consider what we know about Healey Ltd from other sources such as newspaper cuttings and information obtained from the Internet.

b

Consider the frequency with which Healey Ltd has changed advisors.

b

Examine previous accounts and statutory returns, particularly looking for unusual policies or accounting treatments, and the adequacy of accounting records reported upon.

b

Consider the financial stability of the company, particularly with regard t o payment of fees and going concern implications for audit purposes.

b

Look at any other companies with which the directors are associated t o assist in identifying related party transactions.

b

In the case of problems, consider Healey Ltd's previous businesses, and consider obtaining a reference. This could, for example, be from the company's bankers.

Professional clearance Write t o the previous auditors asking for reasons why the appointment should not be acckpted. The client's permission will be required for this. If i t is not forthcoming the appointment would normally be turned down. (ii) The six general threats to independence

' v (I) Self-interest threat - where the auditors have a vested interest in the client, such as a

financial interest in that client and may be reluctant to take actions that would be adverse t o the interests of the audit firm.

v

I

I1

1 )

I

(2) Self-review threat - where the results of non audit services performed by the firm are reflected in the amounts included or disclosed in the financ~alstatements.

(3) Advocacy threat - where the auditors take the cl~ent'sside. for example in a lawsuit.

,(4)

Familiarity threat - where the auditors have a close relationship with client staff and may lose professional scepticism.

( 5 ) Intimidation threat, where the auditor's interests are threatened, for example where they encounter an aggressive and dominating individual.

~ 4 6 ) Management threat, where the auditor runs the risk of taking management decisions.

THElNSlllUTt OF CHARTERED ACCOUNTAN TS IN ENGLAND AVO WAltS

93

Section 2: Accepting and managing engagements (iii) A d d i t i o n a l services r e q u e s t e d

( I ) A d v i c e o n purchase c o n s i d e r a t i o n b

There may be a conflict of interest ~n adv~s~ng on the sale of the shares because as auditor there may be a temptation t o favour M r Allard as he IS the ongolng client.

b

Suggest that M r Morgan obtains independent advice, o r at least that another partner advises M r Morgan. If the latter course is taken, then 'Chinese walls' may be needed t o safeguard the client.

b

A t the extreme, advise neither party.

There will be an increased risk of fee dependency which may impairobjectivity. Judgement may be clouded by the pi-omise of future consulting fees.

b

Ensure fees are kept below tht-esholds outlined in ethical rules.

b

Instigate a system of second partner reviews.

There may be a self-review problem, as investigative'worl< will be followed by audit wol-I<. and the partner may n o t want t o reveal problems found t o the client.

b

The audit work in relation t o the investigative w o r k should be undertaken by separate personnel and reviewed by an independent partner.

(2) O n g o i n g advice b

b

. .

(b)

.

...

b

Investigations may ~nvolvecurrent clients.

b

Different teams should carry out the work, possibly involving spec~alists.

b

Advisory work may turn into decision making.

b

The advisory role should be constantly and carefuvy rev~ewedt o ensure that this does not happen.

b

'Informed management' should be appointed at Healey Ltd.

b

The advisory work should be carried o u t by a different team.

Potential liability (i)

Audit In respect of the audit, the firm has a duty of care t o Healey Ltd and, if it breaches this duty of care and is found t o have carried out a negligent audit causing loss t o Healey Ltd, it may have t o pay damages t o Healey Ltd. This liability cannot be excluded. However, the firm can ,take the following steps t o restrict liability due t o negligence: b

b

Implementing quality control policies and procedures t o ensure that the firm does not carry o u t a negligent audit '

Negotiating a liability cap with Healey Ltd as part of the terms of the engagement so that, in the event of the firm being found liable t o Healey, damages are limited t o a pre-agreed amount

UK case law has generally found that auditors can only be found liable t o third parties in respect of negligent audits in very limited circumstances, such as when the audit firm knew that the third party would rely on audited accounts and did n o t expressly disclaim liability t o that party. The firm should consider whether ~tknows of any partles who.may rely on the audited accounts, such as M r Allard, for example, who might rely on the audited accounts in relation t o i

1 H t INSrl rUTE OF CHARTERED ACCOUNTANTS IN I\LI I N 0

,\NOL V A l l 5

ANSWER BANK determining a purchase price for M r Morgan's shares, and should expressly disclaim liability t o Mr Allard in respect of that use for the audited accounts.

. ,

In addition, t o be certain of no other liabilities in respect of the audit arising, the firm could insert a disclaimer of liability t o all parties other than Healey Ltd in its audit report (known as a Bannerman clause). (ii)

Other services Irr respect of the other services M r Allard is inviting the firm t o accept, liability will be determined by the contract agreed between the various parties - as follows:

b b b

Contract between M r Allard and firm re purchase price Contract between M r Morgan and firm re purchase price Contract between Healey Ltd and firm r e acquisitions

The firm should seek legal advice in respect of these contracts and ensure that their liability exposure is not t o o great. As the w o r k is n o t audit work, they are entitled t o negotiate limitations on their liability and should do so. In particular it may be necessary t o limit liability in the event of the company making acquisitions which then go wrong. The firm should make clear that any investigations they carry out are restricted t o the present time and that they cannot be held liable for the results of future, unknown events. d ~ i r e c t i o n supervision , and review of audit w o r k (this is mandatory under ISA 220) hot review by an independent partner of the audit file before audit report signed L Separate team used for audit and other services Cold reviews of audits with points forward for improvements in future years.

THE IVSTITUTE OF CHARTERED ACCOUNTANTS IN INGLAND ANDWAlII

95 5

Sect~on2: Accepting 2nd mannglng engngemcncs

IHEINSIIIUIt OF CHARTERED ACCOUNTANTS IF. !\<,I

,Awl> h V ' > t,'.,,

r\

ANSWER BANK

@ I

Principal auditor

g$ g:,

The auditor with responsibility fol- I-eporclng on the financial statements of an entity when those financial statements include financial ~nfol-mationof one 01-more colnponents auditedby. .another .... . . . . auditor._

& &': 6;;

Other auditor

An auditor, other than the principal auditor, with I-esponsib!lity fol- reporting on the financial information of a colnponent wliicl,is included in the financial statemerlts audited by the principal . . . auditor. Othei- a u d i t ~ ~include -s affiliated firms, whet1ie1-using the sntne name 01-not, and correspond_eptsas well as unrelated . . auditor-s. .

- . ........

.-

The nature and significance (materiality) of the mnttel- which i s t11e subject of the nlodification t o the financial staternents of Narberth G~.oupplc. Whether the matter which i s the subject of the ~nodificationcan be I-esolved when preparing the financial statements of Narbet-th Group plc.

Information t o evaluate risk

t'

b Audlt

b Rlslc level acceptable t o vcpol tlng pal-tnel-

b Inherent

)

Chat-actet ~scicsof cornpany and CII-cumstances c f a c ~ d ~ t

b Control

)

Informntion I-egal-d~ng cl~ent'ssystem1 of rnternal controls

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b Designated level of detection risk set using the audit I-islt model, a detel-mined by the other three types o f risk

,,

b

Whether internal audit w o r k is performed by pet-SOIIS having adequate technical training/p~.oficiencyas incel-nal auditol's

,

. . . . . .

.

Whether internal audit worlt i s pt-operly planned, supervised, reviewed and documented -

Procedures b VReview policies for hiring and tl-aining staff 1 Review experience and pt-ofessional qualifications of staff b Ensure adequate audit manuals exist ) Review work plans and working papers, eg for evidence of review

THE INSIIIU

Ih thl

L L111) \UP U \ , I 5

Section 3: Planning assurance engagements

5

Use o f internal audit w o r k

Can be used to make initial evaluation

(I)

(2) If relevant to audit, can be used to reduce

b

Wall< through tests to confirm

b

But testing for April t o September 20x6 must be done

b

Hence more substantive procedures

b

But head of department still responsible for July and August 20x6 accounts

b

Head of department y-~ a ynot be fully independent since promotion

own tests of controls (3) If the weaknesses are confirmed by own audit work, will lead to less reliance on contl-ols May be useful info for confirming consistency of financial statements with other infot-mation (management accounts)

(4)

6

Factors r e balance o f procedures Tests o f c o n t r o l (conditions) b b b .

Assessment that conti-01 systems are good Operation of controls evidenced Cost effective compared with substantive procedures

Analytical procedures (conditions)

Availabilitylreliability of relevant data Predictabilitylcomparability of amounts t o analyse Previous experience of effectiveness of approach

h

b

b

Substantive procedures b

7

Balance of work required t o obtain sufficient evidence

Procedures r e non-compliance w i t h laws and regulations (ISA 250 paras 18 a n d 23) b

Enquire of management whether entity is in compliance with lawslregulations

b

Inspect correspondence with relevant licensinglregulatory authorities

b

Obtain written representations that management has disclosed t o the auditor all known actual or , possible non-compliance with lawslregulations whose effects should be considered when preparing financial statements

Additional in U K

8

b

Obtain a general understanding of procedures followed to ensure compliance with relevant legal framework

b

Enquire of management whether they are on notice of any possible instances of non-compliance

b

Written representations to include actual or contingent consequences of the non-compliance

Analytical procedures b

It helps t o iientify areas of risk I t e n a b ~ e s ~ ~ ~ ~ oapproach ~ a u Idt o i determine t nature, timing-and extent -.__.. __of work .. . ... . .-.

b

c

9

Sources o f knowledge b b b b b b

Discussion with management of acquiring company (your existing client) Review of documents connected with acquisition L Discussion with managementlstaff of Jade ,,Tour of company premises , Review of Jade's accounting recorddManagement accountslTrial balance Review trade press and journals J 4

'

b

. .;# .

C-

THE INS1I r U 1 E OF CHARTERED ACCOUNlANl S IN L W G I AN<> tNI1 I&\ I\

.

,. .

'' . . ,

ANS'flER BANK

V b

Internet seal-ch for Industry intell~gence Enquiries of IN-evious audito~.s/Jade'scul-I-ent lawyers Review brocIiir~~es/docirments PI-odirced by ]ade/Jade website

L b

b

) Would I-educe gross profit %

b

Yes

b

N o - - lna~ntainedprices = same gross PI-of~t%

b

N o - no effect on gross profit %

-

could explain fall

inventory increase

Due PI-ofessional care

--

manualslpl-og~.a~ii~iies/p~-ocedul-es

xpected variations

eceivables,

-

b b

01-

cash and cash equivalents could be underst

Cut off PI-ovisions/w~-ite downs

Enquiry of management Minutes of board meetings

al statements, must be disclosed in audit repol-t. disclosed in financial

b b

statements. May be tax liabilit~esnot provided for in financial statements. Item not quantitatively material.

THE INSTITUIE OF CHARTERED ACCOUNTANTS IN ILLIIND h N l ) i ' l A l i S

99

Section 3: Planning assurance engagements 6

Procedures t o address ldentify full list of related parties at commencement of audit from prior year working papers Review minutes of meetings of shareholders and directors b L ~ snames t from statutory books b Make enquiries with directors and staff durtng audit ) b/ Obtain wrltten representations on completeness of disclosure ) Review loan agreements for guarantcrs b Review transactions between the t w o parties t o ensure arm's length basis b

)

I m p a c t on a u d i t approach 1

Little o r no reliance can be placed o n management . . .representationslincreased ............ -. professional scepticism Reassess audit risk in light of doubts about integrity of management As a resul~'samplesizesmay need t o be increased Scrutinise related party transactions more carefully t o ensure at arm's length Implications of management attitude to control environmentfsubstantive approach More external evidence

b

b b b b

b

M a n a g e m e n t accounts in p l a n n i n g Uses Identify significant changes in tradinglbalance sheetlsolvency Highlight newlincreased areas of riskhncertainty Direct audit effort . . Preliminary assessment of materiality

b b b b

Limitations b

b b b

D o n o t cover whole yearlsubject to seasonality. May incorporate budgetedlestimated figures, eg inventories, expenses Accounting policies may not be strictly applied May not include year end adjustmentslprovisions

Risk c o n t r o l strategies (I)

)

Ensure contracts with sub contractors specify deadlines for each piece of work completed

b

Include penalty clauses in all contracts for financial recompense for any overruns

(2) b )

(3)

Take out insurance cover against flooding. (Premiums likely t o be high given recent flooding problems in UK) Build responsibility for flood protection into contracts of subcontractors as far as possible and ensure compensation for flooding is agreed Consider finding a joint venture partner t o join the project. Additional funding would be made available and the risks of the project would then be shared (although the returns would then also be shared)

Effect o n p l a n n i n g )

b

b b

Not material i n itself, if isolated incident But, less reliance o.............. n effective operation of control system Particularlf iinvolving chiefaccountant (CA) ........... Extra testing where%A has authorised payments ........ ... .Doubt cast on representation made by CA i n all areas -,

b

'0°

FJ

--

I H t INSTITUTE O F CHARTERED ACCOUNTANTS IN ENC~AND AND w n m

ANSWER BANK

ernal audit '

- effect of incidents

L~kelyless rel~anceplaced on controllsystems tests

)

~ty respons~ble 4) Due to lack of a v a ~ l a b ~ l ~ t y l a c c o u n t a bof~ lpersons

But could mltlgate effect by checks on w o r k done Must conduct own tests of controls for last three months Systems evaluat~onuseful t o own assessment for plannlng Prov~dedrecords confirmed by walk-through tests Reasons for departu~es, eg lack of Independence, recommendat~onsnot imple~ nted Qual~ficat~ons of new members Recrultm~ntinternal o r external (lngependence)

)

1 1 b )

'

I I Audit objectives of tests of controls )

That controls 3s recorded exlst And are op.erateieffectlvely L Througholjt the p e r ~ o d To ensure system adequate as bas~sfor preparing accounts

22 Steps to determine combination of tests b b

Obtaln upderstand~ngof accounting system and control environment Document accountlng and control systems Confirm by wall<-through tests ,Make prel~m~nat-y assessment of control r ~ s Yd'' k Incorporate assessment of Inherent r ~ s k Determine cost effectiveness of tests of controls

Assess the experts' )

I Independence. Ob\ectlv~tyProfessional qual~f~cat~ons Experience Resources ' Scope of assignment

b )

) ) )

Assessing results of work

Assess appropriateness of a u d ~ ev~dence t re flnanc~alstatement )

)

b )

b ) ) ) ) )

espec~al

. Source data

b )

assertions,

,

- sufflc~ent,relevant, I ellable? Assumpt~onsand methods - reasonable? Reasons for changes slnce prlor p e r ~ o d Results of work In l ~ g hof t aud~tors'own knowledge of buslness

-

'

One off jobslm~n~mal repeat customers Rel~anton brand name ~ d e n t ~ t y Rel~anton word qf mouth recommendat~ons Customers prlce sensltlve Cred~tworthmess of customers C r e d ~pt e r ~ o dtaken by customers Customer sat~sfact~on rel~anton qual~tyof work suppl~edby subcontractors Image presented by subcontractors

9

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN INGLAND AND WALES

Section 3 : Planning assill-ance engagements

25

C o m p o n e n t s o f a u d i t s t r a t e g y and plan i n f l u e n c e d b y k n o w l e d g e of business Rislc assessmelit a Initial 111ate1-iality Reliance o n controls v substantive p r o c e d u r e s ' Analytical PI-ocedures v detailed testing Level and time o f staff ~requiredlbudget Nature, timing and extent o f PI-ocedures Specific al-eas o f attention .. Use o f C A A T s '

26

M a t e r i a l a c c o u r i t i n g cycles Wages and salaries (as consultancy business) W o r l c in progresslcost ledger . Revencie11-eceivables / Pur-chaseslpayables ,

b b b

b

27

Effect o f journal entries Level o f I-isle increased " Materiality reduced M o r e substantive procedul-es, fewel- tests of controls M o r e external evidence desirable (eg receivables). M o r e evidence frorn post 'BS pel-iod (eg w r i t e downs/prorisions) M o r e attention t o areas amended by journals . IYOI-e time allowed for audit worlc and PBSEs review M o r e time allowed f o r [review Probable less reliance o n management representations I Larger sample sizes

.:

28

S u s p e c t e d fraud

b

L o o k for evidence o f ,yeal
b b b

existence checlcs o n employees) 4 Investigate any apparent overridelcircumvention of procedures Engage payl-oll clerlc in conversation and query lifestyle Consider impact o n o t h e r areas (eg bank payment approvals)

b

b b

29

C o n s i d e r a t i o n r e r e d u c t i o n in s u b s t a n t i v e p r o c e d u r e s b

Reasons f o r deviations (eg person responsible o n holiday

b

W h e t h e r deviation indicates

'

\I

b

-

+ isolatedsror)

Laclc of operation of control, ie contl-ol failure

01just lack o f evidence, eg n o initials evidencing checlc performed

b

W h e t h e r quantitative error(s) arose as a result o f the deviations (confirming lack o f operation o f control)

b

W h e t h e r extended tests prove satisfactory, ie n o further deviations found

b

W h e t h e r cornpensatlng c o n t r o l exists - so monetary e r r o r s did n o t arise - -,

THE INSTITUTE OF CHARTERED ACCOUNTANTS hi i lil .I., 1 4 0 \Lli,w,,,<

ANSWER BANK

)

Unrecorded interest f o r late payment

b

Unrecorded provision for damageslbt-each o f contract

b

Evaluate and test contt-01s over payl-oll PI-ocessing

)

Confirm payments in respect o f PAYE and N I C made o n time Confirmation o f status o f any litigation w i t h legal advisers Inspect correspondence

) )

01-

disclosure as contingent liability for

Santandev Ltd

".

Y2

Y2

4 Gross margin issues Operating costs issues WIP and inventory issues Trade receivables issues Effect of new legislation Foreign exchange issues Personal injury claims Marks available

3% 2 2% 5 2% 2 3 2 16

)

W o r k is completed expeditiouslylcontroIs audit costs

1

Facilitates review

)

Prior year audit file and audit teamlpermanent file

1 1

Industry informationlFinanciaI Press Companies House search Management accountslother financial information Internal correspondence and tax files

b )

'

THE INSllrUTE OF CHARTERED ACCOUNTANTS IN

r r i r l b ~ uAUII

WAIES

Section 3: Planning nss~rt-anceengngc,lilclilz Fil-:n's scaff who l ~ ~ had v e cllcnr. i~rvolven~ent dul-ing the year eg audit partner Client itifol-mation cg W C ~ S ~ L C Management lettel-

b

b )

(c)

N o t e s f o r p I a ~ \ n i n g111eetirig Reasons f o r increase in r e v e n i ~ e l i r ~ c r e a sb ey 20% Volume increase from new overseas marltets

)

Cllange in pricinglinflation Revenue I-ecognition policy Revenue may be overstated Incl-eased accivity may give I-ise t o en-ors

b )

b

Reasons f o r fall i n gross p r o f i t m a r g i n Increased cost of new materials May indicate cut-off el-I-01-s May indicate new loss making contracts - overstatement of W I P

b ) )

Reasons f o r i n c r e a s e i n o p e r a t i n g costs

..

Costs in financial statements may be ovel-statedlcost of implementing new legislation May be misclassificationln~isallocation

b b

W h y h a v e i n v e n t o r i e s increased? May mean inventory overstated D u e t o cut-offlinappropriate currency conversion May be ~nadequateprovision for obsoletelslow moving inventory Incrensed costs on new material may n o t be I-ecovel-able from customer - NRV issues

b

b b )

Basis f o r c a l c u l a t i n g W I P a n d FG W I P may be overstated May be errors in estimating stage of completion Lnl-ge claim may lead t o insolvency

b b

R e a s o n f o r increase in t r a d e receivables

b

May be element of it-recoverable debtlinadequate provision for bad debts

b b b

N e w customers ability t o pay - going concern N e w custolner extended credit t e r n ~ s ? Credit checl<~ngof new cirstomers

I-IS~<

Effect o f n e w legislation b

I

Long term effect on Santandel- profitability -going concern Eal-ly implemer\tation puts company at a financial disadvantage

)

P r o c e d u r e s i n p l a c e f o r h e d g i n g against a d v e r s e f o r e i g n c u r r e n c y e x p o s u r e May give I-ise t o losses in financial statements

)

S y s t e m in p l a c e f o r t r a n s l a t i n g f o r e i g n c u r r e n c y t r a n s a c t i o n s May be translation errors leading t o el-I-ors in accounts Currencies may be particula~.lyvolatile in South America

)

b

W h e t h e r c o m p a n y i n v o l v e d in a n y p e r s o n a l i n j u r y c l a i m s May be liabilities n o t provided for May damage company reputation - going .concern

)

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rniahc put thc c(-?rni:);.i~ly at. i t fir1nnci;lI c!rsari~inr!!:;..

9 Apparel btd .-

..

.*.......

-"

.....

......

...

..

?darks (a)

.

