THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

AUDIT PRACTICE
PROFESSIONAL 2 EXAMINATION - APRIL 2006

Time allowed: 31/2 hours and 10 minutes to read the paper Answer questions 1 and 2
and 2 out of questions 3, 4 and 5

1. New Ireland Communications (NIC) owns and operates two of Ireland’s most popular radio stations, for which it
obtained licences for a 5-year period on 1 January 2002. NIC is an Irish registered, Dublin based private company
owned and managed by the New family. NIC has always received a clean audit opinion, with its radio operations
being very well controlled. NIC has adopted International Financial Reporting Standards (IFRS).

As part of its diversification strategy, NIC’s Board hired Dixie Larue as editor for EI, a new monthly general
entertainment magazine for Ireland. Miss Larue was given complete freedom to run EI magazine, which enjoyed
a successful launch of its first edition in April 2006. EI will be published under an arrangement with Irish
Publishers, with this key audit planning issue (KAPI) to be covered in a separate memo by the audit partner, and
thus not for your consideration. This publishing arrangement enabled NIC to limit its initial outlay to €0.5 million
in R&D and to finance the EI start-up from its own cash reserves.

EI generates two types of revenues: (1) advertising sales, which are handled in the same way as those of NIC’s
radio stations through the same advertising agency and (2) news-stand sales, through 60 wholesalers and
retailers, who pay their monthly NIC invoices on the 10th day of the next month.

NIC’s recently hired internal auditor, Hopp Ingmad, informed you of a recent agreement signed by Miss Larue on
behalf of NIC with Conar Tist, an agent representing astronaut Major Tunde of the Republic of Sasko, regarding
the story of the major’s apparent stranding onboard a Soyuz spacecraft that has rotated around the Earth since
1989, after he overslept and missed his return flight.

Per this agreement, a €1 million payment was made by NIC to a Laros Outback Savings and Trust (LOST)
account for eventual payment to the Russian Space Agency to fly Major Tunde back to earth. In return, NIC was
awarded the exclusive world rights to this story, as well as a 20% cut of the €40 million in unclaimed flight pay
held in trust, also at LOST, once Major Tunde returns. Miss Larue recorded both of these events in NIC’s books
of account only when Mr. Tist notified her by e-mail of his collection of the €1 million payment, noting at the same
time his relocation to South America.

You are Paul Herriott CPA, audit manager responsible for the NIC 31 December 2006 year-end audit. You are
alarmed by the above development. You will be using the same experienced audit staff as were assigned to the
previous year’s audit and you note that net profit materiality will remain at 5%. All related computer audit matters
have already been addressed; however NIC has just requested that you also perform a separate systems audit
in order to assess the overall reliability of their computer systems.

REQUIREMENT:

In a memo to your audit partner dated 6 April, you are asked to focus primarily (≥ 75% of marks) on your
identification and treatment of 4 to 5 key audit planning issues (KAPIs). These are issues potentially representing
a risk of material misstatement in the financial statements, arising from important developments in NIC’s
environment/operations/activities, particularly if unusual or complex in nature.

l Your memo will begin with an outline of the impact of the above important developments on audit risk and
its components, incorporating two business risks of relevance to NIC.
l This will be followed by the identification and treatment of each KAPI through a listing of key (1) internal
control focused and (2) financial accounting-reporting focused specific audit procedures/courses of action
to be performed /undertaken, appropriately justified in a preface to each listing.
l Your memo will end with a review of pertinent NIC audit administration/other matters.

You are required to demonstrate your exercise of professional judgment and your understanding of an audit risk
based approach in your identification, ranking and treatment of KAPIs.

Your answer should take into account the case information provided, including the NIC client-prepared summary
financial statements in Appendix 1, whose projected data you are to assume is reasonable unless your
understanding of IFRS and related case information directs you otherwise.

[Total: 30 Marks]

Page 1
Appendix 1 – Summary NIC Financial Statements

NIC Balance Sheet

31 Dec. 2005 31 Dec. 2006

(audited) (projected)
( millions - IFRS)
Intangible assets - 1.5 (2)
Property, plant and equipment 9.0 7.5
Cash and marketable securities 4.5 0.1
Receivables 1.5 10.9 (1)
Total assets 15.0 20.0
Equity 6.0 10.5
Long term borrowings 5.0 4.5
Trade and other payables 4.0 5.0
Total equity and liabilities 15.0 20.0

NIC Income Statement

2005 FY 2006 FY
(audited) (projected)
( millions - IFRS)
Revenues 25.0 43.0 (1)
Operating expenses (22.0) (36.0)
Operating profit on ordinary activities 3.0 7.0
Net finance cost (1.0) (1.0)
Profit from operations 2.0 6.0
Income tax (assume 25% rate) (0.5) (1.5)
Net profit 1.5 4.5

(1) includes €8 million claim on Major Tunde’s back wages

(2) includes €1 million payment for rights to Major Tunde’s story and €0.5 million in R&D start-up costs.

Page 2
2. Shamrock Isle Premium (SIP) produces one type of specialty beer at its Cork brewery, which is sold to
retailers at a price of €1.75 per bottle. SIP also acts as the distributor for Viking beers, a range of slightly
less expensive specialty beers produced in Scandinavia.

The SIP beer production process flows through three departments: the raw materials and packaging
supplies store; production/bottling; and the finished goods warehouse. These movements are evidenced
by Goods Despatch Notes (GDNs) and Goods Received Notes (GRNs).

SIP reported on its 30 April 2006 year-end Balance Sheet €1.5 million in inventory, of which €1.2 million
comprised finished goods: Viking beers ( 0.2 million) and 1 million bottles of SIP beer ( 1.0 million). The
latter figure is derived from the IFRS production costs schedule for April 2006, as shown below, with SIP
using the weighted-average-cost method. You will attend the year-end inventory count. You note that all
beer bottles are bar coded and that there was no inventory at 31 March 2006.

