F8Aa(Int)Mt2A as j08

Monitoring Test MT2A Audit and Assurance International F8AA-MT2A-X08-A Answers & Marking Scheme Accountancy Tuition Centre Ltd ATC Trang 2 1 INTERNAL AND EXTERNAL AUDITORS a Fraud and

The model answers to the questions are longer

and more detailed than would be expected from a

candidate in the examination However, the model

answer may not include all valid points mentioned by

students – credit will be given to students mentioning

such points

The model answer may be used as guide to the form

and standard of answer students should aim to

achieve

Monitoring Test MT2A

Audit and Assurance

(International)

F8AA-MT2A-X08-A

Answers & Marking Scheme

INTERNATIONAL

1 INTERNAL AND EXTERNAL AUDITORS

(a) Fraud and error

„ Management and those charged with governance are responsible for the establishing

systems and controls to prevent and detect fraud and error

„ An effective internal audit department can assist management in the risk

management of fraud and error through recommendations of appropriate internal control and the appraisal and testing of such control

„ The duties of internal auditors are generally determined by the organisation that has

set up the internal audit department and employs the internal auditors Internal auditors normally have a general responsibility to perform their work and their reviews of systems with the possibility of fraud and error in mind

„ This means that when they review the structure and operation of systems they have

regard to strengths in the system that will prevent or detect fraud and error and weaknesses that will facilitate fraud and error

„ When internal auditors discover structural or operational weaknesses that facilitate

or fail to prevent or detect fraud and error, they generally have a duty to report such matters internally (e.g to an audit committee)

„ The precise method of reporting varies from organisation to organisation If internal

auditors discover actual instances of fraud or error, they also have a duty to report it

„ It can be difficult in practice for internal auditors to deal with actual or suspected

management fraud But the “Rules of Professional Conduct” do not permit auditors

to remain silent on the subject

„ If an audit committee is established within the organisation, then they would be the

body to whom the internal auditor should report

„ There is no general duty to report fraud or error outside the organisation and internal

auditors, like other employees, have a duty of confidentiality to the organisation they work for

„ In extreme circumstances however, it may be necessary for internal auditors to

report matters to persons outside the organisation (where money laundering is discovered, for example)

„ External auditors are not, and cannot, be held responsible for the prevention and

detection of fraud and error – that is the responsibility of management

„ External auditors plan and perform their work with an attitude of professional

scepticism ISA 240 “Fraud and Error” states that the audit is designed to detect material errors, which may be due to fraud or error, but this does not mean that the

„ The external auditor should “plan and perform the audit with an attitude of

professional scepticism, recognizing that conditions or events may be found that indicate that fraud or error may exist.”

„ As part of their planning procedures, the external auditor must discuss the

susceptibility of their client’s financial statements to material misstatement caused

by fraud

„ Fraud or error should only be reported in the financial statements to shareholders if

they are material

„ Like internal auditors, external auditors are bound by a duty of confidentiality to

their clients However, in most countries, external auditors do have a number of legal rights and duties to report certain types of suspected fraud, such as money laundering, to certain bodies

(b) Internal audit’s role

(i) Corporate governance

„ The objectives of good corporate governance include: the proper constitution of the

board, proper arrangements for the remuneration of directors, proper mechanisms for shareholder relations, and proper accountability and audit

„ Accountability and audit includes the maintenance of a proper system of internal

control A proper system of internal control includes appropriate risk management systems and overall organisational control

„ Internal audit’s role in the context of these objectives includes assisting management

by suggesting ways in which these objectives can be achieved, and by monitoring progress

Example for manufacturing company

„ The internal auditors can recommend to the board those areas in which structural

changes need to be made in order to comply with codes of corporate governance, such as those issued by the OECD and the World Bank They can recommend processes for setting objectives and targets, and for measuring their achievement

(ii) Risk management

„ Internal audit has a particular interest in investigating and evaluating the company’s

risk management structures Internal audit can manage the provision of the basic data which management can use in order to identify, prioritise and manage the risks facing the company

„ Internal audit can also help by developing models and techniques for identifying,

prioritising and managing risk

Example for manufacturing company

„ In a manufacturing company, risk management issues to be addressed include

operational, financial, health and safety and other regulatory issues Internal audit can help in identifying the issues, evaluating their importance and suggesting mechanisms for managing or transferring the risk

„ The management of risk depends on the business objectives, short and long term,

strategic and operational, and conflicts between objectives These objectives include, for example, the need to provide a return to investors, the need for long-term investment, and the need to produce a quality product Internal audit can help classify those risks

