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HUB OF ACCOUNTANCY

ACCA I ICAEW I CFA I CIA

Au
Audit and
Assurance (AA)

COMPILED BY:
AHMED SHAFI
 Audit and Assurance (AA)

AHMED SHAFI
CORPORATE
GOVERNANCE

AUDIT COMMITTEE:

Subcommittee of board usually comprising NED’s but independent NED’s.

ROLES/RESPONSIBILITIES/FUNCTIONS/FEATURES OF AUDIT COMMITTEE:

1. Monitors integrity of financial statements and any formal announcements relating to company’s
financial performance.
2. Reviews company’s financial controls unless separate risk management, committee is looking
after it.
3. Monitors and reviews internal audit function of the company.
4. Provide recommendations to board regarding external auditors i.e. appointment,
reappointment, remuneration, removal, etc.
5. Monitors and reviews independence and objectivity and eventually effectiveness of audit
process.
6. Also carries out investigation for fraud and error.
7. Available to external auditors for any unresolved issues.

ADVANTAGES OF AUDIT COMMITTEE:

x Provides assurance to shareholders regarding external audit process.

x Strengthens public confidence in the company (double check)
x Provides NED’s an opportunity to play a vital role in corporate governance.
x Helps internal audit function to work with independence and objectivity (as no pressure are
involved)
x Helps create a climate of discipline which reduces chances of fraud and error.

DISADVANTAGES OF AUDIT COMMITTEE:

x NED’s have insufficient time as they are involved with many companies so may lead to poor DM.
x ED’s may not understand purpose of audit committee, may think its supervision on them.
x Costs of audit committee may outweigh benefits.
x NED’s with caliber and skill may be difficult to select and retain.
x Such formal procedures may hinder smooth flow of operations.

Best practices of good corporate governance/Actions that B.O.D should take to meet
corporate governance requirements for listing
x Balance between ED’s and NED’s on Board
x Audit committee established by independent NED’s
x Presence of nomination, remuneration and risk management committees
x Effective audit committee
x CEO and chairman should be different
x Accountability of B.O.D to shareholders

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x Transparency in reporting
x Company’s carrying out CSR
x Good coordination between ED’s and NED’s
x Not paying excessive remuneration
x Remunerations of ED’s (CEO, CFO etc) to be determined by remuneration committee
x Audit committee only has NED’s
x Internal audit department reports to audit committee
x Timely rotation of directors (every three years)
x Directors to be appointed at regular intervals through election ensuring accountability
x Internal audit department
x Regularly holding AGM
x Giving induction training to staff
x At least one member of audit committee having relevant financial experience
x NED’s should not be previously ED’s

Chairman CEO

Head of Board Head of Company

Part Time Full Time
Elected by the shareholder vote Elected by Directors
Must be independent NED ED (involved in company matters)

Role of Chairman Role of CEO

Running the Board Strategy making

Encouraging involvement of all directors Investing and Financing
Appraisal of Board Risk management
Reporting and Signing accounts Board Committee
Information availability for the board Establishing management
Effective communication with shareholders Liason with shareholders
Dealing with issues

Note: CEO and CHAIRMAN should be different because accountability will be done by the same person
who is accountable (bekaar baat)

Board must have a balance of ED’s and NED’s because people doing the work will be monitoring the
work leading to accountability problem (ek aur bekar baat)

IMPORTANT POINT ABOUT BOARD:

Board members are called directors (BOD)

There are two types of members/directors

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ED’s (Executive Directors) : Full time employees, head of key functions like finance, purchasing,
production, etc are given a seat in board, have a dual role (involved in company as well as board)

NED’s (Non-Executive Directors) : are outsiders with no dual role , are not full time employees, no
managerial involvement, just come and attend board meeting.

ED’s and NED’s both take money for service, one is full time one is part time.

10 JUMPER (AIR 6/06) (AMENDED)

You are the audit manager of Tela &Co., a medium-sized firm of accountants. Your firm has just been
asked for assistance from Jumper & Co., a firm of accountant in adjacent country. This country has just
introduced a requirement for entities to conform to the internationally recognized codes on corporate
governance and Jumper & Co. has number of clients where the codes are not being followed. One
example of this, from SGCC, a listed company is shown below. As your country has already appropriate
corporate governance codes in place, Jumper & Co. have asked for your advice regarding he changes
necessary in SGCC to achieve appropriate compliance with corporate governance codes.

Extract from financial statements regarding corporate governance

Mr. Sheppard is the Chief Executive Officer and board chairman of SGCC. He appoints and maintains a
board of five executive and two non-executive directors. While the board sets performance targets for
the senior-managers in the company, no formal targets are set and no review of board policies is carried
out. Board salaries are therefore set and paid by Mr. Sheppard based on his assessment of all the board
members, including him, and not their actual performance

Internal controls in the company are monitored by the senior accountant, although detailed review is
assumed to be carried out by the external auditors; SGCC does not have an internal audit department.
Annual financial statements are produced, providing detailed information on past performance.

Required
Describe five corporate governance weaknesses faced by SGCC and provide recommendations to
address each weakness, to ensure compliance with corporate governance principles.

11 CONOY (6/09) (AMENDED)

Conoy Co designs and manufactures luxury motor vehicles. The company employs 2,500 staff and
consistently makes a net profit of between 10% and 15% of sales. Conoy Co is not listed. Its shares are
held by 15 individuals, most of them from the same family. The maximum shareholding is 15% of the
share capital.

The executive directors are drawn mainly from the shareholders. There are no non-executive directors
because the company legislation in Conoy Co’s jurisdiction does not require any. The executive directors
are very successful in running Conoy Co, partly from their training in production and management
techniques, and partly from their ‘hands-on’ approach providing motivation to employees.

The board is considering the significant expansion of the company. However, the company’s bankers are
concerned with the standard of financial reporting as the financial director (FD) has recently left Conoy
Company. The board are delaying provision of additional financial information until a new FD is
appointed.

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Conoy Co does not have an internal audit department, although the chief internal auditor frequently
comments that the board of Conoy Co does not understand his reports or provide sufficient support for
his department or the internal control systems within the Conoy Company. The board of Conoy Co
concur with this view. Anders and Co, the external auditors have also expressed concern in the area and
the fact that the internal audit department focuses work on control systems, not financial reporting.
Anders and Company are appointed by and report to the board of Conoy Co. The board of Conoy Co are
considering a proposal from the chief internal auditor to establish an audit committee. The committee
would consist of one executive director, the chief internal auditor as well as three new appointees. One
appointee would have a non-executive seat on the board of directors.

Required
Describe five roles of the audit committee and explain how Conoy Co would benefit from each of these
roles.

18 SERENA (12/11) (AMENDED)

Serena VDW has been trading over 20 years and obtained a listing on a stock exchange five years ago. It
provides specialist training in accounting and finance.

The listing rules of the stock exchange require compliance with corporate governance principles and the
directors are fairly confident that they are following best practice in relation to this. However, they have
recently received an email from a significant shareholder, who is concerned that Serena VDW Co does
not comply with corporate governance principles.

Serena VDW Co’s board is comprised of six directors; there are four executives who originally set up the
company and two non-executive directors who joined Serena VDW Co just prior to the listing. Each
director has a specific area of responsibility and only the finance director reviews and financial
statements and budgets.

The chief executive officer, Daniel Brown, set up the audit committee and he sits on this sub-committee
along with the finance director and the non-executive directors. As the board is relatively small, and to
save the costs, no internal audit function has been set up to monitor internal controls.

The executive director’s remuneration is proposed by the finance director and approved by the
chairman. They are paid an annual salary as well as a generous annual revenue related bonus.

Since the company listed, the directors have remained unchanged and none have been subject to re-
election by shareholders.

Required: Describe five corporate governance weaknesses faced by Serena VDW Co and provide
recommendations to address each weakness, to ensure compliance with corporate governance
principles.

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Saxophone Enterprise Co.
Saxophone Enterprises Co (Saxophone) has been trading for 15 years selling insurance and has recently
become a listed company. In accordance with corporate governance principles Saxophone maintains a
small internal audit department. The directors feel that the team needs to increase in size and specialist
skills are required, but they are unsure whether to recruit more internal auditors, or to outsource the
whole function to their external auditors, Cello & Co.

Saxophone is required to comply with corporate governance principles in order to maintain its listed
status; hence the finance director has undertaken a review of whether or not the company complies.

Bill Bassoon is the chairman of Saxophone, until last year he was the chief executive. Bill is unsure if
Saxophone needs more non-executive directors as there are currently three non-executive directors out
of the eight board members. He is considering appointing one of his close friends, who is a retired chief
executive of a manufacturing company, as a non-executive director.

The finance director, Jessie Oboe, decides on the amount of remuneration each director is paid.
Currently all remuneration is in the form of an annual bonus based on the profits. Jessie is considering
setting up an audit committee, but has not undertaken this task yet as she is very busy. A new sales
director was appointed nine months ago. He has yet to undertake his board training as this is normally
provided by the chief executive and this role is currently vacant.

There are a large number of shareholders and therefore the directors believe that it is impractical and
too costly to hold an annual general meeting of shareholders. Instead, the board has suggested sending
out the financial statements and any voting resolutions by email; shareholders can then vote on the
resolutions via email.

Required:

(a) Explain the advantages and disadvantages for each of Saxophone Enterprises Co and Cello &
Co of outsourcing the internal audit department.
(b) In respect of the corporate governance of Saxophone Enterprises Co:
i. Identify and explain FIVE corporate governance weaknesses; and
ii. Provide a recommendation to address each weakness.

14 ETHICS
In order for the public to have confidence in the work performed by professional accountants. It is
essential to have a system of regulation. Regulation can take the form of both ethical and statuary
guidance.
Required:

(a) State the five threats contained within ACCA’s Code of Ethics and Conduct and for each threat
list one example of a circumstance that might create that threat.
(b) Explain the auditor’s ethical responsibilities with regard to client confidentiality and when they
have:
i. An obligatory responsibility
ii. A voluntary responsibility

To disclose client information.

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16 STARK (12/08) (AMENDED)

You are the manger in the audit firm of Ali and co; and this is your first time you have worked on one of
the firm’s established clients , Stark Co. the main activity of Stark Co. is providing investment advice to
individuals regarding saving for retirement, purchase of shares and securities and investing in tax
efficient savings schemes. Stark is regulated by the relevant financial services authority.

You have been asked to start the audit planning for Stark Company by Mr. Son, a partner in Ali &
Company. Mr. Son has been the engagement partner for Stark Company for the previous nine years and
so has excellent knowledge of the client. Mr. Son has informed you that he would like his daughter Zoe
to be part of the audit team this year; Zoe is currently studying for her first fundamentals papers for her
ACCA qualification. Mr. Son also informs you that Mr. Far, the audit senior, received investment advice
from Stark Co during the year and intends to do the same next year.

In an initial meeting with the finance director of Stark Co, you learn that the audit team will not be
entertained on Stark Co’s yacht this year as this cold appear to be an attempt to influence the opinion of
the audit. Instead, he has arranged a balloon flight costing less than one-tenth of the expense of using
the yacht and hopes this will be acceptable. The director also states that the fee for taxation services
this year should be based on a percentage of tax saved and trusts that your firm will accept a fixed fee
for representing Stark Co in a dispute regarding the amount of sales tax payable to the taxation
authorities.

Required:

(a) Explain the ethical threats which may affect the auditor of Stark Co.
(b) For each ethical threat, discuss how the effect of the threat can be mitigated.

Ethical threats to independence and objectivity

Threat Example
Self-Interest x Close business ,family or personal relationships
x Undue fee dependency on one client
x % or contingent fees
x Low balling to win lucrative other work
x Overdue fees
x Gifts and hospitality
x Employment with an assurance client
x Partner on client board
x Loans and guarantees
x Financial interests in a client
x Holding client assets
Self-review x Provision of other non-audit services such as tax internal audit
validation services corporate finance IT systems services.
x Preparing financial statements and accounting records.
x Recent service with an audit client.
Advocacy x Promoting shares in a listed audit client

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x Acting as an advocate in a legal dispute
x Commenting publicity on future events in particular circumstances
Familiarity x Long association with an audit/client
x Close business family or personal relationship
x Gifts and hospitality
Intimidation x Being threatened with removal as auditor
x Dominant person in senior position within the client
x Threat of litigation
x Threat of other lucrative non-audit work not being awarded

15 CODE OF ETHICS AND CONDUCT

(a) Explain each of the five fundamental principles of ACCA’s Code of Ethics and Conduct.
(b) Compliance with the fundamental principles in ACCA’s Code of Ethics and Conduct can be
threatened in a number of ways.

Required:

(i) List the five ethical threats to independence and objectivity and for each threat identify one
example of a circumstance that may create the threat.

19 ORANGE (6/12) (AMENDED)

You are the audit manager of Currant & Co and you are planning the audit of Orange Financials Co
(Orange), who specializes in the provision of loans and financial advice to individuals and companies.
Currant & Co has audited Orange for many years.

The directors are planning to list Orange on a stock exchange within the next few months and have
asked if the engagement partner can attend the meetings with potential investors. In addition, as the
finance director of Orange is likely to be quite busy with the listing, he has asked if Currant & Co can
produce the financial statements for the current year.

During the year, the assistant finance director of Orange left and joined Currant & Co as a partner. It has
been suggested that due to his familiarity with Orange, he should be appointed to provide an
independent partner review for the audit.

Once Orange obtains its stock exchange listing it will require several appointments to be undertaken, for
example, obtaining advice about corporate governance best practice. Currant & Co is very keen to be
appointed to these engagements; however, Orange has implied that in order to gain this work Currant &
Co needs to complete the external audit quickly and with minimal questions/issues.

The finance director has informed you that once the stock exchange listing has been completed, he
would like the engagement team to attend a weekend away at a luxury hotel with his team as a thank
you for all the hard work. In addition, he has offered a senior member of the engagement team a short-
term loan at a significantly reduced interest rate.

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Required:

(a) Explain five ethical threats which may affect the independence of Currant & Co’s audit of
Orange Financials Co.
(b) For each threat explain how it might be reduced to an acceptable level.

13 LV FONES (6/10) (AMENDED)

You are the audit manager of Jones & Co and you are planning the audit of LV Fones Co, a listed
company which has been an audit client for four years and specializes in manufacturing luxury mobile
phones.

During the planning stage of the audit you have obtained the following information. The employees of
LV Fones Co are entitled to purchase mobile phones at a discount of 10%. The audit team has in
previous years been offered the same level of staff discount.

During the year the financial controller of LV Fones was ill and hence unable to work. The company had
no spare staff able to fulfill the role and hence a qualified audit senior of Jones & Co was seconded to
the client for three months. The audit partner has recommended that the audit senior work on the audit
as he has good knowledge of the client. The fee income derived from LV Fones was boosted by this
engagement and along with the audit and tax fee, now accounts for 16% of the firm’s total fees.

From a review of the correspondence files you note that the partner and the finance director have
known each other socially for many years and in fact went on holiday together last summer with their
families. As a result of this friendship the partner has not yet spoken to the client about the fee for last
year’s audit, 20% of which is still outstanding.

Required:

(a) Explain the ethical threats which may affect the independence of Jones & Co’s audit of LV Fones
Co.
(b) For each threat explain how it might be avoided.

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

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

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

Required:

Using the information above:

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

APPOINTMENT ETHICS:

The section covers the procedures that the auditors must undertake to ensure that their appointment is
valid and that they are clear to act.

1.2.1 Before accepting nomination

Before a new audit client is accepted, the auditor must ensure that there is no Independence or other
ethical problems likely to cause conflict with the ethical code. Furthermore, new auditors should ensure
that they have been appointed in a proper legal manner.

The nominee auditors must carry out the following procedure.

ACCEPTING PROCEDURES
Ensure professionally qualified to act Consider whether they could be disqualified on
legal or ethical grounds
Ensure existing resources adequate Consider available time, staff and technical
expertise
Obtain references Make independent enquiries if directors are
not personally known
Communicate with present auditors Enquire whether there are
reasons/circumstances behind the change
which the new auditors ought to know, also as
a courtesy

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CLIENT SCREENING:
* Management Integrity
*Engagement Economics
*Risk
*Relationship with client
*Availability of resources

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An appointment decision chart is shown below

Approach by new audit client

Is this Yes
No need to follow professional
the rules- the auditor can make own
client’s decision

No

NO
Does client
give
permission
to contact

YES

Write for all information pertinent

to the appointment section
Prospective auditor should
decline appointment
Yes

Does old NO
Does client
auditor provide
give old
information
auditor Give old auditor due
relevant to new
permission notice then decide on
appointment?
to reply? YES basis of knowledge
obtained otherwise

Yes

Accept/reject
appointment decision

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1.2.2 Example nomination letter

To: Retiring &Co
This is an example of an initial communication with the previous auditor.
Certified Accountants

Dear Sirs

Re: New Client Co Ltd

We have been asked to allow our name to go forward for nomination as auditors of the above company, and
we should be therefore grateful if you would let us know whether there are any professional reasons why
we should not accept nomination…… .

Acquiring &Co

Certified Accountants

Having negotiated these steps, the auditors will be in a position to accept the nomination, or not, as the
case may be. These procedures are demonstrated in the appointment decision chart.

1.2.3 Procedures after accepting nomination

The following procedures should be carried out after accepting nomination. (Note that these should not
be carried out until the client screening procedures discussed in Section .3 have been carried out.)

(a) Ensure that the outgoing auditors’ removal or resignation has been properly conducted in
accordance with national legislation. The new auditors should see a valid notice of the outgoing
auditors’ resignation, or confirm that the outgoing auditors were properly removed.
(b) Ensure that the new auditors’ appointment is valid. The new auditors should obtain a copy of
the resolution passed at the general meeting appointing them as the company’s auditors.
(c) Set up and submit a letter of engagement to the directors of the company. Letters of
engagement are discussed in the next section.

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Preconditions for an audit
ISA 210 Agreeing the terms of audit engagements states that the objective of the auditor is to accept or
continue an audit engagement only when the basis on which it is to be carried out has been agreed by
establishing whether the preconditions for an audit are present and confirming that there is a common
understanding between the auditor and management of the terms of the engagement.

Key term
The preconditions for an audit are the use by management of an acceptable financial reporting
framework in the preparation of the financial statements and the agreement of management
and, where appropriate, those charged with governance to the premise o which an audit is
conducted.

To determine whether the preconditions for an audit are present, the auditor shall do the following:

(a) Determine whether the financial reporting framework is acceptable. Factors to consider
include the nature of the entity, the purpose of the financial statements, and whether law or
regulation prescribes the applicable financial reporting framework.
(b) Obtain management’s agreement that it acknowledges and understands its responsibilities for
the following.
i. Preparing the financial statements in accordance with the applicable financial reporting
framework.
ii. Internal control that is necessary to enable the preparation of financial statements
which are free from material misstatement.
iii. Providing the auditor with access to all information of which management is aware
that is relevant to the preparation of the financial statements, with additional
information that the auditor may request, and with unrestricted access to entity staff
from which the auditor determines it necessary to obtain audit evidence.

If these preconditions are not present, the auditor shall discuss the matter with the management. The
auditor shall not accept the audit engagement if:

x The auditor has determined that the financial reporting framework to be applied is not
acceptable.
x Management’s agreement referred to above has not been obtained.

The audit engagement letter

Key term
The engagement letter is the written terms of an engagement in the form of a letter.

The auditor shall agree the terms of the engagement with management or those charged with
governance and these shall be recorded in an audit engagement letter or other suitable form of written
agreement. This has to be done before the audit engagement begins so as to avoid misunderstandings
regarding the audit.

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Form and content of the audit engagement letter

The audit engagement letter shall include the following:

x The objective and scope of the audit.

x The auditor’s responsibilities.
x Management’s responsibilities
x Identification of the applicable financial reporting framework for the preparation of the
financial statements
x Reference to the expected form and content of any reports to be issued by the auditor and a
statement that there may be circumstances in which a report may differ from its expected form
and content

Additional matters that may be included

The audit engagement letter may also make reference to the following:

x Fees and billing arrangements

x Request for management to acknowledge receipt of the letter and agree to the terms
outlines in it
x Involvement of other auditors and experts
x Involvement of internal auditors and other staff
x Arrangements to be made with predecessor auditor
x Any restriction of auditor’s liability
x Reference t any further agreements between auditor and entity
x Any obligations to provide audit working papers to other parties

Appendix 1 of ISA 210 includes an example of engagement letter.

Acceptance of a change in terms of Audit Engagement letter

A change in the terms of audit engagement prior to completion may result from:

(a) A change in circumstances affecting the need for the service

(b) A misunderstanding as to the nature of an audit or of the related service originally requested
(c) A restriction on the scope of the audit engagement, whether imposed by management or
caused by circumstances.

Salt & Pepper & Co

Salt & Pepper & Co (Salt & Pepper) is a firm of Chartered Certified Accountants which has been its
revenue decline steadily over the past few years. The firm is looking to increase its revenue and client
base and so has developed a new advertising strategy where it has guaranteed that its audit will
minimize disruption to companies as they will not last longer than two weeks. In addition, Salt & Pepper
has offered all new audit clients a free accounts preparation service for the first year of engagement as
it is believed that the tie spent on the audit will be reduced if the firm has produces financial
statements.

The firm is seeking to reduce the audit costs and has therefore decided not to update the engagement
letters of existing clients, on the basis that these letters do not tend to change much on a yearly basis.
One of Salt & Pepper’s existing client s has proposed that this year’s audit fee should be based on a

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percentage of their final pre-tax profit. The partners are excited about this option as they believe it will
increase the overall audit fee.

Salt & Pepper has recently obtained a new audit client, Cinnamon Brothers Ltd (Cinnamon), whose year
end is 31st December. Cinnamon requires their audit to be completed by the end of February; however,
this is a very busy time for Salt & Pepper and so it is intended to use more junior staff as they are
available. Additionally, in order to save time and cost, Salt & Pepper have not contacted Cinnamon’s
previous auditors.