Revenue issues Gross margin issues (including calculations) Operating margin issues (including calculations) Inventory issues (including calculations) Receivables issues (including calculations) Payables issues (including calculations) Marks available Maximum (b) Consistencylcorroboration Presentationalldisclosure issues Additional w o r k Marks available Maximum Total marks available

1HE lNST!lUTE OF CHARTERED

ACCOUNTANTS Ih

[ k c , > N , ,",, " & L C \

I 05

Section 3: Planning assurance engagements (a)

Planning notes Reason for 16% increase in revenue

b

-

-

--

b

Reason for increase in GP margin: 5 1.6% to 53% --

Lower cost base due to sourcing from China Increase in sales of Elite (higher margin) brand Increase in selling price over and above increase in cost of Elite products Impact of exchange rates

b

Reason for increase in operating margin: 4.4% t o 6.3% (operating costs t o revenue 47.2% to 46.7%)

b

Over and above GP margin

b

Impact of new warehouse management system

b

Increased efficiencies

b

Reason for reduction in inventory days: 13 1 t o 126 (increase in inventory turnover 2.80 to 2.89)

b

Reason for increase in receivables days: 37 t o 42

-

b

Relaxed credit terms to wholesale customers Credit control problemslb'ad debts

Reason for increase in payables days: 5 1 t o 55 -

-

(b)

Volumelnew product lnflationlpricing policy Any new outlets opened Any new wholesale customers Any change in income recognition policylcut off

New suppliers' credit terms Cash flowlworl
Conclusions Whether b

Financial statements are consistent with the auditor's understanding of the business

b

Review procedures corroborate conclusions formed during the course of the audit

b

Any previously unrecognised risk of material misstatement/ financial statements give a true and fair viewlcan issue unmodified audit report

b

Auditor may need t o re-evaluate planned audit procedureslpost balance sheet date work

b

Any new factors which may affect the presentationldisclosures in the financial statements

b

Presentation adopted in the financial statements may have been unduly influenced by the desire t o present matters in a favourablelunfavourable light (prepared using acceptaMelconsistent/appropriate accounting policies)

Potential impact on the financial statements of the aggregate of uncorrected misstatements

Tutcarkal note Th~sanswer in the tnaricing plan produced by the examiner. The examiner has confirmed that the style of t h ~ sannwer is appropriate for use by students in the examination.,

'06

FJ

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN .1rVGLANn AND U'ALr5

Examiner's scranr~.~en ts AIISW~I-s to this cj~~estiorl :~rc-nitled :lie i\ii:!lesc ;:irr.!,ll~ :Ivrxt:lp:.: <:I, tSi:ri rhis was mainly due tn strong [>cr-fol-i~~nrice.. cvi ,:'?lc- (
;ertiorj of rllc; pal>cl, I IC~..;~;..~

Part (a) .

<

..

..

.

This part of he qcleseic.?:lwns gc.!tp; s!iy +:.:c!l :?r:iv...:.t ::;i ;..;tii~iirj:,~~:~; :ii :. j i c L r l r l r ~I-elev;lr.lc yj I~iit!oslit :t)qn!F, !.!nys! a!i(I rheri in revenue, gross PI-cdit !~inrgin.ol)el zi:il!i: i r ~ ~ i . i!lvc.:rtt:?: ~ i ~ ! . y. !.i.<:i:i:.nl.!I~c; .i;!!..l j?;!~;!b\f:~ . , identified potel!t~al!y I-clevnrir crGc.r!t..r c t o i - c i l i ~ i f i hI:?:]:i : > . 1 I~~v~v,c.~;c>! , !I!
)

Considering the absol~~t;:!illcr ~i,ls<: ii, !::;:c:r-,~t,ii!g c:o:;r!: I!,, .>\,!)i?iiy. i!e:.:;!l..,.ikve i.c)r.~.l?s w i i l l c ! ~ t~ ~ . G P E I , ! Y l ~ e ~ ~ g n it!-1;!1 ~ i l l chf g illcrcasr.' ir! c~l:r~!;i!.i~!g c<>.;!s w;)s p! o~,ol.rior~nte!y !c.ss ~1.ialicl.le ir)ci,easc in t-evenr,!:. . a . ~ ~ ; ~ t , yii.1 i t?f)X5 ~ 2nd t h c>vPI';~~! ~ ~ :.!I<>< <>IIII~;~[I~ 'i:::! , Iti>:,h!,! ~~:;;,.~I.~:I;;~:J . ,:;.,.,(i:

)

Considering r h r at!solut.e incr-case iii inventory days I:ad falleri

)

Treating 20x4's figure3 as the cui.!.e!.lc year and 20x5's figtir.es , ~ sc11e cornp:tratives

)

The term 'draft.' wl.iictl was applied to thc 20x5 I-esu!ts ilrciarir 'b~.!c!r,crrcd'instead o f 'actiial n o t yet finalised' as was i n t r l i d c d .

!I~VE:II~:.>I

y


rile

r:? : ? p o ~ . ~ ~t11:it. iat~

c)I.(~~/IP ;:P;~I~ . I ~I:~:.II. t n i l i r ~ ~

Unsuccessful candidates shou!cl r ~ o t et1.s fo!!owil>g: )

The best way t o racklc ;I ql.~csiior-~ like rllis or.~c.eii:u: ~.eqai!.es<:andid;!tes co ar-ialyse financial st;!ternenc irifo~.niationis tc? be !11ethr:(lica! 2nd t c ? ws~.!;clown t.hc! ir!c-c,lr,c.: sr.:itc?rr?ent. and then the balarice sllect 'line by line'. This apr~r.oachwill nlwny.; rcri:1 1:.0 genet-acc r ~ ~ c !~r~rl!-l<s -o than onr. where caritiidatcc lool< to comment o n the v71ious ~.ccot.irirhcadi~,gsentil-ely a t ~-arrtlo~r,.

b

It is really irvpc~.cr~ric rha~ candid:l~$>x re>d :?~>rl PI :)perly digesr: x ! i a r is being t o l d t o them in the question. W t l e t i this rluesrir:,r) i~><:r!li<.:ile
Part (b) Answers t o this part of !.he questic?r~w c ! c disa~poiriri~.ig a; rl?aliy car~didatesn-~isl-eadthe question. A large number of candidates failed t o ; ~ [ ) p l . ( ? r i ar!iat t ~ t.17~ql.iestion nskec:i for- rhe c.oncl~.rsionsthat the audit(;!-s should reach as a I-csult of tlieil- ~.eview(of rhe .finallcia! statements. Many provided an answer- which related t o the conclucions that rhe iiudit.o~slior.~ldrcach as a I-ez~rlccf a review o f wsrl p li!rapp~.opr-iate. y Even when candidates did consequence a l o t o f t h e c c ? t ~ ~ ~ n erliat appreciate that this p < ~ i o- tf tlie tlucstiun was refel-1-irig to 2 I-ovicw of f:he fii.ia!.lcial statements, t o o few candidates made any use o f 1SA 520 paragraph 13 t o 1-~elpchetr) to genei-ate serisible poir~ts: T h e p o i ~ ~ t s most cornn~ol.~ly idencilied by rlie c:nritlidates w t i o did answel. :he q!!?:scio:~ set w e r e those relat:ir!g t o 'consistent with auditor's ~ ~ c ~ d e ~ . s t a r lodfi rthe i g birsiriess' anri 'fil~aricial.;catr,rrierlts give a ti.ile and fair view'. Few candidates considel-cd tht: potential impact o n the financial statc2r:wrics o f the a~g1.6gatcof uilc-or.~-ecr.etl niisstatements.

THE INSIITUIE OF CHAR1ERED ACCOUNlAN1S ,h I+.c,~ nvr, h.ri> u n t r Q

d

:tion 3: Planning assurance engagements

Holly pie:

(a)

Each factor Maximum (b) New client Cash sales Different locations Overseas branches Internal audit Managers local buying power Casual staff Incentive scheme Leases Marks available Maximum Total marks available

(a)

(b)

Y2

5

2% I% 2% I% 3% 3% I% I% I% ~19%

12 17

Factors to take into account when evaluating an internal audit function and its work

b

Organisational statuslno operational responsibilitieslfree t o communicate with external auditor

b

Scope of the function - is it wide enough t o be usefullno limitation of scope?

b

D o management act on the recommendations of internal audit!

b

D o internal audit personnel have adequate traininglcompetencelqualifications!

b

lnternal audit sufficiently independendsenior level reporting lineslaccess t o boardlaudit committee

b

W o r k of assistants is properly supervised, documented, reviewed

b

Existence of internal audit manuals

b

Is sufficient appropriate evidence obtained by internal audidprogrammeslworking papers?

b

Are conclusions reached appropriatelreports consistent with results of work? .

b

Any exceptions or unusual matters disclosed by internal audit are properly resolved

(,

:

Circumstances with reasons New audit client

b b

Lack of cumulative audit knowledge I'lisstated opening balances

Mainlv cash sales

b

Risk of misappropriation of cashlunderstatement of sales

Many different locations

b b

Different locations increase risk of breakdown in controlsllimited monitoring by head office D o we have sufficient resources t o cover geographical spread!

Branches located overseas J

b

Overseas branches risk of incorrect foreign currencv translation

THE INSTITUTE OF CHARTERED ACCOUNTANTS

i

Internal audit function

s first year o f operation Internal audit staffed f r o m main finance department - h o w independentlself-review risk they have appropriate internal audit experience if n o t worked in internal audit before? Manager local buying power

)

rcing consumables locally could lead t o buying at t o o high a price1 collusion with suppliers Lack o f consistent quality o f purchases could damage company's reputation enses m e t in cash increase risk o f misappropriationllack o f adequate documentation for

Incentive scheme for managers )

lncentive scheme could lead t o understatement o f costs/overstatement o f profit

Assets held under leases )

Check for appropriate accounting treatment o f leases

is the marking plan produced by the examiner. T h e examiner has confirmed that the style is appropriate for use by students in the examination.

aminer's comments wers t o this questiorl attained che liigl~estoverall avel-age (-311tl-~c!W ' I section of che papel.. T t ~ i swas due

jtes nchievi~ig,full nial-l<s. It was in rlie open book t e x t aritl had es w h o did n o t score h~ghlygenerally included orily key status' without explairiing tlie tlie scope of this part of the question and applied artnient in the sceriar-io. This was relevant t o part (b) o f

st candidates answered this part o f ttie question well, in pal-ticulal- the circirmstances o f a new audit

nt, cash sales, multiple locations, overseas branches and n bonus scheme. Alrnost all candidates picked up these points and gave valid reasons for theit impor-tance.

ough many candidates did pick up o n the issues of the managers' local buying power, casual staff being out of cash and the newly forrned internal audit function, only the better candidates developed chese

mber of candidates were m o r e concerned w i t h the suitability o f casual staff (co~nnientingthat they PAYE rules. er was unwise b u t failed t o set o u t specifics as t o why this I audit function was a planning issue b u t failed t o refer ed by ttie facts in the question. Only a few candidates as its mer-nbers had been transferred nised that the department could end up reviewirlg its o w n \~/ol-l< the main finance department.

t be dishonest o r badly dressed) as opposed t o co~isideringthe possibility o f breaches of

W

THE INSTITUTE OF CHARTERED ACCOUNTANTS I N ENGLAND A*

WALES

Section 3: Planning assurance engagements C o ~ n n i o nmisconceptions we!-e to any significance. b

set.

rlie following as planninglrisk issues when they were irnlil<ely t o be of

Monthly salaries and other costs paid centrally. The colnpany being a public cornpariy. The nature of the business ..... coffee shops being seen as high risk.

)

b

A nuinber of candidates also becarrle side-tracked by the i s s ~ ~ofe the regulato~.ysysteni in other parts of Europe and a coricel-n over the quality cf the financc: depal-cment after- staff had been tl-ansferred t o internal audit (wheri ct~erewas no indication irl the questioti that these posts had not been adequately filled). C:tr!didates shourld ensure that they first of all deal wi~l.1all the relevant information in the question before irweriti~igissues that are not pi.eserlt. A sigrlificant ~ninoi-ityof car~didnr:c!sinclude!i i l t t:hcir nnswel-s issues that woirld have been considered prior* to appointment and rherefr)~-cwere noc I-elcvant. such as obtaining professional clearance from the previous a~lditorand whether fee th~-c:sholdsnight be breached.

2I

Garme~ltsbtd

Marks Retail operations - risks Retail operations - factors Retail operations - audit w o r k Overdraft facility - risks Overdraft facility - factor Overdraft facility - audit w o r k N e w computer system - risks N e w computer system - factor N e w computer system - audit w o r k Marks available Maximum

Expansion of retailing operations

b

b

110

The company has increased the number of its locations from 2 t o 12.

b

Thiqside o f the business is relatively new.

b

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

W i t h multiple locations there is a risk of nonadherence t o management policies. Management may lack experience and-a track record such that controls may n o t yet be in place.

b

Perform branch visits (including cash counts),

b

Review and test check procedures1 controls.

'ANSWER BANK

$

)

.-

The business is conducted on acashbasis.

There is a risk of unrecorded revenuelunderstatement of income and consequently understatement of VAT and corporation tax.

..

A

d. g;

'*

)

Reconcile till records with bankings.

)

Carry out analytical procedures involving Inter-branch comparisons of @kings

-

'

I::

on a month-by-month

C:.

h.' .,<

basis Comparison of actual with expected margins (established by obtaining details of cost and selling

.a,5 I

-

<-)

,. ,

f'

The company retails fashion clothing. These represent desirable goods susceptible t o @ek In addition, fashion inventories are susceptible t o

b

The risk of shrinkage may mean that inventory records do not reflect actual inventories.

b

Risk of inventory obsolescence.

Attend physical inventory count (at year end if undertaken; alternatively, observe counting procedures if system of continuous o r periodic counting).

k! ti;

b

)

Review adequacy of count instructions, in particular identification of

-

Differences between physical and book inventories

-

Slow-moving lines.

Ascertain level of differences between physical and book inventories. Obtain evidence of action taken in respect 6f , differences.

b

Review inventory movement reportslage analysis.

)

Review post year end movements and selling ~rices.

Section 3: Planning assurance engagements

Increase in overdraft facility b

The company is at its overdraft limit and is seeking to increase its facility.

.. ........ ... . .. . . .... .. ...... . . . . ............. ... ..-. ....... .. ,,,.. ..............,., ...... .......,.., .,,.

b

The overriding risk is that the bank may withdraw the overdraft facility.

; Monitor negotiations with the bank1inspect correspondence with the ,: bank. a:

This could lead to window-dressing and, if the company is unable t o pay i t s debts as they fall due, to going concern problems.

Review management's plans, including cash flow and profit forecasts.

If the new system does not function properly there may be systematic errors, leading to unreliable accounting records.

Review arrangements in respect of setting up the system, especially re

...


-

Obtain written evidence of management's strategy for alternative sources of funding.

..,

New computer system b

The company has installed a new computer system requiring modification.

b

The non-current asset may be materially misstated.

-

Transfer of data (test. check if necessary)

-

Training of staff.

has

Consider the use of CAATs. Inspect invoicelcontract in respect of the purchase of,. the computer.

Examiner's comments This question was generally well answered. Most candidates identified the major issues in the question but very few realised that if there was an understatementcof:incomeas a result of unrecorded cash sales, then VAT and corporation tax would underprovided.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AM) WhLES

. ,

.

.

ANSWER BANK

Curson Ltd

Marks

4:. 8,

Shrinkage - risk

$: Shrinkage - controls

& . Cash - risk

i; Cash - controls &.: Logisticslreorder levels - risks .:8 Logisticslreorder levels - controls Computer system - risks

p.

..s Computer system - controls

Asset management - risk Asset management - controls . Lawslregulations - risk Lawslregulations - controls Profitability - risks Profitability - controls Personnel - risks . Personnel - controls 6; : 3 . Marks available ia, Maximum

'&:

8;:8i.i

I%

5 I

4% 2% 3 I 3 1 I I% I% 2 2 2 4 36%

Risk b

Shrinkage -

,

1 i

b;

a?!

Theft of inventories Damaged or poor qualitylobsolete products.

Control procedures b

Security measures in place on vehicles and in stores.

b

Inventories checked for quantity and quality for acceptance t o retail site.

b

Staff trained in correct and careful handling techniques.

b

Managers only allowed t o change inventory quantities and locations on privilege access codes, and such transactions logged and reviewed by higher level managementlsecurity personnel.

b

Electronic tagging used for higher value goods.

b

Store detectives patrol sites.

b

CCTV used t o keep high value items under surveillance.

b

Packaging designed t o minimise damage.

b

Insurance policy taken out against theft of inventories.

b

Independent review of inventory reports. . ageing -

Risks b b

Theft of cash. Fraudulent consideration accepted in exchange for goods.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN INCL*ND AND WALES

Section 3: Planning assurance engagements C o n t r o l procedures

b

Physical security over cash office, safe and cash collection equipment.

b

CCN

h

Each cashier t o have user I D and access password.

h

Floats checked at beginning and end of shifts.

b

Cash counted independently and held securely until cdl~ected.

b

Bankings carried out by protected security personnel and not retail staff.

b

Staff informed of floor limits for cheques, guarantee cards and crediddebit cards.

b

Consideration not t o be accepted without on-line validation and checking of signatures t o crediddebit cards.

b

Regular independent reconciliations between amounts banked and sales data, and discrepancies followed up.

used t o keep tills under surveillance.

Risks

b

Logistics processes fail t o deliver the right inventory t o the right place at the right time in the right condition.

b

Re-order levels not set at appropriate levels resulting in stockoutsloverstocking.

C o n t r o l procedures

b

Computerised planning and forecasting systems based on prior experience and monitoring of current trends.

b

Regular review of re-order levels by head office.

b

Orders over a given size must be authorised by an experienced manager.

b

Inventories are physically counted at intervals and results used t o correct book records.

b

Differences investigated.

h

Approved suppliers with service level requirements included in contracts.

b

Loss of computerised systems resulting in business interruption.

Risk

C o n t r o l procedures b b b

A business contingency plan which is tested periodically. Redundancy built into computer systems and physical security over them strictly enforced. Maintenance contract.

b

Property, plant and equipment not managed effectively, economically and efficiently (not acquired on a cost-effective basis).

Risk

C o n t r o l procedures

b b

Analytical procedures performed on leaselbuy decision. Repairs and maintenance policy and monitoring procedures t o ensure compliance.

Risks

b

Non-compliance with I~wslregulations,particularly in respect of opening hours (eg employment, Sunday trading local authority, lease restrictions).

b

Failure t o open in busy periods.

m B

THE INSTITUTE OF CHARTERED ACCOUNTANTS .E-DmU.

ANSWER BANK Control procedures

b

Monitoring procedures by head office t o ensure

-

b

b

Managers are aware of restrictions and comply with them Stores are open during busy periods.

Falling profitability/losses due t o tight margins. Under-performing branches.

Control procedures b

b

b

b

Head office control over pricing policies. Use of performance indicators t o monitor branches.

Insufficient experienced staff t o service retail processes (losing staff because of low pay). Failure o f remuneration policy t o result in increased revenue.

Control procedures

xaminer's comments i s question proved to be the most challenging on the paper. A number of candidates drifted into audit ork to be undertalten, in each of the areas they considered, which was outside the scope of the question. e areas of cash, inventories and computer systems were generally well covered. Some candidates spent

long on these areas, often straying beyond the requirement of the question and dealing with the audit

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

'ANSWER BANK. --

. . ... . . .. ... ...,,.

9; ,g.

C"; I. . b .

Performance of bank reconciliationslinvoices matched to delivery note.

b

Internal controls appear to be sufficient for sizelnature of business.

.. ;,',

Bank reconciliation l~kelyto ensure basic errot-s identified and correc ted.

Ig:,

Audit work re key balance sheet and income statement items Non-current assets

3;

b

.F

tl,

Sample check additions per cash book t o invoices and physical inspection.

Inventories

P .

b

Q b ;;I 0.

9' b b

!:.b

8' b ?: ;fi

3,

Check deeds t o confirm title t o land. Check cost of land properly brought forward. Physical inspection of houses at year end. Analytical review re allocation of overhead for reasonableness. Check WIP calculations. Written representation from Eddy Brick.

Receivables

,

b

1 !j

t! b

$1

t;

lnspect correspondence with Local Authoritylseek direct confirmation. Compare VAT receivable balance with amount per day booklafter-date receipts.

Cash at bank

f*;

1 ;t. 1

7::b I : .

Check year end b z n i r ~ c o n c i l i a t i o nincluding dares of clearance of outstanding irems. Obtain bank letter. Direct confirmation o f money market balances.

$i :

Payabler

g:.

? b b

b .,., b

,

lnspect unpaid invoices file and suppliers' statements for invoices relating t o year. Reconcile deposits t o legal correspondence. Reconcile amounts owed t o HM Revenue & Customs with payroll and cash book. Check after-date payments.

Revenue

b

Check revenue figure t o legal cot-respondent For transactions clost2 t o year end - check da

Are appropr.iate cut-off

Wages

b

,

b b b b

. .

