PROFESSIONAL LEVEL EXAMINATION

MONDAY 10 SEPTEMBER 2018

(2½ HOURS)

AUDIT AND ASSURANCE

This exam consists of four questions (100 marks).

Marks breakdown

Question 1 20 marks
Question 2 40 marks
Question 3 26 marks
Question 4 14 marks

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Question 1

1.1 Island Ltd (Island) and Flint Ltd (Flint) are both external audit clients of your firm. Each
company has a year end of 30 September. In April 2018, Flint contracted with Island for
the provision of services. Flint is dissatisfied with the quality of services provided by
Island and is currently taking legal action against Island. The outcome of the legal action
will not be known before the conclusion of both external audits for the year ending
30 September 2018.

Identify and explain the ethical issues arising from the situation outlined above and state
how your firm should address these issues. (4 marks)

1.2 Your firm is the external auditor of Blackett Ltd (Blackett), an unlisted company, and its
wholly-owned subsidiary Coniston Ltd (Coniston). The audit fees for Blackett and
Coniston are £4.2 million and £2.7 million respectively. Your firm also provides annual
tax services to both companies for a total fee of £1.6 million. During the current year,
your firm performed a one-off IT engagement for Blackett for a fee of £1.1 million. Your
firm’s total annual fee income from all its clients is £74.8 million.

Explain what is meant by the self-interest threat in relation to the fee income, arising
from the circumstances outlined above, and state how your firm should address this
threat. (4 marks)

1.3 Your firm is the external auditor of Captain Ltd (Captain) for the year ending
31 December 2018. Your firm plans to use data analytics routines relevant to the audit
of inventory. Captain sells fashion goods from 3,000 retail stores located in
36 countries. The goods are purchased from around the world and are invoiced in each
supplier's local currency.

Describe three data analytics routines relevant to the audit of Captain's inventory.
(3 marks)

1.4 Your firm has been the external auditor of Parrot Ltd (Parrot) for three years. You have
performed preliminary analytical procedures whilst planning the audit for the year ended
30 June 2018. Trade payables days have fallen to 24.9 days compared with 31.6 days
at 30 June 2017. Parrot’s suppliers have credit terms of 30 days.

List the audit procedures you would include in the audit plan for the year ended 30 June
2018 given the change identified in trade payables days. (3 marks)

1.5 Outline how the planned procedures for an engagement to review financial statements
will differ from the planned procedures in respect of an external audit performed under
the Companies Act 2006. Give reasons for the differences. (2 marks)

1.6 Your firm is the external auditor of Pirate Ltd (Pirate). During the current year, Pirate
acquired 100% of the share capital of Oar Ltd (Oar), a company incorporated in the UK.
The year end for both companies is 30 June 2018. Oar’s financial statements are being
audited by Turner LLP (Turner) and your firm intends to use the audit evidence obtained
by Turner for the group audit. Oar is a significant component of Pirate.

Outline the procedures that your firm should undertake because of its intention to use
the audit evidence obtained by Turner for the year ended 30 June 2018. (4 marks)

Total: 20 marks

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Question 2

Your firm is the external auditor of Ransome Guard Ltd (RG), a UK-based company, for the
year ending 30 September 2018. RG designs and sells wireless home security cameras to
retailers.

Homeowners purchase RG’s security cameras from a retailer, install them at their property
and link them to their smartphones via a free mobile app. Homeowners receive alerts in the
app when a camera detects motion at their property and they can also view video recordings
made by the cameras. Some homeowners use RG’s premium service. The premium service
allows storage of larger volumes of video recordings in the app compared with the basic plan,
which is free.

You are the audit senior responsible for planning the audit. The engagement partner has
asked you to consider the following key areas of audit risk:

 Revenue from retailers and the premium service

 Inventory
 Going concern

RG has contracts to supply 32 major retailers in Europe and North America with its security
cameras. Each contract with a retailer states the number of cameras to be supplied in the
contract period and the price to be paid to RG for each camera, denominated in the retailer’s
local currency.

Homeowners who use the premium service pay RG on an annual basis in advance by
entering their credit card details in the app. The annual cost is denominated in the
homeowner’s local currency.