Required:

(a) Describe the steps that Salt & Pepper should take in relation to Cinnamon:
i. Prior to accepting the audit; and
ii. To confirm whether the preconditions for the audit are in place.
(b) State FOUR matters that should be included within an audit engagement letter.
(c) Identify and explain FIVE ethical risks which arise from the above actions of Salt &Pepper &
Co; and
For each ethical risk explain the steps which Salt a& Pepper & Co should adopt to reduce the
risks arising.

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

12 GOOFY (6/11) (AMENDED)

You are an audit manager in NAB & co. a large audit firm which specializes in the audit of retailers. The
firm currently audits Goofy Co, a food retailer, but Goofy Co’s main competitor, Mickey Co, has
approached the audit firm to act as auditors. Both companies are highly competitive and Goofy /co is
concerned that if NAB & Co. audits both companies then confidential information could pass across to
Mickey Co.

Required:

(a) Explain the safeguards that your firm should implement to ensure that this conflict of interest is
properly managed.

Goofy Co’s year end is 31 December, which is traditionally a busy time for NAB & Co. Goofy Co currently
has an internal audit department of five employees but they have struggled to undertake the variety
and extent of work required by the company, hence Goofy Co is considering whether to recruit to
expand the department or to outsource the internal audit department. If outsourced, Goofy Co would
require a team to undertake monthly visits to test controls at the various shops across the country, and
to perform ad hoc operational reviews at shops and head office.

Goofy Co is considering using NAB & co to provide the internal audit services as well as remain as
external auditors.
Required

(b) Discuss the advantage and disadvantages to both Goofy Co and NAB & co of outsourcing their
internal audit department.
Please write your answers to all parts of these questions on the lined pages of the Candidate
Answer Booklet.

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Pink Partners & Co.

You are an audit manager of Pink Partners & Co (Pink) and are planning to audit the Golden Finance Co
(Gold), a banking institution which provides a range of financial services including loans. Your firm has
audited Golden’s company for four years and the company’s end year is 30 September 2015.

At the end of August, Golden’s financial controller left and the new replacement is not due to start until
approximately two months after the year end. The finance director, who is sister-in-law of the audit
engagement partner, has asked if a member of audit team can be seconded to Golden for three months
to act the temporary financial controller.

You are aware that a number of the audit team members currently bank with Golden and two team
members have significant loans owing to the company.

Pink’s taxation department also provides services to Golden. They have been approached by golden to
represent them in negotiations to resolve some outstanding issues with the taxation authorities, for
which the fees quoted, are substantial.

The finance director has informed the audit engagement partner that when the audit is complete, she
would like the whole team to attend an evening watching the national football team play a match
followed by a luxury meal.

Required:
Using the above information:

i.
ii. Identify and explain FIVE ethical threats which may affect the independence of Pink
Partners & Co’s audit of Golden Finance co; and
iii. For each threat, explain how it might be reduced to an acceptable level.

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

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INTERNAL AUDIT

OUTSOURCING THE INTERNAL AUDIT FUNCTION

Rather than having a permanent internal audit presence some organization have chosen to outsource
the function (acquiring the service from a third party) such that they would buy in necessary skills as
they are needed for specific pieces of work.

Background behind outsourcing is the fact that companies cannot afford to have certain department on
permanent basis e.g.

It security, Cafeteria, Human resource, repair Maintenance, internal audit and payroll department etc.
(Mostly those functions are outsourced that are not core departments of the organizations).

ADVANTAGES OF OUTSOURCING

1. Internal audit staff does not need to be permanently recruited or hired.

2. Internal audit staff can be used for a wider range of services.
3. Outsourcer provides specialist service.
4. Outsourcer provides immediate service.
5. Skills required for only a short period of time each year can be provided without incurring the
excessive costs of maintain an in house development.
6. Outsourcer could provide access to new techniques without the need for significant levels of
investment or in house development.
7. With a professional outsourced department, less management time is required on internal audit
activities e.g. appraisals, training and development.
8. Associated cost such as training costs and hiring costs are eliminated.
9. Service can be acquired for the desired period as per the needs of company.
10. Service provider will also indemnify in case of loss to the company.
11. Outsourcing lays the basis of a permanent function by setting such policies and functions.

DISADVANTAGES OF OUTSOURCING

1. Conflict of interest plus independence & objectivity issues may rise if the outsourced internal
audit service is being provided by the company’s external auditors.
2. Outsourced may be expensive to the company as service is being acquired from a professional
service company.
3. An outsourced department may not be as flexible when problem arise, since they do not have a
permanent presence.
4. Standard of service may not be up to the requirement of the company.
5. There is a risk of lack of knowledge, awareness or proper understanding of the organization
objectives and its culture.
6. Loss of in house skills, company staff may oppose outsourcing if it results in existing staff being
made redundant.
7. Lack of control over the audit staff of the outsourced firms.
8. Lack of loyalty may be an issue.

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CONCLUSION

There are number of problems associated with outsourcing, the major one being a possible impairment
of independence.

According to some authors, outsourcing of internal audit is not an effective business solution and that
outsourcing will ultimately increase the costs of company with no added loyalty to the company.
Therefore, the company management should think hard before outsourcing their internal audit
department.

MAJOR ADVANTAGES/ BENEFITS OF HAVING AN INTERNAL AUDIT DEPARTMENT

1. It dispenses the need to employ consultants to act as internal auditors hence saving large sum of
money. This is even especially true when an internal audit department is properly run with well
trained and experienced internal auditors.
2. The internal auditors are intimately acquainted with the business as they are continuously
employed in the same concern and have access to much confidential information and to all
levels of management. Hence, they really are special personnel who have very in depth inner
knowledge which can contribute to the company.
3. The internal audit maintains a group of highly skilled people available to cope with non-
recurring and exceptional jobs which no employees could deal with efficiently and effectively.
4. It ensures that the organizations detailed standard policy and procedures are running smoothly.
This compared to the external auditors primary role of the ability to express the true and fair
view of the client’s financial statement audit.
5. It provides an excellent training ground for establishing and producing future executives for the
company.

LIMITATIONS OF AN INTERNAL AUDIT FUNCTION:

¾ Reporting Mechanism:

There is a limitation if the Internal Audit function is reporting only to CEO. Instead there should be a dual
reporting mechanism i.e. their function must report functionally to audit committee for other matters to
CEO.

¾ Qualification of Internal Auditors:

There is no mandatory requirement for qualification of Internal Auditors, therefore there may be a
limitation due to lack of knowledge.

¾ Scope of work of Internal Auditors:

Limitations of scope of work of Internal Audit department, if such scope is define by B.O.D.

¾ Auditing your own work:

It will impose or create a self review threat. If Internal Audit function is reviewing /audit their own work.

¾ Length of Service:

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Due to long length of service and repetition of work, internal auditors become over familiar with their
work.

¾ Independence of Internal Auditors:

Internal Auditors are ultimately employees of the company therefore they cannot be expected to have
some level of independence as External Auditors.

¾ No standardization or uniformity exists Internal Audit Functions; therefore the work of Internal
Auditors and formats of their reports will vary from company to company.
¾ Due to its huge fixed cost, lots of companies do not encourage or appreciate to have permanent
Internal Audit Department.
¾ There might be resistance from various departments and employees to have an Internal Audit
department as their work will be reviewed and criticized by Internal Audit department.
¾ There is less reliance on the work of internal auditors than external parties and stakeholders, as
for those internal auditors on substance are employees of the company.

PRACTICE QUESTIONS:

17 Governance
SPD Co has been trading for 10 years and provides advice on pensions and other financial products to its
clients. SPD Co is not listed on stock exchange but it’s regulated by a government body which aims to
ensure that financial advice is always provided in the best interests of the customer.

SPD Co has seen rapid growth in its revenue over the last 12 months and expects this trend to continue.
In order to meet client demand and offer new products, SPD Co is now offering more complex financial
products than it has ever done before.

SPD Co is also in need of additional funding to support its anticipated growth and will shortly need to
approach its bank to determine whether additional funding might be available. The Board of Directors is
also considering bank to determine whether or not SPD Co should obtain the listing on a stock exchange
as an alternative way of raising finance.

(a) Explain what is meant by ‘corporate governance’ and explain why it is important.
(b) Discuss the benefits to SPD Co of establishing an internal audit department.

20 Internal audit functions

(a) List the types of activity normally carried out by internal audit departments.
(b) Briefly explain the main differences between internal and external auditors in respect of
objectives, scope of work and reporting responsibilities.
(c) Explain the term ‘outsourcing’ and list three advantages and three disadvantages of outsourcing
an internal audit department.

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24 Wood Industries (AIR 6/05) (amended)

You are the audit manager of Wood Industries Co (Wood), a limited liability company. The company’s
annual revenue is over $10 million.

Required:

(a) Compare the responsibilities of the directors and auditors regarding the published financial
statements of Wood.
(b) The directors of Wood have prepared a cash flow forecast for submission to the bank. They
have asked you as the auditor to provide a limited assurance report on this forecast.

Required:

Briefly explain the difference between reasonable and limited assurance.

25 Regulations and limitations (12/12) (amended)

(a) In order for auditors to operate effectively and to provide an opinion on an entity’s financial
statements, they are given certain rights.

Required:

State three rights of an auditor, excluding those related to resignation and removal.

(b) Explain the overall authority of International Standards on Auditing (ISAs) and how they are
applied in individual countries.
(c) Describe three limitations of external audits.

21 Internal audit responsibilities

(a) There are similarities and differences between the responsibilities of internal and external
auditors. Both internal and external auditors have responsibilities relating to the prevention,
detection and reporting of fraud, for example, but their responsibilities are not the same.

Required
Explain the difference between the responsibilities of internal auditors and external auditors for
the prevention, detection and reporting of fraud and error.

(b) ISA 610 Using the work of internal auditors provides guidance to external auditors when
accessing whether to place reliance on work performed by internal audit.

Required:
Explain factors which should be considered by external auditors before placing reliance on work
of internal auditors

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22 Monte Hodge (6/08) (amended)
Monte Hodge Co has total revenue of $253 million and employs 1,200 people in 15 different locations.
The company provides various financial services, from giving pension and investment advice to
individuals, to maintaining cash books and cash forecasting in small to medium-sized companies. It is
owned by six shareholders, who belong to the same family; it is not listed on any stock exchange and the
shareholders have no intention for applying for a listing. However, and annual is required by statute and
additional regulation of the financial services sector is expected in near future.

Most employees are provided with online, real –time computer systems, which present financial and
stock market information to enable the employees to provide up-to-date advice to their clients.
Accounting systems record income, which is based on fees generated from investment advice.
Expenditure is mainly fixed, being salaries, office rent, lighting and heating, etc. internal control systems
are limited; the directors tending to trusts staff and being more concerned with making profits than
implementing detailed controls.

Four of the shareholders are board members, with one member being the chairman and chief executive
officer. The financial accountant is not qualified, although has many years experience in preparing
financial statements.

Required

Discuss the arguments for and against having an internal audit department in Monte Hodge Co.

23 Avocado (6/12) (amended)

Avocado International Co (Avocado) is a manufacturer of African-inspired wooden toys. You are an audit
manager of Lime & Co, Avocado’s external auditor.

(a) Avocado’s finance director has expressed an interest in Lime & Co performing other review
engagements in addition to the external audit. However, he is unsure how much assurance
would be gained via these engagements and how this differs to the assurance provided by an
external audit.

Required

Identify and explain the level of assurance provided by an external audit and other review engagements.

Avocado’s directors are considering establishing an internal audit department next year, and the
finance director has asked about the differences between internal audit and external audit and
what impact, if any, establishing an internal audit department would have on future external
audits performed by Lime & Co.

Required

(b) Distinguish between internal audit and external audit.

(c) Explain the potential impact on the work performed by Lime & Co during the interim and final
audits, if Avocado International Co was to establish an internal audit department.

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Internal Audit Reports:

There are no formal reporting requirements so report could take any form. Internal auditor
produces report for director and management. These reports are internal to business and not
shared with third parties other than external auditor.

An internal auditors report could state deficiencies, implications on company and

recommendations. Usually at the end of field work, internal auditor produce a draft report which is
sent out for consideration to the relevant managements. The internal auditor will then meet with
management to discuss the work findings and recommendations. This is called “Exit Meeting”.

After meeting internal auditor will produce a formal report which once approved by relevant people
is used to produce final report for B.O.D.

Final report may have different format, one example is outlined below.

Standard report format:

9 Terms of reference
9 Executive summary (condensed version of full report includes background of assignment,
objective of assignment, outcome of work, risks identified, summary of work left to do).
9 Body of report
9 Any additional information
9 Although content and format of final audit report
9 Purpose (objective of audit engagement)
9 Scope (which activities are audited)
9 Results (observation, conclusion, opinions, recommendations, actions)

Attributes of high quality report:

i. Accurate
ii. Objective
iii. Clear
iv. Concise
v. Complete
vi. Timely

Report is provided to people who can take corrective action on issue raised. (Senior Managers).

May also go to:

9 External Auditor
9 Board of director

Others who are interested

9 If any amendments are made to report after it is reviewed, a new report shall be issued
which highlights any changes. This should be distributed to everyone who received original
report.

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9 After issue of final report, management will be given opportunity to provide formal
response to report. This formally communicates what is going to be done about
recommendations raised.

jExample of an internal audit report

6.1 Review reports can take many formats depending on the nature of the assignment.

6.2 The following is an example of a systems review report following an assignment carried out by
internal audit or outsourced to an audit firm. Bear in mind though, that usually this is an internal
report and can therefore be of any format. This is a brief example. More complicated assignments
are likely to summarize the main findings and include a number of appendices containing detailed
information.

REPORT

To: Directors of Robinson Co

From: Internal audit department
Subject: Review of sales system
Period of fieldwork: May 200X

Terms of Reference

The scope of the assignment was to carry out a thorough review of the sales system. This involved
carrying out tests of controls on the existing controls to determine whether the controls were operating
effectively. In addition, we considered the key risks surrounding the sales function and identified any
risks for which we found no related controls. Thus, we have been able to give recommendations
regarding existing controls as well as suggest new controls where we believe they are needed.

Executive Summary
The main findings from our review are:

x The sales system, on the whole, comprises adequate controls

x Some specific control weaknesses were identified and recommendations are given in the
Appendix to the report.

Follow-up

Responsibilities have been allocated for introducing/improving control procedures which we found to
be deficient.
Dated………………
We propose a follow-up review in six months time. Signature………………….

Head Internal Auditor

Dated…………………. Signed………………………………………….

Head Internal Auditor

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Appendix

Detailed identification of weaknesses, risks and recommendations

Weakness Risk Recommendation Responsibility Timescale

There is no credit These new All new customers To be implemented September 200X
check of new customers could should be subject to by the head of the
customers prior to represent an this check and the credit control
taking all order increased risk of bad computer system department
debts should have a
compulsory check
before the sales
order can be
accepted
There is no follow If customers do not There should be a To be implemented September 200X
up of sales order receive their goods monthly and managed by the
unmatched to GDNs as ordered they are reconciliation head of the sales
unlikely to use between the department
Robinson Co for month’s sales order
further purchases and the related
GDNs. Any
unmatched orders
should be followed
up with queries
being directed to
head of sales
Customers are not This could lead to The P.O.D should be To be implemented September 200X
asked to sign the disputes, loss of signed and detained by the head of the
proof of delivery customer goodwill within the sales sales department
and increased bad department along
debts with the order and
invoice

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ELEMENTS OF AUDIT REPORT

Basic elements of audit report Explanation

Title The auditor’s report must have a title that clearly
indicates that it is the report of the independent
auditor. This signifies that the auditor has met all
the ethical requirements concerning
independence and therefore distinguishes the
auditor’s report from other reports.
Addressee The addressee will be determined by law or
regulation, but is likely to be the shareholders or
those charged with governance.
Opinion paragraph The opinion paragraph must identify the entity
being audited, state that the financial statements
have been audited, identify the title of each
statement that comprises the financial statements
being audited, refer to the summary of significant
accounting policies and other explanatory notes,
and specify the dates or period covered by each
statement comprising the financial statements. If
the auditor expresses the unmodified opinion on
financial statements prepared in accordance with
a fair presentation framework, the opinion shall
use on of the following equivalent phases:
x The financial statements present fairly, in
all material respects, in accordance with
[the applicable financial reporting
framework]; or
x The financial statements give a true and a
fair view of… in accordance with [the
applicable financial reporting framework].
Basis for opinion The basis for opinion paragraph must state that
the audit was conducted in accordance with the
ISAs, and refer to the ‘Auditor’s responsibilities for
the audit of the financial statements’ sections
which describes the auditor’s responsibilities
under the ISAs.
The auditor must also state that they are
independent of the audited entity, in accordance
with the relevant ethical requirements relating to
the audit.
Finally, the auditor must state that they believe

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the audit evidence obtained is sufficient and

appropriate to prove a basis for the audit opinion.

Going concern Where the auditor considers a material

uncertainty related to going concern exists, this
should be described in a separate paragraph
headed ‘Material uncertainty related to going
concern.’
Key audit matters For the audit of listed entities, or where required
by law or regulation, the auditor should include a
‘Key audit matters’ section. This section describes
the matters that, in the auditor’s professional
judgment, are most significant t the audit. (See
section below).
Other information For the audit of listed entities or any other entity
where the auditor has obtained other information,
an ‘Other information’ section should include:
x A statement that management is
responsible for the other information
x An identification of the other information
obtained before the date f auditor’s report
(for listed entities, also the other
information expected to be obtained after
the date of auditor’s report)
x A statement that the auditor’s opinion
does not cover the other information
x A description of the auditor’s
responsibilities for reading, considering
and reporting o other information, and
x Where other information has been
obtained, either a statement that the
auditor has nothing to report, or a
description of any uncorrected material
misstatement.
Responsibilities for the financial statements This part of the report describes the
responsibilities of those who are responsible for
the preparation of the financial statements. This
section should describe management’s
responsibility including the following:
x The preparation of the financial
statements in accordance with the
applicable financial reporting framework;
x The implementation of such internal
control as are necessary to enable the
preparation of financial statements that is
free from material misstatement, whether
due to error or fraud.

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x The assessment of the entity’s ability to
continue as a going concern, the
appropriateness of the going concern basis
of accounting and adequacy of related
disclosures;
Reference shall be made to the preparation and
fair presentation of these financial statements’ (or
the preparation of financial statements that give a
true and fair view’) where the financial statements
presentation framework.
Auditor’s responsibilities for the audit of the The report must state that:
financial statements x The auditor’s objectives are to obtain
reasonable assurance whether the
financial statements as a whole are free
from material misstatement, and to issue
an auditor’s report that includes the
auditors opinion; and
x Reasonable assurance is a high level of
assurance, but is not a guarantee that an
audit conducted in accordance with the
ISAs will always detect a material
misstatement when it exists.

The report must also:

x Explain that misstatements can arise from
fraud or error
x Describe the meaning of materiality
x Explain that the auditor exercises
professional judgment and maintains
professional skepticism throughout the
audit
x Describe the auditor’s responsibilities in an
audit
The description of the auditor’s responsibilities
must either be set out in the body of the auditor’s
report, in an appendix to the auditor’s report or by
including a specific reference in the body of the
auditor’s report to such a description on the
website of an appropriate authority, where this is
permitted by law and regulation.
Other reporting responsibilities If the auditor is required by law to report on any
other matters, this must be done in an additional
paragraph titled ‘Report on other legal and
regulatory requirements’ or otherwise as
appropriate.
Name the engagement partner The name of the engagement partner should be
identified, unless such a disclosure is reasonably

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expected to lead a significant personal security

threat.

Auditor’s signature The report must contain the auditor’s signature,

whether this is the auditor’s own name or the
audit firm’s name or both.
Auditor’s address The location where the auditor practices must be
included.
Date of the report The report must be dated no earlier than the date
on which the auditor has obtained sufficient
appropriate audit evidence on which to base the
auditor’s opinion on the financial statements.

EXAMPLES OF DIFFERENT OPINIONS AND BASIS FOR OPINIONS:

Example1: qualified opinion due to material misstatement

In this example, inventories are materially misstated but the effect is not pervasive.

Basis for qualified opinion

The company’s inventories are carried in the statement of financial position at xxx. Management has not
stated inventories at the lower of cost and net realizable value but has stated them solely at cost which
constitutes a departure from International Financial reporting Standards. The company’s records
indicate that the management stated the inventories at the lower of cost and net realizable value, an
amount of xxx would have been required to write the inventories down to their net realizable value.
Accordingly, cost of sales would have been increased by xxx, xxx and xxx, respectively.

Qualified opinion
In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion
paragraph, the financial statements present fairly, in all material respects, (or give a true and fair view
on) the financial position of ABC Company as at December31, 20X1 and (of) its financial performance
and its cash flows for the year then ended in accordance with International Financial Reporting
Standards.

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Example 2: Adverse opinion due to material misstatement with a pervasive effect

This example is an adverse opinion for the house building company we looked at in section 1.3.3, which
included inventory as depreciated non-current assets.

Basis for adverse opinion

The company has included house built for re-sale (including related land) at a cost of $X as non-current
assets and depreciated them at a rate of X% resulting in depreciation of $X. under International Financial
Reporting Standards, these should have been included as Inventory in the financial statements and no
depreciation should have been provided in respect of these. The carrying value of the houses represents
90% of the company’s total assets and the company’s records indicate that…. [Explanation of the effect
on amounts presented in the financial statements].

Adverse opinion
In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion
paragraph, the financial statements do not present fairly (or do not give a true and fair view on) the
financial position of ABC Company as at December 31, 20X1, and (of) its financial performance and its
cash flows for the year then ended in accordance with international financial Reporting Standards.

Example 3: Qualified opinion due to inability to obtain sufficient appropriate audit evidence

In this example, the inventory count was not attended by the auditor, but in the context of the financial
statements, even though inventory could be materially misstated (which the auditor cannot conclude on
so the phrase possible effects’ is used); the effects would not be pervasive.

Basis for qualified opinion

With respect to inventory having a carrying amount $X the audit evidence available to us was limited
because we did not observe the counting of the physical inventory as at 31 December 20X1, since that
date was prior to our appointment as auditor of the company. Owing to the nature of the company’s
records, we were unable to obtain sufficient appropriate audit evidence regarding the inventory
quantities by using other audit procedures.