Production costs (IFRS - €millions) Costs expensed (IFRS - €millions)

Raw materials and packaging supplies 2.8 Purchasing, accounting and MIS (1) 0.4
Direct and indirect brewery labour 0.7 Marketing, sales and distribution 1.0
Brewery assets depreciation 0.5 General administration and finance 0.5
Total production value 4.0 Other normal manufacturing overhead 0.1
Total production volume: 4 million bottles ( ) 75% relates to brewery activities
1

As the audit manager responsible for this audit, you are asked to address the issues identified in the
REQUIREMENT section below. Your firm uses an audit-risk based approach.

REQUIREMENT:

(a) Regarding the auditor’s responsibility in relation to risks of material misstatement at the financial
statement level and assertion level for classes of transactions and account balances, discuss two of
the following three matters, each worth 5 marks:

i) acquisition of understanding of the entity and its environment in order to identify such risks
ii) assessment of such identified risks, incorporating in your answer examples of two such risks
as they relate to SIP finished goods beer inventory
iii) formulation of an audit approach to respond to such assessed risks

You will be guided in your response by ISA 315 - Understanding the Entity and its Environment and
Assessing the Risks of Material Misstatements, and by ISA 330 - Auditor’s Procedures in Response
to Assessed Risks
(10 marks)

(b) Regarding controls over the recording of SIP inventory movements through the three departments and
their corresponding inventory records, list

i) 2 overall aims of such controls

ii) 2 such controls
iii) 2 tests that you would perform on such controls
(5 marks)

(c) Regarding the SIP beer year-end finished goods inventory figure:
i) Assess the fairness of the €1 million SIP beer inventory value by recalculating it, stating any
reasonable assumptions you would make. (6 marks)
ii) List four audit procedures you would perform at the year-end inventory count, noting the key 3
financial statement assertions for which you would seek assurance.
(5 marks)

iii) List three ways you would cost-effectively use Computer Assisted Audit Techniques (CAATS) in
your inventory count work in (ii) and note two safeguards you would take prior to their use.
(4 marks)
[Total: 30 Marks]

Page 3
3. Modern Office Design (MOD) is an Irish registered company that started up operations on 1 March 2006
with an objective of providing companies with an office environment that maximises their employees’
productivity.

The company is 100% owned and managed by the three Modern sisters, who comprise MOD’s senior
management team and Board of Directors, with Sarah as chairman. MOD has enjoyed a promising start,
and is expected to realise between €1 million and €2 million of sales in its first year of operation, with an
expectation of greater growth in the future to be eventually financed through share issues and bank
borrowings.

After a round of golf at the Limerick Golf and Country Club, MOD’s chairman, Sarah Modern approached
you, Marty O’Reilly CPA, sole audit practitioner, regarding helping the Board to decide whether to obtain
an audit or review of MOD’s statutory (full year) and interim (6-month) financial statements, as well as a few
additional queries on the directors’ responsibilities.

Sarah is aware that it is the Directors’ ultimate responsibility to prepare financial statements and that it is
the ultimate responsibility of the auditor to provide assurance on such financial statements, whether in the
form of an audit or review, in terms of the achievement of two attributes: financial statements truth and
fairness and their compliance with Companies Act (1963-2005) provisions.

REQUIREMENT:

Prepare a report to Sarah Modern, Chairman of the Board of MOD in which you address the following
matters:

(a) Distinguish between an audit and review of financial statements in terms of level of:

i) Value provided to external users, stating what the term “value” implies.
(4 marks)

ii) Costs incurred, based on the amount of work performed, using as an example the difference in
procedures between the audit and review performed on receivables year-end balance
and sales internal control system.

(5 marks)
iii) Auditor’s level of independence.
(1 mark)

(b) Discuss two other important considerations that MOD should take into account in making its decision,
and on this basis, recommend the most cost-effective assurance combination for MOD’s statutory and
interim financial statements.
(5 marks)

(c) Regarding the directors’ ultimate responsibility for the preparation of MOD’s statutory financial
statements:

i) List three requirements that they must comply with in exercising this responsibility,

ii) Identify two external reports to shareholders in which this responsibility would be explicitly
stated and state why this is necessary (5 marks)

[Total: 20 Marks]

Page 4
4. Galway Fried Chicken (GFC) is a privately owned fast food restaurant with branches throughout Ireland.
The company is owned by the Galway family, with Colonel Galway holding the position of chairman of the
board and chief executive officer.

Colonel Galway approached you, Francis Mallow, CPA, audit partner responsible for new engagements at
the multi-services public accounting firm Mellon & Mallow CPA (M&M) with regard to your firm becoming
GFC’s new statutory auditors. He indicated to you that GFC’s previous auditors had just been forced to
resign after recently merging with another firm, who are auditors to one of GFC’s rivals. GFC had insisted
on this action in order to safeguard the secrecy of its chicken batter recipe, essential to its good fortune,
from its rivals, and would seek assurances from your firm on this matter before appointing you as their
statutory auditors. The GFC chicken batter recipe is maintained on electronic file on its server, and is
accessible only to Mr. Galway and senior personnel at its chicken batter facility.

The GFC account would be lucrative as, in addition to acting as GFC’s statutory auditors, M&M would also
be requested to provide a wide range of non-audit services such as business valuations, profit forecasts,
tax work including appearing before tax courts as advocate of GFC, management information system work
including the conception and design of accounting systems and policies and strategic management work.

Colonel Galway has informed you that he is prepared to set a meeting of the shareholders to approve your
firm’s appointment in a few days, but you have asked him to defer this until you perform a procedure
necessary for all new clients.