RG’s security cameras are assembled by Pemmican Ltd (Pemmican) a company based in
Asia. Pemmican purchases components for the cameras, based on specifications set out in
its contract with RG. Pemmican delivers the assembled cameras to a shipping company in
Asia which then ships them to one of RG’s 12 warehouses in Europe and North America.
Ownership of the cameras passes to RG when Pemmican delivers them to the shipping
company. In accordance with the contract, Pemmican invoices RG a fixed price,
denominated in sterling, for each camera assembled.

RG maintains a perpetual inventory system at each of its 12 warehouses. Inventory at each

warehouse is counted once a year with one warehouse being selected for counting each
month. Year-end inventory included in the financial statements is based on the quantities
recorded in the perpetual inventory system.

On 30 April 2018, an audit junior attended the inventory count at RG’s UK warehouse and
noted the following issues:

(a) The movement of cameras to and from the warehouse continued throughout the count.

(b) There was a large quantity of one camera, the GrG-I model, which appeared to be old
with damaged packaging. The UK warehouse manager said that he had not had time to
review the aged inventory report for many months.

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(c) There were several discrepancies identified between the perpetual inventory records
and the quantity of physical inventory counted at the warehouse. The UK warehouse
manager explained that adjustments are made to the perpetual inventory records for
any discrepancies without further investigation.

As part of your planning for the year ending 30 September 2018, you met with Susan Walker,
RG’s finance director, who provided you with the following information:

 RG is currently discussing quality issues with Pemmican. Pemmican has been

sourcing cheaper components, which are inferior to those stipulated in its contract with
RG, to improve Pemmican’s profit margin.

 During the year, RG received a significant number of complaints about its cameras
malfunctioning shortly after installation. In response to the resulting adverse media
attention, RG has publicly promised refunds to all affected homeowners. RG’s quality
control team is currently investigating whether the malfunctions are due to the inferior
components used by Pemmican.

 RG is currently renegotiating eight of its retail contracts which are due to expire by
June 2019. Susan is concerned that other retailers might exercise early termination
clauses in their contracts if the quality issues are not resolved quickly.

 In August 2018, RG was the victim of a cyber-attack which prevented RG from

operating for two days. RG’s IT security department is currently investigating whether
any personal data of homeowners was stolen during the attack.

Susan also provided you with the following financial information:

Statement of profit or loss for the year ending 30 September (extract)

2018 2017
(estimated) (audited)
£’000 £’000
Revenue
- Contracts with retailers 132,750 124,120
- Premium service 49,780 35,500
182,530 159,620
Cost of sales (98,710) (97,770)
Gross profit 83,820 61,850

Profit before tax 15,470 30,925

Statement of financial position as at 30 September (extract)

2018 2017
(estimated) (audited)
£’000 £’000
Inventory 13,890 10,500

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At the end of your planning meeting, Susan asked whether you would be interested in
working for RG as financial controller. The position has been vacant for many months. You
are very interested in the offer and intend to discuss this further with Susan.

Requirements

2.1 Justify why revenue, inventory and going concern have been identified as key areas of
audit risk and, for each key area, describe the procedures that should be included in the
audit plan to address those risks.

Present your answer using the following subheadings:

 Revenue from retailers

 Revenue from the premium service
 Inventory
 Going concern
(25 marks)

2.2 For each of the issues (a) to (c) noted by the audit junior, draft points for inclusion in
your firm's report to those charged with governance and management at RG. For each
issue, state the internal control deficiency, outline the possible consequence(s) and
provide recommendations to address the deficiency. (12 marks)

2.3 Identify and explain the threats to independence and objectivity arising from Susan’s
offer for you to become RG’s financial controller. State any actions that you or the
engagement partner should take. (3 marks)

Total: 40 marks

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Question 3

Your firm has been invited to tender for appointment as external auditor of Swallow Group
Ltd (Swallow) for the year ending 31 December 2018. The audit partner considering the
invitation has documented the following information:

Swallow is a specialist engineering company which designs and manufactures

precision equipment for industrial customers in Europe, Asia and Africa. Swallow
operates through three subsidiaries, one based in each continent, and has
manufacturing facilities in 20 countries.