Qualified opinion
In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion
paragraph, the financial statements present fairly, in all material respects, (or give a true and fair view
of) the financial position of ABC Company as at December 31, 20X1, and (of) its financial performance
and its cash flows for the year then ended in accordance with international Financial Reporting
Standards.

Example 4: disclaimer of opinion due to inability to obtain sufficient appropriate audit evidence about
multiple elements of the financial statements

In this example, the auditor has not only been unable to attend the inventory count, but has also been
unable to gain evidence over other areas. As a result the author has concluded the effects of the
possible misstatements could be material and pervasive.

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Basis for disclaimer opinion

We were not appointed as auditors of the company until after December 31, 20X1 and thus did not
observe the counting of physical inventories at the beginning and end of the year. We were unable to
satisfy ourselves by alternative means concerning the inventory quantities held at December 31, 20X0
and 20X1 which are stated in the statement of financial position at xxx and xxx, respectively. In addition,
the introduction of a new computerized accounts receivable system in September 20X1 resulted in
numerous errors in accounts receivable. As of the date of our audit report, management was still in the
process of rectifying the system deficiencies and correcting errors. We were unable to confirm or verify
by xxx as at December 31, 20X1. As a result of these matters, we were unable to determine whether any
adjustments might have been found necessary in respect of recorded or unrecorded inventories and
accounts receivable, and the elements making up the statement of profit or loss, statement of changes
in equity and cash flow statement.

Disclaimer of opinion
Because of the significance of the matters described in the Basis for Disclaimer of Opinion paragraph, we
have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit
opinion. Accordingly, we dot express an opinion on the financial statements.

Answer style FOR SUBSEQUENT EVENTS QUESTIONS

a. Write introduction of case wordings from question.

b. Write “under IAS 10 it is adjusting or non-adjusting and whether adjustment is required or
disclosure is required.”
c. Write three audit procedures:
9 Discuss with management
9 Review supporting documents
9 Obtain legal or expert advice
d. Find materiality as a % of PAT and write impact on audit report:
9 If immaterial no impact on report
9 If material modified report

Grains 4U Co
Grains 4U Co (Grains) manufactures breakfast cereals and has three factories, four warehouses and
three distribution depots spread across North America. The audit for the year ended 31 December 2015
is almost complete and the financial statements and audit report are due to be signed shortly. Profit
before taxation is $7·9 million. The following events have occurred subsequent to the year end and no
amendments or disclosures have been made in the financial statements.

Event 1 – Fire
On 15 February 2016, a fire occurred at the largest of the distribution depots. The fire resulted in
extensive damage to 40% of the company’s vehicles used for dispatching goods to customers; however,
there have been no significant delays to customer deliveries. The company estimates the level of
damage to the vehicles to be in excess of $650,000. Only a minimal level of inventory, approximately
$25,000, was damaged. Grain’s insurance company has started to investigate the fire to assess the
likelihood and level of payment, however, there are concerns the fire was started deliberately, and if
true, would invalidate any insurance cover.

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Event 2 – Inventory
On 18 February 2016, it was discovered that a large batch of Grain’s new cereal brand ‘Loopy Green
Loops’ held in inventory at the yearend was defective, as the cereal contained too much green food
coloring. To date no sales of this new cereal have been made. The cost of the defective batch of
inventory is $915,000 and the defects cannot be corrected. However, the scrapped cereal can be utilized
as a raw material for an alternative cereal brand at a value of $50,000.

Required:
For each of the two subsequent events described above:

(i) Based on the information provided, explain whether the financial statements require
amendment; and
(ii) (ii) Describe audit procedures which should now be performed in order to form a
conclusion on any required amendment.

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

(10 marks)

Humphries Co
(a) Describe the auditor’s responsibility for subsequent events occurring between:

(i) the year-end date and the date the auditor’s report is signed; and
(ii) The date the auditor’s report is signed and the date the financial statements are issued. (5 marks)

(b) Humphries Co operates a chain of food wholesalers across the country and its year end was 30
September 2011. The final audit is nearly complete and it is proposed that the financial statements and
audit report will be signed on 13 December. Revenue for the year is $78 million and profit before
taxation is $7·5 million. The following events have occurred subsequent to the year end.

Receivable
A customer of Humphries Co has been experiencing cash flow problems and its year-end balance is $0·3
million. The company has just become aware that its customer is experiencing significant going concern
difficulties. Humphries believe that as the company has been trading for many years, they will receive
some, if not full, payment from the customer; hence they have not adjusted the receivable balance.

Lawsuit
a key supplier of Humphries Co is suing them for breach of contract. The lawsuit was filed prior to the
year end, and the sum claimed by them is $1 million. This has been disclosed as a contingent liability in
the notes to the financial statements; however correspondence has just arrived from the supplier
indicating that they are willing to settle the case for a payment by Humphries Co of $0·6 million. It is
likely that the company will agree to this.

Warehouse
Humphries Co has three warehouses; following extensive rain on 20 November significant rain and river
water flooded the warehouse located in Bass. All of the inventory was damaged and has been disposed

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of. The insurance company has already been contacted. No amendments or disclosures have been made
in the financial statements.

Required:
For each of the three events above:
(i) discuss whether the financial statements require amendment;

(ii) describe audit procedures that should be performed in order to form a conclusion on the
amendment; And

(ii) explain the impact on the audit report should the issue remain unresolved. (15 marks)

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

(20 marks)

Panda Co
(a) Explain the five elements of an assurance engagement. (5 marks)
(b) Panda Co manufactures chemicals and has a factory and four offsite storage locations for finished
goods. Panda Co’s year end was 30 April 2013. The final audit is almost complete and the financial
statements and audit report are due to be signed next week. Revenue for the year is $55 million and
profit before taxation is $5·6 million.

The following two events have occurred subsequent to the year end. No amendments or disclosures
have been made in the financial statements.

Event 1 – Defective chemicals

Panda Co undertakes extensive quality control checks prior to despatch of any chemicals. Testing on 3
May 2013 found that a batch of chemicals produced in April was defective. The cost of this batch was
$0·85 million. In its current condition it can be sold at a scrap value of $0·1 million. The costs of
correcting the defect are too significant for Panda Co’s management to consider this an alternative
option.

Event 2 – Explosion
An explosion occurred at the smallest of the four offsite storage locations on 20 May 2013. This resulted
in some damage to inventory and property, plant and equipment. Panda Co’s management has
investigated the cause of the explosion and believes that they are unlikely to be able to claim on their
insurance. Management of Panda Co has estimated that the value of damaged inventory and property,
plant and equipment was $0·9 million and it now has no scrap value.

Required:

For each of the two events above:

(i) Explain whether the financial statements require amendment; and
(ii) Describe audit procedures that should be performed in order to form a conclusion on any required

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amendment.
Note: The total marks will be split equally between each event. (12 marks)

(c) The directors do not wish to make any amendments or disclosures to the financial statements
for the explosion (event 2).

Required:
Explain the impact on the audit report should this issue remain unresolved. (3 marks)

(20 marks)

ZeeDiem Co
The date is 3 December 2008. The audit of ZeeDiem Co is nearly complete and the financial statements
and the audit report are due to be signed next week. However, the following additional information on
two material events has just been presented to the auditor. The company’s yearend was 30 September
2008.

Event 1 – Occurred on 10 October 2008

The springs in a new type of mattress have been found to be defective making the mattress unsafe for
use. There have been no sales of this mattress; it was due to be marketed in the next few weeks. The
company’s insurers estimate that inventory to the value of $750,000 has been affected. The insurers
also estimate that the mattresses are now only worth $225,000. No claim can be made against the
supplier of springs as this company is in liquidation with no prospect of any amounts being paid to third
parties. The insurers will not pay ZeeDiem for the fall in value of the inventory as the company was
underinsured. This entire inventory was in the finished goods store at the end of the year and no
movements of inventory have been recorded post year-end.

Event 2 – Occurred 5 November 2008

Production at the Sham Eve factory was halted for one day when a truck carrying dye used in coloring
the fabric on mattresses reversed into a metal pylon, puncturing the vehicle allowing dye to spread
across the factory premises and into a local river. The Environmental Agency is currently considering
whether the release of dye was in breach of environmental legislation. The company’s insurers have not
yet commented on the event.

Required:
For each of the two events above:
(i) Explain whether the financial statements require amendment; and

(ii) Describe audit procedures that should be performed in order to form a conclusion on any required
amendment.

(iii)Explain the impact on audit report if issue remains unresolved

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GOING CONCERN:
1) Events or conditions that cast doubt on Going concern status/Potential Indicators of
Going concern problems
x Net liability or net current liability position
x Fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment
x Indications of withdrawal of financial support by creditors
x Negative operative cash flows (historical or prospective)
x Adverse key financial ratios
x Substantial operating losses or significant deterioration in the value of assets used to generate
cash flows
x Arrears or discontinuance of dividends
x Inability to pay creditors on due dates
x Inability to comply with terms of loan agreements
x Change from credit to cash-on-delivery transactions with suppliers
x Inability to obtain financing for essential new product development or other essential investments
x Management intentions to liquidate or cease operations
x Loss of key management without replacement
x Loss of a major market, key customers, license, or principal suppliers
x Labor difficulties
x Shortages of important supplies
x Emergence of a highly successful competitor
x Non-compliance with capital or other statutory requirements
x Pending legal or regulatory proceedings against the entity that may, if successful, result in claims
that the entity is unlikely to be able to satisfy
x Changes in laws/regulations/government policy expected to adversely affect the entity
x Uninsured or underinsured catastrophes when they occur

2) Audit procedures applied n performing going concern reviews

Specific audit procedures the auditor might carry out could include the following:

x Analyze and discuss cash flow, profit and other relevant forecasts with management.
x Analyze and discuss the entity’s latest available interim financial statements (or management
accounts).
x Review the terms of debentures and loan agreements and determine whether they have been
breached.
x Read minutes of the meetings of shareholders, the board of directors and important
committees for reference of financing difficulties.
x Enquire of the entity’s lawyer regarding litigation and claims.
x Confirm the existence, legality and enforceability of arrangements to provide or maintain
financial support with related and third parties.
x Assess the financial ability of such parties to provide additional funds.
x Consider the entity’s position concerning unfulfilled customer orders.

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x Review events after the period end for items affecting the entity’s ability to continue as a going
concern
x Confirm the existence, terms and adequacy of borrowing facilities.
x Obtaining and reviewing reports of regulatory actions.
x Determining the adequacy of support for any planned disposal of assets.

Strawberry Co
You are the audit manager of Kiwi & Co and you have been provided with financial statements extracts
and the following information about your client, Strawberry Kitchen Designs Ltd (Strawberry), who is a
kitchen manufacturer.
The company’s year-end is 30 April 2012.
Strawberry has recently been experiencing trading difficulties, as its major customer who owes £0·6m to
Strawberry has ceased trading, and it is unlikely any of this will be received. However, the balance is
included within the financial statements extracts below. The sales director has recently left Strawberry
and has yet to be replaced.
The monthly cash flow has shown a net cash outflow for the last two months of the financial year and is
forecast as negative for the forthcoming financial year. As a result of this, the company has been slow in
paying its suppliers and some are threatening legal action to recover the sums owing.
Due to its financial difficulties, Strawberry missed a loan repayment and, as a result of this breach in the
loan covenants, the bank has asked that the loan of £4·8m be repaid in full within six months. The
directors have decided that in order to conserve cash, no final dividend will be paid in 2012.

Financial statements extracts for year ended 30 April:

DRAFT ACTUAL
2012 2011
£m £m

Current Assets
Inventory 3·4 1·6
Receivables 1·4 2·2
Cash – 1·2

Current Liabilities
Trade payables 1·9 0·9
Overdraft 0·8 –
Loans 4·8 0·2

Required:
(a) Explain the potential indicators that Strawberry Kitchen Designs Ltd is not a going concern. (6
marks)
(b) Describe the audit procedures that you should perform in assessing whether or not the company is
a going concern. (6 marks)

(c) Having performed the going concern audit procedures, you have serious concerns in relation to the

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going concern status of Strawberry. The finance director has informed you that as the cash flow issues
are short term he does not propose to make any amendments to the financial statements.

(d):
(i) State Kiwi & Co.’s responsibility for reporting on going concern to the directors of Strawberry
Kitchen Designs Ltd; and (2 marks)
(ii) If the directors refuse to amend the financial statements, describe the impact on the audit report.

(3 marks)

(20 marks)

Clarinet Co
Clarinet Co (Clarinet) is a computer hardware specialist and has been trading for over five years. The
company is funded partly through overdrafts and loans and also by several large shareholders; the year
end is 30 April 2014.

Clarinet has experienced significant growth in previous years; however, in the current year a new
competitor, Drums Design Co (Drums), has entered the market and through competitive pricing has
gained considerable market share from Clarinet. One of Clarinet’s larger customers has stopped trading
with them and has moved its business to Drums. In addition, a number of Clarinet’s specialist developers
have left the company and joined Drums. Clarinet has found it difficult to replace these employees due
to the level of their skills and knowledge. Clarinet has just received notification that its main supplier
who provides the company with specialist electrical equipment has ceased to trade.

Clarinet is looking to develop new products to differentiate itself from the rest of its competitors. It has
approached its shareholders to finance this development; however, they declined to invest further in
Clarinet. Clarinet’s loan is long term and it has met all repayments on time. The overdraft has increased
significantly over the year and the directors have informed you that the overdraft facility is due for
renewal next month, and they are confident it will be renewed. The directors have produced a cash flow
forecast which shows a significantly worsening position over the coming 12 months. They are confident
with the new products being developed, and in light of their trading history of significant growth, believe
it is unnecessary to make any disclosures in the financial statements regarding going concern.

At the year end, Clarinet received notification from one of its customers that the hardware installed by
Clarinet for the customers’ online ordering system has not been operating correctly. As a result, the
customer has lost significant revenue and has informed Clarinet that they intend to take legal action
against them for loss of earnings. Clarinet has investigated the problem post year end and discovered
that other work-in-progress is similarly affected and inventory should be written down. The finance
director believes that as this misstatement was identified after the year end, it can be amended in the
2015 financial statements.

Required:

(a) Describe the procedures the auditors of Clarinet Co should undertake in relation to the
uncorrected inventory misstatement identified above. (4 marks)

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(b) Explain SIX potential indicators that Clarinet Co is not a going concern. (6 marks)

(c) Describe the audit procedures which you should perform in assessing whether or not Clarinet Co is
a going concern. (6 marks)

(d) The auditors have been informed that Clarinet’s bankers will not make a decision on the overdraft
facility until after the audit report is completed. The directors have now agreed to include some going
concern disclosures.

Required:
Describe the impact on the audit report of Clarinet Co if the auditor believes the company is a going
concern but that this is subject to a material uncertainty. (4 marks)

(20 marks)

Medimade Co
(a) Describe Going concern assumption (2 marks)

Medimade Co is an established pharmaceutical company that has for many years generated 90% of its
revenue through the sale of two specific cold and flu u remedies. Medimade has lately seen a real
growth in the level of competition that it faces in its market and demand for its products has
significantly declined. To make matters worse, in the past the company has not invested sufficiently in
new product development and so has been trying to remedy this by recruiting suitably trained scientific
staff, but this has proved more difficult than anticipated.

In addition to recruiting staff the company also needed to invest $2m in plant and machinery. The
company wanted to borrow this sum but was unable to agree suitable terms with the bank; therefore it
used its overdraft facility, which carried a higher interest rate. Consequently, some of Medimade’s
suppliers have been paid much later than usual and hence some of them have withdrawn credit terms
meaning the company must pay cash on delivery. As a result of the above the company’s overdraft
balance has grown substantially.

The directors have produced a cash flow forecast and this shows a significantly worsening position over
the coming 12 months.

The directors have informed you that the bank overdraft facility is due for renewal next month, but they
are confident that it will be renewed. They also strongly believe that the new products which are being
developed will be ready to market soon and hence trading levels will improve and therefore that the
company is a going concern. Therefore they do not intend to make any disclosures in the accounts
regarding going concern.

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Required:

(b) Identify any potential indicators that the company is not a going concern and describe why these
could impact upon the ability of the company to continue trading on a going concern basis. (8 marks)

(c) Explain the audit procedures that the auditor of Medimade should perform in assessing whether or
not the company is a going concern. (6 marks)

(d) The auditors have been informed that Medimade’s bankers will not make a decision on the
overdraft facility until after the audit report is completed. The directors have now agreed to include
going concern disclosures.

Required:
Describe the impact on the audit report of Medimade if the auditor believes the company is a going
concern but a material uncertainty exists. (4 marks)

(20 marks)

WRITTEN REPRESENTATIONS

Written representations are written statements by management provided to the auditor to confirm
certain matters or to support other audit evidence. They do not include the financial statements,
assertions or supporting books and records.

3.1 Written representations about management’s responsibilities

The auditor shall request management to provide written representations on the following matters.

(a) The management has fulfilled its responsibility for the preparation and presentation of the
financial statements as se out in the terms of the audit engagement and whether the financial
statements are prepared and presented in accordance with the applicable financial reporting
framework.
(b) That management has provided the auditor with all relevant information agreed in the terms of
the audit engagement and that all transactions have been recorded and are reflected in the
financial statements.

3.2 Other written representations

Other ISAs require written representations on specific issues but if the auditor considers it necessary
to obtain representations in addition to these to support other audit evidence, the auditor shall
request these other written representations.

The following table includes examples of other written representations.

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Other written representations
Whether the selection and application of accounting policies are appropriate
Plans or intentions that may affect the carrying value or classification of assets and liabilities
Liabilities, both actual and contingent
Title to, or control over, assets, liens or encumbrances on assets and assets pledged as collateral
Aspects of laws, regulations and contractual agreements that may affect the financial statements,
including non-compliance
All deficiencies in internal control that management is aware of have been communicated to the
auditor
Written representations about specific assertions in the financial statements
Significant assumptions used in making accounting estimates are reasonable
All subsequent events requiring adjustment or disclosure have been adjusted or disclosed
The effects of uncorrected misstatements are immaterial, both individually and in aggregate
Management has disclosed all information in relation to fraud or suspected fraud involving
management, employees with significant roles in internal control, and others where fraud could
have a material effect on the financial statements
Management has disclosed all information in relation to allegations of fraud or suspected fraud
communicated by employees, former employees, analysts, regulators or others
Management has disclosed all instances of non-compliance or suspected non-compliance with laws
or regulations

3.3 Quality and reliability of written representations as audit evidence

In Chapter 8 we looked at the quality of audit evidence and pointed out that written
representations are more reliable than oral representations, since oral representations can be
retracted.

However, although written representations are a form of audit evidence, they are from an internal
source and on their own they do not provide sufficient appropriate audit evidence about the issues
they relate to.

In addition, the fact that management has provided reliable written representations does not affect
the nature or extent of other audit evidence obtained by the auditor regarding the fulfillment of
management’s responsibilities, or about specific assertions in the financial statements.

You will have noted at the start of Section 3 on the objectives of the auditor regarding written
representations that the second objective is ‘to support other audit evidence…’ This is because
although written representations are necessary, they cannot provide sufficient appropriate audit
evidence when they stand alone.

3.4 Obtaining written representations

The written representations are usually obtained in the form of a letter addressed to the auditor.

Throughout the course of the audit, the auditors will determine those items on which written
representations are required and should inform management of those areas on which they will be
seeking written representations.

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At the finalization and review stage the auditors will provide management with a draft written
representation containing the necessary representations. The auditors will then ask management to
print the letter on their headed paper, review the representations, and sign the documents and

Questions:

Greenfields Co
Greenfields Co specializes in manufacturing equipment which can help to reduce toxic emissions in the
production of chemicals. The company has grown rapidly over the past eight years and this is due partly
to the warranties that the company gives to its customers. It guarantees its products for five years and if
problems arise in this period it undertakes to fix them, or provide a replacement product. You are the
manager responsible for the audit of Greenfields and you are performing the final review stage of the
audit and have come across the following two issues.

Receivable balance owing from Yellowmix Co

Greenfields has a material receivable balance owing from its customer, Yellowmix Co. During the year-
end audit, your team reviewed the ageing of this balance and found that no payments had been
received from Yellowmix for over six months, and Greenfields would not allow this balance to be
circularized. Instead management has assured your team that they will provide a written representation
confirming that the balance is recoverable.

Warranty provision
the warranty provision included within the statement of financial position is material. The audit team
has performed testing over the calculations and assumptions which are consistent with prior years. The
team has requested a written representation from management confirming the basis and amount of the
provision are reasonable. Management has yet to confirm acceptance of this representation.

Required:
(a) Describe the audit procedures required in respect of accounting estimates. (5 marks)
(b) For each of the two issues above:
(i) Discuss the appropriateness of written representations as a form of audit evidence; and (4 marks)
(ii) Describe additional procedures the auditor should now perform in order to reach a conclusion on
the balance to be included in the financial statements. (6 marks)

Note: The total marks will be split equally between each issue.
(c) The directors of Greenfields have decided not to provide the audit firm with the written
representation for the warranty provision as they feel that it is unnecessary.

Required:
Explain the steps the auditor of Greenfields Co should now take and the impact on the audit report in
relation to the refusal to provide the written representation. (5 marks)

(20 marks)

HIL INDUSTRIES:
HIL is a manufacturer of household appliances. Its products are usually popular because company
provides a three year warranty.

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HIL’s auditor has verified that the basis for arriving at warranty provision Is same as last year, however
he has requested a written representation from management on this. The management has yet to
confirm acceptance of this representation.

Required:

Discuss the importance of written representation and the steps auditor should take and the impact on
audit report if management refuses to give written representation (5 marks)

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SAMPLE MANAGEMENT LETTER

ABC & Co

Certified Accountants

The Board of Directors

Manufacturing Ltd
15 South Street

Members of the board,

Financial statements for the year ended 31 May 20X8

Please find below the report to management which includes sets out deficiencies in internal control we
identified as a result of our review of the accounting systems and procedures operated by your company
during our recent audit. The matters dealt with in the report came to our notice during the conduct of
our normal audit procedures which are designed primarily for the purpose of expressing our opinion on
the financial statements.
Purchases: ordering procedures

Deficiency
During the course of our work we discovered that it was the practice of the stores to order certain goods
from X Co orally without preparing either a purchase requisition or purchase order.