REQUIREMENT:

Prepare a report to Colonel Galway, Chairman of the Board of GFC addressing the following matters:

(a) Regarding the confidentiality of the chicken batter recipe:

i) Discuss the main requirements of the CPA Code of Ethics, Conduct and Practice regarding
confidentiality of client information, and the quality control procedures at M&M to enforce such
requirements.
(3 marks)

ii) Identify those situations where the auditor is required to divulge client information to 3rd party
legal authorities, and whether this would apply to the chicken batter recipe.
(2 marks)

iii) State why there is no risk of inadvertent disclosure of the chicken batter recipe by M&M,
regardless of the above practices.
(2 marks)

iv) Explain how the importance of safeguarding this recipe is taken into account in the audit risk
based approach your firm uses to ensure that the most cost-effective audit is performed in the
best interests of GFC.
(5 marks)

(b) Identify and briefly discuss those non-audit services identified in the case which M&M staff engaged
in the GFC audit would be prevented from performing in compliance with APB Ethical Standard 1 -
Integrity, Objectivity and Independence.
(4 marks)

(c) Discuss what procedure the auditor would have to perform before accepting the Board’s offer of
appointment as statutory auditors, listing two types of assistance that would be required from the
Board in order for M&M to conduct this procedure.
(4 marks)

[Total: 20 Marks]

Page 5
5. You are Chris Potter-Allen CPA, audit partner at the Dublin office of Doyle & Allen CPA. It is Monday 3 April
2006 and you are sitting at your desk, enjoying an early morning coffee. You have just opened the following
e-mail from Bono, a humanitarian ambassador and member of the famed U2 rock group, with whom you
used to ‘jam’ in your secondary school years before embarking on a successful career as a CPA, all the
time keeping in touch with your old friends.

From: ‘Bono’ bono@[Link]

To: ‘Chris Potter-Allen’ cpa@doyle&[Link]
Subject: Advice sought on accepting Board of Directors position as non-executive director
Date: Monday 3 April 2006

Dear Chris,

How are you? I am here in Australia and we have just completed our Vertigo tour. I’ll be back in Dublin soon
and Edge, Clayton, Larry and I all look forward to meeting up with you.

In the meantime, I was wondering if you could help me out with a small matter. I need help in deciding
whether I should accept an appointment as a non-executive member of the board of directors of Irish
Pharmaceuticals (IP), whose shares trade on the Irish Stock Exchange (ISE). IP is a leading manufacturer
of drugs to combat diseases including AIDS, and has a wonderful policy of distributing its AIDS medication
on a non-profit basis to the poorer countries of Africa to fight AIDS, one of the causes I promote. IP has three
core business objectives: (1) effective and efficient operations (2) compliance with applicable laws and
regulations (3) reliable financial reporting.

I would appreciate if you could explain to me the concept of internal control and its interrelationship with IP’s
core objectives and its business risks, as the people at IP have told me that internal control is one of the key
concerns of directors in their exercise of corporate governance.

I would also appreciate if you could briefly explain my responsibility (ies) for internal control, as well as those
of the Audit Committee (to which I may also be appointed should I become a non-executive director),
Internal Audit and the Statutory Auditors, and how each exercises their responsibilities regarding internal
control from a corporate governance viewpoint.

Finally, I would appreciate your input on key considerations that I should take into account in deciding on
whether to accept the above non-executive director and committee appointments.

Looking forward to hearing from you,

Bono.

REQUIREMENT:

Prepare an e-mail response to Bono in which you would address the following:

(a) Explain the concept of internal control, indicating the nature of its interrelationship with IP’s 3 core
objectives and the business risks associated with IP operations.
(5 marks)

(b) Explain the responsibilities for internal control for the purposes of corporate governance of the
following four parties and how they exercise their responsibilities, including their interrelationships
with each other:
i) Internal parties: Board of Directors - Audit Committee - Internal Audit. (6 marks)
ii) Statutory Auditors: direct and indirect (through audit of financial statements). (4 marks)

(c) Briefly explain three key considerations that Bono should take into account regarding himself to
ensure that he will be able to operate effectively as a non-executive director and Audit Committee
member in deciding to accept these appointments.
(5 marks)

[Total: 20 Marks]

END OF PAPER

Page 6
 Suggested Solutions

AUDIT PRACTICE
PROFESSIONAL 2 EXAMINATION - APRIL 2006

Solution 1

Date: 6 April 2006

To: Audit Partner
From: Paul Herriott, CPA, NIC audit engagement manager
Re: KAPIs – 31 December 2006 year-end audit

IMPACT OF KAPIS ON AUDIT RISK AND AUDIT RISK COMPONENTS

Audit risk level decreased due to:
Significant worsening in NIC financial situation (see Issue 2 ) – users likely to be more demanding as
to the reliability of the financial statements.
Inherent risk increased due to:
Business risk associated with new EI magazine business:
l entity’s ability to operate successfully in new complex, highly competitive environment.
l magazine editor’s ability to manage new business successfully.
Discovery of fraud also possibly implies other material misstatements present in the accounts and the
potential for senior management to seek to conceal through ‘window dressing’ of accounts.
Control risk increased due to: Weak internal control reflected by fraud (see Issue 4).
Detection risk decreased accordingly.
Proposed SAP/COA
Adjust audit approach - more extensive, detailed audit procedures .
Verify that Board identifies and effectively monitors business risk associated with new activity.

KAPI 1 - GOING CONCERN ABILITY IMPAIRMENT

The following adverse factors impact on NIC’s ability to continue as a going concern:

Financial
l Significant worsening in NIC’s liquidity as evidenced by following liquidity ratio calculations, when €8
million claim on Major Tunde’s back wages factored out.

