ACCA paper f8 auditiing and assurance F8AA SQB qs j08

STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) Question INTERNATIONAL AUDITING The International Audit and Assurance Standards Board1 (IAASB) is authorised to issued International Standards on Auditing (ISAs) Required: (a) (b) (c) Define an audit State the general principles of an audit Describe the authority attaching to International Standards on Auditing (2 marks) (5 marks) (5 marks) (12 marks) Question AUDIT COMMITTEE The objective of a system of corporate governance is to secure the effective, sound and efficient operation of companies This objective transcends any legislation or voluntary code Good corporate governance embraces not only making the company prosper but also doing business in a legal and ethical manner A key element of corporate governance is the audit committee In many countries the audit committee is a committee of a single board of directors and is of a voluntary nature regulated by voluntary codes In other countries there are committees which are of a supervisory nature and these are regulated by statute For example in Germany all large public companies must have a supervisory board which contains non-executive directors who elect the board Required: (a) Explain how an audit committee could improve the effectiveness of the external auditor’s work (10 marks) (b) Discuss the problems of ensuring the “independence” of the members of the audit committee where the membership is regulated by a voluntary code of practice (5 marks) (c) Discuss the view that the role of the audit committee should not be left to voluntary codes of practice but should be regulated by the law in all countries (5 marks) (20 marks) Question FRAUD AND ERROR Fraud and error present risks to an entity Both internal and external auditors are required to deal with risks to the entity However, the responsibilities of internal and external auditors in relation to the risk of fraud and error differ Required: (a) Explain how the internal audit function helps an entity deal with the risk of fraud and error (7 marks) (b) Explain the responsibilities of external auditors in respect of the risk of fraud and error in an audit of financial statements (7 marks) Formerly International Auditing Practices Committee (IAPC) AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK (c) Stone Holidays is an independent travel agency It does not operate holidays itself It takes commission on holidays sold to customers through its chain of high street shops Staff are partly paid on a commission basis Well-established tour operators run the holidays that Stone Holidays sells The networked reservations system through which holidays are booked and the computerised accounting system are both well-established systems used by many independent travel agencies Payments by customers, including deposits, are accepted in cash and by debit and credit card Stone Holidays is legally required to pay an amount of money (based on its total sales for the year) into a central fund maintained to compensate customers if the agency should cease operations Describe the nature of the risks to which Stone Holidays is subject arising from fraud and error (6 marks) (20 marks) Question ISA 200 ISA 200 Objective and General Principles Governing an Audit of Financial Statements deals with, amongst other matters, the responsibility for financial statements and the concept of reasonable assurance Paragraph of the Statement states that: “An audit in accordance with ISAs is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole.” “Reasonable assurance relates to the whole audit process.” The effect on the audit is explained in paragraph 9: “However, there are inherent limitations in an audit that affect the auditor’s ability to detect material misstatements.” and paragraph 10: “Also, the work undertaken by the auditor to form an opinion is permeated by judgement ” Required: (a) State the respective responsibilities for financial statements of the management of the entity and of its external auditors (6 marks) (b) Describe the inherent limitations facing auditors in undertaking their work (6 marks) In answering part (b) candidates are warned not to confuse inherent limitations with inherent risk (c) Describe the significant types of judgements made by auditors: (i) (ii) in gathering evidence; in arriving at an opinion on the financial statements (4 marks) (4 marks) (20 marks) STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) Question PROFESSIONAL ETHICS Professional ethics are relevant to both external auditors and internal auditors You work for a medium-sized firm of Chartered Certified Accountants with seven offices and 150 employees You firm has been asked to tender for the provision of statutory audit and other services to Billington Travel, a private company providing discounted package holiday services in the Mediterranean The company is growing fast and would represent a substantial amount of fee income for your firm The finance director has explained to you that the company would like the successful firm to provide a number of different services These include the statutory audit and assistance with the preparation of the financial statements The company is also struggling with a new computer system and the finance director considers that a systems review by your firm may be helpful You firm does not have much experience in the travel sector Required: (a) Explain why it is necessary for external auditors to be and be seen to be independent of their audit clients (3 marks) (b) With reference to the ACCA’s Rules of Professional Conduct, describe the ethical matters that should be considered in deciding on whether your firm should tender for: (i) the statutory audit of Billington Travel (4 marks) (ii) the provision of other services to Billington Travel (4 marks) You are a student Chartered Certified Accountant and you are one of four assistant internal auditors in a large manufacturing company You report to the chief internal auditor You have been working on the review of the payables system and you have discovered what you consider to be several serious deficiencies in the structure and operation of the system You have reported these matters in writing to the chief internal auditor but you are aware that none of these matters have been covered in his final report on the system which is due to be presented to management Required: (c) List the actions you might take in these circumstances (6 marks) (d) Explain the dangers of doing nothing in these circumstances (3 marks) (20 marks) Question EASTFIELD DISTRIBUTORS Your firm is the external auditor of Eastfield Distributors, a listed company, which has sales of $25 million and a profit before tax of $1·7 million The company operates from a head office at Eastfield and has sales and inventory holding centres in different parts of the country The directors have decided