Contracts for the design and manufacture of equipment for customers are fixed-price
and are typically longer than 12 months. Swallow recognises revenue and costs based
on the estimated stage of completion of each contract. Full provision is made for any
anticipated losses on contracts.

In response to challenging market conditions during 2017, Swallow undertook a

business reorganisation in the first six months of 2018. This included implementation of
new IT systems and a redesign of its manufacturing processes to improve efficiency.
This has resulted in difficult employee relations because employees working in the
manufacturing facilities claim that the changes compromise health and safety
standards. Swallow has experienced significant adverse publicity about this issue.

Swallow has also changed the way it remunerates the employees in its sales team to
provide greater incentives to win new contracts. Since the changes were made,
Swallow’s fraud and anti-bribery confidential hotline has received increased calls about
the sales practices in some regions.

Swallow’s share capital is owned equally by three siblings, John, Nancy and Kitty
Walker. John and Nancy are directors of Swallow. Kitty left her role as finance director
in June 2018 due to a disagreement and has not been replaced. The disagreement
arose because John and Nancy wish to raise additional loan finance to enable Swallow
to increase investment in research and development. Kitty disagreed with this because
Swallow already invests significant amounts in research and development.

John and Nancy have requested a loan from Swallow’s bank. The bank requires the
audited financial statements for the year ending 31 December 2018 before making a
final decision on the loan. Swallow’s invitation to tender document states: “The
successful firm will be able to demonstrate its ability to complete the 2018 audit on or
before 31 January 2019.”

Swallow’s invitation to tender document also requires your firm to include the following non-
audit services in its tender response:

 Management of Swallow’s payroll

 Assistance in recruiting a new finance director
 Representation of Swallow in a significant dispute with HMRC

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Requirements

3.1 Using the information documented by the audit partner, identify and explain the factors
that should be considered by your firm when deciding whether to submit a tender for
appointment as Swallow’s external auditor.

You do not need to consider the provision of the non-audit services in this part of the
question. (18 marks)

3.2 Assuming your firm is appointed as external auditor of Swallow, explain the threats to
independence and objectivity which may arise if your firm also provides the non-audit
services requested. Outline the safeguards, if any, which should be put in place to
mitigate those threats. (8 marks)

Total: 26 marks

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Question 4

Described below are situations which have arisen at four unrelated clients of your firm.

AMA Zones Ltd (AMA)

Your firm is the external auditor of AMA for the year ended 30 June 2018. AMA’s financial
statements show revenue of £54.8 million, of which £1.1 million relates to cash sales. During
the audit, your firm identified that AMA had no system of internal control over cash sales. No
other audit procedures were available to obtain assurance over cash sales. AMA’s profit
before tax is £9.5 million.

Wild Ltd (Wild)

Your firm is the external auditor of Wild for the year ended 30 June 2018. In March 2018,
Wild sold a property to Holly James. Holly is Wild’s managing director. Wild’s directors have
refused to disclose the sale of the property to Holly in the financial statements for the year
ended 30 June 2018.

Lake Ltd (Lake)

Your firm is performing an engagement to examine and provide assurance on Lake’s cash
flow forecast for the three years ending 30 September 2021. The forecast has been prepared
by Lake’s directors in support of a loan application. Lake’s bank requires the forecast to be
examined and reported on by independent accountants. The cash flow forecast has been
prepared on the assumption that revenue will grow by 8% pa. Your firm believes this is highly
unrealistic because current revenue growth for Lake and the industry in which it operates is
2% pa and 3% pa respectively.

Sail plc (Sail)

Sail is a listed company. Your firm has accepted an assurance engagement to provide an
opinion on Sail’s greenhouse gas (GHG) statement for the year ended 30 June 2018. Sail
has estimated the emissions figures for the period February to June 2018 and is required to
disclose this fact in the GHG statement. Your firm is satisfied with the basis of the estimate
and that it has been appropriately disclosed by Sail. The inclusion of estimates is
fundamental to users’ understanding of the GHG statement.

Requirement

For each of the four situations above, state, with reasons, the implications for your firm’s
audit or assurance reports. Total: 14 marks

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