(cash & ms + receivables) 31 Dec. 2005 31 Dec. 2006

Trade + other payables (6/4) = 1.5 to 1 (3/5) = 0.6 to 1 !!!!

l Only €0.1 million in cash to finance ongoing expenses, noting a considerable amount of magazine
revenues have been received upfront in the form of prepaid subscriptions.
l Potential difficulty in securing new financing as a result of likely fraud (see Issue 3), which converts
projected after-tax net profit of €4.5 million into an after-tax net loss of €1.5 million!!!.

Operational
l Radio stations’ licences subject to renewal.
l New start-up business in highly competitive industry (magazine publishing).

Proposed SAP/COA
IC (Internal control)
1. Verify that Board is aware of and monitoring NIC’s financial situation.
FAR (Financial Accounting and Reporting).
2. Look at cash flow projections and supporting analysis, including existing and projected magazine
sales / consider likelihood of bank providing further financing.
3. Depending on the extent of going concern impairment, need to consider the following impact on audit
reporting:
l Requirement that client prepare financial statements on a non-going concern basis (Balance
Sheet: liquidation values); (Income Statement: cash flow basis): if not – adverse opinion.
l Requirement that client prepare financial statements on a going concern basis with the inclusion
in the audit report of a fundamental uncertainty paragraph.

Page 7
KAPI 2:NEW EI MAGAZINE BUSINESS - €1 MILLION ADVANCE FEE PAYMENT AND €8 MILLION CLAIM
ON ASTRONAUT’S BACK WAGES
Unusual transaction of material value – requires special audit consideration.
NIC is the victim of a likely (advance fee) fraud, with a material impact on the financial statements.
Responsibility to obtain sufficient and appropriate audit evidence to understand why the fraud occurred,
assess its impact and bring it to the attention of the appropriate parties.

Proposed SAP/COA
IC (Internal control)
1. Confirm the existence of an apparent lack of internal control that enabled the fraud to be perpetrated.

i) authorisation of €1 million cheque without senior management’s approval

ii) lack of segregation of duties, with EI editor initiating and accounting for transactions, as well as
having custody of assets (ability to issue cheques).
iii) incorrect accounting entries posted suggesting lack of senior management review.

FAR (Financial Accounting and Reporting)

Specific audit procedures.
Verify fraud occurrence through inspection of documents (bank transfer, agreement) and discuss with Miss
Larue and other involved parties to verify the fraud and the non-recoverability of the funds.
Material misstatements in financial statements amounting to €9 million in net profit overstatement.
1. Overstated revenues and receivables of €8 million due to recognition of non-valid claim on Major
Tunde’s back wages.
2. Overstated intangible assets by €1 million due to recognition as an asset of a €1 million advance fee
that will not generate a subsequent cash inflow and accordingly should be expensed. If client does
not agree to adjust its financial statements for the above material misstatements, this will likely lead
to an adverse opinion on our part.

Reporting duties
1. Duty to report to those charged with corporate governance (Board of Directors) on the details of the
fraud and its material impact on the financial statements. Report should include identification of cause
of fraud and recommended controls for its future prevention.
2. Duty to report the details of the fraud to the Gardai pursuant to the Criminal Justice (Theft and Fraud)
Offences Act 2001.

KAPI 3 – NEW EI MAGAZINE BUSINESS – NEWSTAND SALES

Amount material – particular risk: receivable collection and revenue recognition.
Proposed SAP/COA
IC- revenue occurrence and completeness.
1. Document, understand and assess revenue system and relevant internal controls.
2. Ensure appropriate checks were made regarding financial solvency and that this is monitored.
3. Test client’s monitoring of receivable collection: credit checks and overdue account listings.
4. Dual purpose testing of shipping and transaction recording system control will provide us with
assurance on reasonableness of sales figures.
5. Test periodic reconciliation of subsidiary ledger with G/L.

FAR – receivable and revenue existence and completeness

1. Examine aged receivables listing and select all high risk accounts (overdue) and a representative
sample of ordinary accounts using MUS.
2. Prepare and send positive confirmation to a sample of customers and analyse their replies.
3 Verify subsequent receivable collection in bank statement / examine aged trial balance.
4 Verify appropriateness of revenue recognition policy based on moment of transfer of ownership of
magazines: shipment to retailer/wholesaler or sale by retailer/wholesaler (inventory on consignment).

KAPI 4 – NEW EI MAGAZINE BUSINESS - €0.5 MILLION IN START-UP COSTS

Amount material – particular risk: complexity of item could result in valuation misstatement.
Proposed SAP/COA
IC - expenses.
Depending on the expected frequency of new magazine launches, cost-effective approach might be to
focus on substantive testing, limiting internal control work to identification and assessment.
Essential to verify that start-up of magazine activity was authorised by the Board and that the latter
monitors expenses.

Page 8
 FAR - intangible assets valuation.
Key financial statement assertions: valuation, existence and ownership.
Potential €0.5 million net profit overstatement resulting from the full capitalisation of magazine
development costs as intangible assets and their non-amortisation.
1. Verify proper treatment and allocation of start-up costs, with any research costs incurred required to
be expensed, whereas development costs only capitalised if likely to yield a future benefit.
2. Trace amounts back to supporting documentation (invoices) .
3. Discuss with management why these development costs are not being amortised.

AUDIT ADMINISTRATION/OTHER MATTERS

Audit staff – knowledge acquisition and professional scepticism.
Proposed SAP/COA.
Ensure staff has sufficient knowledge of new business.
Increased professional scepticism due to potential fraud.

Internal audit – potential for use .

Proposed SAP/COA.
Need to assess independence, competence and technical expertise of internal auditor.
Need to assess potential use in order to perform most cost-effective audit.

