Monitoring Test MT2A Audit andAssurance (International) F8AA-MT2A-X08-A Answers & Marking Scheme 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 Accountancy Tuition Centre Ltd ATC INTERNATIONAL 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” 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 audit can be guaranteed to detect material fraud or error The external auditor must consider the risk of material misstatement arising from fraud and error when: planning and performing audit procedures; and evaluating and reporting on the results thereof Accountancy Tuition Centre (International Holdings) Ltd 2008 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 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 Accountancy Tuition Centre (International Holdings) Ltd 2008 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 longterm 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 The choice of the out-sourcing company is important – it must have sufficient resources and experience and there is always a risk associated with this; the contract with the out-sourcing company will have to be carefully worded and the initial contract should only be for a limited period of time Accountancy Tuition Centre (International Holdings) Ltd 2008 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 Accountancy Tuition Centre (International Holdings) Ltd 2008 (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 agent (e.g in respect of the notebooks) Level of client’s insurance cover (e.g in respect of defective product sales) Accountancy Tuition Centre (International Holdings) Ltd 2008 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 Accountancy Tuition Centre (International Holdings) Ltd 2008 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 $400,000 (i.e (1) $95k decrease plus (2) $500k increase) Profit before tax of $2·1m would be a 40% increase on the prior year Accountancy Tuition Centre (International Holdings) Ltd 2008 Marking Scheme For most questions the marking scheme suggests you award 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 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 INTERNAL AND EXTERNAL AUDITORS (a) Generally mark a point up to a maximum (b) mark a point to max of marks for (i) and (ii) and max of for (iii) PLUS mark for each example (1 example per element only) (c) mark per relevant point to a maximum of Marks max 20 –– MICROPRODS (a) Checking the cost of assembled laptops Generally mark a point up to a maximum of (b) Ascertaining NRV of computer inventory Generally mark a point up to a maximum of (c) Confirming adequacy of the warranty provision Generally mark a point up to a maximum of 15 –– PHOENIX (a) Matters Generally mark a point up to a maximum of for each element Audit evidence Generally mark a point up to a maximum of per element (b) Opinion and circumstances Generally mark a point up to a maximum of max max max 12 max 15 –– Accountancy Tuition Centre (International Holdings) Ltd 2008 ... 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... 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... 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