Interim Assessment ACCA Paper F8 (INT) Audit and Assurance June 2009 Interim Assessment – Answers To gain maximum benefit, not refer to these answers until you have completed the interim assessment questions and submitted them for marking KAPLAN PUBLISHING Page of 12 ACCA F8 (INT) Audit and Assurance © Kaplan Financial Limited, 2008 All rights reserved No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing Page of 12 KAPLAN PUBLISHING Interim Assessment ANSWER (a) (b) Confirmations (i) Positive and negative confirmations Negative confirmations request a reply from the customer only if the customer disagrees with the amount Positive confirmations request a reply in any case Negative confirmations are generally only used with a representative sample of a large number of small accounts where internal controls are strong (ii) Positive confirmations There are two types of positive confirmations In the first type, the amount owed is stated by the client and the customer is asked to agree or disagree If the customer disagrees, he is asked to provide an explanation of why he disagrees in the form of reconciling items In the second type, the customer is asked to fill in the balance The advantage of the first type is that the customer may perform the reconciliation The principal disadvantage is the fact that the customer may simply agree with any amount stated, particularly if it is understated With the second type, the customer is less likely to reply as more work is involved, but the amount stated represents what is in the customer’s records It is not possible for the auditor to perform the reconciliation in this case (iii) Reconciling items Reconciling items include: cash, goods and credit notes in transit and other timing differences, debit notes, contras, journal entries, disputed items, and simple errors on the side of either customer or supplier Financial statement assertions – receivables Assets are generally more at risk from overstatement than from understatement There is a risk that receivables are overstated by the under-provision for bad debts If assets are overstated, profits are likely to be overstated and it is therefore sometimes tempting to under-provide for bad debts in order to show a better profit figure, as well as for management purposes Bad debts can sometimes be hidden by the use of credit notes and similar devices; whilst this does not affect the overall profit figure, it can affect the presentation of the financial statements (c) Goodfoot (i) Audit work on receivables and bad debts • Comfort can be taken from the proper operation of internal controls over receivables and it is therefore possible to reduce the level of substantive testing • The primary focus of substantive testing will be the 30 largest accounts can be circularised together with a representative sample of the remainder, paying particular attention to old accounts, nil balances and credit balances • For those accounts where there is no reply, and for any other accounts selected for testing, it will be necessary to gain comfort on the amount receivable by reviewing cash received after the period end Where cash has not been received, it will be necessary to review signed delivery notes, contracts, the pattern of payments, etc KAPLAN PUBLISHING Page of 12 ACCA F8 (INT) Audit and Assurance (ii) • For accounts confirmed, any differences should be thoroughly investigated and followed up, with the help of the client if necessary It should be remembered that, where a customer agrees that an amount is owed, it does not automatically follow that the amount will be paid • The bad debt provision should be reviewed in the light of past experience and current period conditions Generally, specific provisions are permissible for tax purposes but not general provisions and the tax computation should be checked • The arithmetical accuracy of the ledger should be checked as should the correct presentation of the amounts in the financial statements • A review of invoices and credit notes around the period-end may highlight the need for additional provisions • Analytical procedures on the ageing of receivables by comparison with prior periods will give comfort on bad debt provisions • Receivables cut-off testing should be performed to ensure that amounts have been correctly recorded in the correct period Lead schedule for receivables Client: Goodfoot Year end: 31 December 2008 Subject: Receivables Prepared by: AB Reviewed by: Ref This year Draft $ Reference: J1 Date: Date: Adjustments $ Final $ Last year Final $ Trade receivables Less irrecoverable debt provision Other receivables Prepayments Summary of work done Confirmations of material receivables carried out Receivables ageing reviewed and discussed with xx Correspondence with disputed accounts reviewed Material other receivables agreed to confirmation or after date receipts Material invoices agreed to invoices and payment and calculations checked Conclusion Subject to satisfactory resolution of dispute with CDE Ltd (J2) receivables are fairly stated Ref J10 J20 J21 J30 J40 MARKING GUIDE (a) Confirmations (b) Financial statement assertions – receivables (c) (i) (ii) Audit work on receivables and bad debt (1 mark per test if well explained) Lead schedule for receivables Total marks available Page of 12 12 30 KAPLAN PUBLISHING Interim Assessment ANSWER 'Sufficient' audit evidence means 'enough' evidence to enable the auditor