Other services – performance of detailed computer systems audit.

Proposed SAP/COA.
This is a separate assurance engagement from a statutory audit – however synergies can be achieved by
performing duplicate procedures at the time of the audit.
Key areas of focus: management policy, segregation of duties and security (logical and physical access).
Need to liaise with our computer audit department.

Solution 2.

(a) i) Identification of risks of material misstatement.

In order to identify (and assess) risks of material misstatement of the financial statements,
whether due to fraud or error, the auditor is required to obtain an understanding of the entity’s:
1. nature, including selection and application of accounting policies.
2. objectives and strategies and related business risks that might cause material
misstatement in the financial statements.
3. financial performance measurement and review.
4. internal control: control environment, risk assessment process, information system,
control activities, monitoring of controls.
5. environment: industry, regulatory and other external factors, including the reporting
framework.
This understanding can be obtained from inquiries with management, analytical procedures,
observation and inspection, prior period knowledge and discussion with the engagement team.

ii) Assessment of identified risks of material misstatement

1. Relate risks to what can go wrong at the assertion level.
Examples of what can go wrong:
Inventory overstated in the accounts due to:
l theft arising from lack of proper asset safeguard controls (existence).
l improperly allocated costs due to the complexity of the item’s accounting
(valuation).
l improperly claimed title due to the complexity of the nature of the business such as
inventory held on consignment (ownership).
l incorrect recording due to the complexity of the item.

2. Consider whether the risks are of a magnitude that could result in a material
misstatement.
3. Consider the likelihood of the risks causing a material misstatement. The auditor would
use his judgment and his acquisition of an understanding of the entity and the
environment in assessing the identified risks of material misstatement.

Page 9
 iii) Formulation of an approach to respond to assessed risks of material misstatement
Purpose of formulated approach: Reduce audit risk to an acceptably low level
Two phased approach – the auditor should:
1. Determine overall responses to assessed risks at the financial statement level. This would
include emphasising to the team the importance of professional scepticism, allocation of
more staff, using experts or providing more supervision.
2. Design and perform further audit procedures to respond to the assessed risk at the
assertion level.
In designing and performing these audit procedures the auditor must:
i) consider their nature, extent and timing and the need to obtain sufficient and
appropriate audit evidence.
ii) test only those controls for which there is an expectation that they will be operating
effectively and that they relate to an internal control of relevance.
iii) appreciate material items must always be subject to substantive audit procedures.

(b) (i) Aims (ii) Controls (iii) Tests

1. All inventory movements are 1. Segregation of duties between custody 1. Select a sample of inventory movements
authorised and recorded and recording of inventories and agree to GRNs and GDNs
2. Inventory records only include 2. Receipt, checking and recording 2. Vice-versa
items that belong to the client of goods inwards
3. Inventory records include inventory 3. Inventory issues supported by 3. Confirm that movements have been
that exist and is owned by the client appropriate documentation authorised as appropriate
4. Inventory quantities have 4. Maintenance of proper 4. Check sequence of inventory records
been correctly recorded inventory records
5. Cut-off procedures are properly
applied to inventory

c) (i) Per IAS 2 – Inventory, inventory must be valued at ‘lower of cost and net realisable value’. Hence, we
must compute two values at 30 April 2006 year-end to assess conformity.

First value: cost in accordance with the weighted-average cost method (WAC)
WAC incorporates the average of all purchase costs, conversion costs and all other costs incurred in
bringing inventory to its present location under normal operating conditions, excluding any abnormal waste
(raw material excess consumption / idle labour and idle overhead).
WAC is calculated as follows (divide production figures by 4):
Actual capitalised production costs: €1,000,000
Add other production costs that should be capitalised:
Production associated purchasing + MIS + accounting: €100,000 X 75% = € 75,000
Other production overhead = € 25,000
Total capitalised production costs = €1,100,000

Second value: net realisable value (NRV)

NRV is the estimated actual or selling price (net of trade discounts, but before settlement discounts), less
all further costs to completion and all costs to be incurred in the marketing, selling and distribution of the
beer.
NRV is calculated as follows:
NRV = Forecasted sales proceeds – marketing, distribution and sales costs
NRV = ( €1.75 per bottle x 1,000,000 bottles) – ( € 250,000)
NRV = €1,750,000 - €250,000
NRV = €1,500,000

Correct valuation of year-end inventory figure:

Lower of cost ( €1,100,000) and net realisable value ( €1,500,000) => €1,100,000 ≠ €1,000,000 !
Hence existing inventory valuation of €1,000,000 is not fair.

ii) valuation, existence and ownership (as profit seeking entities would have a natural bias/inclination to
overstate their assets).
1. Check that the client’s staff are following instructions.
2. Make test counts to ensure procedures and internal controls are working properly.
3. Ensure that procedures for identifying damaged, obsolete and slow-moving inventory operate
properly.
Page 10
 4. Conclude whether the count has been properly carried out and is sufficiently reliable for
determining the existence of inventories.
5. Consider whether any amendment is necessary to subsequent audit procedures.
6. Gain an overall impression of the levels and values of inventories held so that the auditors may
in due course judge whether the figure for inventories appearing in the financial statements is
reasonable.

(iii) Use of CAATs:

1. Use bar code reader to identify count items and quantities on hand for eventual download into
accounting system for comparison with accounting records.
2. Use of audit software to select sample items (statistical sampling) and analyse results.
3. Use of audit software to perform analytical review beforehand to identify slow moving items.
4. Use of audit software to prepare working papers.

Safeguards:
1. Test bar code reader / audit software beforehand to ensure it operates properly / is compatible
with system.
2. Ensure users properly trained.

Solution 3.