(iii) Organisational control

„ The simple existence of an internal audit function is an example of organisational

control Internal audit can investigate and document existing control systems, as well as test controls, and recommend improvements

Example for manufacturing company

„ Internal audit can help in providing cost-benefit analyses in respect of the

implementation of control procedures, as well as making recommendations on structural control

„ When computer systems are designed, internal audit can ensure that the appropriate

development controls are implemented and tested

(c) Out-sourced internal audit issues

The issues to be considered include:

„ The costs of out-sourcing the function, including the internal administrative costs

and the costs of managing the function These may be more or less than internal costs, and a cost-benefit analysis will help establish the likely financial implications

„ An out-sourced internal audit function will be more independent than an internal

function, but this has to be set off against the (probably) superior knowledge of the business of the existing function

„ Out-sourcing the internal audit function probably means a loss of control, whilst the

responsibility for the function will remain with the company

„ Change management issues have to be addressed which can be time consuming and

expensive Existing staff have to be re-deployed (perhaps to the company to which the function is out-sourced) and there may be resentment of the new internal auditors and deliberate attempts to frustrate them

2 MICROPRODS

(a) Evidence to check the cost of assembled laptops

„ Purchase invoices for component parts to confirm $600 element of cost

„ Reperformance of client’s calculations (e.g averaging of costs, stocksheet

extensions and overhead absorption rates) to verify their accuracy

„ Payroll/timesheet analyses showing allocation/apportionment of production labour

„ Classification/analysis of general ledger (G/L) expense accounts into production and

non-production overheads

„ Calculations of overhead allocation, apportionment and absorption based on a

normal level of activity

„ Production (quantity) records (budget and actual) to support calculations of

overhead absorption rates and any under/over absorption

(b) Evidence to ascertain the NRV of laptops

„ Audit working papers from year-end physical count identifying obsolete, damaged,

returned or otherwise slow-moving inventory

„ After date selling prices, especially of laptops identified at year-end physical count

as returns/damaged etc

„ Latest edition of computer magazine/buyers’ guide to assess market selling prices

and current state of industry

„ Order book to ascertain whether advertising campaign has had any appreciable

effect on level of demand for notebooks

„ Inventory turnover ratios, by model, to identify slow-moving and potentially

obsolete models

„ Client’s records of sales returned identifying faulty inventory

„ Serial numbers of a sample of year-end inventory items to estimate age by reference

to production records

„ Client’s schedule (if any) comparing costs and NRVs of all obsolete, damaged or

otherwise slow-moving items

„ Post year-end invoices/cash book payments supporting advertising campaign to

speed up movements of goods

(c) Evidence to confirm the adequacy of the warranty provision

Tutorial note: When wok done under warranty work is costed, the accounting entries are:

Dr Warranty expense

Cr Materials (replacement components etc.)

Cr Labour (+ overheads)

At the financial year end, management has to estimate a provision for warranty work to be done in the future (therefore uncertain) in respect of sales already made

„ Terms and conditions to identify circumstances which render the warranty

agreement void (e.g negligent use disclaimers and servicing restrictions to authorised personnel)

„ The client’s system for recording computers returned and authorising rectification

work under the terms of warranty

„ A schedule of claims received (including those notified after the end of the reporting

period) identifying those rejected (e.g due to breach of warranty conditions)

„ Rectification cost records and related general ledger accounts showing cost of

replacement components

„ Payroll/timesheet analyses showing cost of service engineering labour

„ Schedule of current year costs incurred under warranty agreements charged against

the warranty provision made in prior year

„ Reperformance of client’s calculations (e.g extrapolation of legitimate claims as a

percentage of sales) to confirm their accuracy

„ Prior knowledge of management’s expertise in determining provisions (i.e the

adequacy of provisions made in previous years based on the extent to which they have been utilised.)