Sample check payroll calculations. Analytical review of payroll costs (eg NI as % of payroll costs). Agree accruals t o post year end payments. Ensure appropriate tl-eatment starters and lea ers Check bonus accrual included

Purchases and expenses ,

b

Sample check entries in cash book t o supporting invoices.

3

nxaminer's comt.riesrts,

k,kswers to part ( a j wer-e ~ e r ~ e l - a l l y ~

IIILIC~I

becter tliari answers t o part {b). wtiicli were often disappointing.

W'

b o u g h answers ro pal-c ( 2 ) wel-e gcrlerally good, many cnrididates scol-ed rheir narks from identifying the i&orr and were il~l.blc r o cxplai~rwhy rlrey co~~t.ribut.cd tc l o w irihcr-oni l.isi. R,t.lie~- worryingly. some andidates suggezted thzt 21-c3spt-e(-)ar-eciby t.he audit fil-rii w o ~ ~not. l d reqt~i!-ca\itiiting. A small tninority I>; hanaged t o rnisl-ead tlitl cl~tcstioricompletely sod tried t o ide~itifyfactof-swllicli ilitlicated high risk.

t;.;,

'art (b) discl-iniinatvt:l t,otwcf:~ittiose catidiclates who 11set.It l . ~ c t ! ~ ap:,licatic>r~ . 2nd t~igherskills pod those who idopted the sc.attt?I- g1.1~:II?~I.O:K~I.The rriosr corilrnori sl~o~rc-oriti~ig w.is r . ! fraili~re ~ ro tailor answers t o the

.. .

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND A N D WALES

Section 3: Planning assurance engagements circunistances of the question. Many candidates trotted out standard tests in respect of bad debts and obsolete inventories, and did not appreciate that they were not relevant in this scenario. The inventory of land and houses was often iricluded within the worl< on non-current assets. indicating candidates' lack of appreciation of the nature of the business and failure t o use information provided in the question.

24

Lersco Ltd

Marks (a)

lnherent risk Control risk Detection risk Reasons for considering risk Marks available Maximum (b) Factors indicating risk (each) Explanation of why a risk (each) Maximum Controls re completeness of recording and safe custody (each) (c) Maximum Total marks available

(a)

Risk Different elements of audit risk Inherent risk: the risk of material error arising regardless of related internal controls/risks associated with the nature and characteristics of the business. Control risk: the risk that internal controls fail t o prevent or detect a material error. Detection risk b b b b

The risk that the auditor's substantive procedures will fail to detect a material error. Detection risk is split into sampling and non-sampling risk. Sampling risk is the risk that the sample is not representative of the population. Non-sampling risk is the risk that all other work by the auditor fails to detect a material errar.

Why auditor needs to consider Risk assessment

b b

Enables the auditor t o plan his audit effectively Ensures audit attention is devoted t o appropriate areas.

The higher the risk, the greater the amount of assurance work required. If inherent risk is high, then the auditor m u g take steps t o reduce detection risk. Steps taken will affect the nature, timing and extent of audit procedures. (b)

Factors contrib&ing to high audit risk b

b b b b b

New audit t o your firm. Fashion is a volatile/seasonal business, especially 'out-of-fashion' inventory. Large chain of stores. Company sells luxury goods. Small number of suppliers. , , Large number of cash transactions (sales/wages). \

118

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENCLAND AND WALES

%

,

ANSWER BANK

b b b

b b b

b

Company deals in foreign currency. Dominantlmaiority shareholder managing director. Managing director's extravagant lifestyle. Managing director is 60, may retire soon. Company's customer returns policy. Large bank borrowings. Casual staff employed.

W h y a risk

(c)

b

Risk of obsolete inventory as company may be stuck with last year's trend (difficult to determine inventory values).

b

lnventory control issue with respect t o number of storeslinventory lost in transit o r double counted.

b

Luxury items first t o go in event of economic downturn - this puts the company at risk.

b

Risk of stock-outslloss of supplierllarge borrowings causing going concern problems.

b

Risk of incomplete recording of sales.

)

Risk of misappropriated cash.

b

Exposure t o foreign exchange risk resulting in misstated inventorylpurchases.

b

Over-dependence on managing director - if unable t o work and no succession in place.

b

Managing director's desire for profit may lead to manipulation of results.

)

Casual staff resulting in misstated PAYE liabilitieslfineslinterestlmisstatedpayroll figure.

b

Customer returns could give rise t o misstated balances in accountslinventory valued at greater than its net realisable value o r may be obsolete.

Internal controls r e c o m p l e t e recording o f sales and safe custody o f cash Sales discount only permitted with manager authorisation. Use of, and maintenance of electronic till and till rolls (EPOS system). lnventory system linked t o EPOS system t o identify 'missing' inventory items. Takings to be banked intactlbanked daily. Restricted access t o tillsleach staff member has unique I D and logs on at start of shift. Floats checked at beginning and end of shift. Cash takings collectedlcounted by at least two staff members1CCTV monitoring of tills. Two staff members t o bank cashluse security firm. Adequate on-site security for cash, eg overnight safe. Daily reconciliation of till rolls t o cash takingslbankings. Regular bank reconciliations. Management review of all reconciliations. Staff references taken up. Spot checks on cash balances.

Examiner's comments Answers to this question attained the h~ghestoverall average of the wricten test questions. Those r candidates who adopted a columnar approach generally produced the most focused answers. Answers to parts (a) and (b) were generally better than answers t o part (c). Some candidates' answers to this question were very lengthy, indicating that they probably spent too much time on this question. In part (a) the majol-ity of candidates,defined the elements correctly, although weaker candidates struggled to provide a satisfacto~.ydefinition of inlierelit risk. Very few candidates split detection risk into i t s two

components, and fewer still went on t o define these components.

A significant number of candidates failed t o show an adequate appreciation of why an auditor needs to consider risk.

?

THE INSTITUTE OF CHARTERED ACCOUNTANTS FIDIIlUID*H)W

i '

i

,.

:.

Sec:tion 3: Planning assurance engagements '

Part (b) was v c ~ y well answered, with the majority of candidates obtaining full marks. The most cornmonly ovcrloolted polnts were those relating t o the age and lifestyle of the managing director, and the potential ilnpl~cationsof this (cg manipulation of results). Many candidates also overlooked the issue of the large bank borrowings and its potential gorng concern impact. Although many candidates identified casual staff as a factor, they failed t o appreciate the PAYE implications.

.

The answers t o part (c) were on the whole disappointing. Many candidates struggled t o identify sufficient co~itrolsover recording of sales and safe custody of cash. Weaker candidates failed t o appreciate that the business was cash based and strayed into the realms of internal controls over credit transactions, citing matching despatch notes with invoices and sales ledger control account reconciliations. The most commonly overlool<ed points were those relating t o spot checlcs on cash balances, regular bank reconciliations and management review of all reconciliations.

,:'

,

'

. I .:, .:.

W r a ~ a kLtd

(a)

(b)

Factors (each) Policies and procedures (each) Maximum Audit procedures (each)

.. ''L;.,

.. .

Y2

I

12 I

.

,

.

:.!

,,,

.

.:,

(a)

Factors which may have contributed to cash flow problems, and policies and procedures to be implemented to improve cash flow Factors

b b b b b b b

Monthly loan instalmentslinterest costs. New customer baselincreased volume of business. Poor credit control procedures. Receivables taking longer t o pay. Delays in invoicing (converting work-in-progress into receivables). Anna's heavy workload may impede effective chasing of slow payers. Removal costs.

Policies and procedures b b b b b b b b b b b

120

Prompt invoicing. Initial credit checks on new customers. Imposition of credit limits with regular review thereof. Checking of age of existing receivable before new work commenced. Delinquent customers put 'on stop'. Dailylweekly review o f aged receivables analysis with follow-up letters. I n t e r k t on overdue amounts. Discount for early payment. Bonus incentive for improvement in cash collectionltargets for cash collection. , .. Referral o f overdue debts t o debt collection agency. '.. Use of debt factoring. .

THE INSTITUTE O F CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

1 ,

.:;, ii:,.,

6 '.F:$: '

Maximum

.i

,(

.,

4

' b

ANSWER BANC

(b) Audit procedures t o ensure t h e l o a n has b e e n p r o p e r l y accounted for

'

b

Inspect loan agreement and ensure compliance with terms and conditionslcovenan,~;

b

Consider the consequences and possible reclassification of liabilities.

b

Direct confirmation from the lender of -

-

:'

,

Principal and unpaid interest at the year end Details o f security.

b

Ensure proper split between current and non-current liability (split between 2-5 and over 5 years).

b

Confirm correctly disclosed

-

i'

Dates and terms of redemption Security.

b

Ensure up t o date with interest and repayments in post balance sheet period.

b

Recalculate loan interestlanalytical procedures and ensure accrued interest properly accountd.for.

Examiner's comments This question was generally well answered, although there was a tendency for weaker candidates t o stray, beyond the requirement in part (a). -e were many good answers to part (a) . However, candidates were generally better at. identifying the :ies and procc?duresto be implemented than they were at identifying the factors which might have , ;contributed to the cash flow problem. The most comnion shortcoming was the failure t o appreciate that delays in despatching and invo~cingcontributed t o negative cash flow. Weaker candidates wasted time f ,trying to identify wealtnesses in the goods inwards system and covering procedures such as segregation o f [duties and authorisation controls instead of focusing on the factors contributing to, and procedures which , iwould alleviate the cash flow problem.

.

T"

I;

%Part(b) of the question was well answered by the majority of candidates. However, a significant number o f iggandidates failed t o demonstrate a Icnowledge of basic auditing procedures in respect o f bank loans; in !particular, a large number o f candidates did n o t consider obtaining direct confirmation of the loan from the 'lender. Other points commonly overlooked included checking compliance with terms of the loan and '. 6 Pnsuring that repayments were up t o date in the post balance sheet period.

TH# INSTITUTE OF CHARTERED ACCOUNTANTS H EMLAND AND WALES

Section 3: Planning assurance engagements

Marks Wages and salaries (including calculations) Gross margin (including calculations) Interest cover Work in progress (including calculations) Receivables (including calculations) Overdraft Other payables Marks available Maximum (b) Measures taken After date receipts Supplier relationships Review of forecasts Covenants Marks available Maximum Modified on grounds of disagreement (c) Modified with emphasis of matter Modified on grounds of limitation on scope Marks available Maximum Total marks available

(a)

b

Wages and salaries as a % of revenue have increased from 60% t o 70%.

b

This impacts on the net profit margin and subsequently on cash flow.

b

The gross profit margin has fallen from 30% to 21%.

b

This means a reduction in the company's ability to cover operating expenses.

b

Interest cover has fallen.

b

This affects the company's ability t o service its debt and could result in foreclosure.

b

WIP has increased from 17.5 days t o 22 days.

b

This may indicate possible problemsldelays with invoicing ultimately impacting on cash flow.

b

The trade receivables collection period is up fromp38.7 days to 67 days.

b

This may indicate -

-

..

b

The cash position (cash and cash

b

There has been a build up of other payables.

b

Possible bad debts An adverse impact on cash flow.

This indicates a risk of inability t o pay debts as they fall due (going concern risk).

. ........,........,.....,.....,.,..,,,,.,,.,...,,,.,,,

,,, ,,

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

b

.

.

.

.-.- .

--

.

The delay in payments may be due to shortage of fundslinabilityto pay debts.

.....-. ....- .- .

A ~ S W EBANK R s t balance sheet m a t t e r s r e l e v a n t t o (a)

b

Measures taken t o -

Control labour costs Speed up invoicing and cash collection.

b

Review after-date receipts from customers.

b

Review actions by payables and whether relationships maintained.

)

Assess whether the company can pay its debts as they fall due (in particular loan repayment).

b

Has the company

-

Stayed within the overdraft limit? N o t breached its covenants?

) Possible f o r m s o f a u d i t r e p o r t The report should be qualified on grounds of disagreement if )

Receivables o r WIP are materially overstated

b

The company is not a going concern and the directors insist o n preparing accounts o n a going concern basis.

The report should be unqualified (with an emphasis of matter paragraph) if

b

The auditor remains uncertain about going concern

b

But there is adequate disclosure in the notes t o the accounts.

An additional paragraph will be required stating that the audit report is n o t qualified in this respect. If disclosure (in a note t o the accounts) is inadequate - the audit report should be qualified on grounds The report should be qualified on the grounds of limitation of scope if evidence reasonably expected to be available has not been obtained and evaluated (eg the directors have not taken adequate steps t o satisfy themselves that it i s appropriate for them t o adopt the going concern basis).

This question was generally well answered. Candidates t.endecl ro pel-form better on parts (a) and (c). (a) was ge~ierallywell answered. The ~ r l o sct o n i ~ n oo~rlission ~l was the ktilure t o consider the possibility the increase in w o r k in progress rnay have rescrlted fl-oln delays i r ~islvoicing. Weaker candidates failed

ers t o past (b) were disappointing as many candidates did n o t relate their answers t o 'the issues raised

in (a)' and wrote about post balance sheet. events in very general and tt1eo1.etica.lterms. A nurnber of candidates wasted time detailing ratios they would calculate on the itenis in the financial statements. Only a minority of candidates considered reviewing the measures taker) t o improve the cash position, such as controlling labour costs and speeding up tlie invoicing process. A significant number of candidates failed t o er reviewing forecasts despite having identified the going cancel-rl risk i r l part (a). ever, wealwr candidates discussed qualified audit reports in ication t o the cil-cumstances of the question. Most and over-lool<edthe possibility of disagreement over accounting treatment due t o material overstaterrrent of I-eceiv;rbles o r work i r l progress.

t THE INSTITUTE OF CHARTERED ACCOUNTANTS lNMCLIVIDLN)WLLI

Section 3: Planning assurance engagements

27

WHAT

Marks (a)

H o w it differs Agreement and confirmation of terms Planning issues Evidence Review and reporting Marks available Maximum Deeds of covenant Postal donations Collections Capital donations Grants Sales o f refreshments Fund raising events Marks available Maximum

(b)

(a)

Differences between this engagement and the statutory audit engagement

The statutory audit is carried o u t under the Companies Act 1985 (CA85) or equivalent legislation. Under the CA85 the statutory auditor has a duty t o carry out whatever w o r k he deems appropriate in order t o reach an opinion on whether the financial statements o f a company give a 'true and fair view'. The auditor's opinion is then reported t o the shareholders in a predetermined form of report (as set out in ISA 700). Here, the auditor has been asked t o perform additional w o r k over and above that of the statutory audit. The scope o f this w o r k will be agreed with management and a particular format of report (addressed t o management) will also be agreed. Approach for assurance engagements )

Agree the scope of work t o be performed and the basis of the report t o be given.

)

Issue written engagement terms detailing the responsibilities of the parties t o the engagement, the scope of the work and the basis of the report t o be presented.

)

Plan the w o r k t o be performed, including -

Assessment of the risks o f error and misstatement Determination of the quantity o f evidence needed t o give the report required.

b

Determine the testing plan t o be performed.

)

Collect and test the detailed evidence.

)

Review the reiults o f the testing o f the evidence and form an overall conclusion on the engagement. I

b

Prepare and present the assurance report.

The approach t o the engagement and all the testing and results must be p!operly documented in a set a of working papers.

124

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

Controls over income (I)

Deeds of covenant

b

Regular review by a responsible official to ensure that all amounts are duly received (most deeds of covenant will probably be paid by bankers' order and this method of payment should be encouraged).

b

Regular monitoring t o ensure that all the payments covenanted are obtained, including income tax refunds.

(2) Postal donations b b b

A t least two persons t o be present at opening of mail. Immediate recording of receipts on a post list. Prompt banking of the money t o ensure maximum interest earned. Independent reconciliation of cash book receipts with post list.

b (3)

Door-to-door and work-place collections b

b b b b

Pre-numbering and sealing of collecting boxes and tins. Provision of identification t o collectors. Prompt collection and removal of proceeds from boxes. A t least two persons t o be involved in counting and recording. Prompt banking of cash intact (ie without using the money collected t o pay expenses).

(4) Capital item donations b

Safe-keeping of documents of title o r registration (eg vehicle registration form).

b

Safe custody of donated assets (eg vehicles should be fitted with alarms and locked).

b

Use restricted to company business by

(5)

Having authorised drivers Installing tachographs.

Local authority grants b

Regular discussion with local authority officials t o ensure all available grants are obtained and that specific payments are received.

b

Authorisation, by directors, of disbursement of grants to ensure expenditure complies with the terms of the grant.

(6) Sales of refreshments at the social centre

b

If level of sales justifies it, a till should be used for all takings which should be banked daily and intact.

b

Inventories of confectionery, sweets, etc should be securely held.

b

Overall tests on gross profit percentage should be made at (say) monthly intervals by the finance director.

b

Some degree of supervision may need t o be present t o prevent losses of inventory through staff pilferage. 'Spot checking' may suffice.

(7) , . Fund-raising events b b b

b

Approval by the board of directors. ~ d e ~ u a tiecords e' of income for each event. Clear responsibility for cash handling allocated t o two persons. Takings t o be banked promptly and intact, with separate authorisation and payment of expenses.

THE INSTJTUTE OF CHARTERED ACCOUNTANTS IN ENGLWD AND WALES

Section 3: Planning assurance engagements

-~F,--.--.,.-..n..-----

"

Marks

(a)

Overseas suppliet-s Ferganto Merger Computer problem Tight deadline Marks available Maximum (b) N o r m a l checking Analytical procedures Tests o f controls Cut-off Supplier statement reconciliations Ferganto Overseas suppliers GRNl Other Implications f o r r e p o r t Marks available Maximum Testing controls and substantive procedures (c) Cut-off Analytical procedures Supplier statements Marks available Maximum Total marks available "

(a)

"--....F..,,,.

"

"

"

---

--

-

Main audit risks for payable~ Overseas suppliers (24% of total trade payables) Given that the clerk retired without replacement, it is possible that controls have declined b o t h during and subsequent t o her illness. Purchases from overseas may involve foreign exchange considerations as well as problems o f late invoicing - all may result in difficulties i n obtaining sufficient evidence in the time available. Recognition o f year end goods i n transit as inventories may depend o n whether shipments are 'free o n board' (FOB) o r 'carriage, insurance, freight' (CIF).

Ferganto plc (5 1 Y2% of total trade payables) Absence o f a year end balance suggests that this major supplier does n o t provide statements against which the completeness o f Pubgames Ltd's recorded trade payable can be checked. Heavy dependence (economic?) o n one supplier may be risky, especially given the new retention clause, which m ~ indicate y a lack o f stability o n the part o f either Pubgames L t d o r Ferganto plc. If there are concerns about the appropriateness o f the going concern basis for Pubgames, the extent o f raw material inventories and indebtedness subject t o reservation o f title clauses must be disclosed in the notes.

Merger Third parties may be seeking to rely o n this year's audited financial statements aJa result o f the merger - any pressure t o manipulate results (eg suppressing liabilities and expenaiture) increases inherent risk.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN fNGLlND AND W , h I I I

-.

ANSWER BANK C o m p u t e r p r o b l e m l G R N l a c c r u a l (9.8% o f t o t a l t r a d e payables) This may be further evidence of a slippage in controls generally (see above) and may render both cutoff work and the GRNl provision difficult t o audit. If the problem in the week after the year end amounted t o a breakdown, inherent risk (as well as control risk) may be increased. T i g h t deadline The very tight deadline increases audit risk. as the timescale for identifying unrecorded liabilities (eg through after-date payments) will be significantly reduced.

(b) Outline a u d i t a p p r o a c h General Normal checking - of amounts from schedule provided back t o supporting schedules, nominal and purchase ledger balances, and through t o financial statements (including checking of casts and cross casts on a sample basis). Also purchase ledger control account reconciliation t o the purchase ledger list of balances. Analytical procedures - on all four areas with as much disaggregation as possible, subject t o availability of , information. Month-on-month analyses should be examined wherever possible with reference t o prior year levels, inventory levels and production schedules. Any significant change in the trade payables payment period should be justified. Particular attention should be paid t o old items. Tests of controls - will be of greater significance, given the preliminary indications of control breakdowns and the tight deadlines which will make gathering of sufficient substantive evidence re year end balances difficult. Cut-off- the combination of computer breakdown, retirement of the overseas clerk, and inherent problems with overseas suppliers will result in a need for significantly increased volume of substantive procedures o n cut-off. Management may try t o manipulate this area, so errors should be carefully investigated before being dismissed as isolated. Supplier statement reconciliations - will be useful in substantiating the GRNl accrual and goods in transit. Ferganto p l c The reason for the new retention clause should be ascertained at an early stage in order t o assess any impact on going concern andlor disclosure. Circularisation is n o t possible but responses t o requests may confirm specific invoices outstanding. This should be the initial line of approach supplemented with analytical procedures, review of after-date cash, reconciliations t o available statements (if any) and checking of individual invoices t o GRNs, the GRNl provision and inventory records. O l d unmatched purchase orders should be investigated t o confirm that they have not resulted in unrecorded liabilities. Overseas suppliers

It may be possible t o faxlphonelemail these suppliers as a speedier alternative t o formal circularisation. A significant proportion of the GRNl provision may be made up of foreign invoices, and cut-off warrants particular attention. The effect of the loss o f the overseas clerk o n controls must be evaluated and the approach and sample sizes adjusted accordingly. Foreign exchange accounting policies should be ascertained at an early stage in order t o assess their appropriateness, the adequacy of disclosure, and compliance with stated policies. GRNl Analytical procedures dnd substantive procedures o n individual invoices accrued for should be supplemented by management representations. This may also apply t o other areas depending o n the strength o f other evidence available. It may be possible t o circularise individual invoices. O t h e r (14.9% o f t o t a l t r a d e payables) Individual balances represent 0.1-0.15% o f total trade payables. As they are not material, detailed testing should be limited.