Implication
There is therefore the possibility of liabilities being set up for unauthorized items and at a non-
competitive price.

Recommendation
We recommend that the buying department should be responsible for such orders and, if they are
placed orally, an official order should be raised as confirmation.

Payables ledger reconciliation

Deficiency
Although your procedures require that the payables ledger is reconciled against the control account on
the nominal ledger at the end of every month, this was not done in December or January.

Implication
The balance on the payables ledger was short by some $2,120 of the nominal ledger control account at
31 January 20X8 for which no explanation could be offered. This implies a serious breakdown in the
purchase invoice and/or cash payment batching and posting procedures.

Recommendation

It is important in future that this reconciliation is performed regularly by a responsible official

independent of the day-to-day payables ledger, cashier and nominal ledger functions.

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Receivables ledger: credit control
Deficiency
As at 28 February 20X8 trade receivables accounted for approximately 12 weeks of sales, although your standard
credit terms are cash within 30 days of statement, equivalent to an average of about 40 days (6 weeks ) of sales.

Implication

This has resulted in increased overdraft usage and difficulty in settling some key suppliers’ accounts on time.

Recommendation

We recommend that a more structured system of debt collection be considered using standard letters and that
statements should be sent out a week earlier at possible.

Preparation of payroll and maintenance of personnel records

Deficiency

Under your present system, just two members of staff are entirely and equally responsible for the maintenance of
personnel records and preparation of the payroll. Furthermore, the only independent check of any nature on the
payroll is that the chief accountant confirms that the amount of the wages cheque could be presented to him for
signature agrees with total of the net wages column in the payroll. This latter check does not involve any
consideration of the reasonableness of the amount of the total net wages cheque or the monies being shown as due
to individual employees.

Implication

It is a serious weakness of your present system that so much responsibility is vested in the hands of just two people.
This situation is made worse by the fact that there is no clearly defined division of the duties between the two of
them. In our opinion, it would be far too easy for fraud to take place in this area (e.g; by inserting the names of
‘dummy workmen’ into the personnel records and hence on to the payroll and/or for clerical errors to go
undetected.

Recommendations

i. Some person other than two wages clerks be made responsible for maintaining the personnel records and
for periodically (but on a surprise basis (checking them against the details on the payroll.
ii. The two wages clerks be allocated specific duties in relation to the preparation of the payroll, with each
clerk independently reviewing the work of the other.
iii. When the payroll is presented in support of the cheque for signature to the chief accountant, he should be
responsible for assessing the reasonableness for the overall charge for wages that week.

Please note that this report only sets out those significant deficiencies identified during our audit. If more extensive
procedures on internal control had been carried out, we have identified and reported more deficiencies.

This letter has been produced for the sole use of our company. It must not be disclosed to a third party, or quoted
or referred to, without our written consent. No responsibility is assumed by us to any other person.

We should like to take this opportunity of thanking your staff for their co-operation and assistance during the
course of our audit.

Yours faithfully
ABC & Co

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INTERNAL CONTROLS
CONTROL OBJECTIVES OF DIFFERENT SYSTEMS

Sales system Purchase system Inventory system Bank and cash Payroll system
system
1. To ensure all To ensure all To ensure all To ensure cash To ensure payroll
sales purchase purchase/sale of receipts or transactions are
transactions are transactions are inventory are payments are recorded in
recorded in recorded in recorded in recorded in correct
correct correct correct correct accounting
accounting accounting accounting accounting period
period period period period
2. To ensure all To ensure all To ensure all To ensure cash To ensure payroll
sales purchase purchase/sale of receipts or transactions are
transactions are transactions are inventory have payments are recorded in
correctly correctly been recorded in charged to correct
recorded in recorded in accounting correct accounting
accounting accounting system accounting system
system system system
3. To ensure To ensure To ensure To ensure all To ensure all
recorded sales recorded recorded cash receipts and payroll costs are
represent gods purchase inventory payments are recorded
or services represent goods represent recorded
provided or services inventory that
received physically exists
4. To ensure one To ensure one To ensure all To ensure all To ensure
person is not person is not inventory cash payments payments are
responsible for responsible for movements have are authorized only made to
taking orders, making orders, been authorized bonfire
recording sales recording employees
and receiving purchase and
payments giving payment

INTERNAL CONTROL SYSYTEMS

The auditors must understand the accounting system and control environment in order to determine
their audit approach.

Internal control is the process designed and affected by those charged with governance, management,
and other personnel to provide reasonable assurance about the achievement of the entity’s objectives
with regard to reliability of financial reporting, effectiveness and efficiency of operations and
compliance with applicable laws and regulations.

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Internal control has five components:
x The control environment
x The entity’s risk assessment process
x The information system relevant to financial reporting
x Control activities
x Monitoring of controls

INTERNAL CONTROL COMPONENTS:

ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity
and Its Environment considers the components of an entity’s internal control. It identifies the following
components:

1. Control environment

The control environment includes the governance and management functions and the attitudes,
awareness, and actions of those charged with governance and management concerning the entity’s
internal control and its importance in the entity. The control environment sets the tone of an
organization, influencing the control consciousness of its people.

The control environment has many elements such as communication and enforcement of integrity and
ethical values, commitment to competence, participation of those charged with governance,
management’s philosophy and operating style, organizational structure, assignment of authority and
responsibility and human resource policies and practices.

2. Entity’s risk assessment process

For financial reporting purposes, the entity’s risk assessment process includes how management
identifies business risks relevant to the preparation of financial statements in accordance with the
entity’s applicable financial reporting framework. It estimates their significance, assesses the likelihood
of their occurrence, and decides upon actions to respond to and manage them and the results thereof.

3. Information system, including the related business processes, relevant to financial reporting,
and communication

The information system relevant to financial reporting objectives, which includes the accounting system,
consists of the procedures and records designed and established initiate, record, process, and report
entity transactions (as well as events and conditions) and to maintain accountability for the related
assets, liabilities and equity.

4. Control activities relevant to the audit

Control activities are the policies and procedures which help ensure that management directives are
carried out. Control activities, whether within information technology or manual systems, have various
objectives and are applied at various organizational and functional levels.

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5. Monitoring of controls

Monitoring of controls is a process to assess the effectiveness of internal control performance over
time. It involves assessing the effectiveness of controls in a timely basis and taking necessary remedial
actions. Management accomplishes the monitoring of controls through ongoing activities, separate
evaluations, or a combination of the two. Ongoing monitoring activities are often built into the normal
recurring activities of an entity and include regular management and supervisory activities.

1.7 Limitations of accounting and control systems

Any internal control system can only provide the directors with reasonable assurance that their
objectives are reached, because of inherent limitations. These include:

x The costs of control not overweighing their benefits

x The potential for human error
x Collusion between employees
x The possibility of controls being bypassed or overridden by management
x Controls being designed to cope with routine and not non-routine transactions

Matters to consider by auditor in deciding whether deficiency in internal control is significant

x The amounts exposed to deficiencies

x The volume of activity that has occurred or could occur
x The importance of the controls to the financial reporting process
x The cause and frequency of the expectations identified as a result of the deficiencies
x The interaction of the deficiency with other deficiencies in internal control

Indicators of significant deficiencies in internal control

x Evidence of ineffective aspects of the control environment

x Absence of a risk assessment process
x Evidence of an ineffective entity risk assessment process
x Evidence of an ineffective response to identified significant risks
x Misstatements detected by the auditor’s procedures that were not prevented, or detected and
corrected, by the entity’s internal control
x Restatement of previously issued financial statements that were corrected for a material
misstatement due to fraud or error
x Evidence of management’s inability to oversee the preparation of the financial statements.

The auditor shall communicate any significant deficiencies in internal control to those charged with
governance on a timely basis. The auditor shall also communicate in writing to management on timely
basis significant deficiencies in internal control that the auditor has communicated or intends to.

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General IT controls are policies and procedures that relate to many applications and support the
effective functioning of application controls by helping to ensure the continued proper operation of
information systems. They commonly include controls over data centre and network operations, system
software acquisition, change and maintenance, access security, and application system acquisition,
development and maintenance.

Application controls are manual or automated procedures that typically operate at a business process
level. They can be preventive or detective in nature and are designed to ensure the integrity of the
accounting records. Accordingly, they relate to procedures used to initiate, record, process and report
transactions or other financial data.

METHODS OF DOCUMENTING INTERNAL CONTROL SYSTEM:

There are 4 methods of documenting internal controls which include:

1) Narrative notes
2) Flowcharts
3) Questionnaires
4) Checklists

1. Narrative notes

Narrative consists of a written description of the system; they would detail what occurs in the system at
each stage and would include any controls which operate at each stage.

Advantages of this method include:

9 They are simple to record; after discussion with staff members

9 They can facilitate understanding by all members of the internal audit team, especially more
junior members who might find alternative methods too complex.

Disadvantages of this method include:

9 Narrative notes may prove to be too cumbersome, especially if the system is too complex.
9 This method can make it more difficult to identify missing internal controls as the notes
record the detail but do not identify control exceptions clearly.
2. Questionnaire

Internal control questionnaire (ICQ) or internal control evaluation questionnaire (ICEQ) contain a list of
questions; ICQs are used to assess whether control exist whereas ICEQs test the effectiveness of the
controls.

Advantages of this method include:

9 Questionnaires are quick to prepare, which means they are a timely method for recording the
system.
9 They ensure that all controls present within the system are considered and recorded; hence
missing controls or deficiencies are clearly highlighted by the internal audit team.

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Disadvantages of this method include:

9 It can be easy for the staff members to overstate the level of controls present as they are asked
a series of questions relating to potential controls.
9 A standard list of questions may miss out unusual controls.

3. Flowcharts

Flowcharts are a graphic illustration of the internal control system for the system. Lines usually
demonstrate the sequence of events and standard symbols are used to signify controls or documents.

Advantages of this method include:

9 It is easy to view the system in its entirety as it is all presented together in one diagram.
9 Due to the use of standard symbol for controls, they are easy to spot as are any missing
controls.

Disadvantages of this method include:

9 They can sometimes be difficult to amend, as any amendments may require the whole flowchart
to be redrawn.
9 There is still the need for narrative notes to accompany the flowchart and hence it can be a time
consuming method.

GENERAL WEAKNESS IN SALES SYSTEM

¾ Lack of segregation of duties.
¾ Manual work being done.
¾ Credit limits only set when new customer comes and not updated.
¾ Credit limits not set by senior levels
¾ Any document not being sequentially numbered
¾ Sales involves raised before goods are dispatched.
¾ Important work is done by clerk level employee.
¾ Sending statements to customers not regularly.
¾ Reconciliation not being done regularly.
¾ Accepting orders on telephone
¾ Customers exceeding credit limit without any authorization.
¾ Not checking stock availability at the time of receiving order.
¾ Discounts not authorized by senior level managers.
¾ Not checking goods dispatched with purchase order.
¾ Writing order details on a plain paper.
¾ Using cheap courier companies.
¾ Website not integrated with inventory system.
¾ Dispatched goods not recorded in GDN
¾ Key documents (invoices, GDN) lacking signature.

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GENERAL WEAKNESS IN PURCHASE SYSTEM
¾ Purchase order not sequentially numbered.
¾ Purchase order not being authorized or only purchase order above a certain amount being
authorized.
¾ Not using any approved supplier, ordering anyone.
¾ Unnecessary delaying payments to supplier.
¾ Senior personnel only viewing total payments, not the whole list.
¾ Reconciliation not on a regular basis.
¾ Invoices manually checked against GRN.
¾ Goods being received without checking. Against purchase order.
¾ On receiving goods just checking quantity not quality.
¾ Accepting goods without checking.
¾ Not facilitating customers in case stocks finished.
¾ Placing orders without consulting sales manager.
¾ Purchase order not authorized or authorized by a single person.
¾ Inventory records not perpetual.
¾ GRN prepared by low level staff.

PAST PAPER QUESTIONS

Oregano Co
You are a member of the recently formed internal audit department of Oregano Co (Oregano). The
company manufactures tinned fruit and vegetables which are supplied to large and small food retailers.
Management and those charged with governance of Oregano have concerns about the effectiveness of
their sales and despatch system and have asked internal audit to document and review the system.

Sales and despatch system

Sales orders are mainly placed through Oregano’s website but some are made via telephone. Online
orders are automatically checked against inventory records for availability; telephone orders, however,
are checked manually by order clerks after the call. A follow-up call is usually made to customers if there
is insufficient inventory. When taking telephone orders, clerks note down the details on plain paper and
afterwards they complete a three part pre-printed order form. These order forms are not sequentially
numbered and are sent manually to both despatch and the accounts department.

As the company is expanding, customers are able to place online orders which will exceed their agreed
credit limit by 10%. Online orders are automatically forwarded to the despatch and accounts
department.

A daily pick list is printed by the despatch department and this is used by the warehouse team to
despatch goods. The goods are accompanied by a despatch note and all customers are required to sign a
copy of this. On return, the signed despatch notes are given to the warehouse team to file.

The sales quantities are entered from the despatch notes and the authorised sales prices are generated
by the invoicing system. If a discount has been given, this has to be manually entered by the sales clerk
onto the invoice. Due to the expansion of the company, and as there is a large number of sale invoices,

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extra accounts staff have been asked to help out temporarily with producing the sales invoices.
Normally it is only two sales clerks who produce the sales invoices.

Required:

(a) Describe TWO methods for documenting the sales and despatch system; and for each explain an
advantage and a disadvantage of using this method. (6 marks)
(b) List TWO control objectives of Oregano Co’s sales and despatch system. (2 marks)
(c) Identify and explain SIX deficiencies in Oregano Co’s sales and despatch system and provide a
recommendation to address each of these deficiencies. (12 marks)
(20 marks)

Hummingbird Co
Hummingbird Scents Co (Hummingbird) manufactures and sells luxury toiletries; they have been trading
for over 20 years and the company’s yearend is 30 September 2014. Hummingbird sells products to
trade customers via its own website; this represents 60% of revenue. Remaining revenue is generated
by contracts to supply toiletries to hotels. Below is a description of the sales system.

Hotel revenue
The hotel revenue is made up of four key customers. Hummingbird has one sales clerk, Brenda, who
maintains all aspects of this revenue stream; Brenda receives customer orders, raises sales invoices and
processes payments. In raising invoices, the sales system automatically inserts the online trade customer
prices for products. However, each hotel customer has contracted prices which are lower than the
online prices and hence Brenda manually edits the invoices prior to dispatch.

Online revenue
New trade customers are set up in the sales ledger master file upon passing suitable credit checks, and a
credit limit is set at this stage by the finance director. Customers place online orders up to their pre-set
credit limit; they receive an email confirmation and the sales order interfaces into the despatch system.
The order number is linked to the customer account number. Goods are despatched daily with a goods
despatched note which is referenced to the sales order number but are not sequentially numbered.
Hummingbird used to despatch goods via a reliable national courier company. However, to reduce costs
they have changed to a cheaper local courier and some orders have been delivered to customers late.

Trade customers’ sales invoices are automatically generated by the system on the day the online order
is placed. The prices are inserted in accordance with the website rates. Occasionally Hummingbird
makes special offers or discounts sales; when this occurs the master file data has to be amended to
ensure that the correct prices are used on invoices. This task is usually performed by a senior sales
ledger clerk.

Revenue and receivables records

On a monthly basis statements are sent to the hotel customers; a number of trade customers have been
requesting monthly statements and Hummingbird is considering this request. The company only
reconciles the sales ledger control account at the end of September in order to verify the year-end
balance.

Required:
(a) As the external auditor of Hummingbird Co, write a report to management in respect of the sales
system described above which:

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(i) Identifies and explains SEVEN deficiencies in the sales system; and
(ii) Provides a recommendation to address each of these deficiencies.

A covering letter IS required.

Note: Up to two marks will be awarded within this requirement for presentation and the remaining
marks will be split equally between each part. (16 marks)

Pear International Co
Pear International Co (Pear) is a manufacturer of electrical equipment. It has factories across the country
and its customer base includes retailers as well as individuals, to whom direct sales are made through
their website. The company’s yearend is 30 September 2012. You are an audit supervisor of Apple & Co
and are currently reviewing documentation of Pear’s internal control in preparation for the interim
audit.

Pear’s website allows individuals to order goods directly, and full payment is taken in advance. Currently
the website is not integrated into the inventory system and inventory levels are not checked at the time
when orders are placed.

Goods are dispatched via local couriers; however, they do not always record customer signatures as
proof that the customer has received the goods. Over the past 12 months there have been customer
complaints about the delay between sales orders and receipt of goods. Pear has investigated these and
found that, in each case, the sales order had been entered into the sales system correctly but was not
forwarded to the despatch department for fulfilling.

Pear’s retail customers undergo credit checks prior to being accepted and credit limits are set
accordingly by sales ledger clerks. These customers place their orders through one of the sales team,
who decides on sales discount levels.

Raw materials used in the manufacturing process are purchased from a wide range of suppliers. As a
result of staff changes in the purchase ledger department, supplier statement reconciliations are no
longer performed. Additionally, changes to supplier details in the purchase ledger master file can be
undertaken by purchase ledger clerks as well as supervisors.

In the past six months Pear has changed part of its manufacturing process and as a result some new
equipment has been purchased, however, there are considerable levels of plant and equipment which
are now surplus to requirement. Purchase requisitions for all new equipment have been authorized by
production supervisors and little has been done to reduce the surplus of old equipment.

Required:
In respect of the internal control of Pear International Co:
(i) Identify and explain FIVE deficiencies;
(ii) Recommend a control to address each of these deficiencies; and
(iii) Describe a test of control Apple & Co would perform to assess if each of these controls is
operating effectively. (15 marks)

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Describe substantive procedures you should perform at the year end to confirm each of the following
for plant and equipment:
(i) Additions; and
(ii) Disposals. (4 marks)
Identify and explain the level of assurance provided by an external audit and other review
engagements. (3 marks)

Fox Industries
(a) ISA 260 Communication with Those Charged with Governance provides guidance to auditors in
relation to communicating with those charged with governance on matters arising from the audit of an
entity’s financial statements.

Required:
(i) Explain why it is important that auditors communicate throughout the audit with those charged
with governance; and (2 marks)
(ii) Describe THREE examples of matters that the auditors may communicate to those charged with
governance. (3 marks)

Introduction
Fox Industries Co (Fox) manufactures engineering parts. It has one operating site and a customer base
spread across Europe. The company’s year-end was 30 April 2013. Below is a description of the
purchasing and payments system.

Purchasing system
whenever production materials are required, the relevant department sends a requisition form to the
ordering department. An order clerk raises a purchase order and contacts a number of suppliers to see
which can despatch the goods first. This supplier is then chosen. The order clerk sends out the purchase
order. This is not sequentially numbered and only orders above $5,000 require authorisation.
Purchase invoices are input daily by the purchase ledger clerk, who has been in the role for many years
and, as an experienced team member, he does not apply any application controls over the input
process. Every week the purchase day book automatically updates the purchase ledger, the purchase
ledger is then posted manually to the general ledger by the purchase ledger clerk.

Payments system
Fox maintains a current account and a number of saving (deposit) accounts. The current account is
reconciled weekly but the saving (deposit) accounts are only reconciled every two months.

In order to maximise their cash and bank balance, Fox has a policy of delaying payments to all suppliers
for as long as possible. Suppliers are paid by a bank transfer. The finance director is given the total
amount of the payments list, which he authorises and then processes the bank payments.

Required:
(b) As the external auditors of Fox Industries Co, write a report to management in respect of the
purchasing and payments system described above which:
(i) Identifies and explains FOUR deficiencies in the system; and
(ii) Explains the possible implication of each deficiency; and
(iii) Provides a recommendation to address each deficiency.
A covering letter IS required.

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Note: Up to two marks will be awarded within this requirement for presentation and the remaining
marks will be split equally between each part. (14 marks)

(c) Identify and explain FOUR application controls that should be adopted by Fox Industries Co to
ensure the completeness and accuracy of the input of purchase invoices. (4 marks)
(d) Describe substantive procedures the auditor should perform to confirm the bank and cash balance
of Fox Industries Co at the year end. (7 marks)

Cherry Blossom Co
Cherry Blossom Co (Cherry) manufactures custom made furniture and its year end is 30 April. The
company purchases its raw materials from a wide range of suppliers. Below is a description of Cherry’s
purchasing system.

When production supervisors require raw materials, they complete a requisition form and this is
submitted to the purchase ordering department. Requisition forms do not require authorisation and no
reference is made to the current inventory levels of the materials being requested. Staff in the purchase
ordering department uses the requisitions to raise sequentially numbered purchase orders based on the
approved suppliers list, which was last updated 24 months ago. The purchasing director authorises the
orders prior to these being sent to the suppliers.

When the goods are received, the warehouse department verifies the quantity to the suppliers despatch
note and checks that the quality of the goods received are satisfactory. They complete a sequentially
numbered goods received note (GRN) and send a copy of the GRN to the finance department.

Purchase invoices are sent directly to the purchase ledger clerk, who stores them in a manual file until
the end of each week. He then inputs them into the purchase ledger using batch controls and gives each
invoice a unique number based on the supplier code. The invoices are reviewed and authorised for
payment by the finance director, but the actual payment is only made 60 days after the invoice is input
into the system.

Required:
In respect of the purchasing system of Cherry Blossom Co:
(i) Identify and explain FIVE deficiencies; and
(ii) Recommend a control to address each of these deficiencies.
Note: The total marks will be split equally between each part.

(10 marks)

GENERAL WEAKNESSES IN PAYROLL SYSTEM

¾ No segregation of duties in payroll and HR department.
¾ No personnel files maintained for employees.
¾ No review and authorization of overtime hours.
¾ No formal approval and communication of increments and promotions.
¾ No monitoring of clocking in card process.
¾ No check on wages calculations generated by system.
¾ Rate increment decision only taken by HR department and not by the board.
¾ Pay slips are handwritten.

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¾ Pay packets are handed over to supervisors.