„ Correspondence with customers requesting work to be done under warranty or

identifying manufacturing defects

„ Consumer reports in specialist magazines commenting on the reliability of the

client’s products

„ Terms and conditions of notebook purchases from Far Eastern supplier (e.g whether

any recourse or counter-claim provisions)

„ Physical condition of returned goods

„ Repair invoices in respect of rectification work sub-contracted or referred to a local

3 PHOENIX

(1) Trade investment

(i) Matters

„ Assuming that Pegasus is insolvent (e.g a receiver or liquidator has been appointed)

this is an adjusting event after the reporting period (IAS 10)

„ As the recoverable amount is likely to be $nil, a $80,000 impairment loss should be

recognised in the statement of comprehensive income for the year to 31 March (IAS 36)

„ As the likelihood of any distribution of the declared dividends is remote, the

$15,000 dividends receivable should be written off

„ The total expense of $95,000 represents 5·6% of draft profit before tax and may be

material Consideration should be given to whether or not it is material to the statement of financial position

„ Separate disclosure (IAS 1) may be appropriate to explaining Phoenix’s

performance for the year

(ii) Audit evidence

„ A copy of the press report

„ The audited accounts of Pegasus for the year ended 30 September showing whether

there are assets with market values in excess of book values

„ The receiver’s (or liquidator’s) statement of affairs indicating whether any

distribution is possible

„ Written management representation confirming that there have been no events since

the end of the reporting period other than Pegasus’s insolvency

(2) Future maintenance

(i) Matters

„ The accounting treatment of maintenance costs should be consistent with prior

years However, IAS 37 does not permit the recognition of a provision that does not meet the recognition criteria for liabilities

„ Overhaul expenditure to restore or maintain the future economic benefits expected

from the plant and equipment should normally be recognised as an expense when it

is incurred (IAS16)

„ However, blast furnaces are of a type of plant and equipment that require relining

after a specified period The components (blast furnace interiors) which require replacement are separate assets that should be depreciated over the replacement cycle To the extent that the $500k includes the cost of replacing separate assets, it represents future capital cost

„ Prudence does not permit the creation of hidden reserves and excessive provisions

This “provision” does not therefore meet the IAS 37 definition:

‰ there is no uncertainty about the timing (August);

‰ there may be relatively little uncertainty about the amounts involved;

‰ there is no liability as at 31 March

„ This is the first time that the blast furnaces need this form of maintenance IAS 37

has been in issue since 1999 and its requirements should be well understood

(ii) Audit evidence

„ Discussion with senior management their reasons for having made the provision this

year (but not in previous years) and whether any costs have been contracted for to identify any elements that cannot be escaped, e.g cancellation clauses

„ External tenders or quotes for sub-contracted work, again to identify any

cancellation clauses that may need to be provided for

„ Rework from facts obtained of what auditor’s believe provision should be and

compare to client’s schedule showing make-up of provision

„ Consider why management felt it necessary to establish this provision Was it an

attempt to “profit smooth”? Is there any evidence of future material expenditure which would have been offset against this provision?

(3) Impact on audit opinion

„ The trade investment write off ($80,000) represents 4.7% of profit before tax and

may be considered, on its own, as not being material Add to that the connected dividend of $15,000, then the overall impact becomes 5.6%

„ Whilst both may still not be considered as material, it does seem odd for the

management to wish to carry an investment that would be disclosed in the notes when that investment no longer exists

„ Consideration should also be given to the status of the statement of financial

position position (facts not given) If this investment is material to that category, then it should be adjusted Should the client refuse to adjust, then the audit opinion should be qualified “except for” on the basis of overstatement of an asset

(investment and receivable)

„ The provision represents 29% of draft profit before tax and is therefore material If

the provision is not reversed the audit opinion should be qualified “except for” on grounds of non-compliance with IAS 37

„ Draft profit before tax ($1·7m) shows a 13% increase on the previous year If

adjustments are made for points (1) and (2) , profit will be increased by at least

Marking Scheme

For most questions the marking scheme suggests you award 1 mark a point However, the mark you award for each point will depend on its relevance and the depth of the student’s discussion So, a brief point may be worth 1/2 mark or less while a point with a longer and deeper discussion could be worth 2 marks

Also, marks are not allocated to specific points, as the student may mention a valid point which is not given in the model answer – obviously the student should be given credit for the point

Many questions require the students to include a range of points in their answer, so an answer which concentrates on one (or a few) points should normally be given a lower mark than one which considers

a range of points

Marks

1 INTERNAL AND EXTERNAL AUDITORS

(b) 1 mark a point to max of 2 marks for (i) and (ii) and max of 1 for (iii)

PLUS 1 mark for each example (1 example per element only) max 8

20

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(a) Checking the cost of assembled laptops

(b) Ascertaining NRV of computer inventory

(c) Confirming adequacy of the warranty provision

15

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(a) Matters

Generally 1 mark a point up to a maximum of 4 for each element max 7

Audit evidence

Generally 1 mark a point up to a maximum of 4 per element max 7

max 12

(b) Opinion and circumstances

max 15

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