It may be possible t o circularise a small sample of the largest 'other' payables before the year erld and

.

perform a 'roll-forward' t o save time for more risky areas at the year end. I THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WdltS

Section 3: Planning assul-ance engagements Any lil<eliliood o f a qualification Given the above, an 'except for' qualification on the grounds of limitation of scope is possible, and this should be discussed with the client as this may affect merger negotiations. The client may prefer t o delay rather than present qualified financial statements. (c)

Understatement errors Audit techniques which may help t o identify understatement errors in the payables cycle include the following. )

Testing of authorisation and approval controls with regard t o purchase orders, t o ensure that all items authorised are then recorded.

)

Substantive procedures, tracing from a goods received noce to purchase invoice, t o the purchases and suppliers account in the nominal ledger (via a purchase day book).

)

Careful review of cut-off regarding purchase invoices around the year end, specifically with regard t o invoices for goods received prior to the year end but where no liability has been recognised. Cut-off testing would stem initially from auditors' physical inventory count procedures and test counts.

b

Analytical procedures on year end balances, using purchases turnover by supplier as an indication of the liltely level of year end balance (as well as last year's balances).

b

Suppliers' statement reconciliations with purchase ledger account balances.

THE INSTITUl E OF CHARTERED ACCOUNTANT 5 IN I Y C L A Y ~ A r i r it,,,, t s

ANSWER BAYK

rsq!l

1 !: :,

3 2 2 Limitations Marks available

4 I1

4 Conflict of interest Management threatlprocedures Self-interest threatlprocedures Opening balances Going concern Related party issues

3 3 I%

3 3 4

2 2% 2 28

Accounting records Marks available

Other reports under legislation 01- I-egulation Other reports with agreed scope Marks available

4 4 4 12

9

; (d)

Each benefit

I 4 -

Total marks available

40 .. .~ -.

(ii)

.

- ..... ... . . . ..

b

Draft financial statements and financial statements from previous years in order t o be able t o compare the financial position this year with previous years and t o be able t o compare management accounts (already obtained) with draft financial statements t o highlight any major differences between internal and external I-eporting (accounting policiej, possible errors and possible adjustments that require investigation)

b

Budgets for all sections of business (brandedlsupel-marl<etlgout-metlexport)and t o ascertain if the director's comments about sales and margins appears correct

b

Detail sales information on all ranges, month by month, preferably for current and previous year t o investigate the finance director's comments about inargins.

Limitations One limitation ofanalytical procedures at the planning stage of an audit is that the auditor needs a good understanding of the business t o interpret the results of analytical procedures. If analytical procedures are performed mechanically, a consistency of results from one year t o the next may in fact conceal a material error which may not be identified. Effective analytical procedures need t o be carried o u t by experienced members of staff and they rely upon good quality and reliable information being available from the client which may not always be available.

THE lNSrl7 U7 E OF CHARTERED ACCOUNTANTS IN LUGLAND AND \V.AIC(

129 ,

t

Section 3: Planning assurance engagements

. .

~ b ) File n o t e

)

b

This constitutes a selfreview threat. If the computer system i s found t o be unt-eliable, it may be difficult for the auditor t o report the weaknesses t o management. If the weakness were t o result in material errors in the financial statements, the auditor may be compromised in formulating his audit opinion.

)

Prior to appointment we have advised Nosh Ltd as t o which computer system t o introduce.

)

Use a different audit team t o that which advised o n the computer system.

)

Close scrutiny of new system as n o reliance onlappearance of reliance on work carried out before appointment as auditors. SO

)

Second partner review of the audit.

ES5 does n o t allow an audit firm t o design, provide o r implement I T systems which

-

W o u l d be important t o any significant part of the accounting system, and

-

O n which the auditors would place reliance

)

Potential future conflict of interest if w e are asked t o advise o n the suitability of Nosh Ltd acquiring another of our clients.

b

Advisory work includes advice on expanding the business by the acquisition of similar businesses. This could potentially include the acquisition of another audit client.

b

Ensure that existing audit clients are excluded from advisory w o r k in respect of acquisitions.

)

As we are very involved with the client, there may be the risk of becoming too familiar with Nosh Ltd. This could reduce our objectivity.

b

W e may become too involved with this client due to the other services of tax and advice which we are t o offer.

b

Restrict all work t o advisory work only and ensure that no management decisions are madelappear t o be made.

- -

b

b

-

There is a management threat implicit in non-audit services. The audit04 may become too dependent o n the regular fee income of Nosh Ltd, which may impair objectiv~tyand independence.

THE INSTITUTE OF CHARTERED ACCOUNTANTS 1N INGLANU AND WALIS

b The auditor is to perform additional w o r k of tax and advisory services as well as the annual audit.

Ensure 'informed management' is designated by Nosh Ltd. b

Obtain a second partner review of the audit.

b

Constantly review fee level t o ensure that it does n o t exceed 15% of gross fee income

+

b Opening balances may be misstated, resulting in incorrect closing balances and comparatives.

b

Nosh Ltd is a new audit client.

c

b Check opening balan'tes'hak been brought forward correctly from last year's closing position. b Enquire of management how opening balances were calculated. b

Review prior period's accounting records and control procedures to see if any errors are apparent.

b Perform substantive procedures on opening balances if other procedures are unsatisfactory.

..,,,, ,,,,,.,,,...............,,,.,,,..,,........... ........, ...,,............................ .......... ...................... ....

b Nosh Ltd may not be a going concern if it loses the supermarket as its customer. Financial statements may be incorrectly drawn up on a going concern basis.

b Nosh Ltd has a one year renewable contract with a national supermarket chain.

b Establish what proportion of sales is made to the supermarket by examining sales figures for the year in the sales day book. b

Scrutinise correspondence with supermarket for any signs of dissatisfaction.

b

Perform sensitivity analysis on forecasts t o assess impact of loss of contract.

b Ascertain if contract has been re-signed post year end and physically inspect a copy of the contract.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AM) WALES

b

$3 1 J

9.

Section 3: Planning assurance engagements

b The financial statements may fail t o disclose material related party transactions.

b The managing director has a controlling interest in a major supplier.

b

Review purchase day book and cash payments book for transactions with Plasco Ltd.

b

Check that notes t o financial statements disclose the related party transactions.

b Purchases may not be on normal commercial terms.

b Compare Plasco Ltd's prices and terms t o the industry average.

b

Check that the, engagement terms include either auditing both companies o r access t o the auditor of Plasco Ltd.

b

Obtain a management representation that all transactions included are in the normal course of business and at arm's length.

b

Perform extensive cut-off procedures.

b

Extend procedures for testing overstatement.

b

Check correct translation rates are used by agreeing them to the Financial Times.

b

Perform sensitivity analysis on forecasts to assess impact on currency fluctuations.

b

Check ability of computer system t o deal with foreign currencies.

b

Review controls exercised over changeover.

-

b

b

Revenue and margins may be overstated.

Revenue, receivables and foreign exchange differences may be misstated.

b Accounting records may be unreliable, resulting in incorrect figures in the

(c)

b

Revenue and margins have improved in the year due to significant expansion.

b The company's export market has grown, and this is likely t o involve transactions in foreign currencies.

b

New computer system introduced in the year.

- --

Comparison of different forms of assurance (i)

Audit reports under the Companies Act The Companies Act 1985 (CA85) requires all companies to prepare annual financial statements for circulatio: t o their shareholders and for filing with the Registrar of Companies at Companies House. Unless the company qualifies for exemption from audit, the financial statements must be audited by a,:registered auditor' who makes his audit report t o the shareholders, not the management In the opinion given in the audit report, the auditor makes a positive assertion whether the financial statements give a 'true and fair' view and have been properly prepared in accordance with the detailed rules on financial statement disclosures which are set out in the CA85. The auditor also makes a positive assertion whether the directors' report is consistent with the , I financial statements. T

132

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

.

ANSWERBANK The opinion given by the auditor therefore conveys a high level of assurance about the financial statements, but not an absolute level. An absolute level of assurance is probably impossible; even if all the transactions of the company were examined (and this would be prohibitively time consuming and expensive to perform), could there be confidence that no transaction had been omitted entirely? Therefore, in relation t o the timeliness (users want up-to-date information) and cost, the audit report gives a satisfactorily high level of assurance t o the normal user of the financial statements. (ii)

Other reports under legislation or regulation Assurance firms may be engaged t o prepare a report on the financial statements and other information presented by organisations which are required t o report under special legislation o r regulations.

-

', 7

r

The assurance firm will approach the engagement in much the same way as performing an audit on a company under the CA85. It would need t o understand the special nature of the organisation and the relevant legislation and regulations, as well as considering any specific guidance on the sector which has been developed by the accountancy profession. In addition t o reporting on the financial statements, the assurance firm may also be required t o give a report direct to a regulator, in accordance with instructions issued by the regulator. As with an audit opinion on a company, the resulting opinion will usually give a positive assertion about the 'truth and fairness' and 'proper preparation' of the financial statements. This report also gives a high, but not absolute, level of assurance about the financial information. The opinion, and any report t o a regulator, may also refer t o more specific matters such as the organisation's compliance with rules on accounting systems and record keeping, o r compliance with solvency rules set by the regulator. The report on these specific matters is a positive assertion about compliance with these aspects of the rules, and will convey a high level of assurance t o the regulator and other readers of the information.

(iii) Other reports where the scope of the work and of the report to be provided are

agreed between the two parties 'Other reports' embraces the many other circumstances where an assurance firm is engaged by another party t o provide a report on a piece of information. The scope of the engagement is not set down by regulation, so the assurance firm and the client must agree on the terms of engagement. In particular, the engagement letter must specify

b b

The scope of the work t o be performed by the assurance firm The form of the report t o be given by the assurance firm.

The level of assurance given by the final report will be dependent upon the amount of work performed by the assurance firm and the agreed wording of the report. This can vary from a high level of assurance (very extensive testing needed) t o a limited level (less detailed examination). The principal benefit of an audit is that the shareholders are given independent, professional verification that the financial statements give a true and fair view. Although some might consider this to be of limited value to Mr Tuck, who owns and manages Nosh Ltd (and hence is legally responsible for the financial statements), it may be of value in respect of Nosh Ltd for the following reasons:

b

Nosh Ltd may have minority shareholders not involved in management

b

Mr Tuck may not bf an accounting expert (indeed he is likely not t o be) so while he is responsible for the financial statements he may not have prepared them, and kill appreciate assurance on them from an expert.

,

In addition, the audit gives credibility t o the financial statements which may be used for various purposes, such as t o raise finance for expansion from the bank o r other sources o r by overseas customers trying t o determine if Nosh will be a reliable supplier. Lastly, there may be subsidiary benefits t o Nosh Ltd of having an audit, such as professional advice on control systems o r accounting issues through audit communications. ;,,

'

1

,

.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

*

.. Section 3: Planning assurance engagements

Examiner's comments (part (a) only) This question was generally well answered. However, weaker candidates wasted time in dealing with matters t o be considered by the auditor before accepting appointment, and on appointment procedures which were not required as the auditor had already been appointed. The n~ajorityof candidates scored well on the professional issues but only a minority of candidates considered the higher skill point relating to the potential future conflict of interest which might arise in respect of advising on the acquisition of another client. The audit risks were generally well covered except for the possibility of misstated opening balances.

30

Medical Diagnostics Ltd

Marks (a)

Net assets implications Sales issue October margin Staff costs Establishment costs Inventory Deferred revenue Non-current assets Interest Marks available Maximum (b) Revenue recognition Inventory Management manipulation Compressed timetable Sales cut-off Consistency of accounting policies Accruals/provisions Generic risks - identification (each) Generic risks - why key to MDL (each) Maximum (c) Each procedure Maximum Total marks available

(a)

Items identified from review of management accounts b

Year end net assets are almost exactly f 1.2 million warranted in the sale and purchase agreement.

b

Could be indication that results have been manipulated to meet but not exceed target.

b

Sales for October 20x3 are low compared t o monthly average and much lower than predicted

b

Overall margin for October 20x3 is very low

b

Appears to be due to:

-

Higher than usual subcontract manufacture costs Additional inventory provisions made in month (To lesser extent) higher other costs

I

1 i

rr

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN E N C L W D A N D WALES

b

Sales staff costs for month appear high even though sales for month are low, total cost for year is above budget even though budgeted sales target not met

b

Establishment costs for month are high and result in total for year above budget

b

Would expect such costs t o be highly predictable

)

Year end inventory is on budget despite higher than forecast provision implies degree of inventory build up at year end

b

Increase in deferred revenue requires investigation, would expect deferred maintenance balance t o be reasonably steady (although increasing as revenue increases)

b

Significant increase more likely t o be due t o deferral o f equipment sales

b

Movement in non current assets may suggest high depreciation charge o r impairment provision in last month

1

O d d no interest income given high cash balance

(b) Risks Revenue recognition Question o f when revenue should be taken involves significant judgement, and it is necessary t o T u r e that revenues have been correctly and consistently accounted for. Inventory The products are high tech so may become obsolete leading t o inventory overvaluation. Also need t o check labour and overhead absorption rates are appropriate. Management manipulation of resultslfraud

b

PID and FD own entire issued share capital and will benefit personally from sale

b

Accounts t o be used t o determinelconfirm purchase price

b

In their interests t o meet but not exceed net assets figure of f 1.2 million

1

Substantial contingent consideration dependent on growth in future years - hence motivation t o defer profits once target net assets met.

Compressed timetable for issue of accounts

b

i

May be difficult t o complete work and gain sufficient evidence in time available

Sale cut-off

b

Some indication that sales may have been deferred into next year

b

Need t o ensure that where this has occurred is in line with revenue recognition policy - ie that equipment requires customisation etc and no acceptance certificate has been received.

.

Consistent application of accounting policies generally

b

lnventory provision increased at year end. May be valid reasons but may be indicative of inconsistent and more prudent approach

b

Need t o ensure increase justified and will not merely reverse in next year

b

Also seems t o be,high depreciationlimpairment provision in last month - again need t o ensure entries justified and not simply manipulation o f results

i'General accrualslprovisions b Need t o ensure all provisionslaccruals relate t o real obligations I

b

Areas for particular focus are

-

Establishment costs accruals Subcontract labour accruals Sales commission accruals (given low end of year sales) Bonus accruals (given results below budget) THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

Section 3: Planning assurance engagements Completeness of prepaymentslsundry receivables b

Need to ensure all payments relating t o 20X31X4 expenses are properly deferred

b

Also that sundry income re interest etc is completely recorded and not understated

O t h e r ( m o r e generic ,risks but nevertheless valid) Receivable collectability Adequacylreasonableness of tax accrual Adequacy of warranty provisions Related party transactions with directors o r their associates Compliance with relevant laws and regulations given equipment supplied Adequacy of systems t o cope with growth Lack of adequate segregation within accounts function given number of staff

b b b b )

b b

(c)

A u d i t w o r k in t h e area of revenue recognition b

Review client controls over the point at which sales are recognised in the accounts and over communication between sales and accounts departments

b

Obtain analysis of equipment sales revenue recognised in the year

b

Perform cut-off tests o n items recognised close t o year end

b

Select a sample for testing and ensure that equipment was delivered before year end

b

Review contract with customer for unusual customisation/integration, review acceptance certificate and ensure signed and dated pre year end

b

Review other sales t o the same customer and ensure that there is no evidence of customisation/integration work which has been billed separately rather than included with the

initial equipment sale

136

b

Consider any equipment revenues which have been deferred at year end and ensure that either the equipment was delivered post year end o r that customisation work was required and was not completed until after year end

b

Consider level of sales post year end and investigate if abnormally high

b

.Test a sample of revenues from installationltraining work

b

By reference t o engineers' time sheets, course attendance revenues etc, ensure revenue recognised in correct period

b

Obtain full explanations for any other types of 'consulting work and ensure appropriate revenue recognition

b

Select a sample of invoices for ongoing support and ensure included on client's spreadsheet used t o calculate service revenues

b

Ensure deferred element correctly calculated

b

Check clerical accuracy of client's spreadsheet

b

Test check a sample of items from spreadsheet to copy invoiceslcash receipts

b

Circularise a sample of customers t o ensure existence/accuracy of year end receivables

b

Could also i n ~ l u d econfirmation of terms of sale and point of completion

b

Review post year end cash receipts

b

Review year end receivables ledger for old and unpaid items and consider whether this is indicative of premature or inappropriate revenue recognition

b

Review post year end credit notes

b

Review year end inventory for completed machines in which revenue recognition has been deferred. Obtain evidence of post year end deliverylcompletion of customisation w o r k etc

THE INSTITUTE OF CHARTERED ACCOUNTANTS H E N C L A M AND WAL'PILES

8 ,

'

Sporticus Ltd

Marks Style and presentation of letter Organisational status Scope of function Technical competence Due care Marks available Maximum Systems documentation Tests o f control sales and cash Tests of control purchases Substantive testing Marks available Maximum (b) Benefits t o management Cost savings External audit costs Marks available Maximum Design and operation of systems and controls (c) Reliability of management information Prevention and detection o f fraud Compliance with laws and regulations Money laundering Marks available Maximum Total marks available (a)

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN E N G L M AND WALES

Section 3: Planning assurance engagements (a)

Letter to David Campbell ABC Auditors I Long Lane Leamington Spa Warwickshire CV32 2EX

D Campbell Esq Sporticus Ltd Maple House Worthing Street Cannock Staffordshire ST47 2BA

2 October 20x9

Dear David

Audit year ended 30 September 20x9 As requested, I have detailed below how we will be able to make use of your internal audit department in our assessment of control risk for this year's audit. (i)

Factors that could limit our ability to use the work of the internal audit department in our assessment of control risk Organisational status For the work of the internal audit function to be effective it is important that it has access t o the highest level of management and is allowed to communicate freely with the external auditor. The department currently reports t o yourself, but ideally it should report t o a director independent of the finance function or the board of directors as a whole. If our ability t o discuss key issues with the internal auditors were restricted this could limit the way in which we use their results. Based on the relationship we have developed with yourself and your fellow directors I do not anticipate that we will have a problem in this respect.

Scope of functions performed W e will need t o assess the nature of the work specifically performed. W e have been informed that the company's control system has been evaluated and documented and that control procedures have been tested, all of which would be relevant t o oGr audit work. W e will also consider the extent of the procedures covered and the ability of the three staff members in the department t o deal adequately with the 50 separate locations. If we conclude that the department is under-resourced either in terms of manpower or computer facilities, our reliance would be limited. Management's response to recommendations made by the department is also a key part of the process overall. If the board fails t o respond to the reports produced by internal audit, the relevance cd the work of the department is reduced.

Technical competence While the department does seem t o include a good balance of accounting and computer expertise, the three staff members are all relatively new t o the roles which they are now performing. W e would need t o assess whether they are clear as to their terms of reference and the overall aim of the tasks. W e would also be concerned about their independence. In this case two of the staff have been transferred internally and while the advantage of this is their background knowledge, they may

138

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN CNCLPiND AND WALTS

.

,

i

ANSWER BANK

well be in a position where they are reviewing systems they have put in themselves and work which they have performed themselves. The extent t o which this is the case may affect our ability t o rely on their work. Whether the work has been carried out with due professional care

The work should be properly planned, supervised, reviewed and documented. Working papers must be made available t o us. W e will assess these t o determine, for example, whether sufficient evidence has been collected t o support conclusions and whether these conclusions seem logical, based on the evidence collected. The adequacy of audit manuals and work programmes would also be considered. (ii)

The effect on our audit and the extent to which we may make use of the work of the internal audit department Systems documentation Effect on the audit

As the internal audit department has evaluated and documented the system, w e will n o t need to repeat this process. Instead w e can confirm the system as recorded by them using walk through checks. Extent of reliance

This will depend on the depth of the documentation, eg how detailed it is, whether it includes records of key controls. It will also depend o n the skill and competence of the individual producing the information, particularly if information is in flowchart form. If Peter Adams has been responsible for this work there is a risk that he will have described the system as he believes it t o be from his previous experience in the accounts department, rather ,than as it is operating in practice. Tests of controls: sales and cash Effect on the audit

W e will need t o assess the results of the w o r k performed on sales and cash. Where controls have been satisfactorily tested our independent testing can be reduced. Extent of reliance

This will depend o n the competence o f the work, whether sufficient evidence has been obtained t o draw conclusions and whether the conclusions appear in line with the evidence. However, even if this is the case, because sales is a particularly high risk area of the audit, we will not be able t o rely solely on this evidence. Some independent work will need to be undertaken. Tests of controls: purchases Effect on the audit

As this w o r k has still t o be performed we will liaise with internal audit r e the audit coverage, test levels, sample selection, documentation and review procedures. Extent of reliance

As we will have had an input in the way in which this w o r k has been performed, provided it is carried o u t as discussed w e will be able t o rely on the results more heavily. Nevertheless, while this will reduce the amount o f work which we need t o perform, some independent testing will r still be required. Substantive testing

..'