to form his opinion What is 'enough' is a matter of professional judgement 'Appropriate' breaks down into two qualities: reliable and relevant And 'sufficient', 'reliable' and 'relevant' are all interlinked There is a link between sufficient and reliable: usually the more reliable the evidence, the less of it the auditor will need However, if the evidence is found to be unreliable, looking at a greater quantity of such evidence will never be sufficient The nature of the evidence the auditor wants (its relevance) depends on the nature of the transaction or balance being tested and the assertion being tested However, there are some general characteristics of evidence: The best evidence is: • independent external evidence • internal evidence subject to effective internal controls • evidence obtained directly by the auditor • documentary evidence • original evidence Less reliable evidence is: • internally generated • internal evidence not subject to internal controls • evidence obtained indirectly or by inference • oral evidence • photocopies or facsimiles So, to summarise, appropriate evidence is relevant to the transaction, balance and assertion being tested and it has the characteristics of the best evidence; sufficient evidence means enough evidence to enable the auditor to form his opinion and that is a matter of professional judgement Total marks available 10 Marking guide – up to mark per point, ½ mark if explanation is weak KAPLAN PUBLISHING Page of 12 ACCA F8 (INT) Audit and Assurance ANSWER (a) Meanings Audit risk is the risk of forming the wrong conclusion from audit procedures This means giving an unqualified opinion when a qualified opinion would be most appropriate (or vice versa) Inherent risk is the risk that material errors may arise from the nature of the business, its transactions, or its industry, irrespective of the control system in place For example, any cash-based business is inherently risky because it is difficult to guarantee completeness of recording with such a weak audit trail Control risk is the risk that a company’s internal control system may fail to prevent, detect, and correct errors and omissions For example, a company with high staff turnover may suffer higher control risk because the staff are not in place long enough to be fully aware of necessary procedures Detection risk is the risk that the auditor’s substantive procedures fail to detect material errors and omissions Detection risk is likely to increase as sample sizes are reduced Also, detection risk can be reduced by increasing the experience and general quality of the audit team (b) Factors to consider Factor Explanation Going concern Perfumes are a luxury product and are therefore more likely to suffer reduced demand in a recession Will need to assess the current economic environment and consider recent trends in perfume sales Declining profits suggest the company’s future prospects may be in doubt Need to assess company’s future plans for evidence that this trend can be reversed Need to assess company’s financial resources to assess how long company can continue to finance such losses The loss of such a key member of staff (the former MD) may have implications for the company’s long-term health Assess level of involvement of previous MD, and discuss board changes with the client Monitor trend in performance since changes made Financial statements Declining profits, combined with a desire to achieve a listing, will increase the pressure to overstate the profits of the company Page of 12 Audit team will need to consider all areas of estimation and judgement with care (and a certain amount of scepticism) KAPLAN PUBLISHING Interim Assessment Factor Explanation Inventory The incentive scheme may lead to overproduction, which may suggest that inventories are over valued Monitor the trend in inventory balances, and compare with sales figures to assess over-stocking If sales continue to decline, this may further suggest that inventories cannot be sold and are therefore over valued The inventory provision may be inadequate, therefore will need to understand management’s process for calculating the provision and review for reasonableness Products are made for specific customers If any customers leave, some inventories may be unsaleable to anyone else, suggesting they are over valued Discuss how client-specific product lines are, and establish extent of write-offs when previous customers have left The Finance Director’s move to parttime status may result in a greater level of errors in general Monitor trend in accounting adjustments since this change to establish extent of any problem May need to bias audit work towards latter part of the year Multiple locations are likely to require a visit, especially for inventory count attendance and asset verification purposes Establish likely inventory levels/key assets at each site, and plan visits accordingly Control risk Recent board changes are likely to result in the control systems being changed In the short term, changes in management may lead to a weakening of controls until new systems are in place Will need to assess controls over the year to establish whether they have weakened since the changes The declining profits themselves may be an indicator of poor controls In general, controls will need to be analysed and any changes documented If controls appear strong, they will be tested If tests suggest they are