¾ Pay packets are handed on day before weekends i.e. Friday.
¾ No notification of leavers by HR department to payroll departments on timely basis.
¾ Major calculations done by clerks.
¾ Overtime not authorized or only authorized above a certain limit.
¾ Senior personnel only checking total calculations not each employee.
¾ Wages system in the hands of one or two staff members.
¾ Cash in the hands of clerical staff.
¾ Handwritten documents i.e. not computerized.

GENERAL WEAKNESS IN INVENTORY SYSTEM

¾ No segregation of duties.
¾ Warehouse manager involved in other tasks as well.
¾ Movement of goods continuing during inventory count.
¾ Damaged goods not clearly identified.
¾ Inventory sheets not sequentially numbered.
¾ Inventory sheets not signed by counting team.
¾ Not marking items as “complete” after counting.
¾ Internal audit involved in inventory count.
¾ Warehouse manager supervising inventory count.
¾ Amendment possible on count sheets.
¾ Stores personnel counting inventory.
¾ Count teams allowed deciding which areas to count.

Chuck Industries Co
Introduction and client background

You are the audit senior of Blair & Co and your team has just completed the interim audit of Chuck
Industries Co, whose year end is 31 January 2012. You are in the process of reviewing the systems
testing completed on the payroll cycle, as well as preparing the audit programmes for the final audit.

Chuck Industries Co manufactures lights and the manufacturing process is predominantly automated;
however there is a workforce of 85 employees, who monitor the machines, as well as approximately 50
employees who work in sales and administration. The company manufactures 24 hours a day seven days
a week.

Below is a description of the payroll system along with deficiencies identified by the audit team:

Factory workforce

The company operates three shifts every day with employees working eight hours each. They are
required to clock in and out using an employee swipe card, which identifies the employee number and
links into the hours worked report produced by the computerized payroll system. Employees are paid on

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an hourly basis for each hour worked. There is no monitoring/supervision of the clocking in/out process
and an employee was witnessed clocking in several employees using their employee swipe cards.

The payroll department calculates on a weekly basis the cash wages to be paid to the workforce, based
on the hours worked report multiplied by the hourly wage rate, with appropriate tax deductions. These
calculations are not checked by anyone as they are generated by the payroll system. During the year the
hourly wage was increased by the Human Resources (HR) department and this was notified to the
payroll department verbally.

Each Friday, the payroll department prepares the pay packets and physically hands these out to the
workforce, who operate the morning and late afternoon shifts, upon production of identification.
However, for the night shift workers, the pay packets are given to the factory supervisor to distribute. If
any night shift employees are absent on pay day then the factory supervisor keeps these wages and
returns them to the payroll department on Monday.

Sales and administration staff

the sales and administration staff is paid monthly by bank transfer. Employee numbers do fluctuate and
during July two administration staff joined; however, due to staff holidays in the HR department, they
delayed informing the payroll department, resulting in incorrect salaries being paid out.

Required:

(a) For the deficiencies already identified in the payroll system of Chuck Industries Co:
(i) explain the possible implications of these; and
(ii) suggest a recommendation to address each deficiency. (12 marks)

(b) Describe substantive procedures you should now perform to confirm the accuracy and
completeness of Chuck Industries’ payroll charge. (6 marks)

(c) Last week the company had a visit from the tax authorities who reviewed the wages calculations
and discovered that incorrect levels of tax had been deducted by the payroll system, as the tax rates
from the previous year had not been updated. The finance director has queried with the audit team
why they did not identify this non-compliance with tax legislation during last year’s audit.

Required:
Explain the responsibilities of management and auditors of Chuck Industries Co in relation to
compliance with law and regulations under ISA 250 Consideration of Laws and Regulations in an Audit
of Financial Statements.
(4 marks)

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Trombone Co
Trombone Co (Trombone) operates a chain of hotels across the country. Trombone employs in excess of
250 permanent employees and its year end is 31 August 2014. You are the audit supervisor of Viola & Co
and are currently reviewing the documentation of Trombone’s payroll system, detailed below, in
preparation for the interim audit.

Trombone’s payroll system

Permanent employees work a standard number of hours per week as specified in their employment
contract. However, when the hotels are busy, staff can be requested by management to work additional
shifts as overtime. This can either be paid on a monthly basis or taken as days off.

Employee’s record any overtime worked and days taken off on weekly overtime sheets which are sent to
the payroll department. The standard hours per employee are automatically set up in the system and
the overtime sheets are entered by clerks into the payroll package, which automatically calculates the
gross and net pay along with relevant deductions. These calculations are not checked at all. Wages are
increased by the rate of inflation each year and the clerks are responsible for updating the standing data
in the payroll system.

Employees are paid on a monthly basis by bank transfer for their contracted weekly hours and for any
overtime worked in the previous month. If employees choose to be paid for overtime, authorisation is
required by department heads of any overtime in excess of 30% of standard hours. If employees choose
instead to take days off, the payroll clerks should check back to the ‘overtime worked’ report; however,
this report is not always checked.

The ‘overtime worked’ report, which details any overtime recorded by employees, is run by the payroll
department weekly and emailed to department heads for authorisation. The payroll department asks
department heads to only report if there are any errors recorded. Department heads are required to
arrange for overtime sheets to be authorised by an alternative responsible official if they are away on
annual leave; however, there are instances where this arrangement has not occurred.

The payroll package produces a list of payments per employee; this links into the bank system to
produce a list of automatic payments. The finance director reviews the total list of bank transfers and
compares this to the total amount to be paid per the payroll records; if any issues arise then the
automatic bank transfer can be manually changed by the finance director.

Required:
(a) in respect of the payroll system of Trombone Co:

(i) Identify and explain FIVE deficiencies;

(ii) Recommend a control to address each of these deficiencies; and
(iii) Describe a test of control Viola & Co should perform to assess if each of these controls is operating
effectively.. (15 marks)

(b) Explain the difference between an interim and a final audit. (5 marks)
(c) Describe substantive procedures you should perform at the final audit to confirm the
completeness and accuracy of Trombone Co’s payroll expense. (6 marks)

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Bonsai Trading Co
(a) ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the
Entity and Its Environment describes the five components of an entity’s internal control.

Required:

Identify and briefly explain the FIVE components of an entity’s internal control. (5 marks)

(b) Bonsai Trading Co (Bonsai) manufactures electrical equipment, and its year end is 30 September
2015. You are the audit supervisor of Poplar & Co and are developing the audit programmes for the
forthcoming interim audit. The company’s internal audit department has provided you with
documentation relating to the non-current assets cycle including the related controls listed below.
– Bonsai has a capital expenditure committee and all purchase orders for capital items are required to
be authorised by this committee.
– On receipt, each asset is assigned a unique serial number and this is recorded on the asset and in the
non-current assets register.
– When the asset arrives, a goods received note (GRN) is completed which details the nature of the
expenditure (i.e. whether it is capital or revenue), and the GRN classification is reviewed and initialed by
a responsible official. Copies of the GRNs relating to capital expenditure are then submitted to the
finance department for updating of the non-current assets register.
– Periodically, internal audit undertakes a review of assets in the register and compares them to assets
on site, using the serial number to confirm existence of the asset.
– Access to the non-current assets register is restricted through passwords to a small number of staff in
the finance department.

Required:
Describe a test of control which the auditor of Bonsai Trading Co would perform to assess whether or
not each of the non-current asset controls listed above is operating effectively. (5 marks)

(10 marks)

Lily Window Glass Co

Lily Window Glass Co (Lily) is a glass manufacturer, which operates from a large production facility,
where it undertakes continuous production 24 hours a day, seven days a week. Also on this site are two
warehouses, where the company’s raw materials and finished goods are stored. Lily’s year end is 31
December.

Lily is finalising the arrangements for the year-end inventory count, which is to be undertaken on 31
December 2012. The finished windows are stored within 20 aisles of the first warehouse. The second
warehouse is for large piles of raw materials, such as sand, used in the manufacture of glass.

The following arrangements have been made for the inventory count:

The warehouse manager will supervise the count as he is most familiar with the inventory. There will be
ten teams of counters and each team will contain two members of staff, one from the finance and one
from the manufacturing department. None of the warehouse staff, other than the manager, will be

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involved in the count.

Each team will count an aisle of finished goods by counting up and then down each aisle. As this process
is systematic, it is not felt that the team will need to flag areas once counted. Once the team has
finished counting an aisle, they will hand in their sheets and be given a set for another aisle of the
warehouse. In addition to the above, to assist with the inventory counting, there will be two teams of
counters from the internal audit department and they will perform inventory counts.

The count sheets are sequentially numbered, and the product codes and descriptions are printed on
them but no quantities. If the counters identify any inventory which is not on their sheets, then they are
to enter the item on a separate sheet, which is not numbered. Once all counting is complete, the
sequence of the sheets is checked and any additional sheets are also handed in at this stage. All sheets
are completed in ink.

Any damaged goods identified by the counters will be too heavy to move to a central location, hence
they are to be left where they are but the counter is to make a note on the inventory sheets detailing
the level of damage.

As Lily undertakes continuous production, there will continue to be movements of raw materials and
finished goods in and out of the warehouse during the count. These will be kept to a minimum where
possible.

The level of work-in-progress in the manufacturing plant is to be assessed by the warehouse manager. It
is likely that this will be an immaterial balance. In addition, the raw materials quantities are to be
approximated by measuring the height and width of the raw material piles.

In the past this task has been undertaken by a specialist; however, the warehouse manager feels
confident that he can perform this task.

Required:
Describe the procedures to be undertaken by the auditor DURING the inventory count of Lily Window
Glass Co in order to gain sufficient appropriate audit evidence. (6 marks)

For the inventory count arrangements of Lily Window Glass Co:

(i) Identify and explain SIX deficiencies; and
(ii) Provide a recommendation to address each deficiency.
The total marks will be split equally between each part (12 marks)

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Tinkerbell Toys Co

Introduction
Tinkerbell Toys Co (Tinkerbell) is a manufacturer of children’s building block toys; they have been
trading for over 35 years and they sell to a wide variety of customers including large and small toy
retailers across the country. The company’s year-end is 31 May 2011.

The company has a large manufacturing plant, four large warehouses and a head office. Upon
manufacture, the toys are stored in one of the warehouses until they are despatched to customers. The
company does not have an internal audit department.

Sales ordering, goods despatched and invoicing

Each customer has a unique customer account number and this is used to enter sales orders when they
are received in writing from customers. The orders are entered by an order clerk and the system
automatically checks that the goods are available and that the order will not take the customer over
their credit limit. For new customers, a sales manager completes a credit application; this is checked
through a credit agency and a credit limit entered into the system by the credit controller. The company
has a price list, which is updated twice a year. Larger customers are entitled to a discount; this is agreed
by the sales director and set up within the customer master file.

Once the order is entered an acceptance is automatically sent to the customer by mail/email confirming
the goods ordered and a likely despatch date. The order is then sorted by address of customer. The
warehouse closest to the customer receives the order electronically and a despatch list and sequentially
numbered goods despatch notes (GDNs) are automatically generated. The warehouse team packs the
goods from the despatch list and, before they are sent out, a second member of the team double checks
the despatch list to the GDN, which accompanies the goods.

Once despatched, a copy of the GDN is sent to the accounts team at head office and a sequentially
numbered sales invoice is raised and checked to the GDN. Periodically a computer sequence check is
performed for any missing sales invoice numbers.

Fraud
During the year a material fraud was uncovered. It involved cash/cheque receipts from customers being
diverted into employees’ personal accounts. In order to cover up the fraud, receipts from subsequent
unrelated customers would then be recorded against the earlier outstanding receivable balances and
this cycle of fraud would continue.

The fraud occurred because two members of staff ‘who were related’ colluded. One processed cash
receipts and prepared the weekly bank reconciliation; the other employee recorded customer receipts
in the sales ledger. An unrelated sales ledger clerk was supposed to send out monthly customer
statements but this was not performed. The bank reconciliations each had a small unreconciled amount
but no-one reviewed the reconciliations after they were prepared. The fraud was only uncovered when
the two employees went on holiday at the same time and it was
discovered that cash receipts from different customers were being applied to older receivable balances
to hide the earlier sums stolen.

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Required:

(a) Recommend SIX tests of controls the auditor would normally carry out on the sales system of
Tinkerbell, and explain the objective for each test. (12 marks)

(b) Describe substantive procedures the auditor should perform to confirm Tinkerbell’s year-end
receivables balance. (8 marks)

(c) Identify and explain controls Tinkerbell should implement to reduce the risk of fraud occurring
again and, for each control, describe how it would mitigate the risk. (6 marks)

Brenan & Co

Introduction – audit firm

You are an audit senior in Brennon & Co, a firm providing audit and assurance services. At the request of
an audit partner, you are preparing the audit programme for the income and receivables systems of
Seeley Co.

Audit documentation is available from the previous year’s audit, including internal control
questionnaires and audit programmes for the despatch and sales system. The audit approach last year
did not involve the use of computer-assisted audit techniques (CAATs); the same approach will be taken
this year. As far as you are aware, Seeley’s system of internal control has not changed in the last year.

Client background – sales system

Seeley Co is a wholesaler of electrical goods such as kettles, televisions, MP3 players, etc. The company
maintains one large warehouse in a major city. The customers of Seeley are always owners of small
retail shops, where electrical goods are sold to members of the public. Seeley only sells to authorised
customers; following appropriate credit checks, each customer is given a Seeley identification card to
confirm their status. The card must be used to obtain goods from the warehouse.

Despatch and sales system

The despatch and sales system operates as follows:

1. Customers visit Seeley’s warehouse and load the goods they require into their vans after showing
their Seeley identification card to despatch staff.
2. A pre-numbered goods despatch note (GDN) is produced and signed by the customer and a member
of Seeley’s despatch staff confirming goods taken.
3. One copy of the GDN is sent to the accounts department, the second copy is retained in the despatch
department.
4. Accounts staff enters goods despatch information onto the computerised sales system. The GDN is
signed.
5. The computer system produces the sales invoice, with reference to the inventory master file for
product details and prices, maintains the sales day book and also the receivables ledger. The receivables
control account is balanced by the computer.

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6. Invoices are printed out and sent to each customer in the post with paper copies maintained in the
accounts department. Invoices are compared to GDNs by accounts staff and signed.
7. Paper copies of the receivables ledger control account and list of aged receivables are also available.
8. Error reports are produced showing breaks in the GDN sequence.

Required:

(a) Using information from the scenario, list six tests of control that an auditor would
normally carry out on the despatch and sales system at Seeley Co and explain the reason
for each test. (12 marks)

(b) State and explain the meaning of four assertions that relate to the direct confirmation of
receivables. (4 marks)

Scarlet & Co

You are an audit senior of Scarlet & Co and are in the process of reviewing the systems testing
completed on the payroll cycle of Bronze Industries Co (Bronze), as well as preparing the audit
programmes for the final audit.

Bronze operate several chemical processing factories across the country, it manufactures 24 hours a
day, seven days a week and employees work a standard shift of eight hours and are paid for hours
worked at an hourly rate. Factory employees are paid weekly, with approximately 80% being paid by
bank transfer and 20% in cash; the different payment methods are due to employee preferences and
Bronze has no plans to change these methods. The administration and sales teams are paid monthly by
bank transfer.

Factory staff are each issued a sequentially numbered clock card which details their employee number
and name.

Employees swipe their cards at the beginning and end of the eight-hour shift and this process is not
supervised. During the shift employees are entitled to a 30-minute paid break and employees do not
need to clock out to access the dining area. Clock card data links into the payroll system, which
automatically calculates gross and net pay along with any statutory deductions. The payroll supervisor
for each payment run checks on a sample basis some of these calculations to ensure the system is
operating effectively.

Bronze has a human resources department which is responsible for setting up new permanent
employees and leavers.

Appointments of temporary staff are made by factory production supervisors. Occasionally overtime is
required of factory staff, usually to fill gaps caused by staff holidays. Overtime reports which detail the
amount of overtime worked are sent out quarterly by the payroll department to production supervisors
for their review.

To encourage staff to attend work on time for all shifts Bronze pays a discretionary bonus every six
months to factory staff; the production supervisors determine the amounts to be paid. This is

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communicated in writing by the production supervisors to the payroll department and the bonus is
input by a clerk into the system.

For employees paid by bank transfer, the payroll manager reviews the list of the payments and agrees to
the payroll records prior to authorising the bank payment. If any changes are required, the payroll
manager amends the records. For employees paid in cash, the pay packets are prepared in the payroll
department and a clerk distributes them to employees; as she knows most of these individuals she does
not require proof of identity.

Required:
(a) Identify and explain FIVE internal control STRENGTHS in Bronze Industries Co.’s payroll system. (5
marks)

(b) Identify and explain SIX internal control DEFICIENCIES in Bronze Industries Co.’s payroll system and
provide a RECOMMENDATION to address each of these deficiencies. (12 marks)

(c) Describe substantive ANALYTICAL PROCEDURES you should perform to confirm Bronze Industries
Co.’s payroll expense. (3 marks)
(20 marks)

GENERAL WEAKNESS IN CASH AND BANK SYSTEM

¾ No physical controls over cash i.e. cash not kept in safe deposit box locker/vault.
¾ Cash not insured.
¾ Cash not banked timely.
¾ Cash not banked by a single person who is authorized, can be banked by anyone.
¾ Bank reconciliation not done on timely basis and not approved as well.
¾ Petty cash vouchers not approved.
¾ Petty cash vouchers not having support documents.
¾ Petty cash expenses above limit.
¾ Petty cash limit exceeding average monthly petty cash balance.
¾ No regular and surprise cash count.
¾ No segregation of duties.
¾ Cash book not updated on a timely basis.
¾ All cash and bank payments approved by authorized personnel.
¾ Petty cash vouchers not sequentially numbered.
¾ Petty cash vouchers not approved by senior official at reimbursement time.

GENERAL WEAKNESS IN CAP/REVENUE EXP CYCLE

¾ Capital/ revenue expenditure budget not prepared and approved by finance director plus whole
board.

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¾ No capital expenditure form prepared and signed by authorized personnel for fixed asset
purchased.
¾ No quotation obtained from approved vendors.
¾ No purchase order raised.
¾ No GRN made on fixed asset arrival.
¾ Fixed asset register not updated on arrival.
¾ No inspection of fixed asset on arrival.
¾ No capitalization policy as per IAS 16.
¾ No reconciliation between physical and recorded inventory of Fixed asswts at repeated
intervals.
¾ No physical controls of fixed asset

Shiny Happy Windows Co

Shiny Happy Windows Co (SHW) is a window cleaning company. Customers’ windows are cleaned
monthly, the window cleaner then posts a stamped addressed envelope for payment through the
customer’s front door.

SHW has a large number of receivable balances and these customers pay by cheque or cash, which is
received in the stamped addressed envelopes in the post. The following procedures are applied to the
cash received cycle:

1. A junior clerk from the accounts department opens the post and if any cheques or cash have been
sent, she records the receipts in the cash received log and then places all the monies into the locked
small cash box.

2. The contents of the cash box are counted each day and every few days these sums are banked by
whichever member of the finance team is available.

3. The cashier records the details of the cash received log into the cash receipts day book and also
updates the sales ledger.

4. Usually on a monthly basis the cashier performs a bank reconciliation, which he then fi les, if he
misses a month then he catches this up in the following month’s reconciliation.

Required:
For the cash cycle of SHW:

(i) Identify and explain THREE deficiencies in the system; (3 marks)

(ii) Suggest controls to address each of these deficiencies; and (3 marks)
(iii) List tests of controls the auditor of SHW would perform to assess if the controls are operating
effectively. (3 marks)
(c) Describe substantive procedures an auditor would perform in verifying a company’s bank balance.

(7 marks)
(16 marks)

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Blake Co

Introduction
Blake Co assembles specialist motor vehicles such as Lorries, buses and trucks. The company owns four
assembly plants to which parts are delivered and assembled into the motor vehicles. The motor vehicles
are assembled using a mix of robot and manual production lines. The ‘human’ workers normally work a
standard eight hour day, although this is supplemented by overtime on a regular basis as Blake has a full
order book. There is one shift per day; mass production and around the clock working are not possible
due to the specialist nature of the motor vehicles being assembled.

Wages system – shift workers

Shift-workers arrive for work at about 7.00 am and ‘clock in’ using an electronic identification card. The
card is scanned by the time recording system and each production shift-worker’s identification number
is read from their card by the scanner.

The worker is then logged in as being at work. Shift-workers are paid from the time of logging in. The
logging in process is not monitored as it is assumed that shift-workers would not work without first
logging in on the time recording system.
Shift-workers are split into groups of about 25 employees, with each group under the supervision of a
shift foreman. Each day, each group of shift-workers is allocated a specific vehicle to manufacture. At
least 400 vehicles have to be manufactured each day by each work group.

If necessary, overtime is worked to complete the day’s quota of vehicles. The shift foreman is not
required to monitor the extent of any overtime working although the foreman does ensure workers are
not taking unnecessary or prolonged breaks which would automatically increase the amount of
overtime worked. Shift-workers log off at the end of each shift by re-scanning their identification card.

Payment of wages
Details of hours worked each week are sent electronically to the payroll department, where hours
worked are allocated by the computerised wages system to each employee’s wages records. Staff in the
payroll department compare hours worked from the time recording system to the computerised wages
system, and enters a code word to confirm the accuracy of transfer.

The code word also acts as authorisation to calculate net wages. The code word is the name of a
domestic cat belonging to the department head and is therefore generally known around the
department.

Each week the computerized wages system calculates:

(i) Gross wages, using the standard rate and overtime rates per hour for each employee,
(ii) statutory deductions from wages, and
(iii) net pay.

The list of net pay for each employee is sent over Blake’s internal network to the accounts department.
In the accounts department, an accounts clerk ensures that employee bank details are on file. The clerk
then authorises and makes payment to those employees using Blake’s online banking systems. Every

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few weeks the financial accountant reviews the total amount of wages made to ensure that the
management accounts are accurate.

Termination of employees
Occasionally, employees leave Blake. When this happens, the personnel department sends an e-mail to
the payroll department detailing the employee’s termination date and any unclaimed holiday pay.
The receipt of the e-mail by the payroll department is not monitored by the personnel department.
Salaries system – shift managers
All shift managers are paid an annual salary; there are no overtime payments. Salaries were increased in
July by 3% and an annual bonus of 5% of salary was paid in November.