Effect on the audit

W i t h your agreement it may be possible for us t o use your staff t o carry out substantive procedures. This would result in a more efficient audit and a reduction in costs.

: THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

Sec

3: Planning assurance engagements Extent of reliance Any substantive work would be carefully selected. Your staff may safely be involved in low risk areas. High risk areas, areas of judgement and any conclusions on audit evidence would be dealt with independently by us.

I hope that these points have answered your query. If you would like t o discuss this further please do not hesitate to contact me. Yours sincerely Max Bobath

Advantages of an effective internal audit function b

b

Provides management with

-

A positive assurance as t o the adequacy of the control systems and their operation

-

Objective analyses, appraisals, recommendations and information concerning the activities reviewed

-

A body of expertise and knowledge of best practice (a form of internal management consultancy).

Should lead to quantifiable cost savings where recommendations are implemented and lead to -

-

b

A reduction in inefficiencies A reduction in costs An improvement in receipts An improvement in effectiveness.

May lead to a reduction in external audit time (and costs) where the external auditor is able to rely on the work of the department and it is cost-effective for him t o do so.

Responsibilities of management, internal auditors and external auditors (i) The design and operation of systems and controls Management is responsible for putting in place an effective internal control system. lnternal auditors contribute to the ongoing effectiveness of the internal control system by reviewing it and making recommendations for improvement. However, they do not have primary responsibility for establishing or maintaining it. They are themselves one element of the internal control system established by management. External auditors are not responsible for the effectiveness of, nor are they a part of, the company's internal control system. Their responsibility is to report in 'true and fair' terms t o shareholders on the financial statements. However, their findings during thdt work often provide management with useful comments on and recommendations for improvements in the internal ' control system (via the report t o management). (ii)

The reliability of management information Management has ultimate responsibility for ensuring that there are systems in place t o provide reliable information to enable them t o run the buiiness effectively. As above, the appointment of an Jnternal auditor may well help them to ensure that such systems are in place. Internal auditors have a responsibility for reporting on whether the systems that have been put in place by management to produce reliable financial and non-financial information are working effectively. External aiditors, in reporting t o shareholders, will consider the reliability of the information but have no responsibility for it.

140

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND bND WALES

The prevention and detection of fraud Management is ultimately responsible for the prevention and detection of fra internal audit party can fulfil part of that duty as the existence of an internal could both b b

Act as a deterrent to frauds being carried out in the first place Uncover fraud as part of routine or special investigations

External auditors are not responsible for the prevention or detection of fraud at their clients. However, they are responsible for planning and performing audits in a way that seeks to identify material misstatements in financial statements. Of course, if a fraud has been perpetrated then it may have had material impact on financial statements, however, as fraud is by its nature concealed, it may be that however well the audit is planned and performed it does not uncover fraud.

Company compliance with laws and regulations Management is responsible for ensuring that the company complies with laws and regulations that apply to it. This is another area where an internal audit department may assist management in carrying out its duties as the job of keeping up to date on what laws and regulations apply to the company and monitoring whether the company does comply may be delegated to the internal' audit department. External auditors are responsible for ensuring that any lack of compliance does not have a material impact on financial statements. As auditors are supposed to have an understanding of the entity and i t s environment they should be aware of the types of laws and regulations applicable to the company, even if they are not experts in all those laws themselves.

Money laundering As outlined above management is responsible for ensuring that the company complies with the law and this would include the criminal activities that constitute money laundering. Internal auditors who discover money laundering at their place of work should seek legal advice about their position. Disclosure of'money laundering to SOCA would constitute a protected disclosure under employment law so they should be protected from suffering a detriment at work for making the disclosure and would be protected from possible criminal charges for not making disclosures. External auditors are required by law to report suspicions of money laundering to SOCA (or the firm's MLRO, who will then make the disclosure) or else they commit a criminal offence.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN M G L W O WD WALES

Section 3: Planning assurance engagements

32 Atlantis I t d

Marks lmportance of obtaining an understanding of the business Sources of information Procedures to obtain the information Marks available Maximum (b) Central processing Inventory movements Discounts and bonuses Invoicing Marks available Maximum Approach to audit of revenue (c) Audit work - inventories Audit work - revenue Audit work - receivables Audit work - general Marks available Maximum Total marks available

(a)

(a)

lmportance of obtaining an understandingof the business Auditors are required by ISA 3 15 (UK and Ireland) Understandingthe Entity and its Environment and Assessing the Risks of Material Misstatement to obtain an understanding of the entity and i t s environment, including its internal control. The purpose of obtaining the information i s to identify problem areas which might cause difficulties in collecting evidence or drawing conclusions and identifying risky areas so that audif&Eprkcan be directed at those areas. In addition, having an understanding of the entity provides a frame,+of reference for the auditor when exercising audit judgement, for example, when s&inb materiality or determining sample sizes to use.

Sources of information The auditors would use external sources of information about the general industry (kitchenware and bathware), their own sources for example, prior year audit files and the permanent audit file, audit personnel who know the client and client sources. In the case of Atlantis, client sources might include:

b

A company website

b

Company staff Internal control procedures manual Company marketing material Company price.lfsts Company correspondence (for example, with customers, solicitors, etc)

b b b

b

THE INSTITUTE OF CHARTERED ACCOUNTANTS I N ENGLAND A N 0 WALES

Procedures to obtain the information L I

Auditors must carry out a combination of the following procedures t o obtain an understanding of the business:

b b b

Analytical procedures Observation and inspection Inquiries of client personnel

In addition it is a requirement o f ISA 3 15 that the audit team discuss the client's business and the susceptibility o f the financial statements t o fraud.

Central processing

(I)

b Returns from branches may be lost o r delayed.

b Figures available t o management may be inaccurate o r out o f date, resulting in accounting errors and poor decision making.

b

b

lnventory losses may go unnoticed.

b

Inaccurate information may be given t o customers r e inventory availability.

b

lnventory levels may be misstated.

(2)

lnventory levels recorded by head office may be inaccurate.

,

lnventory movements

b

Items in transit between branches at the year end may n o t be correctly accounted for.

b lnventory movements and revenue may not be recorded in the same accounting periods.

b

May result in loss o f customer goodwill.

b A bonus based on revenue does not necessarily lead t o higher profits.

b

Managers may offer excessive discounts resulting in lower profits.

b The bonus may be an incentive t o misstate revenue deliberately.

b May lead t o window dressing, raising bogus invoices pre year end, matched by bogus credit notes post year end.

b

Incorrect deliveries may be made if deliveries are n o t controlled by branch taking original order.

b Gross profit may be misstated due t o cut-off errors.

\

Discounts and bonuses

(3)

b

I

Managers may be overpaid.

b Accounting errors may result, eg sales cut-off. b

Delegating decisions over discounting t o managers makes it more difficult t o prepare budg~tslforecastscentrally.

b

Performance appraisal is difficult where budgets are unreliable.

b

The company may misjudge its cash flow requirements.

8

THE INSTITUTE OF CHARTERED ACCOUNTANTS N LffiL&NU &NU WALLS

143

$

Section 3: Planning assurance engagements

(4)

(c)

Invoicing

b

There is a significant time delay between delivery and billing.

b

Lengthens the time taken t o receive payment, and hence increases working capital requirements.

b

There may be up t o t w o weeks' accrued income at any point in time

b

Management accounts may be out of date.

b

Greater risk of cut-off errors resulting in understatement of profit.

Approach to audit of revenue There are various potential approaches t o the audit of revenue. The auditor could take a wholly substantive approach and carry out tests of details on a sample of sales invoices. However, as revenue consists of a large number of items this is unlikely t o be an efficient approach. Realistically the auditor is likely t o take a mixed approach t o auditing revenue if the client appears t o have effective controls over revenue and sales. In a mixed approach, the auditor would ascertain and test the controls existing over sales and conclude whether the system was capable of producing a reliable figure for revenue. As it is not appropriate t o rely on controls testing alone in respect of a material figure in financial statements, and as revenue is extremely likely t o be material, some substantive procedures would then be carried out. These could take the form of analytical procedures. These are often used in conjunction with revenue as businesses often have substantial amounts of information available about sales, and there are often detailed budgets and projections as well as breakdowns of actual figures. However, in this case, management discretion in relation t o pricing means that revenue is less predictable than might otherwise be the case and tests of details are likely to be more appropriate.

Substantive audit work Inventory quantities

b

Attend physical inventory cQunuat branches on a rotational basis.

b

Agree a sample of physical quantities t o branch records, and vice versa.

b

Inspect inventory movement dockets raised around year end, and ensure the inventory item has be& recorded only once if goods not yet despatched t o customer by the year end.

b

Agree deliveries recorded around the year end t o inventory records and invoices raised t o identify cut-off errors.

b

Reconcile branch inventory levels t o head office records.

Revenue

b

Perform a sequence check on all documentation t o ensure completeness.

b

Follow through a sample of transactions from sales order through t o delivery notes and sales invoices. T

b

Check calculations of invoices.

b

Match sales invoices raised around year end to despatch notes t o ensure correct cut-off.

b

For a sample, compare discounts offered t o the parameters set out by head ofice.

b

Review post year end credit notes raised t o ensure those relating t o pre year end sales are identified.

W

THE INSTITUTE OF CHARTERED ACCOUNTANTS H E W L A N D A N D WALES

b

Include copies of customers' sales ledger accounts t o have best chance o f detecting fraud.

b

Agree after-date cash received and remittance advices t o year end receivables.

')I

General b

Perform analytical procedures by comparing gross profit margins branch by branch and t o budget and previous years.

Pallas Ltd

(a)

Recent appointment Nature of businesslequipment Telephone orders Bonus scheme Changes in software Agents Overseas suppliers Matters t o discuss - '/z mark each Marks available Maximum (b) Internal controls - non current assets Internal controls - non recoverability of trade receivables Marks available Maximum (c) (i) Different risks SORP requirements Restricted funds Reports t o Charities Commission Additional w o r k Marks available Maximum (ii) Public moneylaccountability Wider scope Audit Commission National Audit Office Marks available Maximum Total marks available

(a)

2% 3% 1% I%

3% 2% 2% 6 23 % 14

8

7 I5

I

8

2 2 2 2 2 10

8

2 8

2 2 14

10 40

,

Potential audit r&ks b

Recent appointment as auditor

-

b

Lack o f cumulative audit knowledgelknowledge of business .. . . Possible misstatehent of opening balances

Nature of businesslnature o f non-current assets -

-

Eauioment theft -1- r - - susceotible - - - - r - - - to - - Five year straight line basis may not be applicable t o all assets Obsoleteldamaged equipment may affect carrying value THE INSTITUTE OF CHARTERED ' ACCOUNTANTS H IffiL@NDAND WLLES

145

'

Section 3: Planning assurance engagements b

Pallas takes customer orders by telephone

-

May give rise t o disputed orders

Bonus schemelmanagement bias

b

-

The scheme provides an incentive for directors t o overstate incomelunderstate expenditure

Changes in software

b

-

IYisstatements may increase as a result of manual transfer of informationlloss of data Custom written software may contain bugs causing errors Lack of staff familiarity with system may cause errors

Sales agents have authority t o discount/chase up receivables

b

-

May lead t o fraudulent activity if discounts offered in return for cash (or other eg) May give rise t o bad debts if sales agent not chasing up debts appropriately

Camera equipment sourced from overseas

b

-

May lead t o incorrect values in financial statements if incorrectly translated Unrecognised foreign exchange loss may occur

Matters to discuss

(b)

146

b

Security procedure taken t o ensure that assets securely held

b

Discuss rationale for depreciation policyllevel of losseslprofit on disposal of equipment

b

The nature of any conditions attached t o the bonus scheme

b

The effect on profits since the introduction of the scheme

b

The anticipated level of bonus payable this year

b

The procedures used t o ensure that all accounting information correctly transferred from old system t o the new

b

Was there any parallel running of the old system t o ensure operating correctly?

b

The extent and nature of any problems with the new system

b

Adequate backup arrangements in place

b

The extent of any training given t o staff in the new system's use

b

Discuss procedures used for translation of foreign exchange translations

b

Establish whether management monitoring procedures are in place

Control procedures b

Log serial number of each non-current asset so they can be separately identified

b

All equipment t o be security taggedlmonitored by CCTV at warehouselkept under lock and key when not on hire

b

All movements of equipment t o be supported by authorised booking out sheet

b

Segregation of duties between warehouseperson and person signing booking out sheet

b

Periodic physi;al checking of items not out on hire t o asset register

)

For items on longierm hire, periodic confirmation with customer that they have the asset

b

Pallas t o maintain appropriate insurance cover for equipment

b

Ensure customer's signature obtained for all courier dbliverieslcollections as proof they have received equipment

b

Checking of all new customers (ID) t o ensure bona fide

b

Credit check customerslset credit limits with regular review br appropriateness of the level set

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN lNCl4ND A N D WALES

ANSWER BANK b

Request t o see copy of customer insurance policy for more expensive hired items

b

Request security deposit from customers for more expensive items

b

Formal debt collection procedures t o be carried out by staff other than sales agents

P

For longer hire periods, invoice each month rather than wait until end of hire period

b

Ensure all orders are confirmed in writing

Differences between a non specialised profit orientated entity audit and the audits of specialised entities (i)

Caring Hands UK Ltd, a registered charity The key initial thing t o note is that Caring Hands UK Ltd is a company (as denoted by the Ltd in its name) and therefore, if it meets the statutory requirement limit, it will require a statutory company audit in the same way that Pallas does. Caring Hands UK Ltd will be at liberty t o appoint its own auditors, in the same way that Pallas Ltd is. The charity is likely t o appoint auditors that have experience and a good reputation with charities in the same way that Pallas will seek t o appoint auditors with experience and reputation in its industry. The statutory audit will n o t differ largely from the audit of Pallas, except in the ways that all statutory audits differ from one another as they are tailored t o the particular client and set o f financial statements. For example, the audit will differ because:

b

The risks facing Caring Hands UK are likely t o be different from the risks facing Pallas

b

The financial statements of Caring Hands UK are likely t o be prepared under a different framework than Pallas, that is, the Charities SORP

b

Therefore, the risk of misstatements in the financial statements will be different, for example, the auditors will have t o consider matters such as restricted funds

b

The auditor might have requirements t o make reports t o the Charities Commission if any breaches of regulatory requirements are discovered.

In addition, a charity may have items that it wants the auditor t o address, in addition t o statutory requirements. For example, it may want assurance work carried out on whether the charity is achieving its objectives. Where the charity engages the auditor t o provide services in addition t o the statutory audit, the auditor must ensure that these terms are clearly clarified in the engagement letter and must ensure that he carries out procedures appropriate t o provide assurance in those areas. Although the Trustees may feel this aspect of the w o r k t o be more important than the statutory audit, the statutory audit is a legal requirement, and must be carried out properly, regardless of any other objectives being met by the auditor. (ii)

Public audits A county council and a central government department are both entities in the public sector, spending public money under mandate from Parliament. As such, they will both be subject t o a public audit. Public audits differ from private company audits (such as the audit that Pallas has) because they are generally wider in scope. A public audit will generally address the following issues:

b

An audit of thefinancial statements (this is the same as a private audit, although the public sector entity &ay have different reporting requirements depending on its nature)

b

A regularity audit which ensures that money is being spent according t o the legislation governing the entity

P

A propriety audit which ensures that money is being spent in an appr&riate manner, that is ethically and in accordance with public expectations (for exaAple, tha~contractsare not merely granted t o councillors' family members) a

E. I

? THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

Section 3: Planning assurance engagements b

A value for money audit which ensures that money i s being spent appropriately, that is, a good balance is struck between spending less, spending well and spending wisely. Value for money i s important in all public audits, but particularly in local government audits, such as the audit of the county council.

Public audits are carried out in accordance with the principle of independence, as are private company audits. However, public sector organisations are not entitled t o appoint their own auditors, but are audited by particular bodies.

County council The audit of the county council will be carried out by the Audit Commission, either by its own employees, o r it will appoint an approved private firm of auditors t o carry out the audit to i t s principles. The Audit Commission is a public body which is independent of the government.

:

Central government department The central government department will be audited by the National Audit Office. The N A O is also independent of the government and reports to Parliament on the result of its audit of the government department. This process i s scrutinised by the Public Accounts Committee, a special committee set up by Parliament.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND A M ) WALES

.

Short form questions

Inclusion in report to management?

b

( I ) Yes - lack of physical control over premises (2)

No

(3) Yes - lack of control over cash receipts Inclusion in letter of representation?

b

(1)

No

(2)

No

(3)

Yes - completeness of income

;' 2

Incorrect classification last year

,%

b

Comparatives form part of financial statements

b

But no opinion on comparatives as such

b

No effect on current year figures

b

If comparatives not adjusted, should consider.implications for report-

b

If comparatives adjusted andadequately,disclosed, no qualification

8: $

g 0

PC.:

;

3

;

Misclassification o f expenses

b

Qualified 'except for' opinion on income statement nqualified opinion on balance sheet and 'standard' basis of opinion paragraph

b

Matter i s material disagreement but not pervasive

b

Does not affect balance sheet

E (ii)

b

Emphasis of matter paragraph on going concern uncertainty

b

Qualified 'except for' if considered material without being pervasive

b

Adverse opinion if considered material and pervasive

b

Disagreement over non-disclosure

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND A N D WALES

149 -

Section 4: Concluding and reporting on assurance engagements

5

Meaning and purpose of statement

b

Have considered whether presentation true and fair

b

Disclosures required by accounting standards and CA 85 adequate

b

Comfort t o users that accounts complete for their needs

Chairman's statement Action b

Normally no statutory responsibility for auditor to review chairman's statement (CS) for consistency with accounts

b

If, however, requirement for directors' report to include a 'fair review of the development of the business during the year' had been cross-referenced to the CS, statutory responsibility will apply

b

If a non-statutory responsibility, auditor needs to consider if CS undermines credibility of financial statements

b

Unlikely this will be the case; however, auditor should encourage chairman t o revise contents of his statement

b

If a statutory responsibility, auditor should encourage client t o change CS

b

If refused, a reference t o the non-consistency with the accounts will be required

I m p a c t o n audit r e p o r t b

Audit report will not be qualified

b

Statement referring t o the inconsistency should appear after opinion paragraph immediately above auditor's signature

Conclusions f r o m review o f financial statements b

Accounts prepared using acceptablelconsistent/appropriate accounting eolicies

b

Accounts are compatible with knowledgeof the business

b

Directors'/chairman's report consistent with accounts

I '

I

I

S

7

b

Disclosures are adequate and suitable

b

Accounts comply with statutory requirements

b

Conclusions drawn from tests support opinion

Effect o n audit r e p o r t

(i) b

(ii)

Significant uncertainty

b

Emphasis of matter paragraph

b

Unqualified

b

Disagreement - lack of disclosure

b

Disclosure given in report

b

Adverse opinion t

b Accounts do not give true and fair view Breach in company policy Consequences b

Duplicate orders

b

Use of unauthorised suppliers

b

Termslprices negotiated with unauthorised suppliers generally less favourable

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLkND AND WALES

b

Purchase of unauthorised non-business goods and services

b

Goods may not be t o appropriate standards o r requirements

b

May result in breach of budgets and loss of control by buying department

b

Invoices may n o t be entered in purchase ledger, resulting in understated liabilities

Recommendations

b

All significant purchase orders over predetermined limit t o be placed by buying department except for small orders (say under L1,000)

b

Employees in breach of company procedures t o be informed in writing

b

Circulate company policy to all staff, and staff t o confirm in writing that they understand company policy

b

All suppliers to be informed in writing of company policy

M a t t e r s to be c o n s i d e r e d b

Check opening balances correctly brought forward

b

Review client working papers for prior year

b

Check appropriateness o f accounting policieslaccounting policies consistently applied year t o year

b

Any changes appropriately accounted forldisclosed

b

Substantive w o r k on opening balances (where no alternative available)

b

State in audit report that comparative figures not audited (ISA 710)

)

Ensure disclosure of lack of audit in prior year in financial statements

)

Integrity of accounting systemlstrength of control environment

Additional p r o c e d u r e s )

Discuss with management implications of relegationlmanagement plans

b

Obtain and review updated cash flow forecasts based on playing in a lower division

b

Reconsider the going concern basis, eg loan covenants, overdraft limits

b

Assess whether financial statements need amending

b

Ensure fact that team has been relegated has been adequately disclosed

b

Review board minutes

b

Analytical review of forecast revenues with published third division revenues

F u r t h e r i n f o r m a t i o n and why r e q u i r e d (I)

(2)

b

Amount of cheque confirms balance outstanding

b

Cheque received, banked and posted after year end

b

T o confirm as acceptable timing difference in conclusion

b

Provided for at year end = acceptable timing difference

b

N o t provided for = error in conclusion of test

r

b Whether isolated occGrrence o r not b

For need t o extrapolate o r n o t in conclusion

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND W,AICS

Section 4: Concluding and reporting o n assurance engagements 13

Effect on audit report Fletcher Ltd

b

Qualified opinion

)

'Except for'

b

Limitation o n scope

b

Disclaimer of opinion

b

Unable to form opinion o n true and fair

Both

b

Description of circumstances/amounts

U K (both)

b

N o t obtained all information necessary for audit

b

Unable t o determine whether proper records maintained

Dervish Ltd

14

Going concern b

Going concern is fundamental underlying assumption

b

Assumption that business can continue operating for foreseeable future

(i)

b

(ii)

15

Disclosure of Statement of relevant facts

-

Nature of concern

-

Assumptions made i n using going concern basis

-

Plans and actions taken

b

Statement that accounts n o t prepared o n going concern basis ie prepared on a break up basis

b

Assets written down t o recoverable amounts

b

Liabilities re-assessed

b

And reclassified from long t o short term

Differences: assurance v audit report

- Finch Inc not members

b

Addressee

b

Responsibilities - refer t o terms of engagement, not law

b

Basis of opinion - state not an audit

b

Opinion - no reference t o

-

b

16

-

True and fair CA85

Signature - not registered auditors

Reports to those charged with governance in the UK ISA 260 requires that auditors should communicate matters of governance interest that arise from the audit t o those charged with governance. LIK auditors are required t o take the following steps.