operating effectively throughout the year, substantive testing can be reduced Historically, this is a family-run company and formal controls may therefore be lacking Multiple locations make it harder for centralised management to control the business It may be possible to follow a controls based approach for part of the year (e.g until the management changes), then follow a substantive approach from then on Audit strategy There is likely to be a high volume of transactions in sales, purchases and inventory KAPLAN PUBLISHING Suggests that a controls-based approach, backed up by analytical substantive procedures, would be most efficient Page of 12 ACCA F8 (INT) Audit and Assurance Factor Explanation Other In a privately-owned family company, directors may be treating personal expenditure as business expenditure, leading to an understatement of directors’ emoluments (c) Careful review of any unusual payments, or payments to directors, to ensure personal and business expenditure separated If inherent risk is high, and controls are not considered strong enough to deal with these inherent risks (i.e control risk is high), then detection risk will need to be lowered This can be achieved by: • increased substantive testing (larger samples) • better sample selection (e.g using statistical sampling) • using a more experienced audit team ANSWER (a) Issue • Largest fee income/additional services give rise to fee dependency/selfinterest threat • Fear of losing fee may influence auditor’s judgement Safeguards • Regular review to ensure recurring fees below recommended thresholds/ firm's own threshold Issue • Acting for 20 years gives rise to familiarity/trust/complacency threat • Auditor may be over-influenced by the personality and qualities of directors and management, and consequently too sympathetic • Auditor may become too trusting of management representations so as to be insufficiently rigorous in testing them because he knows the issue too well Safeguards • Periodic rotation of senior staff • If listed, audit partner required to be rotated after five years Page of 12 KAPLAN PUBLISHING Interim Assessment Issue Marks Additional services also give rise to: • Self-review threat – reluctant to challenge the outcome of a previous engagement/report adversely on colleagues' work • Possible low-balling – low audit fee to retain lucrative consultancy work • Conflict of interest by acting for individual directors and the company – may be tempted to favour one party at the expense of the other Safeguards • Use of different teams with separate reporting lines • Independent partner review Issue Former employee having joined client gives rise to: • Familiarity threat – too much reliance on representations of former employee • Former self-interest threat – manager may have been too sympathetic Safeguards • The former employee should not derive benefits from the firm/participate in the firm's business or professional activities • The firm should review any significant judgements made by the manager prior to leaving the firm • Quality control procedures in place to ensure healthy professional scepticism 10 (b) (i) The statutory audit The Code of Ethics and Conduct states that it is important that the firm is competent to undertake the audit; it must have adequate resources in terms of staff with sufficient experience in this sector The fact that the services to be provided would constitute a substantial amount of fee income in a new area of business indicates that the firm might not, at present, have those resources It may be appropriate to consider whether experience in this sector can be bought in by the recruitment of additional staff The firm should consider whether staff are available at the right time of year and whether the work fits in with the firm’s existing obligations The Code of Ethics and Conduct also states that the firm must be independent of its clients; in particular, this means that it must not take too much of its fee income from one client (or group of clients) KAPLAN PUBLISHING Page of 12 ACCA F8 (INT) Audit and Assurance Marks Generally, for non-public interest clients, the fee income (including income from additional services) should not exceed 15% of the gross practice income If that figure is exceeded, it may be possible to consider providing some, but not all, of the services requested (ii) The provision of other services Preparation of financial statements It is generally acceptable under the Rules of Professional Conduct for auditors to provide assistance with the preparation of financial statements for private company clients, provided that the client takes full responsibility for the accounting records and financial statements It is important to know why the company needs assistance in this area and it would be preferable in the long run for the company to be able to prepare its own financial statements It is important that those preparing the financial statements are independent of those performing the audit as far as possible, in order that the firm is seen to remain independent Systems review The external auditor is often well placed to provide assistance with such reviews as the firm obtains a working knowledge of systems during the course of the audit However, there is always the danger that the firm finds itself in the position of having to report on a system that it has helped to improve, and it may be difficult in such circumstances