Required:
(a) List FOUR control objectives of a wages system. (2 marks)
(b) As the external auditors of Blake Co, write a management letter to the directors in respect of the
shift-workers’ wages recording and payment systems which:

(i) Identifies and explains FOUR weaknesses in that system;

(ii) Explains the possible effect of each weakness
(iii) Provides a recommendation to alleviate each weakness.

Note up to two marks will be awarded within this requirement for presentation. (14 marks)

Hessonite & Co
You are an audit senior of Hessonite & Co and are in the process of reviewing the inventory system
documentation for your audit client, Lemon Quartz Co (Quartz) which manufactures computer
equipment. The company’s factory and warehouse are based on one large site, and their year-end is 30
June 2016. Quartz is planning to undertake a full inventory count at the year-end of its raw materials,
work in progress and finished goods and you will be attending this count. In preparation you have been
reviewing the inventory count instructions for finished goods provided by Quartz.

The count will be undertaken by 15 teams of two counters from the warehouse department with
Quartz’s financial controller providing overall supervision. Each team of two is allocated a number of
bays within the warehouse to count and they are provided with sequentially numbered inventory sheets
which contain product codes and quantities extracted from the inventory records. The counters move
through each allocated bay counting the inventory and confirming that it agrees with the inventory
sheets. Where a discrepancy is found, they note this on the sheet.

The warehouse is large and approximately 10% of the bays have been rented out to third parties with
similar operations; these are scattered throughout the warehouse. For completeness, the counters have
been asked to count the inventory for all bays noting the third party inventories on separate blank
inventory sheets, and the finance department will make any necessary adjustments.

Some of Quartz’s finished goods are high in value and are stored in a locked area of the warehouse and
all the counting teams will be given the code to access this area. There will be no despatches of
inventory during the count and it is not anticipated that there will be any deliveries from suppliers.

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Each area is counted once by the allocated team; the sheets are completed in ink, signed by the team
and returned after each bay is counted. As no two teams are allocated the same bays, there will be no
need to flag that an area has been counted. On completion of the count, the financial controller will
confirm with each team that they have returned their inventory sheets.

Required:

(a) In respect of the inventory count procedures for Lemon Quartz Co:

(i) Identify and explain FIVE deficiencies;

(ii) Recommend a control to address each of these deficiencies; and
(iii) Describe a TEST OF CONTROL the external auditors would perform to assess if each of these
controls, if implemented, is operating effectively (15 marks)

(b) Quartz’s finance director has asked your firm to undertake a non-audit assurance engagement
later in the year. The audit junior has not been involved in such an assignment before and has asked
you to explain what an assurance engagement involves

Required:

Explain the five elements of an assurance engagement. (5marks)

(20 marks)

SUBSTANTIVE PROCEDURES

PROCEDURES FOR INVENTORY

TO CONFIRM VALUATION OF INVENTORY

1. For a sample of inventory of goods at year end, ensure cost is correctly stated by comparing cost
per records to a recent purchase invoice.
2. For a sample of manufactured items, obtain cost sheets and confirm material cost to purchase
invoice, as cost to time sheets etc.
3. Review aged inventory reports and discuss with management why slow moving goods have not
been written off/ down.
4. Review average inventory days of current year and compare with previous years, discuss
variations with management.
5. Follow up any damaged/ obsolete items noted by auditor at inventory counts to ensure
inventory records have been updated correctly.
6. Select a sample of goods and review post year end invoices to ascertain if NRV is above cost or
not.

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FOR INVENTORY HELD AT THIRD PARTY LOCATIONS
1. Inspect any documentation in respect of third party inventory.
2. Inspect any reports produced by auditors of warehouse in relation to adequacy of controls over
inventory.
3. Attend inventory count at third party warehouse to see controls.
4. Send letter requesting direct confirmation on inventory balance held at year end from third
party warehouses (quantity and condition).

FOR DAMAGED INVENTORY

1. Obtain a schedule of damaged inventory and cost to ensure accuracy.
2. During inventory count identify quantity of damaged goods and agree to schedule.
3. Discuss with management their plans for disposing off these goods, whether they have NRV or
to be scrapped.
4. For goods sold post year end, agree to sales invoice to assess NRV.
5. Agree cost of inventory to supporting documentation.

TO VERIFY STANDARD COST

1. Ensure standard cost is reviewed and updated periodically.
2. Discuss with management basis of standard cost.
3. Review variance between standard cost actual cost.
4. Discuss variance with management.

TO CONFIRM INVENTORY CUT OFF

1. Note last numbers of GRN and delivery notes at year end physical count.
2. Trace above numbers to sale and debtors records.
3. Add goods in transit to inventory count and include in inventory compilation.
4. Goods sold but not delivered not to be counted and excluded from inventory compilation.

PROCEDURES RELATED TO INVENTORY COUNTS

BEFORE INVENTORY COUNT (PLANNING ATTENDANCE AT INVENTORY COUNT)

1. Book audit staff to attend inventory counts.
2. Obtain copy of inventory count instructions from client.
3. Ascertain whether any inventory is held by third parties.
4. Review prior year working papers.
5. Prepare audit programme for the count.

DURING INVENTORY COUNT (ATTENDANCE AT INVENTORY COUNT)

1. Record any inventory held at third party and ensures it is excluded from count.
2. Re perform procedures adopted by warehouse manager.
3. Observe procedures of warehouse manager in assessing level of WIP.
4. Observe procedures of inventory movement during the count, to ensure no omission or double
counting.
5. Select sample of damaged items noted and inspect them to ensure correctly noted.
6. Observe counting items to ensure instructions are being followed.
7. Select a sample and perform test counts from sheet to floor and floor to sheet.

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AFTER THE INVENTORY COUNT (FOLLOW UP)

1. Trace items test counted to final inventory sheets.
2. Observe whether all count records have been included in final inventory sheets.
3. Inspect final inventory sheets to ensure supported by count records.
4. Confirm clients final valuation of inventory has been calculated correctly.
5. Follow up queries and notify problems to management.

FOR CONTINUOUS/PERPETUAL INVENTORY COUNTS

1. Ensure controls are adequate by attending at least one perpetual count.
2. Review schedule of counts to confirm all inventory lines have been counted or are due to be
counted at least once a year.
3. Undertake test counts from records to floor and floor to records.
4. Review any adjustments made to inventory records on a monthly basis to identify differences
arising.
5. Consistent differences will require discussion with management as it indicates inventory records
are not adequately maintained.

PROCEDURES FOR NON CURRENT ASSETS

TANGIBLE NON CURRENT ASSETS

1. Carry out physical inspection of fixed assets (E)
2. Verify ownership of property by inspecting title deeds and registration documents (R & O)
3. Verify ownership of motor vehicles by inspecting motor registration documents (R & O).
4. Review lease agreements to ensure correctly treated as finance or operating lease ( R & O)
5. Select a sample of physically present assets in company and inspect asset register to ensure they
are included. (C)
6. Reconcile general ledger with schedule of PPE (c )
7. Re perform reconciliation of non-current asset register to general ledger, investigate difference
(c )
8. Recalculate deep exp for the year.
9. Review depreciation policies for reasonableness by comparison to last year , industry average.
10. Agree revalued amounts to a valuation report.

ADDITIONS AND DISPOSALS OF NCA

Additions:
1. Select a sample of additions and agree cost to suppliers invoice.
2. Obtain a breakdown of additions, cast the list and agree all additions added in NCA register.
3. Review board minutes to ensure purchased authorized by Board of Directors.

Disposals:
1. Select a sample of disposals and agree proceeds to sales invoices.
2. Obtain breakdown of disposals, cast the list and agree all disposals removed from NCA register.
3. Review board minutes to ensure disposals authorized by board.

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CAPITAL EXPENDITURE
1. For items treated as capital, agree to invoices to ascertain whether they are in fact capital and
correctly included with PPE.
2. For items treated as repairs, agree to invoices to ensure they are in fact not capital and correctly
expensed to Profit and loss account
3. Obtain a schedule of capital expenditure and ensure accuracy.
4. For capital items, agree to NCA register to ensure they are correctly included.

DEPRECIATION
1) Review depreciation rates and compare to industry average.
2) Review profits and loss on disposal of assets.
3) Review disclosure of depreciation charges and policies in draft financial statements.
4) Perform a proof in total calculations for depreciation charged.

REVALUATIONS
1) Agree revaluation amounts to valuation statement provided by valuer.
2) Ensure revalued amounts of assets are correctly included in NCA register.
3) Ensure disclosures of revaluation comply with IAS 16 (PPE).
4) Obtain a schedule of assets revalued and cast to confirm completeness and accuracy.

INTANGIBLE NON CURRENT ASSETS

1) Ensure valuation of intangible is reasonable through discussion with management.
2) Recalculate amortization calculation.
3) Inspect specialist valuation of intangibles for reasonableness.
4) Recalculate to ensure calculation is correct.

SELF CONSTRUCTED ASSETS

1. Verify material, labour, OH costs to invoices, wage records etc.
2. Review costs to ensure to profit element has been included.
3. Ensure expenditure is analyzed correctly and properly charged to capital.
4. Review accounts to ensure consistency in finance cost capitalized or not capitalized.

PROCEDURES ON CASH AND BANK

CASH AND BANK BALANCE

1. Obtain company’s bank reconciliation and check additions to ensure arithmetic accuracy.
2. Obtain a bank confirmation letter from bankers.
3. Verify balance as per bank statement to an original year end bank statement and also to bank
confirmation letter.
4. Examine bank confirmation letter for details of any security provided by the company.
5. Review cash book and bank statements for any unusual items.
6. Agree all balances listed on bank confirmation letter to company’s bank reconciliations.
7. Trace all unpresented cheques/outstanding lodgements to a pre year and cash book and post
year end/ bank statement.

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8. Review financial statement to ensure disclosure of cash and bank balance are complete and
accurate.
9. Count cash balances with cash budget.
10. Compare changes in cash balance from last year.
11. Determine all cash received till last day is included in cash in hand.

PROCEDURES ON DEBTORS, CREDITORS, REVENUE AND PAYROLL

RECEIVABLES

1. Perform a positive receivable circularization for a sample of receivables.

2. For a non-responses, with clients, permission, send a follow up circularization.
3. If no response to follow up, with client’s permission, telephone the customer and ask whether
they are able to respond in writing to circularization request.
4. If still no responses, perform alternative procedures to confirm recievable.
5. Calculate average receivable days and compare with previous years, investigate differences.
6. Select a sample of GDN’s before and just after the year end and compare with sales invoice to
ensure recorded in correct period.
7. Review sales ledger for any credit balance and discuss with management whether these should
be reclassified as payable.
8. Ensure receivables included as current asset in financial statements.
9. Select a sample of year end receivable balance and agree back to supporting documentation to
ensure existence.
10. Reconcile sales ledger control account sales ledger list of balance.

PAYABLES

1. Perform a trade payables circularization for a sample of payables.

2. For non responses with client’s permission, send a follow circularization.
3. If no response to follow up, with client’s permission telephone the supplier and ask whether
they are able to respond in writing to circularization request.
4. If still no responses, perform alternative procedures to confirm payables.
5. Calculate payable days and compare with previous years, investigate differences.
6. Select a sample of GRN’s before the year end and compare with purchase invoices to ensure
recorded in correct period.
7. Review purchase ledger for any debit balance and discuss with management whether they
should be reclassified as receivables.
8. Ensure payables included as current liability in financial statement.
9. Select a sample of year end payable balance and agree back to supporting documentation to
ensure existence.
10. Reconcile purchase ledger control account to purchase ledger list of balances.

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REVENUE

1. Compare overall revenue against prior years and budgets, investigate differences.
2. Calculate gross profit margin and compare to previous years, investigate differences.
3. Obtain a schedule of sales broken down into major categories and compare this to prior year ,
investigate differences.
4. Select a sample of sales invoices and recalculate sales tax has been correctly applied to invoice.
5. Select a sample of credit notes, trace through original invoice to ensure invoice correctly
removed from sales.
6. Select a sample of customer orders and agree to dispatch notes and sales invoices through to
inclusion in sales ledger to ensure completeness of revenue.
7. Select a sample of both pre and post year end, compare to sales invoice to ensure recorded in
correct accounting period.

PAYROLL

1. Agree total net pay per payroll records to bank transfer.

2. Agree individual salaries per payroll records to personnel records.
3. Compare payroll expenditures to prior year, investigate differences.
4. Re-perform calculations of deductions, to confirm correct deductions have been made in
payroll.
5. For a sample of employees, recalculate gross and net pay and agree to payroll records.
6. Agree total wages as per payroll system to trial balance, investigate difference.
7. Cast a sample of payroll records to confirm accuracy.
8. Compare monthly payroll charges to budgets.

INCREASED RISK OF FRAUD ANYWHERE

1. Review board minutes for management discussion evidence on any fraud.

2. Discuss with concerned manager, nature of fraud, how it occurred and financial impact.
3. Discuss with management as to whether they are aware of any potential frauds.
4. Review and test internal controls surrounding the area to assess whether fraud may have
occurred.
5. Obtain a written representation from management acknowledging they have disclosed to
auditor all knowledge of actual and suspected fraud

PROCEDURES ON CONTINGENCIES, NON CURRENT LIABILITIES, CAPITAL AND RELATED ISSUES

NON CURRENT LIABILITIES/ BANK LOAN

1) Review draft accounts to ensure disclosures for NCL are correct.

2) Review board minutes to confirm approval of loan.
3) Obtain direct confirmation from lenders.
4) Verify loan requirements from cash book and bank statement.
5) Verify interest expense charged in Profit and loss account accordingly.
6) Ensure proper allocation of current and long term portion.
7) Agree name of lender to register of debenture holders.

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CONTINGENCIES

1. Make appropriate inquiries of management and other in house legal advisors.

2. Review minutes of board meeting.
3. Review correspondence between entity and lawyers.
4. Review legal expense account.
5. Consider direct confirmation from lawyers for their point of view.
6. Consider whether expert advice may be required from outside sources other than lawyer.

SHARE CAPITAL

1. Agree authorized share capital with statutory documents governing company’s constitution.
2. Agree changes to authorized share capital with properly authorized resolution.

ISSUE OF SHARES

1. Verify nay issue of share capital with board minutes.

2. Ensure issue is within terms of constitution.
3. Confirm that cash or other consideration has been received.

TRANSFER OF SHARES

1. Verify transfer of shares by board minutes, stamped transfer form, correspondence documents
2. Review balance on share capital accounts in total list with amount of issued share capital in
general lodger.

DIVIDENDS

1. Agree dividends paid in previous year to authority minutes books.

2. Agree dividends payments to documentary evidence.
3. Test that dividends do not contravene distribution provisions.

RESERVES

1. Agree movements on reserves to supporting authority.

2. Ensure movements of reserves do not contravene legislation.
3. Ensure proper disclosures have been made of movement on reserves by inspection of financial
statement.

PROCEDURES FOR DIRECTORS EMOLUMENTS, WORK IN PROGRESS, OPENING BALANCES AND

EXPENSES

DIRECTOR EMOLUMENTS

1. Agree individual payments to payroll records.

2. Review board minutes for evidence of any emoluments agreed.
3. Consider adequacy of disclosures of director’s emoluments in accordance with legislation.
4. Obtain written representations from management confirming completeness of emoluments.
5. Obtain schedule of director’s remuneration and cast addition of schedule.
6. Review director’s contracts to ensure emoluments consistent with contracts.
7. Compare emoluments to last year’s and budgets.

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OPENING BALANCE

1. Agree opening balance to prior year financial statement closing balance to confirm they have
been correctly b/f
2. Review prior year auditor working paper to obtain evidence regarding opening balance.
3. Determine whether opening balance reflects application of appropriate accounting policies.
4. Perform specific audit procedures to obtain evidence regarding opening balance.

WORK IN PROGRESS

1. Cast the schedule of total work in progress and agree to trial balance and financial statement.
2. Agree sample of work in progress assessed to work in progress schedule.
3. Agree percentage completion is correct.
4. Observe procedures carried out by the company in assessing level of work in progress.
5. Discuss with management how percentage completions are attributed to work in progress.
6. Agree for a sample that percentage completions assessed are in accordance with company’s
policies communicated prior to the assessment.

EXPENSE

1. Compare current year expense with last year, inquiring difference.

2. For a sample of expenses, verify supporting documentation like payment voucher, bank
statement, expense invoices, etc.
3. Ensure expense pertain to relevant accounting period.
4. Ensure proper classification of expense as per nature. (capital/revenue)
5. Trace total of expense from general ledger and trial balance.
6. Recalculate casting of schedule provided by client.

PROCEDURES FOR ACCRUALS

GENERAL ACCRUALS

1. Ensure accruals pertain to nature of business.

2. Ensure reasonableness of accruals made.
3. Compare accruals of current year from last year balance accruals, investigate differences.
4. Re-perform calculation of accruals for accuracy.
5. Agree subsequent payments to post year end cash book and bank statement.
6. Review adequacy of disclosures in accordance with legislation.

ACCRUAL FOR INCOME TAX/OTHER TAX PAYABLE

1. Compare accrual of current year from last year, investigate differences.

2. Ensure reasonableness of accrual made
3. Re-perform calculation of accrual for accuracy.
4. Agree subsequent payments to post year and cash book and bank statement.
5. Review adequacy of disclosure in accordance with legislation.
6. Review correspondence with tax authorities to assess if any payments are due, as they have to
be included in accruals

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PROCEDURES FOR PROVISIONS

PROVISION FOR LAWSUIT/ COURT CASE/ DAMAGES

1. Discuss with management nature of dispute, to ensure full understanding of issue is obtained
and to assess whether obligation exists.
2. Obtain lawyer confirmation to obtain their views as to probability of claim being successful .
3. Review board minutes to understand whether directors believe the claim to be successful or
not.
4. Obtain written representation from management confirming their view that claim is unlikely to
be successful and hence no provision is required.
5. Ensure adequate disclosure is made in financial statement as per Applicable financial reporting
framework

PROVISION FOR WARANTY

1. Verify warranty provision from industry norms .

2. Verify subsequent claims from customers.
3. Obtain written representation from management to ensure reasonableness of warranty
provision.
4. Recalculate the warranty provision for accuracy.
5. Verify post trends of warranty provision, investigate differences.

PROVISION FOR RECEIVABLES

1. Review board minutes to identify whether there are any concerns in relations to payments by
customers.
2. Review whether there are any after date cash receipts for slow moving receivables.
3. Review customer correspondence to identify any balances in dispute or unlikely to be paid.
4. Calculate potential level of receivables which are not recoverable and assess whether material
or not.
5. Review aged receivables ledger for slow moving balances, discuss their status with credit
controller.

PROVISION FOR REORGANIZATION/RESTRUCTURING OR REDUNDANCY

1. Review adequacy of disclosures to ensure compliance with IAS 37.

2. Review board minutes to ensure discussion on provision.
3. Obtain written representation from management to confirm completeness of provisions.
4. Cast breakdown of provision to ensure calculation is correct.
5. Review announcement to ensure announced before year end.
6. Review supporting documents to ensure decision formally announced.

(PAST PAPERS EXAMINER ANSWERS ARE TO BE FOLLOWED AND DISCUSSED IN CLASS)

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AUDIT PLANNING AND DOCUMENTATION
AUDIT DOCUMENTATION

It is stated that audit procedure which has not been documented is assured not to have been
performed.

That is why all procedures performed are required to be documented. They are documented on a piece
of paper called “working papers”.

WORKING PAPERS

Working papers are records of:

9 Procedures performed
9 Evidence obtained
9 Conclusions required.

Inventory checking and bank confirmations are examples.

WHY WORKING PAPERS ARE IMPORTANT/ ADVANTAGES / OBJECTIVES OF WORKING PAPERS

9 Act as proof
9 Help in legal issues
9 Control i.e helps partner in checking work of team.
9 Helps for next year audit planning especially in case of opening balance

Examples of working papers:

x Information obtained during audit for understanding entity and its environment.
x Information regarding accounting and internal control system efficiently.
x Extracts or copies of important legal documents.
x Analysis of significant transactions.
x Various audit procedures performed during audit.
x Third party confirmations.
x Key agreements and contracts.

Form and content of working papers

Form and content of working papers is also called qualities and features of good working papers.

They are affected by matters such as:

9 Size and complexity of entity

9 Nature of procedures to be performed
9 Identified risks
9 Significance of evidence obtained
9 Exceptions identified
But they should clearly identify the following:

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9 Firm name
9 Name of client
9 b/s date
9 subject (inventory, record, etc)
9 reference (FA, CA,001, 002)
9 procedure performed
9 evidence obtained
9 who prepared (sign)
9 who received (sign )
9 any other issues
9 date o which prepared
9 review date

There are Two types of working papers

x current working papers

x permanent working papers

Current working papers:

They are also called current audit files which are relevant for current audit always in hand.
They should have the following:

ƒ financial statement
ƒ reconciliation
ƒ errors
ƒ sampling
ƒ third party communication

Permanent working papers:

They are permanent audit files. They are fixed in nature and kept in box.
They should have the following:

ƒ engagement letter
ƒ Memorandum & Articles of association
ƒ Lease and sales agreement
ƒ Previous year accounts
FOR HOW LONG TO RETAIN WORKING PAPERS

Different bodies have different guidelines

x ACCA recommends minimum 7 years retention after that up to auditor to decide.

x Working papers is the property of the auditor, can it be disclosed to third party? (confidentiality)

Can be disclosed to management but if it will create doubt on independence then not.

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STANDARDIZED AND AUTOMATED WORKING PAPERS

x Traditionally were manual.

x Now standardized (pre printed standard) questionaries’ by (ICAP /ACCA)

Automated working papers have now been prepared via excel or audit software, making
documentation work much easier.

Advantages of automated working papers Disadvantages of automated working papers

x Less errors x Virus
x Neater and cleaner x Electricity dependency
x Time saved x Boredom (auto audit )
x Easy transmission via internet

AUDIT PLANNING

When planning starts few weeks before start of the audit.