MARTY O’REILLY CPA

REPORT TO SARAH MODERN - CHAIRMAN OF THE BOARD OF MOD

Dear Sarah:

Please find below the assistance you requested in deciding whether to request an audit or review
assurance engagement, as well as a few additional matters you raised regarding the directors’
responsibilities.

(a) Distinction between the two in terms of levels of assurance, cost and practitioner's ethics.

(i) Level of value v level of assurance

Value to external users is in effect the degree of assurance of the reliability and relevance of
financial statements offered to users relying on such financial statements to make economic
decisions. An audit provides a higher degree of assurance (level of value) to external users than
a review as an audit offers a positive opinion on the achievement of the two attributes, whereas
a review only offers negative assurance that nothing has come to the attention of the auditor.

(ii) Level of cost v amount of work

Not surprisingly, the assurance engagement offering the highest assurance is also the costliest,
as it requires the performance of more work. For example, regarding assurance offered on
receivables and sales, and their related internal control system:
l an audit would require the acquisition of an understanding of the sales accounting system
and its internal control, and its testing for operational effectiveness to determine if reliance
can be placed on it and it is cost effective do to so, as well as the testing of balances
through the performance of procedures such as confirmation and inspection, seeking
external evidence for external parties (inspection of client’s representations on
confirmations returned to auditors).
l a review would require the performance of no sales system work and would rely on the
performance of limited procedures on company supplied evidence (enquiry, discussion
and analysis).

(iii) Level of independence

Regardless of the nature of assurance engagement (audit versus review), the auditor has to
maintain the highest level of independence.

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 (b) Two key considerations to take into account in making your choice.
1. dominant consideration: MOD is legally required to have a statutory audit of its annual accounts
if its sales exceed a certain threshold level as set by the Companies Act 1963-2005, which
currently is €1.5 million.
2. the existence of any potential or eventual users of the financial statements other than the
owner-managers, particularly external financiers such as new shareholders, banks and
government agencies that would prefer the higher form of assurance offered by an independent
statutory audit.

Recommendation:
As your business will likely exceed the statutory minimum limit for a statutory audit sooner or
later, we recommend that you opt for a statutory audit of your year-end financial statements
and a review of your interim financial statements, as external users normally place less reliance
on the latter.

(c) Director’s responsibilities for preparation of company’s financial statements

i) In preparing those financial statements, the Directors are required to:
l select suitable accounting policies and then apply them consistently;
l make judgements and estimates that are reasonable and prudent;
l comply with applicable accounting standards, subject to any material departures
disclosed and explained in the financial statements;
l prepare the financial statements on the going concern basis unless it is inappropriate to
presume that the Company, and the Group as a whole, will continue in business.

ii) The disclosure of the director’s main responsibility in the Auditor’s Report and Directors’ Report
to shareholders is essential in order to avoid any misunderstanding of the respective roles of
the auditor and directors, thereby minimising any expectations gap that may exist.

Sincerely,
Marty O’Reilly,
CPA

Solution 4.
Mellon and Mallow CPA

Report to Colonel Galway, Chairman of the Board of GFC

Dear Colonel Galway:

Please find below my responses to matters that you raised regarding our appointment as GFC auditors.

(a) i) We can offer you the following assurances regarding the safeguarding of the confidentiality of
all GFC information acquired through an M&M audit.
l The CPA Code of Ethics, Conduct and Practice requires CPAs to respect the
confidentiality of information of our client’s and employers affairs acquired in the course
of professional services, with this confidentiality maintained even after the end of the
business relationship between the CPA and the client.
l We have established procedures at our firm to safeguard confidentiality:
1. confidentiality policy/guidelines including the non-assignment of staff with potential
conflict of interests.
2. circulation and communication to audit staff.
3. enforcement through direction and supervision during audit.
ii) We are only required to divulge client information to 3rd party legal authorities in a limited
number of situations as prescribed by law, relating to a potential act of money laundering, fraud
or commission of an indictable offence, which would never concern your chicken batter recipe.
iii) M&M would never need to see GFC’s secret chicken batter recipe for the purposes of their
audit, and accordingly would not seek to reproduce or view it, and would only attempt to access
it for the purposes of testing operational effectiveness of access controls.
iv) The conduct of our audit using an audit risk based approach would require us to pay special
attention to factors that could result in a material misstatement in GFC’s financial statements.

Page 12
 This would include the (business) risk of inappropriate disclosure of GFC’s secret chicken batter
recipe, which if it were to occur could impair GFC’s ability to continue as a going concern. One
means by which this business risk could be contained and material misstatement risk minimised
would be strong access preventative controls to the recipe on the server. Accordingly, we would
ensure during the course of the audit that proper physical access controls (eg: server located in
locked room) and logical access controls (eg: firewall, passwords) exist and are operating
effectively in order to ensure that such risk is contained, as well as proper ethics checks on staff
having access to the server, offering any recommendations for improvement.

(b) Non-audit services

Our compliance with APB Ethical Standard 1 – Integrity, Objectivity and Independence would prevent
our audit engagement team from performing the following services for you:
1. selection of accounting policies and design of accounting system, as these are distinct
management responsibilities – however, we would be able to advise you on such matters.
2. act as advocate before the tax court if the item concerned is material to the financial statements
or where the outcome is dependent on audit judgment.

(c) Before we can accept your offer of appointment as statutory auditors, we would have to first perform
a client assessment acceptance procedure in order to see if we can cost-effectively serve you in this
capacity. We would require your assistance in this matter in the form of:
1. Provision of references for GFC directors.
2. Communicating with the previous auditors to advise them that we shall be contacting them
shortly (to confirm the reason for their resignation).
3. Provision of copies of certificate of incorporation/partnership, evidence of entity’s registered
address and listing of shareholders & directors/partners in order to meet the verification of
identity requirements of the 1994 Money Laundering Act.