to be critical of the system This detracts from the firm’s ability to remain independent and, in this case, given that it is the first year of audit and that assistance is also needed with the preparation of financial statements, it seems preferable not to tender for the systems review this year 20 Marking guide – mark per point (½ mark if not well explained) Page 10 of 12 KAPLAN PUBLISHING Interim Assessment ANSWER (a) The duties of the auditor of Lopit are defined by auditing standards (such as ISAs) and by local statute An audit is an independent, professional examination of, and expression of an opinion on, the financial statements of the company The opinion is given as to whether a true and fair view is presented of the company’s affairs as at the end of its financial year (balance sheet), and of the company’s profit or loss for its financial year (income statement), and whether the financial statements have been properly prepared in accordance with an identified financial reporting framework The auditor is typically required to report specifically on matters such as: (i) Proper accounting records have not been kept (ii) The financial statements are not in agreement with the accounting records and returns (iii) He has not received all of the information and explanations which he deemed necessary for the performance of his duties (iv) Proper returns have not been received from branches not visited (v) Information disclosed in the directors’ report is inconsistent with that given in the financial statements Certain information may also be required to be disclosed in the audit report if the company fails to disclose it in the financial statements, e.g details of the directors’ emoluments and particulars of loans to officers In addition to local statutory requirements, it will also be necessary for the auditor to ensure that his audit is performed according to the auditing standards in force The directors may extend the scope of the audit beyond the statutory requirements if the auditor is agreeable, but they cannot limit the scope of the audit or indemnify the auditor against any legal action arising from the non-performance of duties at the directors’ request (b) As Lopit is a newly-formed company, the directors may typically appoint the first auditor to hold office until the conclusion of the first AGM The auditor has no relationship with the directors other than as the practical means by which the company enters into a contract with the auditor The directors are responsible for the preparation of financial statements, and the auditor for the formation and expression of an opinion on those statements to the members of Lopit for a fee KAPLAN PUBLISHING Page 11 of 12 ACCA F8 (INT) Audit and Assurance (c) As an auditor of a limited liability company, the following rights are typically given by legislation: (i) To receive notice to attend and be heard at all general meetings (ii) To obtain access at all times to all accounting records (iii) To be informed of any proposal for dismissal, and to take certain actions in that event (iv) To obtain all necessary information and explanations, as required, from a subsidiary and its auditor and, in any other case, to require information to be provided by the parent company (d) The directors not generally have the authority in their capacity as directors to dismiss the auditor An auditor is removed from office by the passing of a resolution by the members in general meeting (e) Practical matters to be considered: It would be impossible to accept the appointment as specified by the directors The scope of an audit cannot be limited at the request of directors If the appointment is still desired, it will be necessary to discuss the matter with the directors and eliminate the misunderstanding of the audit requirement Is the practice sufficiently large to satisfactorily perform the audit, or is the audit during a particularly busy period for the practice? Do we have knowledge of the industry and the required expertise to provide a satisfactory service? Is the client a high risk client? Inherent risk factors associated with the potential client should be considered Ethical matters to be considered: This is a newly-formed company so there will be no requirement to contact existing auditors The fees from this appointment should not exceed 15% of the gross practice income (This figure would be reduced to 10% in the case of listed or public interest companies, which does not appear to be the case for Lopit.) Any personal relationship with an officer or employee should be carefully considered – such personnel should be excluded from the audit team Any financial involvement with the company such as a shareholding or a loan to or from the company would be regarded as unethical Page 12 of 12 KAPLAN PUBLISHING ... available 10 Marking guide – up to mark per point, ½ mark if explanation is weak KAPLAN PUBLISHING Page of 12 ACCA F8 (INT) Audit and Assurance ANSWER (a) Meanings Audit risk is the risk of forming... systems review this year 20 Marking guide – mark per point (½ mark if not well explained) Page 10 of 12 KAPLAN PUBLISHING Interim Assessment ANSWER (a) The duties of the auditor of Lopit are defined... retrieval system, without prior permission from Kaplan Publishing Page of 12 KAPLAN PUBLISHING Interim Assessment ANSWER (a) (b) Confirmations (i) Positive and negative confirmations Negative confirmations