The auditor should plan an audit so that engagement will performed in an efficient and effective
manner.
Mandatory as well as needs to be documented.

Advantages/importance of planning:

x Helps auditor devote appropriate attention to important areas.

x Helps auditor identify and resolve problems on a timely basis.
x Helps properly organize audit so that performed in effective manner.
x Helps in selection of appropriate team members.
x Helps direction, supervision and review of work.
x Assist in coordination of work done by auditor and expert.

Note: planning an audit involves establishing the “overall audit strategy” and
“developing an audit plan” (there are two parts)

x Audit strategy is the overall strategy which sets at direction, scope and timing of audit. Strategy
is then converted into a detailed audit plan.

CONTENTS OF AUDIT STRATEGY/ MATTERS TO CONSIDER IN ESTABLISHING AUDIT STRATEGY

¾ Understanding entity and its environment

¾ Financial reporting framework
¾ Availability of client personnel
¾ Nature of buyers segments
¾ What resources are to be deployed
¾ Use of experts

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¾ Selection of team
¾ Engagement budgetry

x Audit plan is more detailed than audit strategy which tells nature, timing and extent of audit
procedures.

CONTENTS OF DETAILED AUDIT PLAN/MATTERS TO CONSIDER IN AUDIT PLAN

¾ Description of nature, timing and extent of planned risk assessment procedures.

¾ Description of nature, timing and extent of planned audit procedures.
¾ Timetable of planned audit work.
¾ Materially etc.

INTERIM AND FINAL AUDIT

Auditors usually carry out audit work in one or more sittings. This is referred to as interim and final
audit.
Main audit is final audit as at that time report is issued. But if all work is kept for end time, may fall
short of time. That’s why auditor does some work before, this is called interim audit.
For example purchases figure will come at year end , so will be audited in end but purchase cycle can be
checked before whether its working fine or not (interim).
Similarly Designing of procedures can be earlier (interim) but procedures will be performed in end
(final).

INTERIM AND FINAL AUDIT PROCEDURES

Interim audit procedures may include: Final audit procedures include:

x Inherit risk assessment and gaining an x Substantive procedures involving
understanding of the entity verification of statement of financial
x Recording the entity’s system of internal position balances and amounts in the
control statement of profit or loss
x Evaluating the design of internal controls x Obtaining third party confirmations
x Carrying out tests of control on the x Analytical procedures relating to figures in
company’s internal controls to ensure they the financial statements
are operating as expected x Subsequent events review
x Performing substantive testing of x Agreeing to the financial statements to the
transactions/balances to gain evidence accounting records
that the books and records are a reliable x Examining adjustments made during the
basis for the preparation of financial process of preparing the financial
statements statements
x Identification of issues that may have an x Consideration of the going concern status
impact on work to take place at the final of the entity
audit x Performing tests to ensure that the
conclusions formed at the interim audit
are still valid
x Obtaining written representations

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Impact of interim audit work on the final audit in general

The benefit of spreading audit procedures over an interim and final audit is that it is possible to provide
shareholders and other users of the financial statements with the audited accounts sooner than if all
audit procedures were carried out at a final audit taking place after the year end.

Performing audit procedures before the period-end can assist in identifying significant matters at an
early stage of the audit and help resolve them with management’s assistance or develop an effective
audit approach to address them. This reduces the time taken at the final audit to gain the remaining
sufficient appropriate audit evidence needed.

MATERIALITY
*All that information because of whose omission/ misstatement our decision would not change is
immaterial information.

*All that information whose omission/misstatement, individually or in aggregate could influence the
decision of user on financial statement is material information.

HOW MATERIALITY IS ASSESSED?

In assessing level of materiality, auditor must:

1. Consider both quantity and quality of misstatements. Quantity refer to size and quality refers
that amount may be low in value but could influence use’s decision like director’s transactions.
2. Consider setting performance materiality level, which is set below materiality and is used for
particular transactions.
3. Assessment of materiality is ultimately a matter of auditor’s professional judgement, the
following benchmarks and percentages may be appropriate

„ profit after tax 5%

„ gross profit 0.5-1%
„ revenue 0.5%-1%
„ total assets 1%-2%
„ net assets 2%-5%
„ profit before tax 5%-10%

PERFORMANCE MATERIALITY
If we determine materiality as 5% of PAT and it comes to $100000, a number of transactions with less
than $100000 may be dismissed on the grounds that it is immaterial. For this reason auditor is required
to set performance materiality, which is lower than total materiality and this means a lower threshold is
applied.

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“Performance materiality is the amount set by auditor at less than materiality for financial statement as
a whole to reduce to an appropriately low level the probability that aggregate of uncorrected
misstatements exceeds total materiality.”

™ Planning materiality is also called tolerable error.

CAN LEVEL OF MATERIALITY BE REVISED?

Yes, if there is:

1. Change in auditor’s understanding of entity and its operations.

2. Change in circumstances during audit.
3. Revision of risk.

WHY AUDITOR NEEDS TO ASSESS MATERIALITY

1. During planning of audit:

Auditor will plan to spend more time on areas which are material.

2. During the audit:

Auditor will focus more attention in material transactions.

3. Reading opinion:

Materiality helps auditors to decide what opinion to give.

DOCUMENTATION OF MATERIALITY

ISA requires following to be documented:

1. Materiality for financial statement as a whole

2. Performance materiality
3. Any revisions of materiality

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UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT
The auditor is required to obtain understanding of entity and its environment to be able to assess risk of
material misstatements.

Three important questions are:

Why ? 9 To identify and assess the risks of material misstatement in the financial
statements
9 To enable the auditor to design and perform further audit procedures
9 To provide a frame of reference for exercising audit judgement, for example,
when setting audit materiality
What? 9 Industry, regulatory and other external factors, including the applicable
financial reporting framework
9 Nature of the entity, including operations, ownership and governance,
investments, structure and financing
9 Entity’s selection and application of accounting policies
9 Objectives and strategies and related business risks that might cause material
misstatement in the financial statements
9 Measurement and review of the entity’s financial performance
9 Internal control (which we shall look at in detail in Chapter 9)
How? 9 Inquiries of management, appropriate individuals within the internal audit
function and others within the entity
9 Analytical procedures
9 Observation and inspection
9 Prior period knowledge
9 Client acceptance or continuance process
9 Discussion by the audit team of the susceptibility of the financial statements
material misstatement
9 Information from other engagements undertaken for the entity

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FRAUD AND ERROR

FRAUD

The term fraud refers to an international act by one or more individuals among management, those
charged with governance, employees or third parties involving the use of deception to obtain an unjust
or illegal advantage.

Fraud involving one or more members of management or those charged with governance is referred to
as “Management Fraud”; fraud involving only employees of the entity is referred to as “Employee
Fraud”.

Types of fraud:

- Misstatement resulting from Misappropriation of Assets.

- Misstatement resulting from Fraudulent Financial Reporting.

EXAMPLES OF MISAPPROPRIATION OF ASSETS:

1. Embezzling receipts e.g, Diverting business receipts into personnel bank accounts.
2. Stealing physical assets or intellectual property e.g. stealing inventory for use or sale, stealing
scrap for resale or disclosing tech data to competitors etc.
3. Causing an entity to pay for goods or services not received e.g. (payments to fictitious vendors,
payment to fictitious employees)
4. Using an entity’s assets for personal use e.g (using company cars and computers )
5. Misappropriation of assets is often accompanied by false or misleading records or documents in
order to conceal the fact that the assets are missing or have been pledged without proper
authorization.

EXAMPLES OF FRAUDULENT FINANCIAL REPORTING:

1. Manipulation falsification or alteration of accounting records or supporting documentation.

2. Misrepresentation or intentional omission from the financial statements of events,
transactions or other significant information.
3. Intentional/ misapplication of accounting principles relating to the amounts, classification
manner of presentation or disclosure.

Fraudulent financial reporting also involves fraud via management override of controls. Such
fraud can be committed by management overriding controls using such techniques as:

1. Recording fictitious journals entries. (fraudulent entries)

2. Inappropriately adjusting assumptions used to estimate account balances.
3. Omitting, advancing or delaying recognition in the financial statements of events and
transactions.
4. Concealing or not disclosing facts that could affect the amounts recorded in the financial
statements.
5. Altering records and terms related to significant and unusual transactions.

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Responsibility of management and those charged with governance in relation to fraud
The primary and forecast responsibility for the prevention and detection of fraud rests with both those
charged with Governance and the management.

It is important that management with the oversight of those charged with governance place a strong
emphasis on fraud prevention and detection, which may Reduce Opportunities for fraud to take place
and act as fraud deterrence, which will persuade individual and employees not to commit fraud because
of the likelihood of detection and punishment.

This involves a commitment to creating a culture of honesty and ethical behavior which can only be
reinforced by an active oversight by those charged with Governance. (Strong Control Environment).

Responsibilities of auditor in relation to fraud and error:

An auditor conducting an audit in accordance with ISA 240 The Auditor’s Responsibilities Relating to
Fraud in an Audit of Financial Statements is responsible for obtaining reasonable assurance that the
financial statements taken as a whole are …. from material misstatement, whether caused by fraud or
error.

In order to fulfill this responsibility auditors are required to identify and assess the risks of material
misstatement of the financial statements due to fraud.

The auditor will need to obtain sufficient appropriate audit evidence regarding the assessed risks of
material misstatement due to fraud, through designing and implementing appropriate responses.

In addition, the auditor must respond appropriately to fraud or suspected fraud identified during the
audit.

When obtaining reasonable assurance, the auditor is responsible for maintaining professional skepticism
throughout the audit, considering the potential for management override of controls and recognizing
the fact that audit procedures that are ……. In detecting error may not be effective in detecting fraud.

To ensure that the whole engagement team is aware of the risks and responsibilities for fraud and error,
ISA s require that a discussion is held within the team. For members not present at the meeting the
engagement partner should determine which matters are to be communicated to them.

Obtaining written representations in fraud:

ISA 240 requires the auditor to obtain written representations from management and those charged
with governance that:

x They acknowledge their responsibility for the design, implementation and maintenance of
internal control to prevent and detect fraud.
x They have disclosed to the auditor management’s assessment of the risk of fraud in the financial
statements.
x They have disclosed to the auditor their knowledge of fraud/ suspected fraud involving
management, employees with significant roles in internal control, and others where fraud could
have a material effect on the financial statements.
x They have disclosed to the auditor their knowledge of any allegations of fraud/ suspected fraud
communicated by employees, former employees, analysts, regulators or others.

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Communication of fraud to those charged with governance:

If the auditor identifies fraud or receives information that a fraud may exist, the auditor shall report this
on a timely basis to the appropriate level of management.

If the auditor identifies or suspects fraud involving management, employees with significant roles in
internal control, and others where fraud could have a material effect on the financial statements, he
shall communicate this on a timely basis to those charged with governance.

The auditor also needs to consider whether there is a responsibility to report to the regulatory or
enforcement authorities- the auditor’s professional duty of confidentiality may be overridden by laws
and statutes in certain jurisdictions.

NON COMPLIANCE

Compliance means follow all laws, rules and regulations. If laws, rules and regulations are not followed
this is called non-compliance.

INDICATORS OF NON-COMPLIANCE:

The following factors may indicate non-compliance with laws and regulations:

x Investigations by regulatory authorities and government departments

x Payment of fines or penalties
x Payments for unspecified services or loans to consultants, related parties, employees or
government employees
x Sales commissions or agents’ fees that appear excessive
x Purchasing at prices significantly above/below market price
x Unusual payments in cash
x Unusual transactions with companies registered in tax havens
x Payment for goods and services made to a country different to the one in which the goods and
services originated
x Payments without proper exchange control documentation
x Existence of an information system that fails to provide an adequate audit trail or sufficient
evidence
x Unauthorized transactions or improperly recorded transactions
x Adverse media comment

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AUDIT PROCEDURES WHEN NON-COMPLIANCE IS IDENTIFIED OR SUSPECTED

The following table summarises audit procedures to be performed when non-compliance is identified or
suspected.

Non-compliance: audit procedures

Obtain understanding of nature of act and circumstances
Obtain further information to evaluate possible effect on financial statements
Discuss with management and those charged with governance
Consider need to obtain legal advice if sufficient information not provided and matter is material
Evaluate effect on auditor’s opinion if sufficient information not obtained
Evaluate implications on investment and reliability of written representations

REPORTING IDENTIFIED OR SUSPECTED NON-COPLIANCE

The auditor shall communicate with those charged with governance, but if the auditor suspects that
those charged with governance are involved, the auditor shall communicate with the next higher level of
authority such as the audit committee or supervisory board. If this does not exist, the auditor shall
consider the need to obtain legal advice.

The auditor shall consider the impact on the auditor’s report if he/she concludes that the non-
compliance has a material effect on the financial statements and has not been adequately reflected or is
prevented by the management and those charged with governance from obtaining sufficient
appropriate audit evidence to evaluate whether non-compliance is material to the financial statements.

The auditor shall determine whether identified or suspected non-compliance has to be reported to the
regulatory and enforcement authorities. Although the auditor must maintain the fundamental principle
of confidentiality, in some jurisdictions the duty of confidentiality may be overridden by law or statute.

(CAAT’s) COMPUTER ASSISSTED AUDIT TECHNIQUES

CAAT’s are the use of computer for audit work.

In some cases there are large volumes of data and processes are too complex, in such cases we use
CAAT’s

Advantages of CAAT’s:

1. Auditors can test programs controls as well as general internal controls (log in id and passwords)
associated with clients system.
2. CAAT’s reduce waste of time on manual routine calculations, increasing efficiency.
3. Auditors can test greater number of items more quickly.
4. CAAT’S are cost effective in long term if client does not change its system.
5. CAAT’s help in increasing sample size which reduces overall risk.

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Disadvantages of CAAT’s:

1. Setting up software needed for CAAT can be time consuming and costly.
2. Audit staff will need to be trained so that they have sufficient level of IT knowledge.
3. Not all client system will be compatible with software used for CAAT’s.
4. There is a risk that live client data is corrupted and lost during use of CAAT’s.

There are two common types of CAAT’s

x Test data
x Audit software

Test Data:

Test data techniques are used in conducting audit procedures by entering data into an entity’s computer
system, and comparing results obtained with predetermined (to be/ should have been) results. Test
data is used for Test of controls

Advantages of test data:

1) Provides evidence that software or computer system used by the client is working
effectively.
2) Future costs are likely to be low if client does not change its system.

Disadvantages of test data:

1. Initial time and costs may be high.

2. Test data only tests operation of system at a single point of time and not for the whole
period under review.

Audit software:

Audit software consists of computer programs used by auditors as part of their auditing procedures to
process data of audit significance from entity’s accounting system (used for substantive procedures).

Advantages of audit software:

1. It can perform calculations more quickly than manual.

2. Audit software makes it possible to test more items.
3. It is cost effective in long term if client does not change its system.
4. It can increase sample size reducing overall risk.

Disadvantages of audit software:

1. Costs of designing tests using audit software can be substantial.

2. Experienced and trained staff will be required resulting in increased cost.
3. If errors are made I design of software, time and costs may waste.
4. If audit software is used during live running system, there is a risk that system is disrupted.

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General audit procedures that could be carried out using audit software (CAAT’s)

x Scan file to search for large and unusual items.

x Select a sample of items for testing which is representative of population.
x Cast the items to ensure accuracy.
x Verify access to system is limited to authorize personnel only.
x Perform analytical review by comparing with prior year to identify differences.

General audit procedures that could be carried out using test data(CAAT’s)

CONTROLS TEST DATA

1) System identifies when a customer’s 1) Enter few transactions which are
account balance exceeds limit within credit limits, system should
accept. Also enter few transactions
above credit limit, system should
reject
2) Discounts are only given after approval 2) Enter discounts without approval
system should reject
3) Website is integrated with inventory 3) Enter an order not in stock, system
system should reject it
4) System allows dispatcher of goods 4) Enter transactions with authorization,
only after authorities to be accepted by system, enter
transactions without authorization,
system should reject it

Auditing around the computer Auditing through the computer

Involves picking source documents at normal and Involves auditor trying to understand the system.
verifying corresponding outputs with inputs Consists auditing the computer processing system
example, multiply unit price with units sold to or data produced by the system to determine how
ensure revenue figure is correct. much reliance can be placed on controls
programmed in the system.

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NOT FOR PROFIT ORGANIZATIONS

Examples

1) Charities
2) Hospitals
3) Schools
4) Clubs
5) Societies
6) Associates

An audit of NFPO may vary from “ for profit audit” due to:

x Objectives
x Purpose for which audit is required

When carrying out an audit of NFPO, it is vital that auditor establishes:

x Whether a statutory audit is required

x If audit is not required, what are objectives of engagement
x What the engagement is to report on
x To whom report should be addressed
x What form report should take
x The audit risk.

The audit risk:

There are certain risks applicable for NFPO that may not be applicable to other small companies. These
are:

1. Inherent Risk:

x The regulation is quite complex

x Donations are quite significant
x Establishing ownership and timing of voluntary income is difficult specially where funds are
raised by non-controlled bodies
x There is lack of predictable income
x There is uncertainty of future income
x There is complexity of tax rules
x Certain key statistics are sensitive, such as proportion of resources used in administration
x They have to avoid buildup of reserves which appear excessive

2. Control Risk:

x Directors /trustees commit less time to organize affairs

x Directors/trustees are not that qualified
x Frequency of board/ trustee meetings is less

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x Trustees may not be independent from each other
x What is the division of duties between management and trustees.

Audit reporting for NFPO:

For NFPO where statutory audit is required, the same report will be issued as discussed earlier.

When NFPO is having an audit for benefit of members/trustees or a government funded entity is
being audited, standard audit report may not be required. However, auditor should make following
matters alter:

x Addressee of report
x What report relates to
x Scope of engagement
x Responsibilities of auditor and management/ trustees
x Work done
x Opinion drawn

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ANALYTICAL PROCEDURES
Explanation of analytical procedures:

Analytical procedures are used in obtaining an understanding of an entity and its environment and in
the overall review at the end of the audit.

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

Analytical procedures can be used as:

x Comparison of comparable information to prior periods to identify unusual changes or

fluctuations in amounts.
x Comparison of actual or anticipated results of the entity with budgets and/or forecasts, or the
expectations of the auditor in order to determine the potential accuracy or those results.
x Comparison to industry information either for the industry as a whole or by comparison to
entities of similar size to the client to determine whether receivable days, for example, are
reasonable.

Objectives of ANALYTICAL PROCEDURES at different stages of audit:

1) Risk assessment stage:(START)

At the beginning analytical procedures are used of the audit to help the auditor to obtain an
understanding of the entity and assess the risk of material misstatement. Audit procedures can then
directed to these ‘risky’ areas.

2) Performance stage:(DURING)

Analytical procedures can be used as substantive procedures in determining the risk of material
misstatement AT assertion level during work on the income statement and statement of final position
(balance sheet).

3) Opinion formation stage:(END)

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

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AUDIT PROCEDURES AND SAMPLING
1) SERVICE ORGANIZATION:

™ User entity: it is the entity whose financial statements are being audited.
™ User auditor: it is the firm who audits financial statement of user entity.
™ Service organization: it is the organization providing service to user entity regarding financial
statement.
™ Service auditor: it is the auditor of service organization who at the request of service
organization provides assurance report on controls of services organization to user auditor.

(May be possible KPMG thinks that God knows our client is taking service from which entity, they
can take information Of service organization from service auditor).

Example of service provided by service organization:

¾ Payroll processing
¾ Maintenance of records etc.

User auditor will check:

¾ Nature of contract between service organization and user entity (shares offered)
¾ Degree of interaction
¾ Nature of service provided
¾ Length of contract

User auditor must obtain understanding of service organization either through:

™ Report from service auditor.

™ Contacting service organization through user entity.
™ Visiting service organization to perform procedures.
™ Sending another auditor to perform procedures ( provided competent and independent)

Responsibility:

User auditor is solely responsible for audit opinion. No mentioning of service auditor name in audit
report. If name mentioned, clearly state he is not responsible.

2) USING THE WORK OF AN EXPERT:

Expert: Any person / firm having specialization in any field other than audit and accounting. Example:
diamond, gold, cement, oil sector, aircraft engineering, etc.

Management expert: A person/firm expert in field other than audit and accounting used by
management to help prepare financial statement.

Audit expert: A person/firm expert in field other than audit and accounting used by auditor to help in
gaining evidence.

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If auditor relies on work of experts, he will need to consider some factors:

x Independence
x Objectivity
x License
x Reputation
x Qualification

ISA 620 requires auditor to agree in writing the following with auditor’s expert:

1. Nature, scope and objectives of work.

2. Roles and responsibilities of auditor and expert.
3. Nature, timing and extent of communication between auditor and expert including form of
report.
4. Confidentiality requirements

Auditor must review and supervise work of expert as in the end he will be responsible for opinion not
the expert.
Audit report not to mention name of expert, if mentioned it should clearly stated that he is not
responsible.

3) USING THE WORK OF INTERNAL AUDITOR:

External auditor can rely on work of internal auditor, but he will consider some factors:

x Qualification
x Objectivity
x Independence (relative)
x Competence
x Status in the organization
x Reporting structure (to audit committee or Management)
x Scope of work (what work is done, powers etc.)
x Documentation done by him

External auditor must determine:

x Whether work of internal auditor can be used and if so to what extent.

x Whether work is appropriate for purpose of audit.
x Direct, supervise and review the work.

External auditor must communicate with those charged with governance on how he intends to use the
work of internal auditor. He must also communicate with internal auditor to improve communication.
Lastly, before finally using the work, external auditor must read reports of internal audit function to
obtain an understanding of their work. They should check whether:

1. Work was properly planned, performed, supervised, reviewed and documented.

2. Whether SAAE was obtained by internal auditor on work.
3. Whether conclusions reached are appropriate.

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4. External auditor may also re-examine items already examined by internal auditor, may observe
some procedures performed by him.

Direct assistance by internal auditors:

Refers to use of internal auditors to perform audit procedures under direction, supervision and review
of external auditors.

(In some cases it is completely not allowed)

When external auditors have used direct assistance from internal auditors, external auditors must
document:

¾ Threat to objectivity of internal auditor and level of competence of internal auditor.