Sincerely,
Francis Mallow
CPA,
Mellon & Mallow CPA

Solution 5.
To: ‘Bono’ bono@[Link]
From: ‘Chris Potter-Allen’ cpa@doyle&[Link]
Subject: Advice sought on accepting Board of Directors position as non-executive director
Date: Monday 3 April 2006

Hey Bono!

It’s always nice to hear from you and I look forward to meeting you and the band when you get back to Dublin. In
the meantime, I hope my response below will help you in your decision.

(a) Explanation of the concept of internal control (and its interrelationship with core objectives and business
risks) Internal control is basically systems and procedures designed and effected by those charged with
governance, that is the Board of Directors of the company and those to whom its application they have
delegated (management and other personnel) to provide reasonable assurance about the achievement of
the company objectives, such as the three you listed for IP.
Internal control is designed and implemented to address identified business risk* that threatens the
achievement of any of the company’s objectives.
Internal control essentially comprise: the company’s senior management’s attitude toward control and
specific control procedures (like authorisations), collectively known as control systems, as well as its
information system relating to financial reporting and its monitoring of financial reporting, and, last but not
least, its assessment process for business risk*.

* Business risk is the risk inherent to the company from its operations of which there are three types:
1. Operational risk: for example that suppliers won’t supply products when needed
2. Financial risk: interest rates will rise and make the company’s loans too expensive
3. Compliance risk: company might unwittingly break the law and be fined

Page 13
 (b) Internal control (from a corporate governance perspective) responsibility of various parties and their
interrelationships
i) Internal parties
Board of Directors
The Board of Directors (collective known as the Board) is ultimately responsible for the
company’s internal control and reviewing its effectiveness. The Board uses the Audit
Committee and Internal Audit to assist it in the discharge of its duty. The Board is required by
ISEQ to report to shareholders in the corporate governance section of the Directors’ Report in
the Annual Report of the internal control design and implementation and their review of its
effectiveness.

Audit Committee
The Audit Committee appointed by the Board advises the latter on the effectiveness of Internal
Audit’s discharge of its responsibilities for internal control by monitoring its work through the
review of Internal Audit reports on internal control.

Internal Audit
Internal Audit’s key responsibilities regarding internal control are to:
(1) monitor the overall internal control process and
(2) provide assurance that the internal control systems which the company’s departments
have designed and implemented meet the company objectives and operate effectively,
thereby necessitating the assessment and testing of internal controls.

ii) Statutory Auditors

Directly
l review if corporate governance statement (incorporating internal control matters) reflects
the Company’s compliance with the nine provisions of the Financial Reporting Council’s
Code specified for its review by the Listing Rules.
l report in their Auditor’s Report if it does not.
Indirectly:
l Statutory Auditors, for the purposes of their work (issuance of an opinion that the
financial statements do not contain any material misstatements), provide assurance on a
significant subset of internal control: internal controls of relevance.
l Internal control of relevance: the achievement of reliable financial reporting
objective: financial reporting and business risks assessment internal control to mitigate
against the risk of material misstatement in financial statements).
l Accordingly, they issue a management letter of deficiencies identified. As this internal
control of relevance is a subset of the corporate governance internal control you are
responsible for, this document will accordingly be of interest to you.

(c) Three major considerations regarding yourself that you should take into account to ensure that you
will be able to operate effectively as a non-executive director if you accept the appointment:

1. Your independence
You should ensure that you are free of any relationships or constraints that could significantly
interfere with the exercise of your independent judgment, such as a business relationship or the
receipt of consultancy payments from IP.

2. Your capabilities
You should be proficient in the areas of expertise in which the Board will call upon your
services.
Hence, you may want to brush up on your technical knowledge on internal controls and
financial audits if you decide to accept an appointment to the Audit Committee.

3. Your availability
Attending the Board of Directors’ meetings, which would ideally occur on a monthly or
bi-monthly basis, as well as Audit Committee meetings, which potentially could be as frequent,
may be difficult given your busy schedule.

Cheers,
CPA

Page 14
MARKING KEYS

1. Presentation (format, style, language, prioritisation) – up to a maximum of 2

Impact of KAPIs on audit risk and audit risk components

Audit risk
Decreased due to 1/4
Significant worsening in financial situation = more demanding users 1
Inherent risk
Increased due to 1/4
One mark for each relevant business risk identified up to a maximum of 2
Increased potential for other misstatements in accounts given fraud 1
Poor financial condition / going concern 1
Control risk
Increased due to 1/4
Weak internal control 1
Detection risk
Decreased 1/4
More extensive, detailed audit procedures 1
Available marks 10
Maximum marks 5

KAPI 1 – Impairment of going concern capability

Significant issue taking precedence over all other audit issues 1

Financial factors
Liquidity analysis incorporating ratio calculations 2
Potential difficulty in securing loan because of loss reported instead of profit 2
Operational factors
Radio licenses renewal 1
New start-up business in highly competitive industry 1
Proposed SAP/COA
Verify the Board properly monitors business risk associated with new activity 1
One mark for each of the four SAP/COAs raised 4
Available marks 12
Maximum marks 7

KAPI 2 - New magazine business: advanced fee and unclaimed wages

Unusual material transaction requiring special audit consideration 2
Likely fraud requiring auditor to exercise 3 major duties (1/2 mark each) 2
Proposed SAP/COA - IC
One mark for each IC related up to a maximum of 3
Proposed SAP/COA - FAR
One mark for each FAR related up to a maximum of 2
Identification of two misstatements 2
Requirement to adjust financial statements or adverse opinion 1
Details of requirement to report to the Board up to a maximum of 1
1 /2
Details of requirement to report to the Gardai 11/2
Available marks 15
Maximum marks 10