Listed compapy audit clients (ISA 260 para 1 1-5) b

Report significant facts and matters which bear upon auditor's objectivitylindependence

b

Disclose

-

Relationships which have a bearing on objectivitylindependence Related safeguards Total fees charged by auditor for provision of other services

b

Confirm in writing that auditor is independent

b

O r that there are concerns which seek t o discuss with audit committee THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WhLES

'ANSWER BANK

' t

All entities (ISA 260 para \ 1-7) Communicate outline of naturelscope of work propose t o undertake and form of report expect t o make

b

Post balance sheet tests b

Consider whether provision in place

b

Whether any monies r e amount outstanding received from Gamlec since balance sheet date

b

Correspondence from receiverllikelihood of receipts

b

Whether any additional goods despatched t o Gamlec

b

Whether receivership of major customer will impact on going concern status of Beaconlprovides evidence of problems in the industry

Effect on audit report b

Unqualified opinion if note considered adequate

b

If note inadequate o r disagree with basis of preparation - qualified opinion

b

Modified - emphasis of matter paragraph included in audit report

b

Drawing users' attention t o note

b

Statement that report not qualified in this respect

Other reports under legislation or regulation Four examples from the following.

Local authorities

b

Have special accountability to their local communities

b Insurance companies

b

Hold large sums of money on behalf of customers

b

Hold large sums of money on behalf of customers

b

Hold large sums of money on behalf of customers

b

Hold people's retirement savings

b

The public donate money in good faith

b

Handle large amounts of clients' monies

b

b

Banks

b Insurance brokers b

Pension schemes

b Charities b

Solicitors' firms

Further information re disagreed balance b

Whether receivedlbanked prior t o year end t o establish whether a cut-off error

b

Whether received and posted t o ledger shortly after year end t o assess whether an acceptable timing difference

Whether to rely on written representation

b

Internal controls in place over cash saleslsegregation of duties

b

b

Whether independent analytical review of GP%lreconciliations r Whether GP% in line with industry sector

b

lntegritYlattitud&'&f MDlwell informed

b

Lifestyle of M D in relation t o stated income

b

Whether audit testing consistent with representations

i

'

/

Section 4: Concluding and reporting on assurance engagements

I

22

W h y investigate further

b

Cash book may have been left open after year end (inappropriate cut-otT)loverstatementof cashlimpact on trade receivables collection period

b

Management t o be informed of delay in banking

-

Poor cash managementlcash flow Teeming and lading

Marks (a)

Each component Maximum Post year end sales to Japanese customer Forecast issues Contractual issues Inventory issues Post year end management accounts Japanese customer status Enquiry of management1Minutes Post year end receipts Supplierslpayables issues Funding issues Non current asset issues Marks available Maximum Modificationlqualification Modificationlemphasisof matter Marks available Maximum

(b)

(c)

Total mal-l<savailable

(a)

b

Significant changes t o the business.

b

Review of financial statements.

b

Weaknesses identified in company's systems.

b

Comparison of actual audit costs t o budget.

)

Scope for provision of other services.

b

Significant issues arisinglmanagement letter points.

)

W o r k still outstandinglunresolved matters.

b

Proposed audit opinion.

b

Changes to original audit strategy.

b

Pending litigationlmaterial uncertainties.

b

Summary of aggregate effect of likely misstatement.

P

I W EYCCANO

nw W ~ L E S

I I

18

Principal components o f completion m e m o

THE INSTITUTE OF CHARTERED ACCOUNTANTS

I

II

ANSWER BANK (b) Subsequent events review

(c)

b

Review post year end sales t o see if in line with contract.

b

Review cash flow forecast for Anagram.

b

Can they stay within overdraft?

b

Can they make bank loan repaymentslability to meet liabilities as fall due.

b

Ensure bank covenants adhered to.

b

Review sales contract for any compensation re breach of contractldamagesavailable in event of non performance.

)

Review any legal correspondencelspeal
b

Enquire as to alternative use for raw materials.

b

Are there alternative customers for finished goods?

b

Review post year end inventory levels.

b

Review post year end inventory write offs.

b

Review post year end trading resultslmanagementaccounts.

b

Obtain market infolaccounts for Japanese customer - assess status.

b

Enquire of management as to situation with contractlcustomerldiscuss advances in industry.

b

Review meeting minutes.

b

Review post year end cash receipts from customer.

b

Review post year end payables days for evidence of strain.

b

Any action by suppliers post year end.

b

Identification of alternative funding sources.

b

Correspondence with bank.

1

Non-current asset impairment review.

1

Assess equipment second hand value.

Impact o n audit r e p o r t Modify: b

Going concern unresolved and inadequate disclosure.

Disagreement due to: b

Inventory overstated.

b

Trade receivables overstated.

b

Non-current assets require impairment provision.

Company not going concern and directors insist on preparing on this basis.

If adequate disclosure re going concern: b

Emphasis of matterlsignificant uncertainty.

b

Audit report not qualified.

C!

FTutorial note b'

LThis answer is the marking plan produced by the examiner. The exa ithis sniwer is appropriate for use by students in the examination. t'

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

Section 4: Concluding and reporting on assurance engagements

Examiner's corvr ment s Atiswets ro pal-ts !a) of this quesrion were disappointirig. Part (b) was generally well answered but carididates did r ~ ope~-for.-in t well on part (c). Pet-fol-n?ai?ce on part (a) of tlie qt~estionwas very disappointing. Candidates demonstrated very little undel-stnridirigof the PI-incipalcomponents that would be expected in an audit completion memorandum. A few c;tr~Clidatesn o ~ e dtlie following: C

Rcview of the finaricial statements

?

S:g!>ificantissues arising from the audit

r

L. ' -

;,at ison of actual audrt costs to budget

t

Sr
t

C h ~ ~ t~o the ~ e orlginal s audit strategy

1

"8

l r 2sed audit opinion

-.....-- -.- .... -.?c:. ,c4r';;did,~~s r~:!c~nd~r.sccod t b r.equirernerit ~ a n d listed che pr-incipalcor~~ponencs of a ,-.-. :.>. ;..., . .. . ,. . . r.iting c3nterits such a s 'obtain n~ar~agernent I-esponse to the points raised'.

,.. :

.

-..<-

,-

i.i>Cfi,''rT'y

:..

F-!-I I b! c f t!~isquestion was generally well answered with a large number of candidates noting the following :l>e ~nainareas t o direct attention to during the subsequent events review:

2s

b

Adherence t o bank covenants

b

Abi1it.y to repay bank loan and other liabilities as they fall due and stay within the overdraft limits

b

Ca~.t-c~iponderl~e with legal advisers and customers

b

Post year end inventory levels, post year end inventory write-offs. post year end sales and trading I-esults and post year end cash receipts

Only a few candidates noted the following areas to focus on during the subsequent events review:

b

Non-current asset itr\pairrnent

)

Second harid value of equipment

b

Identification of alternative soitrces of funding

b

Assessnient of japanese customer by review of accounts and rnarltet information.

In part (c) the lnajority of candidates orily stated the modification to the audit report that could arise from an unl-esolved going concern issue and inadequate disclosures. Only a few candidates outlined and considered the various circumstances identified in the question and the impact these might have on the audit report. For example, candidates rarely mentioned that the audit report might be modified due t o a disagreement over the non-current asset impairment provision, o r if the accounts are prepared on a going coricerrl basis when they shoilld be prepared on a break-up basis.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND A N 0 WALES

Garb Ltd

+ -

--Marks

(a)

Meaning of going concern Why auditor should consider going concern Marks available Maximum (b) Profit forecasts reasonableness of assumptions Post year end management accounts Profits profile Cash flow forecasts - reasonableness of assumptions Ability to meet debtslstay within overdraft facility General points (each) Marks available Maximum (c) Significant uncertaintylemphasis of matter Failure to disclose uncertainty Marks available Maximum Total marks available

-

(a) What is meant by the going concern concept, and why the auditor should consider whether a company is a going concern The going concern basis presumes that the entity will continue in operational existence for the foreseeable future. Both the Companies Act 1985 and accounting standards require financial statements t o be prepared on the going concern basis. ISA 570 requires auditors t o consider the entity's ability to continue as a going concern, and ensure appropriate disclosure in the financial statements. If the going concern basis is inappropriate, a company may need to ascribe different values to items in the financial statements (ie prepare the financial statements on a break-up basis).

b

Assets may need t o be written down to recoverable amounts o r reclassified.

b

Liabilities may need to be restated to reflect changes in amount or date of maturity.

b

Additional liabilities for losseslredundancies may arise.

(b) Matters to be considered when reviewing the profit and cash flow forecasts in order to assess whether the company is a going concern Profit forecast b

,

Reasonableness of assumptions, particularly in respect of -

-

-

Anticipated level of revenue taking into account new contractslloss of major customer Whether margins reflect terms of historicallnew sales contracts Whether terms of contract agreed with major supplier Penalties in respect of late payments t o HM Revenue & Customs Projected exchange rates.

Section 4: Concluding and reporting on assurance engagements

P

Consider the extent t o which forecasts for expired periods are supported by management accountslevents after the balance sheet date.

b

Consider profits profile (ie quality of profits) - ensure profits are from trading and not from sale of non-current assets.

Cash flow forecast b

Reasonableness of assumptions, in particular

-

P

Expected cash collection performancelstatus of receivables Basis of payment terms t o existing suppliers (may indicate tightening by suppliers).

Company's ability t o meet its debts as they fall due and stay within overdraft limit.

General

(c)

b

Susceptibility of key components t o sensitivity analysis.

b

Any unanticipated costs of closure incurred in the post balance sheet period have been accounted for.

b

Competence of preparers of forecasts by reference t o previous forecasting.

b

Accuracy of additions and calculationslconsistency between cash flow and profit forecasts.

b

Whether any of the projections would result in debt covenants being breached.

Implications for the audit report if the negotiations for the replacement loan are not completed by the time the audit report i s signed This would constitute a material matter re a going concern problem which should be highlighted in the audit report. The audit report should be unqualified if there is adequate disclosure in the accounts. The report should include

b )

An emphasis of matter paragraph referring t o the disclosure With specific reference t o the fact that the report is not qualified.

The audit report should be qualified if the uncertainty is not adequately disclosed in the notes t o the, accounts.

Answers to this question were dis;\ppoi~.~tir~p,. It had the lowesc ;ivci :!EC perfo~.rnances01.1p;t~.t(b).

i1?31-1<, w k ~ i c twas l

irlainly due r.o poor

Part (a) was genel.ally ~velia~lswct.cd. Referenc::~to the Co~lr~arlic~c Act alic! ISA 570 Cioiiig Corlcer.~~ ~ v r l - the e 1'110st conimolr oinissioi~s. Answers t o part (b) were very disappointing. Many candidates did not al-iswerthe questiotl, a t d ir~stead provided a cllecl<list of factors wti~chniiglit indicate that tl.~ecot.rlpatly was not a going corlcel-n. Those candidates who focused on the ],I-ofit and cash flow forecasts, as r.t?q!,ir.ed by the qi~estion,generally scol-ed high marks. : In part (c) tho& candidates wlio apprcci,,ted that. ttle iss~.~e was a 5ignificarlr. i~ncertaintyusi~allyscored full marks on this part of the question. 'Tl~osccandidates who failed to idesitify i t as a significant uncertainty tended to waste time writirlg lengr.hy arlswers about tlhe groutldj for qilalificatiorl irl general and not in the context of [tie issue identified in the question.

158

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLANDAND wnLrs

Plumb btd

Marks Each matter Explanation (each) Maximum (b) Modifiedlemphasis of matter Qualifiedlexcept for disagreement Adverse opinion Qualified limitation on scopeldisclaimer Marks available Maximum (c) Income Expenditure Receipts Payments Consistency between cash Row and profit forecasts Marks available Maximum Total marks available

(a)

_

Y2

I 6

2 2 I% 2 7%

6

2 7 2 3 I 15 8 20

b Fixed price contracts

b Cost overruns may result in losses

b Retentions

b

_ ....

...........................................

.........................................................

. .

..........

...

b Sale of retail operations

--

.___ .l-__-.-l

.

b

-

....

May not be paid if work is faultyladverse impact on cash flow Unable t o generate funds from operations to repay loan

b Proceeds may not be sufficient t o cover loan --

........

,

..-..

.

..-

.-.

b Legal claimldispute

b Substantial damages may have t o be paid

b Loss of business as unlikely to retain major customer -..- .

b

-

Trading at overdraft limit

b Going- concern status in doubt

ncreased facility. . ........ ,

b

If not a going concern the basis of the preparation of the accounts will be affected

b

May require disclosure in the audit report as an emphasis of matter

........................................................................

-,

........

...............................................

-....................................

(b) Audit reports b

Modified, but unqualified, with emphasis of matterlexplanatory paragraph -

-

Material uncertainty about the going concern status and Adequate disclosure in the financial statements of the uncertainty

THE INSTITUTE OF CHARTERED

ACCOUNTANTS IN ENGLAM) AND WALES

159

Section 4: Concluding and reporting on assul-ance engagements Qualified except for disagreement

b

-

b

Adverse - do not give true and fair view

-

b

Disagreement over basis of preparation

Except fol-ldisclaimet- of opinionllimitation of scope

(c)

Disagreement over disclosut-e details But happy about basis of preparation

Evidence reasonably expected t o be available is not available Management unwilling t o make or extend assessment of going concern

Matters to consider Income

b

-

Includes income from retail operations to date of disposallexcludes income from retail operations following disposal

-

Allows for loss of income from major customer

Expenditure

b

-

Allowance made for any loss of bulk discounts due t o reduction of purchase of consumables Includes legal costs of fighting legal action Wages to reflect reduction in operations due to loss of major customer Additional overdraft interest but no loan interest following repayment of loan Costs of rectification work Profit or loss on disposal of retail operations included Accounting policies are consistent with historical financial statements

Cash flow

b

Receipts

-

Timing allows for retentions Reflects disposal proceeds

Payments

-

Loan repayment made in February Includes costs of disposal Suppliers paid in accordance with their terms of trading

General

b

-

Items in cash flow are consistent with profit forecast

Taltoriall note This nlrswet. is the !-rla~-l
9:i:ix ql..:!:if:io~~ ;.%el-:: gr.:lctally good although the!-c was sorne evidence that a stmall minority of caric!idnrc.s l ~ ? dI - L I I I silt o f ti~nr.01, t h i qi.tcslion. Car~didatessliould he careful to allocate their time pl.cpt.!-ly i:c:iwc~r, c1.c I:;,b*n ~ 3 l - of c ~t.i.1~. p3per and between each written test question. A : ' ~ ~ i t ? ! - 51 0

alr~~nst: ;:it c::ndidace: ndo!~c.eda colurr~i~ar approach with I.r\acters it1 one column and explanations tlie ott?er w/.ticb! ~ ; . o ~ ! J cfc?ci~sed cc! a!ll;inlel.s. The nrajority of cnrididates easily identified the ltey matters

11.1 P:I~.!. (a)

i!i

THE INSTI I U TE OF CHARTERED ACCOUNTANTS IN ENCLAND I Y D LVblCl

ANSWER BANK fro111 tlie cluesrion but. tlic! <:>r~c:sw l l o sco~.r!ilI~igl,lywt.t-c! those w h o developed tlleil- explanatioris. For example, m o s t ca~ldidzl:.eslisc.cd rile cotnpc?tlsal.io!~cl;lint lodged by Duilcla plc as a niattel. for- concern wit11 the explanation chat. significant da!i?ages ~nighr.ei!sl.tc. 1.-low eve^., only some candidates w e n t o n t o suggest that a furthel- I-csolt of 1Iw clainr was liltely to b e t l l c loss o f Br~ildaplc as a niajor customer. Similarly. almost all listed tlie sale o f the retail o p e r a t i o ~ i sas a Inactel. f o r c o n c e r n w i t h t h e explatlation that w i t h o u t sucll a sale the loan could n o t b e repaid. H o w e v e r , only a f e y candidates c o ~ n r n e n t e dor1 the sel-iousness o f t h e conipany having t o sell irs assets t o rneet its debts. A l l identified going cor1cel.n as an issue b u t some set this down against alrllost e v e r y identified rnatter (and didn't always explain exactly w h y t h e matter gave cause for concernj. Mal-Its w(?~.e o r ~ l yawal-ded o n c e f o r n \ e n t i o n o f going concern. In Pal-t (b) t h e ~ n n j o r i t yof car~didatessliowccl a pleasir~g~ . ~ n c l e ~ - s t a ~oi df itnhge types o f audit r e p o r t modifications w h i c l l rvay nl isc f r o m a g o i r ~ gcollcel-n problen\. H o w e v c r , a significant n u m b e r misread the question and gave nll t l ~ etypes o f audit r e p o r t s whic:li w e r e possible (ie unmodified as well as modified) and ~ t reports thereby wasted valuable t h e . A nliriot-ity of c;tr~did;lt.es w e r e clearly confused a b o ~ audit altogethel-. Sorne failed to de~nonstt.acean undel-scar~dingo f t h e meaning o f 'modify' - they did n o t appreciate that a r e p o r t cc?uld b e modified witJ.10~1tbeing qualified. A f e w ca~ididatesacti~allyconfused qualified audir r e p o r t s w i t h urlqt~alifiedaudit r e p o r t s - they thought, incorrectly, t h a t a qualified repor-t was a clean r e p o r t . A sigr~ificarltni.rmbe~-a f candidates. w h o did appear t o have s o ~ i ~understanding e of the topic, failed to gain as many 1na1.k~as t h e y m i g h t have d o n e d u e to badly w o r d e d answers 01-a failure t o tailor t h e types o f moc!ification t o goirig corlcel-1.1 issues. -l'l~osew h o set o u t t h e various possibilities in accordance w i t h tllr requii.el.nerlt cleal-ly and s ~ r c c i ~ i c tused ly tlleil- tilrle efficiently and scored highly. A significant n u r r ~ b e ro f catdidares wasted time a n d pl-ovided a detailed and unnecessary explanation o f the going conce1.n concept. Although therc! w e r e s o m e g o o d a r ~ s w e r sro Part (c) many candidates wasted t i m e t r o t t i n g o u t general matters to consicier w h e n r e v i e w i n g p r o f i t and cash f l o w forecasts. These general points (ie, previous forecasting experience o f manageinent, checlting casts a n d calculations etc) w e r e not required. T h e question clearly stated ' t h e specific m a t t e r s t o b e considered w h e n reviewing t l i e assu~riptionsunderlying the income and exper1dita1.c . . . 2nd t h e receipts 2nd payrr~ents' (ie, p r o f i t l p r o c e e d s f r o m sale o f retail operations, loan I-epayrrlent). Candid;ltes also n e e d to be careful w l i e n answering this t y p e o f question t o ensure tliey otily i n c l ~ r d eincorl-le/expcrrclit~~~~e~prc)~itjloss items untie1 t h e pi.ofit forecast a n d only cash impact i t e ~ r i sunder t h e cash f l o w forecast. F o r example, w i t h respect to t h e sale o f the retail opel-atiuns. marks wet-e only given undet. t h e p r o f i t fol-ecasr f o r profit o f - loss on disposal a n d o n l y under t h e cash flow t wasted time forecast f o r disposal PI-ocecds. S o n w candidates strayed b e y o n d t h e I - c q r i i r e ~ n e nand considering w l l e t t ~ e rt h e conlpany w o u l d indeed t u r n out t o be a going cancel-11.