¾ Basis for decision regarding nature and extent of work performed by internal auditor.
¾ Who reviewed the work performed and date and extent of that review?

4) ACCOUNTING ESTIMATES:

Financial statement are not on accurate basis, many items are an estimate like ones involve estimated
life, estimated scrap value, provisions etc.

™ An estimate is an approximation of monetary amount in the absence of actual information.

™ Management is responsible for setting of estimate as they will prepare financial statement.
Auditor is concerned because estimate creates more chances of fraud. For example, may be
management bonus is dependent on profits, they will decrease provision estimate to increase
profit and get bonus (may be).
™ It is often difficult for the auditor to obtain accurate evidence on reliability of estimate. It is also
difficult for auditor to challenge management estimate as management will always say we have
a better understanding of business.

Auditor must check:

¾ Basis of estimate (source)

¾ Reasonableness of estimate (method, assumptions)
¾ Review outcomes of estimates made previously
¾ Applicable FRF

If auditor disagrees with management on estimates, he can perform procedures as follows:

x Evaluate whether estimates are reasonable

x Obtain SAAE that disclosure are correct
x If estimation gives rise to risk, evaluate estimation uncertainty
x Review judgements and decisions of management to check bias
x Obtain written representations

Estimation uncertainty: Chances of estimate getting wrong. 4%-5% will work.

Management point estimate: What management thinks.

Audit point estimate: What auditor thinks regarding estimate.

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FIVE PROCEDRES OF OBTAINING EVIDENCE (CAIRO)

1. Confirmation:

It represents evidence obtained by auditor as a direct response from third party.

2. Analytical procedures:

It involves evaluation of financial information through analysis of plausible relationship among financial
and non financial data.

3. Inquiry:

It involves seeking information from knowledgeable persons, both within and outside the entity.

4. Inspection of records/ assets:

It involves physical examination of supporting documents or assets.

5. Recalculation:

It consists of checking the mathematical accuracy of documents or records. Recalculation may be

performed manually or electronically.

6. Observation:

It involves looking at a process or procedure being performed by others.

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AUDIT RISK
AUDIT RISK EXAMPLES

1. Increased revenue or capital expenditure, there is a risk that items are incorrectly treated as
capital or revenue in financial statement.
2. Increased R and D cost, there is a risk that items are not properly treated as per IAS 38.
3. Increase in provisions and contingent liabilities, there is a risk due to internal nature of these
items.
4. Decline in business/industry/margins or increase in competition, there is a risk of going
concern issues.
5. Increased bank loans, there is a risk of going concern issues due to high gearing.
6. Elimination of layer of management/ employees made redundant, risk that company may
not have made provision as per IAS 37.
7. Assets/inventory ordered or procured at year end with no certainty that they will be at year
end, there is a risk of over/ under statement of inventory/ assets.
8. There are various locations for storage of inventory, there is a risk that 100% verification is
not possible.
9. Some inventory warehouses are owned and some are rented, risk that rented warehouses
are included in PPE.
10. Introduction of new accounting/ I.T systems during the year, risk that new systems may not
completely get data from old systems.
11. Revaluation of assets during the year, risk of assets getting over/ under valued in financial
system.
12. Doubtful/dubious product being manufactured, risk of going concern issues due to any law.
13. Top management/personnel left the company close to balance sheet data, risk of errors due
to increased work load.
14. Default of major customers/customers struggling to pay, risk of receivable balance being
overstated.
15. Significant internal control weaknesses in sales/purchase systems, risk of over/under
statement of sales and purchases.
16. Out of court settlement done with any party, risk that provisions were overstated.
17. If there is work in progress in the company, risk that it may be over/under stated.
18. Excess/ surplus inventory and fixed assets, risk of theft or misappropriation.
19. First year of audit/ new audit client, risk of not detecting issues.
20. Short time period for audit completion, risk of errors not being detected due to pressures.
21. Sales/profit/asset related bonus being offered, risk sales/profit/asset being overstated.
22. Disposal of fixed asset, risk that they are not removed from assets thereby overstating asset.
23. Inventory not being valued at lower of cost or NRV, risk of over/under statement of
inventory.
24. Not making any adjustments if inventory is damaged, risk that inventory would be
overstated.

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COMPONENTS OF AUDIT RISK

Audit risk is made up of the following components:

Inherent risk is the susceptibility of an assertion about a class of transaction, account balance or
disclosure to a misstatement that could be material either individually or when aggregated with other
misstatements, before consideration of any related controls.

Factors which may increase inherent risk include:

¾ Changes in the nature of the industry the company operates in.

¾ A high degree of regulation over certain areas of the business.
¾ Going concern issues and loss of significant customers.
¾ Expanding into new territories.
¾ Events or transactions that involve significant accounting estimates.
¾ Developing new products or services, or moving into new lines of business.
¾ The application of new accounting standards.
¾ Accounting measurements that involve complex processes.
¾ Pending litigation and contingent liabilities.

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

The following factors may increase control risk:

¾ Changes in key personnel such as the departure of key management

¾ A lack of personnel with appropriate accounting skills
¾ Deficiencies in internal control
¾ Changes in the IT environment
¾ Installation of significant new IT systems related to financial reporting

Detention risk is the risk that the procedures performed by the auditor to reduce audit risk to an
acceptability low level will not detect a misstatement that exists and that could be material, either
individually or when aggregated with other misstatements.

Detection risk is affected by sampling and non-sampling risk. Factors which may result in an increase
include:

¾ Poor planning
¾ Inappropriate assignment of personnel to the engagement team
¾ Failing to apply professional skepticism
¾ Inadequate supervision and review of the audit work performed
¾ Incorrect sample sizes
¾ Incorrect sampling techniques performed

(Note: Only one example of a factor increasing the relevant risk was needed for each component.)

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Donald Co

Donald Co operates an airline business. The company’s yearend is 31 July 2011.

You are the audit senior and you have started planning the audit. Your manager has asked you to have a meeting with the
client and to identify any relevant audit risks so that the audit plan can be completed. From your
meeting you ascertain the following
In order to expand their flight network, Donald Co will need to acquire more airplanes; they have placed orders for another
six planes at an estimated total cost of $20m and the company is not sure whether these planes will be
received by the year end. In addition the company has spent an estimated $15m on refurbishing their
existing planes. In order to fund the expansion Donald Co has applied for a loan of $25m. It has yet to
hear from the bank as to whether it will lend them the money.

The company receives bookings from travel agents as well as directly via their website. The travel agents
are given a 90-day credit period to pay Donald Co, however, due to difficult trading conditions a number of the receivables
are struggling to pay. The website was launched in 2010 and has consistently encountered difficulties with customer
complaints that tickets have been booked and paid for online but Donald Co has no record of them and
hence has sold the seat to another customer. Donald Co used to sell tickets via a large call center located near
to their head office. However, in May they closed it down and made the large workforce redundant.

Required:

Using the information provided, describe FIVE audit risks and explain the auditor’s response to
each risk in planning the audit of Donald Co.
(10 marks)

Abrahams Co
Abrahams Co develops, manufactures and sells a range of pharmaceuticals and has a wide customer
base across Europe and Asia. You are the audit manager of Nate & Co and you are planning the audit of
Abrahams Co whose financial year end is 31 January. You attended a planning meeting with the finance
director and engagement partner and are now reviewing the meeting notes in order to produce the
audit strategy and plan. Revenue for the year is forecast at $25 million.

During the year the company has spent $2·2 million on developing several new products. Some of these
are in the early stages of development whilst others are nearing completion. The finance director has
confirmed that all projects are likely to be successful and so he is intending to capitalize the full $2·2
million.

Once products have completed the development stage, Abrahams begins manufacturing them. At the
yearend it is anticipated that there will be significant levels of work in progress. In addition the company
uses a standard costing method to value inventory; the standard costs are set when a product is first
manufactured and are not usually updated. In order to fulfill customer orders promptly, Abrahams Co
has warehouses for finished goods located across Europe and Asia; approximately one third of these are
third party warehouses where Abrahams just rents space.

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In September a new accounting package was introduced. This is a bespoke system developed by the
information technology (IT) manager. The old and new packages were not run in parallel as it was felt
that this would be too onerous for the accounting team. Two months after the system changeover the IT
manager left the company; a new manager has been recruited but is not due to start work until January.

In order to fund the development of new products, Abrahams has restructured its finance and raised $1
million through issuing shares at a premium and $2·5 million through a long-term loan. There are bank
covenants attached to the loan, the main one relating to a minimum level of total assets. If these
covenants are breached then the loan becomes immediately repayable. The company has a policy of
revaluing land and buildings, and the finance director has announced that all land and buildings will be
revalued as at the year end.

The reporting timetable for audit completion of Abrahams Co is quite short, and the finance director
would like to report results even earlier this year.

Required:
(b) Using the information provided, identify and describe FIVE audit risks and explain the auditor’s
response to each risk in planning the audit of Abrahams Co. (10 marks)

(c) Describe substantive procedures you should perform to obtain sufficient appropriate evidence in
relation to:

(i) Inventory held at the third party warehouses; and

(ii) Use of standard costs for inventory valuation. (4 marks)
(20 marks)

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Sunflower Stores Co
Sunflower Stores Co (Sunflower) operates 25 food supermarkets. The company’s yearend is 31
December 2012. The audit manager and partner recently attended a planning meeting with the finance
director and have provided you with the planning notes below.

You are the audit senior, and this is your first year on this audit. In order to familiarise yourself with
Sunflower, the audit manager has asked you to undertake some research in order to gain an
understanding of Sunflower, so that you are able to assist in the planning process. He has then asked
that you identify relevant audit risks from the notes below and also consider how the team should
respond to these risks.

Sunflower has spent $1·6 million in refurbishing all of its supermarkets; as part of this refurbishment
programme their central warehouse has been extended and a smaller warehouse, which was only
occasionally used, has been disposed of at a profit. In order to finance this refurbishment, a sum of $1·5
million was borrowed from the bank. This is due to be repaid over five years.

The company will be performing a year-end inventory count at the central warehouse as well as at all 25
supermarkets on 31 December. Inventory is valued at selling price less an average profit margin as the
finance director believes that this is a close approximation to cost.

Prior to 2012, each of the supermarkets maintained their own financial records and submitted returns
monthly to head office. During 2012 all accounting records have been centralized within head office.
Therefore at the beginning of the year, each supermarket’s opening balances were transferred into head
office’s accounting records. The increased workload at head office has led to some changes in the
finance department and in November 2012 the financial controller left. His replacement will start in late
December.

Required:
(a) List FIVE sources of information that would be of use in gaining an understanding of Sunflower
Stores Co, and for each source describe what you would expect to obtain. (5 marks)

(b) Using the information provided, describe FIVE audit risks and explain the auditor’s response to
each risk in planning the audit of Sunflower Stores Co. (10 marks)

(c) The finance director of Sunflower Stores Co is considering establishing an internal audit
department.

Required:
Describe the factors the finance director should consider before establishing an internal audit
department.

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Minty Cola Co
Minty Cola Co (Minty) manufactures fizzy drinks such as cola and lemonade as well as other soft drinks
and its year end is 31 December 2013. You are the audit manager of Parsley & Co and are currently
planning the audit of Minty.

You attended the planning meeting with the engagement partner and finance director last week and
recorded the minutes from the meeting shown below. You are reviewing these as part of the process of
preparing the audit strategy.

Minutes of planning meeting for Minty

Minty’s trading results have been strong this year and the company is forecasting revenue of $85
million, which is an increase from the previous year. The company has invested significantly in the cola
and fizzy drinks production process at the factory. This resulted in expenditure of $5 million on updating,
repairing and replacing a significant amount of the machinery used in the production process.

As the level of production has increased, the company has expanded the number of warehouses it uses
to store inventory. It now utilises 15 warehouses; some are owned by Minty and some are rented from
third parties. There will be inventory counts taking place at all 15 of these sites at the year end.

A new accounting general ledger has been introduced at the beginning of the year, with the old and new
systems being run in parallel for a period of two months.

As a result of the increase in revenue, Minty has recently recruited a new credit controller to chase
outstanding receivables. The finance director thinks it is not necessary to continue to maintain an
allowance for receivables and so has released the opening allowance of $1·5 million.

In addition, Minty has incurred expenditure of $4·5 million on developing a new brand of fizzy soft
drinks. The company started this process in January 2013 and is close to launching their new product
into the market place.

The finance director stated that there was a problem in November in the mixing of raw materials within
the production process which resulted in a large batch of cola products tasting different. A number of
these products were sold; however, due to complaints by customers about the flavour, no further sales
of these goods have been made. No adjustment has been made to the valuation of the damaged
inventory, which will still be held at cost of $1 million at the year end.

As in previous years, the management of Minty is due to be paid a significant annual bonus based on the
value of year-end total assets.

Required:

(a) Explain audit risk and the components of audit risk. (5 marks)

(b) Using the minutes provided, identify and describe SIX audit risks, and explain the auditor’s
response to each risk, in planning the audit of Minty Cola Co. (12 marks)

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(c) Identify the main areas, other than audit risks, that should be included within the audit strategy
document for Minty Cola Co; and for each area provide an example relevant to the audit. (4 marks)

(d) Describe substantive procedures the audit team should perform to obtain sufficient and
appropriate audit evidence in relation to the following three matters:
(i) The treatment of the $5 million expenditure incurred on improving the factory production process;
(ii) The release of the $1·5 million allowance for receivables; and
(iii) The damaged inventory.
Note: The total marks will be split equally between each part. (9 marks)

(30 marks)

White & Co

(a) In agreeing the terms of an audit engagement, the auditor is required to agree the basis on which the
audit is tobe carried out. This involves establishing whether the preconditions for an audit are present
and confirming that there is a common understanding between the auditor and management of the
terms of the engagement.

Required:

Describe the process the auditor should undertake to assess whether the PRECONDITIONS for an audit
are present. (3 marks)

(b) List FOUR examples of matters the auditor may consider when obtaining an understanding of the
entity.
(2 marks)
(c) You are the audit senior of White & Co and are planning the audit of Redsmith Co for the year ended
30 September 2010. The company produces printers and has been a client of your firm for two years;
your audit manager has already had a planning meeting with the finance director. He has provided you
with the following notes of his meeting and financial statement extracts.

Redsmith’s management was disappointed with the 2009 results and so in 2010 undertook a number of
strategies to improve the trading results. This included the introduction of a generous sales-related
bonus scheme for their salesmen and a high profile advertising campaign. In addition, as market
conditions are difficult for their customers, they have extended the credit period given to them.

The finance director of Redsmith has reviewed the inventory valuation policy and has included
additional overheads incurred this year as he considers them to be production related. He is happy with
the 2010 results and feels that they are a good reflection of the improved trading levels.

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Financial statement extracts for year ended 30 September DRAFT ACTUAL

2010 2009
$m $m

Revenue 23·0 18·0

Cost of sales (11·0) (10·0)
––––– –––––
Gross profit 12·0 8·0
Operating expenses (7·5) (4·0)
––––– –––––
Profit before interest and taxation 4·5 4·0
–––––– –––––

Inventory 2·1 1·6

Receivables 4·5 3·0
Cash – 2·3
Trade payables 1·6 1·2
Overdraft 0·9 –

Required:

Using the information above:

(i) Calculate FIVE ratios, for BOTH years, which would assist the audit senior in planning the audit; and
(5 marks)
(ii) From a review of the above information and the ratios calculated, explain the audit risks that arise
and describe the appropriate response to these risks. (10 marks)
(20 marks)

Rhino & Co
You are the audit senior of Rhino & Co and you are planning the audit of Kangaroo Construction Co
(Kangaroo) for the year ended 31 March 2013. Kangaroo specialises in building houses and provides a
five-year building warranty to its customers. Your audit manager has held a planning meeting with the
finance director. He has provided you with the following notes of his meeting and financial statement
extracts:

Kangaroo has had a difficult year; house prices have fallen and, as a result, revenue has dropped. In
order to address this, management has offered significantly extended credit terms to their customers.
However, demand has fallen such that there are still some completed houses in inventory where the
selling price may be below cost. During the year, whilst calculating depreciation, the directors extended
the useful lives of plant and machinery from three years to five years. This reduced the annual
depreciation charge.

The directors need to meet a target profit before interest and taxation of $0·5 million in order to be paid
their annual bonus. In addition, to try and improve profits, Kangaroo changed their main material
supplier to a cheaper alternative. This has resulted in some customers claiming on their building
warranties for extensive repairs. To help with operating cash flow, the directors borrowed $1 million
from the bank during the year. This is due for repayment at the end of 2013.

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Financial statement extracts for year ended 31 March

DRAFT ACTUAL
2013 2012
$m $m

Revenue 12·5 15·0

Cost of sales (7·0) (8·0)
–––– ––––
Gross profit 5·5 7·0
Operating expenses (5·0) (5·1)
–––– ––––
Profit before interest and taxation 0·5 1·9
–––– ––––
Inventory 1·9 1·4
Receivables 3·1 2·0
Cash 0.8 1·9
Trade payables 1·6 1·2
Loan 1·0 –

Required:

Using the information above:

(i) Calculate FIVE ratios, for BOTH years, which would assist the audit senior in planning the audit
(5 marks)

(ii) Using the information provided and the ratios calculated, identify and describe FIVE audit risks and
explain the auditor’s response to each risk in planning the audit of Kangaroo Construction Co.

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Maple & Co
You are the audit supervisor of Maple & Co and are currently planning the audit of an existing client,
Sycamore Science Co (Sycamore), whose yearend was 30 April 2015. Sycamore is a pharmaceutical
company, which manufactures and supplies a wide range of medical supplies. The draft financial
statements show revenue of $35·6 million and profit before tax of $5·9 million.

Sycamore’s previous finance director left the company in December 2014 after it was discovered that he
had been claiming fraudulent expenses from the company for a significant period of time. A new finance
director was appointed in January 2015 who was previously a financial controller of a bank, and she has
expressed surprise that Maple & Co had not uncovered the fraud during last year’s audit.

During the year Sycamore has spent $1·8 million on developing several new products. These projects are
at different stages of development and the draft financial statements show the full amount of $1·8
million within intangible assets. In order to fund this development, $2·0 million was borrowed from the
bank and is due for repayment over a ten-year period. The bank has attached minimum profit targets as
part of the loan covenants.

The new finance director has informed the audit partner that since the year end there has been an
increased number of sales returns and that in the month of May over $0·5 million of goods sold in April
were returned.

Maple & Co attended the year-end inventory count at Sycamore’s warehouse. The auditor present
raised concerns that during the count there were movements of goods in and out the warehouse and
this process did not seem well controlled.

During the year, a review of plant and equipment in the factory was undertaken and surplus plant was
sold, resulting in a profit on disposal of $210,000.

Required:

(a) State Maples & Co’s responsibilities in relation to the prevention and detection of fraud and
error. (4 marks)

(b) Describe SIX audit risks, and explain the auditor’s response to each risk, in planning the
audit of Sycamore Science Co. (12 marks)

(c) Sycamore’s new finance director has read about review engagements and is interested in the
possibility of Maple & Co undertaking these in the future. However, she is unsure how these
engagements differ from an external audit and how much assurance would be gained from this
type of engagement.

Required:

(i) Explain the purpose of review engagements and how these differ from external audits; and (2
marks)
(ii) Describe the level of assurance provided by external audits and review engagements. (2 marks)
(20 marks)

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Amethyst & Co
You are an audit supervisor of Amethyst & Co and are currently planning the audit of your client,
Aquamarine Co (Aquamarine) which manufactures elevators. Its year end is 31 July 2016 and the
forecast profit before tax is $15·2 million.

The company undertakes continuous production in its factory, therefore at the yearend it is anticipated
that work in progress will be approximately $950,000. In order to improve the manufacturing process,
Aquamarine placed an order in April for $720,000 of new plant and machinery; one third of this order
was received in May with the remainder expected to be delivered by the supplier in late July or early
August.

At the beginning of the year, Aquamarine purchased a patent for $1·3 million which gives them the
exclusive right to manufacture specialized elevator equipment for five years. In order to finance this
purchase, Aquamarine borrowed $1·2 million from the bank which is repayable over five years.

In January 2016 Aquamarine outsourced its payroll processing to an external service organisation, Coral
Payrolls Co (Coral). Coral handles all elements of the payroll cycle and sends monthly reports to
Aquamarine detailing the payroll costs. Aquamarine ran its own payroll until 31 December 2015, at
which point the records were transferred over to Coral.

The company has a policy of revaluing land and buildings and the finance director has announced that
all land and buildings will be revalued at the year end. During a review of the management accounts for
the month of May 2016, you have noticed that receivables have increased significantly on the previous
year end and against May 2015.

The finance director has informed you that the company is planning to make approximately 65
employees redundant after the year end. No decision has been made as to when this will be announced,
but it is likely to be prior to the year end.

Required:
(b) Describe SIX audit risks, and explain the auditor’s response to each risk, in planning the audit of
Aquamarine Co. (12 marks)
(c) Explain the additional factors Amethyst & Co should consider during the audit in relation to
Aquamarine Co.’s use of the payroll service organisation.
(3 marks)

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Five procedures for obtaining evidence (CAIRO)

1. CONFIRMATION:

It represents evidence obtained by auditor as a direct response from third party.

2. ANALYTICAL PROCEDURES:

It involves evaluation of financial information through analysis of plausible relationship between

financial and non financial data.

3. INQUIRY:

It involves seeking information from knowledgeable persons, both written and outside the entity.

4. INSPECTION OF RECORDS:

It involves physical examination of supporting documents or assets.

5. RECALCULATION:

It consists of checking mathematical accuracy of documents.

6. OBSERVATION:

It involves looking at a procedure being performed by others.

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

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

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

Required:
Using the information above: Describe FIVE corporate governance weaknesses faced by Tangerine
Tech Co and provide a recommendation to address each weakness to ensure compliance with
corporate governance principles.

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(10 marks)

(i) Describe FIVE types of procedures for obtaining audit evidence; and
(ii) For each type of procedure, describe an example relevant to the audit of BANK balances.

Note: The total marks will be split equally between each part. (10 marks)

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