KAPI 3: New EI magazine business – Magazines stands sales

Particular risk: collectability and recording / material value 2
Proposed SAP/COA - IC
One mark for each IC related up to a maximum of 4
Proposed SAP/COA - FAR
One mark for each FAR related up to a maximum of 4
Available marks 10
Maximum marks 6

Page 1
 KAPI 4: New EI magazine business - €0.5 million in start-up cost
Particular risk: complexity of item / material value 2
Proposed SAP/COA - IC
Substantive approach / start-up authorized by Board 2
Proposed SAP/COA - FAR
One mark for each FAR related up to a maximum of 3
Available marks 7
Maximum marks 4

Audit administration/other matters

Related audit staff points up to a maximum of 3
Related internal audit points up to a maximum of 3
Related systems audit points up to a maximum of 3
Available marks 9
Maximum marks 5

Total available marks 39

Total maximum marks 30

2. (a) Candidates were required to answer any two of the following three matters
i) 1 mark per each area of understanding 5
1/2 mark for each method used up to a maximum of 11/2
Available marks 61/2
Maximum marks 5

ii) 1 mark for each step of process 3

2 examples of such risks as they relate to inventory 2
use of judgment (1) and prior understanding (1/2) 11/2
Available marks 61/2
Maximum marks 5

iii) purpose 1/2

identification and description of phase 1 2
identification and description (3 points to consider) of phase 2 4
Available marks 1
6 /2
Maximum marks 5

(b) i) two aims of such controls 2

ii) two controls 2
iii) two tests to perform on such controls 2
Available marks 6
Maximum marks 5

(c) i) beer inventory valuation

requirement to use IAS 2 1
calculation of cost: theory (1) + calculations (2) up to a maximum of 3
calculation of nrv: theory (1) + calculations (2) up to a maximum of 3
hence beer valuation not correct 1
Available marks 8
Maximum marks 6

ii) year-end inventory count procedure

1/2mark for each correct financial statement assertions up to a max of 1
1 mark for each procedure 6
Available marks 7
Maximum marks 5

Page 1
 iii) CAATS
one mark for each type of CAAT use up to a maximum of 4
1/2 mark for each safeguard up to a maximum of 1
Available marks 5
Maximum marks 4
Total available marks 39
Total maximum marks 30

3. Presentation (format, style, language) – up to a maximum of 1

(a) i) level of value = level of assurance + explanation 2

audit offers higher level of assurance than review 1
explanation why - up to a maximum of 2
Available marks 5
Maximum marks 4

ii) level of cost is higher for audit because of greater assurance offered 1
explanation of audit work performed on receivables up to a maximum of 3
explanation of review work performed on receivables up to a maximum of 2
Available marks 6
Maximum marks 5

iii) level of independence the same 1

Available mark 1
Maximum mark 1

(b) overriding consideration : 1

Companies Act requirement in minimum thresholds breached 2
other key consideration: users of information and their assurance needs 2
recommendation 1
Available marks 6
Maximum marks 5

(c) one mark for each directors’ responsibilities up to a maximum of 3

one mark for each report identified 2
minimize misunderstanding of roles 1
Available marks 6
Maximum marks 5
Total available marks 25
Total maximum marks 20

4. Presentation (format, style, language) – up to a maximum of 1

(a) i) CPA Code of Ethics requirement + explanation 2

One mark for each quality control procedure up to a maximum of 3
Available marks 5
Maximum marks 3

(ii) Exceptional requirement to divulge information to 3rd parties + explanation 2

Available marks 1
Maximum marks 2

iii) batter recipe itself is not of relevance to the auditor/ hence no

need to document 2
Available marks 2
Maximum marks 2

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 iv) RBAA requires special attention paid to
factors => material misstatement 1
One such factor would be the inadvertent disclosure of batter recipe 1
Potential going concern implications 1
Hence focus on proper access preventative controls to recipe on server 1
In the form of strong physical access controls (eg: locked room) 1
In the form of strong logical access controls (eg: passwords, firewall …) 1
In the form of proper ethics checks 1
Verify operational effectiveness and make recommendations 1
Available mark 8
Maximum mark 5

(b) selection of accounting policies/ accounting system design = management’s work 2

act as advocate before tax court if outcome dependant upon judgment 2
Available marks 4
Maximum marks 4

(c) client acceptance procedure + explanation 2

one mark for each type of assistance up to a maximum of 3
Available marks 5
Maximum marks 4
Total available marks 27
Total maximum marks 20

5. Presentation (format, style, language) – up to a maximum of 1

(a) definition of internal control 2

interrelationship with company objectives 1
interrelationship with business risk 1
explanation of business risk 1
identification of one internal control component relating to business risk 1
identification of four other components (1/2 mark each) - up to a maximum of 1
Available marks 7
Maximum marks 5

(b) i) BOD
Ultimate responsibility 1
Interrelationships with Audit Committee and Internal Audit 1
ISEQ reporting requirement 1
Audit Committee
role description 1
Internal Audit
Monitor overall process 1
Check internal control systems meet objectives and operate effectively 2
Requires assessment and testing 1
Available marks 8
Maximum marks 6

ii) Statutory Auditors

Directly
Required to check that corporate governance statement (including internal
control) reflects compliance with the provisions of the FRC code 1
If not must state in Auditor’s Report 1
Indirectly
internal control of relevance identification and explanation 2
weaknesses reported in management letter 1
Available marks 5
Maximum marks 4

Page 1
(c) one mark for each consideration up to a maximum of 3
one mark for each consideration explanation up to a maximum of 3
Available marks 6
Maximum marks 5
Total available marks 27
Total maximum marks 20

Page 1