Delux Hateis btkj

-----Marks R o o m lettings - discounts R o o m lettings - c r e d i t limits Property, plant a n d e q u i p m e n t C o m p u t e r system - file server C o m p u t e r system - passwords Marks available r Maximum (b) Each a t t r i b u t e Maximum (c) Independence issues Nature, scope o f w o r k a n d f o r m of r e p o r t Marks available Maximum Total marks available

(a)

THE INSTITUTE

OF CHARTERED ACCOUNTANTS

IN ENGLAND AND WALES

Section 4: Concluding and reporting on assurance engagements (a)

For inclusion in a report to management (I)

Room lettings

- corporate customers

Discounts Possible consequences b

As a direct result, Delux Hotels Ltd is losing income so that margins will be eroded.

b

Indirectly, the granting of large discounts not backed up by company policy could lead to customer dissatisfaction with inconsistent pricing.

b

A general ethos of non-adherence to management policies could lead to a loss of management controllrespect.

Recommendations b b b b b

Rangellimit checks should be exercised by software (with authorisation linked t o identity). Exception reporting of discounts granted with independent review thereof. All exceptions should be cleared by the reservations manager. All breaches of company policy should be investigated by a responsible official. Employees should be made aware of the importance of adhering t o company procedures.

Credit limits Possible consequences b

b

Bad debts could arise because of sales being made without reference to credit limits. Working capital may be unnecessarily tied up, with adverse interest implications.

Recommendations

(2)

b

Credit limits should be introduced for all customers with credit accounts.

b

These limits should be regularly reviewed by head office in conjunction with hotel managers and credit ratings.

b

Independent review of aged receivable analysis.

b

Follow up of slow payers.

'

Property, plant and equipment Possible consequences b

Property, plant and equipment may not be acquired on the most favourable terms.

Recommendations

(3)

b

Independent review of quotes by estateslproperty manager who should evidence review by signature.

b

Employees involved to be informed in writing in respect of breach of company policy.

Computer system File server Possible consequences b

lncreLsed risk of theft and damage.

b

Loss of file server will result in systems breakdownlbusiness interruption.

Recommendations b

File server should be sited in a lockable room with access restricted t o authorised personnel by use of keyslPINs.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALLS

.

,

ANSWER BANK

Passwords Possible consequences

b

Long intervals betweeri password changes increase liltelihood of password becoming known. increasing I-isl
b

Company should have a policy which requires passwords to be changed every 30160190 days (or after a specified number of accesses) and when staff leave.

b

Change should be systems-enforced and disallow re-use of former passwords and use of common words.

(b) Attributes for effective communication to those charged with governance Timing - Communication should be on a sufficiently prompt basis t o enable those charged with governance t o take appropriate action. For example, findings from the audit that are relevant to the financial statements should usually be communicated before those financial statements are approved. Extent, form and frequency - must be appropriate. This will vary depending on the size and nature of the entity and the way in which those running the entity operate. Expectatior~s- In order that effective communication i s established, the expectations of both the auditors and those charged with governance r e the form, level of detail and timing of communications should be established at an early stage in the audit process. This should limit the scope for misunderstandings. Addressee - The auditor will need t o use his judgement to decide who is the appropriate addressee. In some cases i t may be appropriate t o communicate t o a committee. In others it may be necessary to go directly t o the board of directors. Form of communication - Communication may be made orally o r in writing. Which is appropriate depends on factors such as the size of the entity, communication lines, nature of the matters being reported, statutory requirements and specific arrangements made. Comments made by management - should be incorporated in the communication where those comments will aid the understanding of those charged with governance. Previous year's points - If there i s no new relevant information to communicate, the auditors'should make those charged with governance aware that this is the case. Alternatively, if the auditors feel that appropriate action has not been taken, they may decide t o repeat the point in a current communication.

A disclaimer - should be included t o remind third parties who see the communication that

it was not

prepared with third parties in mind. (c) Additional matters to be reported to those charged with governance in the UK ISA 260 is written primarily in the context of reporting matters which arise from the audit. However, to listed and other public interest entity clients, the UK auditor must also (ISA 260, para 11-5)

1

Report significant facts and matters which bear upon his objectivity o r independence

1

Disclose

-

b

Any relationships which have a bearing on his objectivity or independence The related safeguards which have been put in place The total fees charged by him as auditor for the provision of other services

Confirm his independence in writing, o r report that there are concerns which he wishes t o discuss with the audit committee.

To all client entitles, the UK auditor must communicate an outline of the nature and scope of work he proposes to undertake and the form of report he expects t o make (ISA 260 para 1 1-7).

THE INS7 ITUTE OF CHARTERED ACCOUNTANTS IN [NGt ANDlAND WhlfS

Section 4: Concluding and reporting on assurance engagements

Exal-r~iner'scomments (part (a) only) G e n e r a l cotnments "!\)isrl!.lestion was generally well answered and well laid out. However, despite the note stacing that 'a covrl-ing letrel- is not rcquil-ed', a nt~lnbcrof candidates wasted time producing this.

Many cnrldidates denlonstrated a coni~nercialawareness that discounting was often necessary in order t o let a roorn. rather tha.11lose business so that some discretion in respect of discounting was perniissible. t-foweve~., a significant number of car-ldidates thought that tlie hotel manager should autliorise all discounts. and cor~sequentlyfailed to identify the use of exception reporting as a nieans of monitoring adherence t o cotnparly policy.

Candidates performed well

011this

part of the question.

Property, p l a n t and equipmerit The majot-ity of candidates identified that pt.opet.ty, plant and equipment may not be acquired on the most fnvoul-able rctt-n~s, ntitl the need for an independent review of the quotes. Only a minority of candidates identified chc importance of I-epriniatiding employees for breaching company procedures. C o m p u t e r systeni File server Tlie majority of candidates identified the risk of theft, damage and systems failurelbusiness interruption and the need for pliysical controls t o restrict access t o authorised personnel. However, many candidates wasted time writing at length about general corltrols within a computer environment.

Passwords -l-his part of the question was well answered by most candidates. However, a significant number thought that tlie ability of staff to change their own passwords was a problem and consequently did not identify that the systern should enforce staff t o change passwords on a regular basis.

39

Sallmor~oidLtd

Marks (a)

Each factor Consequential risk (each) Each feature Significance of each feature Maximum Audit reports under the Companies Acts (b) Other reports under legislation o r regulation Other reports , Marks available Maximum Total marks available

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND

wo wnirs

ANSWER BANK (a) Assurance assignment

Factors and consequential risks re inventory values

(i)

b Water is supplied from bore holes.

b If the water supply runs low o r is contaminated the fish may die.

b The fish are susceptible t o disease related t o inventory levels.

b ~vea n moderate deterioration in water supply may reduce the usable capacity of the cages below 300,000 fish.

b If parasites etc cannot be properly controlled. the true maximum inventory levels will have t o be reduced if quality is t o be maintained.

1 Poor quality inventories will have a lower net realisable value. b Inventories held in poor conditions may attract legal action from animal welfare groups leading t o possible fines and loss of reputation. reduce attractiveness of the inventories t o the marketplace leading t o a fall in their saleable value.

b If fish inventory levels canngt be maintained at expected levels then an excess of pellets will arise, the value of which deteriorates over time.

b Feed pellets can deteriorate.

1 This situation would be worsened by accidental o r deliberate damage t o the silos breaching the airtight conditions as this would further shorten the life expectancy of these inventories. -...........................

.....................................................................................................................................................

1 Salmonoid Ltd sells t o the major

.

-...

..- ................................

b If the supermarket chains were t o find an alternative supplier for prepared fish, then inventories held for despatch would have n o value unless an alternative customer o f equivalent size can be found.

supermarket chains.

b Frozen inventories are held.

b The company holds up t o one month's supply of frozen fish. Failure t o maintain temperatures at the required level would lead t o the loss of these inventories.

b Insurance cover over frozen inventories is due for renewal. t

-.

-.

......-..-.....

-

.. .-

.

b W i t h policies due for renewal it is essential that these are adequate t o cover potential claims, otherwise the going concern status of the business could be threatened. -,

......

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

I65

Section 4: Concluding and reporting on assurance engagements (ii)

Features of assurance report on inventory values and significance

Description of engagement

b

An assurance report is not a legal requirement, but is commissioned by an individual or organisation for a particular purpose. It is important that this party is identified (ie the Sterndale Bank).

1

It is important that the report clarifies the purpose for which the worlc was undertaken, II. .... ..

Responsibilities clearly stated so that the user(s) of the report does not misunderstand the role of .

.

..

..

.

..

.. .

. .

. ..

Restricted purpose

b

Some assurance reports are for a restricted purpose, such as exclusively to support a loan. This must be stated.

Standards applied

b

When undertaking an audit assignment the ground rules are clear, financial statements should have been prepared using accounting standards and the auditors should have conformed with auditing standards.

b

Assurance work will often be conducted with reference to other standards, such as the

Conclusionlreservations

b

The assurance report is not reporting on truth and fairness, but a conclusion from the practitioner is still required. In the case of Salmonoid Ltd this should indicate the sensitivity of inventory values and the threat to loan security of adverse changes.

b

Name of firmlsignature

b

Ultimately it is this signature that gives the commissioner of the report confidence, or otherwise, in the issue reviewed.

b

Date

b

This i s vital t o the practitioner t o ensure he is not held liable for events after the report has been completed.

.

(b)

.

Comparison of different forms of assurance

(i)

Audit reports under the Companies Act

The CA85 requires all companies t o prepare annual financial statements for circulation t o their shareholdgrs and for filing with the Registrar of Companies at Companies House. Unless the company qualifies for exemption from audit, the financial statements must be audited by a 'registered auditor' who makes his audit report to the shareholders, not t o the management. In the opinion given in the audit report, the auditor malces a positive assertion whether the financial statements give a 'true and fair' view and have been properly prepared in accordance with the detailed rules on financial statement disclosures. The auditor also makes a positive assertion whether the directors' report i s consistent with the financial statements. The opinion given by the auditor therefore conveys a h~ghlevel of assurance about the financial statements, but not an absolute level. An absolute level of assurance i s imposs~ble; evenjf all the THE INSTITUTE OF CHARTERED ACCOUNTANTS 11.1 [-:'.,All,,

I , ' , , , ,,I

1 I1-

ANSWER BANK transactions of the company were examined (and this would be prohibitively time-consuming and expensive t o perform), could there be confidence that no transaction had been omitted entirely! Therefore, in relation t o the timeliness (users want up-to-date information) and cost the audit report gives a satisfactorily high level of assurance t o the normal user of the financial statements. (ii)

O t h e r r e p o r t s under legislation o r regulation Assurance firms may be engaged t o prepare a report on the financial statements and other information presented by organisations which are required t o report under special legislation or regulations. The assurance firm will approach the engagement in much,the same way as performing an audit on a company under the CA85. It would need t o understand the special nature of the organisation and the relevant legislation and regulations, as well as considering any specific guidance on the sector which has been developed by the accountancy profession. In addition t o reporting on the financial statements, the assurance firm may also be required to give a report direct t o a regulator, in accordance with instructions issued by the regulator. As with an audit opinion on a company, the resulting opinion will usually give a positive assertion about the 'truth and fairness' and 'proper preparation' of the financial statements. This report also gives a high, but not absolute, level of assurance about the financial information. The opinion, and any report t o a regulator, may also refer t o more specific matters such as the organisation's compliance with rules on accounting systems and record keeping, or compliance with solvency rules set by the regulator. The report on these specific matters is a positive assertion about compliance with these aspects of the rules, and will convey a high level of assurance t o the regulator and other readers of the information.

(iii) O t h e r r e p o r t s w h e r e t h e scope o f t h e w o r k and of t h e r e p o r t to be provided are agreed b e t w e e n t h e t w o parties 'Other reports' embraces the many other circumstances where an assurance firm is engaged by another party t o provide a report on a piece of information. The scope of the engagement is not set down by regulation, so the assurance firm and the client must agree on the terms of engagement. In particular, the engagement letter must specify

b b

The scope of the work t o be performed by the assurance firm The form of report to be given by the assurance firm.

The level of assurance given by the final report will be dependent upon the amount of work performed by the assurance firm and the agreed wording of the report. This can vary from a high level of assurance (very extensive testing needed) t o a limited level (less detailed examination).

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

Section 4: Concluding and reporting on assurance engagements

.---

Marks (a)

Role of materiality Problems Marks available Maximum (b) Betta Networks: Conclusion Reasons Effect Rayton: Conclusion Reasons Viva: Conclusion Reasons Effect Marks available Maximum Total marks available

(a) The role of the concept of materiality in the conduct of an audit and why i t can be a difficult area for auditors

Role

A matter i s material if its omission o r misstatement would reasonably influence the decisions of an addressee of the auditors' report. Preliminary materiality is established at the planning stage and revisited at the completion stage in the light of potential adjustments. Materiality influences b b b b

The nature, timing and extent of audit work Whether or not an error is corrected before the financial statements are published Whether an itemlpolicylchange in policy is separately disclosed Whether the audit report is qualified.

Problems The difficulties of the concept of materiality for the auditor arise from the following. b

The diverse nature of the addressees of audit reports.

b

The fact that materiality is not capable of mathematical definition: it is both qualitative and quantitative.

-

It should only be considered in relation to context and not applied indiscriminately without regard to the particular circumstances. It requires the use of professional judgement or is determined by a responsible individual.

Yardsticks are used in practice, eg % of pre-tax profit, % of assets etc (including the aggregation of individually immaterial items) but these are not suitable for items which yay be material b/ nature, eg if the Companies Act requires an item to be accounted for or disclosed in'a particular manner, it is

168

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

' A ~ S W E RBANK more likely to be regarded as material than an item for which there is no such requirement or where a profit is turned into a loss or net assets into net liabilities. Lower yardsticks may be required for unusuallnon-recurring items.

(b) Type of audit report and reasons Betta Networks plc b

Qualifiedladverse audit report due to disagreement over accounting treatment

b

Since f8.5m exceeds pre-tax profits, the matter i s material.

b

It i s also likely t o be considered pervasive as capitalisation of repairs and maintenance costs results in a reported profit instead of a loss.

b

An adverse opinion would probably therefore be given, as the accounts as a whole may be considered misleading (pervasive).

b

The report would state that the financial statements do not give a true and fair view with the reason and the amount stated in a paragraph before the opinion paragraph.

Rayton Ltd

t

b

An unqualified audit report would be given.

b

This is because the difference between cost and IVRV i s £60,000 (240,000 - 180.000). At 2.5% of pre-tax profits this is unlikely t o be considered material unless there are other uncorrected errors.

Viva Ltd b

b b

b

Qualified audit report due t o disagreement over lack of disclosure. The size of the error is irrelevant as this is a related party transaction. An 'except for' report would be given as the financial statements otherwise give a true and fair view. The reason and amount involved would be stated in a paragraph before the opinion paragraph.

Examiner's cornmerits Candidates were well prepared for the topics covel.ed ill this question. Answers to this question scored the highest average on the WT section of the paper. Although part (a) was generally well answered, the ~najorit.~ of canclidatfs foctrsed on the definition of materiality and why it was a PI-obleni for a~~ditors. Or~lya nii~iol-ityof candidates considered the irnpact materiality has 011

b b b b

Nature, timing and extent of audit work 01. not an error is cor-rccted beforc ctie financial statements are published W1ietIie1-an itern/policylchnnge in policy is separately disclosed WI1ethe1-the audit repol-t is qualified.

whet lie^

In part (b), answers t o Betta Networks plc and Viva Ltd were better than ariswers t o Rayton Ltd. Irl respect of Raytori Ltd, a significant number of ca~.~didates did not appreciate chat materiality should have been considered in the context of the diffcrer~cebetween cost and net realisable value. These candidates considered materiality in ;he context of cost of inventol-ics, and therefore incorrectly concluded that the matter was material and required a qualification. A minority of candidates incorrectly thought that an 'except for' opinion was an c~nqt~alified opinion. 'There was also sonic conft~sionbetween an adverse and 'except for' opinion.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN CNGl AND AND WALES

Section 4: Concluding and reporting on assurance engagements

4l

Audit report phrases

Marks (a)

lndependent auditors' report Which comprise We do not accept responsibility t o Our opinion In accordance with lSAs Test basis Reasonable assurance Free from material misstatement True and fair view Registered auditors Marks available Maximum (b) Each point Maximum Total marks available

(a)

Meaning and purpose of underlined phrases lndependent auditors' report Shareholders appoint directors to run the company on their behalf. They want an independent report to make sure that the directors are preparing the financial statements on a true and fair basis. An auditor is appointed to go in and review on this basis. The auditor must be independent of the company otherwise his report has no worth. He must be unbiased, objective and not subject to any influence by the directors.

Which comprise The financial statements refer to the income statement, balance sheet, statement of changes in equity, cash flow statement and notes. It is only these financial statements which are subject to audit. The annual report which contains the financial statements also contains a great deal of other information which is not subject to audit. Some people may interpret financial statements in different ways. To clarify matters the audit report states explicitly which pages contain the financial statements and hence what has been audited. While the auditor has a professional duty to read the 'other information' to ensure that it is not misleading, he does not need t o audit it. This is stressed again in the 'responsibilities' section of the report.

W e do not accept or assume responsibility to anyone other than the company arid the company's members Following a Scottish legal case when it was found that the Royal Bank of Scotland was entitled t o rely on the published financial statements of a company for the purposes of lending the company money, UK auditors have introduced this extra paragraph into their audit reports. All previous legal cases on the subject had restricted the auditor's legal duty of care to the members of the company only, but the Bannerman decision (named after the auditors in the case) called,this into question. The wording of the paragraph is designed to restrict the auditor's duty of cgre. 'Y

170

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WAlES

ANSWER BANK O u r opinio~i As explained above, the independent auditors' report gives credibility to the financial statements. By stressing that it is an opinion, the auditor conveys that judgement has been used and it is not a guarantee that there are no erl-ors whatsoever. In accordance w i t h International Standards o n Auditing (UK and Ireland) Auditing Standards are basic principles and essential procedures with which auditors are required to comply. The fact that these standards have been followed gives users of financial statements reassurance that high quality standards have been followed during the course of the audit, and the audit has been conducted properly. The reference to International standards is in line with guidance from the International Forum for Accountancy Development which recommended that auditors' reports on financial statements should clearly identify the national financial reporting frameworl< used by the preparers of the financial statements and the auditing standards that are applicable to the auditors. O n a t e s t basis , Auditors do not test every single transaction during an audit, as this would be an inefficient way of reaching an opinion. Auditors test a sample of transactions and use these results to draw conclusions about whole populations. This is highlighted in the report to dispel the misconception that the auditor checks everything.

Reasonable assurance An unqualified audit report is not an absolute guarantee that a set of financial statements is free from all error. There i s always a small audit risl( that the wrong opinion has been reached. It is not possible t o be certain that there are no errors, since there are estimates in the financial statements which involve the use of judgement. In addition, not all transactions have been tested, so it is possible that some will be recorded incorrectly. However, the auditor will do sufficient work to give a user reasonable assurance that the financial statements are true and fair. Free f r o m m a t e r i a l m i s s t a t e m e n t This ensures that the financial statements are not misleading and there are no significant errors which would influence an addressee of the report. There could be errors but they would not be significant. A t r u e and fair view There is no formal definition of what 'true and fair' means. 'True' implies accurate and 'fair' implies free from bias. The financial statements should not be misleading and all disclosures should be adequate. preparing financial statements in accordance with generally accepted accounting principles will imply that they are true and fair. The auditor has a specific duty under the Componiec Act to report as t o the truth and fairness of the financial statements. Registered auditors This demonstrates that the auditor is a member of a recognised supervisory body and therefore has the authority to perform an audit. (b)

Objectives o f requiring unqualified a u d i t r e p o r t s t o b e published in a standard f o r m b

T o promote the use of common language t o assist the user's understanding of the meaning of the report.

b

T o promote comparability between reports so it i s easier t o recognise when a report i s qualified.

b

T o attempt t o narrow the expectation gap - the difference between the public's'perception of the auditor's responsibilities and the legal and professional reality.

b

T o limit scope for litigation.

b

T o convey t o the reader the nature and context of the audit opinion.

I

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

Section 4: Concluding and reporting on assurance engagements

1;'

li,

b

T o indicate the type of assurance concerning the financial statements the auditor feels i s warranted, based on the evidence obtained.

1

-Marks (a)

Completing a checklist Final analytical review Marks available Maximum (b) Each matter t o consider Maximum (c) CCEP: Conclusion Reasons Effect Prime Volunteers: Conclusion Reasons Effect Worldwide: Conclusion Reasons Effect Marks available Maximum Total marla available

(a) !

Reasons and benefits of completing a disclosure checklist and carrying out final analytical procedures when conducting final checks on the financial statements The completion of a disclosure checklist ensures that b

The financial statements have been prepared using acceptable accounting policies

b

Disclosures in the financial statements are complete and appropriate

b

The financial statements are in compliance with statutory requirements and accounting standards.

The checl<list also b

Provides an efficient method of checking

)

Provides a quality control procedure

b

Ensures that information in the directors' report is consistent with the financial statements.

By carrying out final analytical procedures the auditor

b

Ensures the financial statements reflect his knowledge of the business

b

Looks for any changes in ratios that are unexpected

b

Checks consistency with the results of his other audit work

b

Ensures that he has all the information and explanations t o allow him t o form an opinion on the financial statements. .r 1

1 THE INSTITUTE OF CHARTERED ACCOUNTANTS IN tNCLANO AND W\LIS

ANSWER BANK

5 marks worth of material.

Matters to consider as part of a going concern review of CCEP

(b)

I

: !

+ '. . .. ,

b

Whether the going concern basis of preparation is appropriate.

b

The adequacy of disclosures regarding going concern.

b

Management's plans t o deal with any going concern threat and the likelihood of success of those plans.

b

Whether management has prepared budgets and cash flow forecasts for at least the next year.

b

Whether forecasts indicate the ability of the company t o pay debts as they fall due.

b

Consider the reliability o f previous budgetslcash flows and the proficiency of the preparer.

b

Bank facilities and date of renewal.

b

Ability t o comply with terms of covenants in loan agreements.

b

Forward order booklnew customers.

b

Ability t o sell inventory at full price (forced sale of inventory).

b

Recoverability of receivables (including timescale).

b

Post balance sheet events which may indicate whether a tax liability will arise.

.

"Tutorial note

:

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i

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.

.

(c)

Impact on audit report and explanation CCEP Ltd Type of report and reason The report would be unqualified because b b

Full disclosure has been given of the contingent liability Which is a material uncertainty which may affect the going concern status.

Effect on report An additional 'emphasis of matter' paragraph should be added t o the report, drawing users' attention t o the note t o the accounts with a specific statement that the report is not qualified in this respect.

Prime Volunteers Ltd Type of report and reason An adverse opinion should be given due t o

b b b

Disagreement ov.er accounting treatment O f a material amount way in excess of profit Which is therefore likely t o be pervasive t o the financial statements.

Effect on report b

In an additional paragraph before the opinion paragraph state the reason (disagreement over accrual for freehold property) and amount of f 170,000.

b

In the opinion paragraph state that the financial statements do not give a true andqair view. !. THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALLS

Section 4: Concluding and reporting on assurance engagements

Worldwide Ltd Type of report and reason

A qualified audit report should be given on the grounds of limitation on scope because b b

Evidence reasonably expected t o be available is not available in this instance The issue is material as it represents 60% of inventory.

Effect on report b

Give an 'except for' report if the matter is not pervasive.

b

Give a disclaimer of opinion ('we do not express an opinion') if the matter is considered pervasive.

b

State that there was a limitation on scope in the basis of opinion paragraph.

b

In the UK make statements that all information necessary for the audit has not been received and in respect of whether proper accounting records were maintained.

. Tutorial note ,

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Examiner's comments Answers t o this question scored the lowest overall average on the written test section of the paper. This disguised the fact that answers t o part (c) were generally very good. Answers t o part (a) and, in particular, part (b) were disappointing. Answers on the final analytical review were genet-ally better than answers on the disclosure checklist. This is because a significant nuniber of candidates misread the question in respect of the disclosure checklist and answered in terms of an audit completion checklist. Statements such as 'ensure all areas covered' and 'a check that all work is done' were common among weaker candidates. The points most commonly identified were in relation t o the completeness of disclosures and co~npliancewith statutory and regulatory requirements. Those candidates who split the requirement between reasons and benefits tended t o identify a greater number of points. Answers to part (b) of the question were very disappointing. Weaker candidates focused on the possible outconles of the HPI Revenue & Customs enquiry and did not consider the broader aspects of a going concern review. In particular candidates omitted t o consider forward orders and recoverability of inventories and receivables. Many candidates highlighted profit instead of cash as being important. Some candidates wasted time listing financial issues and consequences flowing from a potential going concern problem rather than addressing tlie matters to be considered in clarifying whether o r not the company was a going concern. The following comments relate to part (c).

CCEP Ltd The majority of candidates appreciated that the situation was a miaterial uncertainty affecting going coricern and consequently went on to get the points in respect of the effect on the audit report. The most commonly ovel-looked points were those relating t o the emphasis of matter paragraph, ie drawing users' attention t o the note t o the accounts, and a specific statement that the report is not qualified in this I-espect. However, a significant number of candidates thought the situation represented a limitation on scope which it clearly was not as the auditor had not been prevented frorn obtaining evidence which might reasonably be expected t o be available t o support the figure or disclosure in the financial statements.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLANDAND WALES

ANSWER

BANK

Prime Voluriteers Ltd This pat-t of the question was genet-ally well answered. However, a number of candidates gave as a justification for- an adverse opinion that a profit would be turned into a loss rather than a small into a large surplus. Worldwide L t d This part of the qitestior~was well answered I-egardir~gthe grounds for and type of qualification. However, only a minority of candidates considered whether the limitatiori on scope had in~plicationsin the UK for the availability of information and propel- accoi~ntingI-ecords. General

A significant number of candidates thought, incot-rectly, that an 'except for' opinion was an unqualified opinion.

Vista plc

Marks (a)

Threshold Expectation gap Independence issues Advantages of legal requirement Disadvantages of legal requirement Conclusion Marks available Maximum (b) Each condition Maximum (c) Vista: Conclusion Reasons Effect Expo: Conclusion Reasons Effect Pharm: Conclusion - disclosure adequate Conclusion - inadequate disclosure Reasons Effect Mog: Conclusion Reasons Hubbard: Conclusion -'disclosure adequate Conclusion - inadequate disclosure Reasons Effect Marks available Maximum Total marks available

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

175

Section 4: Concluding and reporting on assurance engagements (a)

Value of an audit Introduction The government's relaxation of the statutory audit requirement for companies with turn'over of less than or equal to £5.6 million allowed agreement t o be reached between the shareholders of such smaller companies and their auditors on the type and level of service required, if an audit was required at all. If the exemption from the statutory audit were extended to all companies, a number of existing problems attributable to the current audit function could be solved. Expectation gap The audit profession currently defines an audit by reference to ISA 200 Objeaive and General Principles Governing an Audit of Financial Statements. An auditor's responsibilities are limited to those expressed by statute or other authority. The shareholder group and other users of the financial statements have always had a wider expectation of the audit function. instance, many people expect auditors to prevent and detect fraud and all errors. There is also a belief that the auditors should give a guarantee as t o the company's ability t o continue as a going concern.

or

Deregulation of the audit would mean that auditors and their clients could reach mutual agreement on responsibilities, thereby closing the 'expectation gap'. The APB has indicated that compromise on responsibilities is the most preferable outcome. However, it would not be appropriate t o extend the auditor's duties to cover those which are already the responsibility of management. The users of financial statements must understand that prevention and detection of errors and fraud and the ability of the company to continue as a going concern are management responsibilities. The auditor is an independent expert forming an opinion, not the person performing the work in the first instance. independence The audit process arose from an independent review of the directors' stewardship of companies in which shareholders had invested. Other users of financial statements have come to regard the audit opinion as credible because the auditors are separate from the persons responsible for preparation of the accounts. The Auditing Practices Board has taken responsibility for ensuring independence through the issue of ethical standards, including the instruction t o firms to rotate the engagement partners of listed companies every five years.

It i s unlil<ely that deregulating the audit function further will enhance independence. In fact it could make the situation worse. The auditors would spend even more time with the directors and thereby familiarity could potentially be increased. Advantages and disadvantages of a legal audit requirement Advantages The existence of a statutory requirement for audit generally reflects the view that there is a public interest in ensuring proper accountability by those who direct or manage companies. r

The current statutory audit requirement ('true and fair view' and 'properly prepared') may be regarded as the minimum statutory 'benchmark' for a company audit. Additional requirements can then be contracted for, where cost is justified by benefit. An argument for such a benchmark for all companies is that i t provides a uniform and reliable quality of assurance (essential to public confidence in auditing). A further problem is that many auditors, at present, do not have the skills and experiehce necessary for extending their role, for example in relation to value for money and forensic audits.'The professional bodies would need to educate and train auditors in such additional aspscts.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN [NCIAND AND WALES

ANSWER BANK Creditors andlor potential investors would still have the benefit of a statutory audit. Disadvantages The scope of the statutory audit cannot be flexible. A feature of the initial relaxation was that it gave shareholders of the very smallest companies the option of not having an audit. Large businesses run by professional managers. with highly developed internal audit operations and boards of independent nonexecutive directors, have no choice. If the current statutory audit were abolished for these companies, audit committees could agree audit scope t o maximise value t o their shareholders. Companies with an effective internal audit department reporting to non-executive audit committees could opt for a 'light-weight' audit concentrating on financial statement disclosures. If shareholders thought it worth paying for, they could impose explicit obligations, for example, t o detect fraud. A further option may be a value for money (VFM) audit, which involves the assessment of management's performance in making the best use of the resources available, in terms of economy. efficiency and effectiveness.

A VFM audit is already provided for local authorities. All shareholders would, no doubt, welcome independent advice on the quality of their management. However, an assessment would s t i l l need to be made as to whether the auditor had the requisite skills to provide such a service. Auditors already provide advice on internal controls and their effectiveness, as part of their management letter produced after the audit. This is already an important 'value added' output from the audit process. However, within the context of a statutory audit auditors may be inhibited from expressing all of their concerns, especially those which are more judgemental, such as a view on management, as this could widen their liability and increase the chances of litigation. Conclusion

To bring the current statutory requirement to an end would not bring audits in 'true and fair' and 'properly prepared' terms to an end (as many companies would still think them worth having). As neither the government, the accounting profession, large companies nor shareholders seem likely to press for total abolition, the most likely scenario for the future scope of audit is a statutory minimum audit with additional contractual agreements in the form of other assurance engagements.

(b)

Companies Acts conditions for an unmodified audit report )

The financial statements give a true and fair viewlare not materially misstatedlare not misleading.

b

The financial statements have been properly prepared in accordance with the Companies Act 1985.

b

The directors' report i s consistent with the financial statements.

b

Information in respect of directors' remuneration and transactions has been disclosed.

b

The auditor has received all the information and explanations considered necessary for the audit.

b

Proper accounting records (including returns from branches) have been maintained.

b

The accounts are in agreement with the accounting records.

(c) Type of audit reports Vista plc

r

b

Qualify on grounds of a material disagreement.

b

The matter is material as the amount of the loss exceeds the pre-tax profit.

b

Give an 'except for' qualification if the matter is not considered pervasive/misleading.

b

Give an adverse opinion if considered material and pervasive, ie the financial statements do not show a true and fair view.

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN W G I A N D

d W WALES

Section 4: Concluding and reporting on assurance engagements b

An additional paragraph, in the opinion section, should include details of the reason for the qualification and the impact on the financial statements.

Expo Ltd b

Qualify on grounds of a material limitation on scope, ie evidence reasonably expected t o be available i s not available in this instance.

b

The matter is material as it affects 75% of inventories.

)

Give an 'except for' qualification if the matter is not considered pervasivelrnisleading.

b

Give a disclaimer (of opinion) if considered pervasivelmisleading (ie do not express an opinion).

)

In the UK, as there has been a limitation on scope, need t o refer to -

In the basis of opinion paragraph, a description of the limitation on scope

-

In the opinion paragraph, whether all information necessary for the audit has been received and whether proper accounting records have been maintained.

Pharm plc b

Give an unqualified opinion if disclosure is adequate.

b

Constitutes a material matter re going concern which should be highlighted as the matter is likely to have a significant impact on the business.

b

An emphasis of matter paragraph is required explaining the matter and stating that the opinion is not qualified in this respect.

b

If the note to the accounts is inadequate, qualify on the grounds of disagreement.

M o g pic Give an unqualified opinion. The write-down of inventory to its NRV would reduce profit by 4% and reduce net assets and inventory by less than I %each. It is therefore unlikely that the misstatement would be considered material. The auditor might, however, be put on guard to ensure that f35.000 is the maximum misstatement and that all other categories of inventory are correctly valued. Significant departures from accounting standards are required t o be disclosed in the financial statements. Because the impact on the financial statements of this accounting departure is limited, the auditor is unlikely t o consider it to be significant.

Hubbard Ltd Give a modified but unqualified report. The outcome of the legal action is still a long way off. A t this stage the case has not come to court and only limited facts are known. This matter therefore constitutes a significant uncertainty. A provision will not need t o be made in the accounts but full disclosure should be given. Providing the auditor is satisfied that the directors' disclosure of the action is sufficiently detailed t o highlight all of the circumstances as they are known, no qualification will result though he should consider modifing his report by adding an emphasis of matter paragraph drawing attention t o the uncertainty.

,

If, however, the auditor takes the view that the disclosure of the action in the notes t o the accounts i s unclear, he should qualify his report 'except for' on the grounds of a disagreement as t o the extent of disclosure of a material fact.

"

g

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

'

ANSWER BANK

Marks (a)

Each benefit Maximum (b) Each indicatolSpecific procedul-es Management discussio1~1confi1-rnation Implications for financial statements Inlplications for report Maximum (c) (i) LOSS of customer N e t current liabilities Increase in inventories IIICI-ease in receivables Increase in borrowings Increase in payables (ii) Review of forecasts Other points (each) (iii) Unmodified I-eport Modifiedlunqualified Modified - disagreement Modified - limitation on scope Maximum Total marks available

(a)

Benefits to the company and i t s management of having a full audit b

Enhanced credibility of the financial information/lacl< of bias.

b

More reliable information results in more informed decisions.

b

The audit may act as a deterrent to fraudlstop management abusing assets.

b

Provides management with assurance that they are complying with statutory responsibilities1 infol-lnation filed meets statutory requirements.

-tBypdWe&-r -

----

--

Identification of weaknesses and recommendations Reducing r i s k and improving performance.

b

An audit imposes discipline (encourages best practice) which i s useful when companies grow.

b

When audit exenlption limits are exceeded, may avoid -

b

The cost of extra work, and Potential'future qualification over opening balances.

Where a company has plans to sell the businessloffer its shares publicly within the next few years. audited accounts will assist that process (such an offering may not be possible without audited accounts for the past three years).

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND AND WALES

Section 4: Concluding and reporting on assurance engagements

(b)

(i)

Indicators of going concern problems Ten from the following.

Financial indicators b

Net liabilities o r net current liability position

b

Necessary borrowing facilities have not been agreed

1

Fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment, or excessive reliance on short-term borrowings

1

b

Major debt repayment falling due where refinancing is necessary to the entity's continued existence i Major restructuring of debt

b

Indications of withdrawal of financial support by creditors

b

Negative operating cash flows indicated by historical or prospective financial statements

b

Adverse key financial ratios

1

Substantial operating losses or significant deterioration in the value of assets used t o generate cash flows

b

Major losses or cash flow problems which have arisen since the balance sheet date

b

Arrears o r discontinuance of dividends

b

Inability t o pay creditors on due dates

b

Inability t o comply with terms of loan agreements

b

Reduction in normal terms of credit by suppliers

b

Change from credit to cash-on-delivery transactions with suppliers

b

Inability t o obtain financing for essential new product development or other essential investments

b

Substantial sale of non-current assets not intended to be replaced

Operating indicators b

Loss of key management without replacement

b

Loss of key staff without replacement

b

Loss of a major market, franchises, licence, or principal supplier

b

Labour difficulties or shortages of important supplies

b

Fundamental change in the market or technology t o which the entity i s unable t o adapt adequately

b

Excessive dependence on a few product lines where the market is depressed

b

Technical developments which render a key product obsolete

Other indicators b

Non-compliance with capital or other statutory requirements

b

Pending legal proceedings against the entity that may, if successful, result in judgements that could not be met

b

Changes in legislation or government policy

1

Issues which involve a range of possible outcomes so wide that an unfavourable result could affect the appropriateness of the going concern basis

THE INSTITUTE OF CHARTERED ACCOUNTANTS IN ENGLAND 4ND W A R S

' ANSWER BANK (b)

(ii)

Auditors' responsibilities in respect of going concern

The auditor has t o satisfy himself that the financial statements have been prepared on the correct basis, that is, that the company is a going concern. This will partly be satisfied by routine audit work, such as ensuring that receivables are paying their debt after the year end but the auditor will also carry out specific going concern procedures, such as: b

Reviewing the future plans of the business and budgets for the forthcoming year.

b

Reviewing the company's borrowing facilities and ensuring any related covenants will not be breached.

b

Reading relevant minutes and correspondence t o ensure that there are no indications of going concern problems.

The auditors should also discuss the going concern assumptions with management and obtain written representations of their opinions. ISA 570 requires the auditor t o consider the appropriateness of management's use of the going concern assumption in the preparation of the financial statements because this has implications for the basis of preparation of the financial statements and or disclosures in the financial statements. If the going concern basis is not appropriate, then the break up basis will have to be used and this will have t o be disclosed in the notes t o the financial statements. This will have implications for the amounts at which items are included in the financial statements, in particular: b

Assets may need t o be written down t o recoverable amounts or reclassified

b

Liabilities may need t o be restated t o reflect changes in amount o r date of maturity

b

Additional liabilities for losses may arise.

If there is a material uncertainty about the going concern basis, then there will be implications for the audit report. If the uncertainty has been disclosed in the financial statements, the auditor will issue an unqualified report but include an emphasis of matter paragraph drawing attention t o the disclosures on going concern. If going concern uncertainties are not adequately disclosed or the financial statements are prepared on an inappropriate basis, the auditor will issue a qualified audit report. (c)

(i)

Matters which give cause for concern and why they give cause for concern Loss of major customerlloss for year b

This will have an adverse impact on cash flow.

Current liabilities exceeding current assets b

The company may not beable t o meet its debts as they fall due (going concern).

lncrease in inventories

- 22%

b

This i s despite the fall in revenue.

b

There may be obsolete, slow moving or damaged inventory where net realisable value i s less than cost.

b

There may be inventory relating t o the lost customer which needs t o be written down.

lncrease in trage receivables

- I I%

b

Again, this is despite the fall in revenue.

b

There may be possible badldoubtful debts.

-

Short-term finance dependencylincrease in borrowings 2 I %

b b

Any overdraft may be called in at any time. The bank may foreclose if loan repayments are not repaid or interest is not paid.

.

'

THE INSTITUTE

OF CHARTERED ACCOUNTANTS IN ENGLAND AND WAl F(

,

I 8I

Section 4: Concluding and repot-ting o n assur-ance engagements

Increase in trade payables b b

P (ii)

- 4% /increase in tax payable

Coupled with delayed payments to H M Revenue & Customs. Creditors may petition for a winding up. Late payment of tax will attract penalties in the form of interest.

Post balance sheet review work

P

Review profit and cash flow forecasts

-

Assess whether the company can pay its debts as they fall due (in particular the loan repayment), and

-

Stay within i t s overdraft facility.

b

Ensure compliance with any covenants.

b

Review after date inventory movementslselling prices after the year end.

b

Review after date receipts from receivables.

b

Review after date saleslnew contract agreements.

P

Review actions by creditorslensure relationships maintained.

b

Monitor negotiations with prospective customerslbank.

(iii) The different types of audit report and the circi~mstancesin which they are appropriate b

Unqualified (with no modification) if the issues have been resolved and there is no uncertainty about going concern.

b

Unqualified with an emphasis of matter paragraph if uricertoiri about going concern but there is adequate disclosure in the notes t o the accounts. The emphasis of matter paragt-aph will explain the situation and state that the audit report is n o t qualified in this respect.

P

Qualified on the grounds of disagreement if

b

-

Disclosure (note t o accounts) regarding the uncertainty is inodequote

-

Receivables or. inventory are materially overstated

-

The company is not a going concern and the dir-ect01.sinsist on pr-epat-ingthe accounts on a going concern basis.

Qualified on the grounds of limitation on scope if evidence reasonably expected t o be available has not been obtained.

THE INSTITUTE OF CHARTERED

ACCOUNTANTS IN ENGLAND AND WALES

REVIEW FORM - AUDIT AND ASSURANCE

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