the company has reached a size when it needs an internal audit department As is becoming increasingly common, the directors have asked your firm to provide this service to the company as well as being the statutory auditor of the company’s annual financial statements In answering the question, you should consider: (i) the effects of the Association of Chartered Certified Accountants’ Rules of Professional Conduct in relation to providing an internal audit service to Eastfield Distributors (ii) the extent to which your audit firm can rely on the internal audit work when carrying out the statutory audit of Eastfield Distributors AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK (iii) the arrangements over control of the work and reporting of the internal audit staff: − the extent to which the internal audit staff should be responsible to Eastfield Distributors, and who should control their work − the extent to which the internal audit staff should be responsible to a manager or partner of the external audit firm, and whether the same manager and partner should be responsible for both the internal audit staff of Eastfield Distributors and the external audit Required: (a) Describe the matters you should consider and the action you will take to ensure your firm remains independent as external auditor of the annual financial statements (8 marks) (b) Describe the advantages and disadvantages to Eastfield Distributors of your firm providing an internal audit service (7 marks) (c) Describe the advantages and disadvantages to your audit firm of providing an internal audit service to Eastfield Distributors (5 marks) (20 marks) Question ABEL & CO Abel & Co, Chartered Certified Accountants, recently held a staff training session on quality control The session concluded with staff being invited to raise matters from their experience relating to the ethical rules on independence Some of these matters are given below (a) Shortly before commencing the final audit of a large listed company, a junior staff member on the audit team inherited a substantial number of shares in that company No action was taken because, although representing a large investment for the staff member concerned, the number of shares was totally immaterial with respect to the company Moreover, the partner knew that, when the company’s results were announced, the share price would rise and he did not think it was fair to require the staff member to sell them now (5 marks) (b) The management accountant of another listed company client had an accident and was away from work for three months At the time of the accident the audit senior was winding up the prior year’s audit and, because of his familiarity with the company’s management accounting system, it was agreed that he would take over as management accountant for the three months (5 marks) (c) In its management letter to another audit client, Abel & Co warned the company that their computer system lacked essential controls The company decided to install a totally new computer system and Abel & Co’s management consultancy department was appointed to design the new system (5 marks) (d) Abel & Co was recently approached by a large company that was not, then, an audit client, for a second opinion The company was in dispute with its existing auditors who were proposing to issue a modified auditor’s report because of disagreement over inventory valuation Abel & Co’s technical partner reviewed the evidence provided by the company and advised the company that its accounting treatment was in order Shortly afterwards Abel & Co was invited to accept nomination as auditors The reply to the letter of enquiry to the existing auditors made it clear that the inventory valuation dispute was not as straightforward as the company had made it out to be (5 marks) STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) Required: Discuss the possibility that Abel & Co had impaired their independence or otherwise acted unprofessionally in each of the situations described (20 marks) Question VISWA Viswa is a company that provides call centre services for a variety of organisations It operates in a medium sized city and your firm is the largest audit firm in the city Viswa is owned and run by two entrepreneurs with experience in this sector and has been in existence for five years It is expanding rapidly in terms of its client base, the number of staff it employs and its profits It is now 15 June 2004 and you have been approached to perform the audit for the year ending 30 June 2004 Your firm has not audited this company before Viswa has had three different firms of auditors since its incorporation Viswa’s directors have indicated to you informally that the reason they wish to change auditors is because of a disagreement about certain disclosures in the financial statements in the previous year The directors consider that the disagreement is a trivial matter and have indicated that the company accountant will be able to provide you with the details once the audit has commenced Your firm has explained that before accepting the appointment, there are various matters to be considered within the firm and other procedures to be undertaken, some of which will require the co-operation of the directors Your firm has other clients that operate call centres The directors have asked your firm to commence the audit immediately because audited accounts are needed by the bank by 30 July 2004 Your firm is very busy at this time of year Required: (a) Describe the matters to consider within your firm and the other procedures that must be undertaken before accepting the appointment as auditor to Viswa (10 marks) (b) Explain why it would be inappropriate to commence the audit before consideration of the matters and the procedures referred to in (a) above have been completed (5 marks) (c) Explain the purpose of an engagement letter and list its contents (5 marks) (20 marks) Question LALD You are the auditor of LALD, a limited liability company The main activity of the company is the construction of buildings ranging in size from individual houses to large offices and blocks of flats Under the laws of the country LALD operates in, LALD must add sales tax to all buildings sold and they pay this tax to the government at the end of each month The largest non-current asset on LALD’s statement of financial position is the plant and machinery used in the construction of buildings Due to the variety of different assets used, four different subclasses of plant and machinery are recognised, each with its own rate of depreciation You are now reaching the end of the audit work for the year ended 30 September 2005 There are two specific matters where additional audit work is required: (i) The sales tax for the month of August was not paid to the government This appears to have been an accidental error and the amount involved is not material to the financial statements AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK (ii) The complicated method of calculating depreciation for plant and machinery appears to have resulted in depreciation being calculated incorrectly, with the result that depreciation may have been under-provided in the financial statements You have determined that the under-provision is material to the financial statements and therefore need to modify the audit report The directors have informed you that they not intend to take any action regarding the underprovision of depreciation They also disagree with your action and have threatened to remove your company as the auditors of LALD unless you agree not to modify your report Required: Explain the procedures that the directors must follow in order to remove your company as the auditors of LALD (6 marks) Question 10 WORKING PAPERS “Working papers” according to ISA 230 Documentation are “designed and organised to meet the circumstances and the auditor’s needs for each individual audit” Required: (a) Describe the working papers which would be of particular assistance to you as a newly appointed senior in charge of a recurring audit at the final audit stage (the previous senior having left the firm after the interim audit): (i) (ii) (b) in familiarising yourself with the client company; when you are planning the current year’s final audit (12 marks) Identify and explain the criteria which you would use to judge the quality of working papers (8 marks) (20 marks) Question 11 PLANNING DOCUMENTATION “The auditor should document the overall audit strategy … to record the key decisions considered necessary to properly plan … and the audit plan … setting out the planned nature, timing and extent of risk assessment procedures … ” Required: (a) Distinguish between the “overall audit strategy” and “audit plan” (b) Discuss the advantages and disadvantages of using standardised audit programs (6 marks) (c) Viewco, a limited liability company, is a manufacturer of TVs and video recorders It carries out a full physical inventory count at its central warehouse every year on 31 December, its financial year end Inventories of finished goods are normally of the order of $3 million, with inventories of components and work in progress normally approximately $1 million (6 marks) You are the audit senior responsible for the audit of Viewco for the year ending 31 December 2005 Together with a junior member of staff, you will be attending Viewco’s physical inventory count STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) Required: State, with reasons, what information the working papers relating to this attendance should contain (8 marks) (20 marks) Question 12 NORBERT Norbert is a local company which designs and builds racing yachts It has a small yard 400 kilometres away which it purchased recently Most of the yachts are built to customer specification However, as trade has been slack recently, the company is building some yachts without orders in the hope of obtaining buyers when the market picks up Most of the company’s output is for export and it quotes its prices in Euros2 You are been asked to act as senior in charge of the audit The company has a year end of 30 September It is apparent from the previous year’s audit file that the company has always had weak internal controls The company is currently amending its designs to take advantage of new technology and has invested a considerable amount of time and money in this Consequently it is heavily indebted to the bank The bank overdraft facility is to be reviewed in November and the bank manager has requested that the latest audited accounts be available for that review The chief executive has asked you to complete the audit by 31 October as he wishes to ensure the continuing availability of the overdraft facility before attending a major trade fair in late November Required: (a) Describe the matters that you should consider when planning the audit of Norbert (7 marks) (b) Explain why each matter must be taken into account (7 marks) (14 marks) Question 13 AUDIT RISK It is important for an auditor to consider audit and business risk when planning, carrying out and coming to an opinion on the financial statements of a company Risks that a business will not be able to achieve its objectives mostly translate into a risk that a material error or misstatement will be in the financial statements The auditor should plan and perform the audit to reduce audit risk to an acceptably low level Whilst there are many audit risk models used by auditors, ISA 200 Objective and general principles governing an audit of financial statements has categorised audit risk into: (1) (2) (3) inherent risk control risk; and detection risk You are to assume that this is not the local currency AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK Required: (a) Define the following terms: (i) (ii) (iii) (iv) audit risk inherent risk control risk detection risk (4 marks) (b) Explain the factors which affect inherent risk in an audit (c) Describe the work you will carry out to quantify the control risk in a purchases system (5 marks) (d) In relation to detection risk: (6 marks) (i) explain the effect on the detection risk of the inherent risk and control risk, if the auditor requires a particular value of audit risk; (ii) briefly describe the audit checks you will perform in verifying trade payables and accruals, and how these tests are affected by the value of the detection risk (5 marks) (20 marks) Question 14 ANALYTICAL PROCEDURES AND MATERIALITY (a) Analytical procedures are an important and powerful tool for auditors in explaining the performance of a business They are used at the planning, testing and review stages of the audit Required: Preliminary analytical procedures are often performed on accounting ratios Explain the possible reasons for the following changes found at the planning stage of the audit: (i) an increase in the current ratio; (ii) a decrease in the gross profit margin; (iii) an increase in the inventory holding period; (iv) an increase in dividend cover; (v) an increase in capital gearing (leverage) (10 marks) NB: No marks will be awarded for showing the calculation of the ratio, all parts carry equal marks STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) (b) The concept of materiality is fundamental to the work of auditors Matters that are immaterial are not reported in financial statements Required: (i) explain the concept of materiality; (ii) describe how materiality affects the audit work performed by auditors; (4 marks) (iii) give an example of qualitative materiality (4 marks) (2 marks) (20 marks) Question 15 PLANNING ANALYTICAL REVIEW You have been presented with the following draft financial information about Hivex, a very successful company that develops and licences specialist computer software and hardware Its non-current assets mainly consist of property, computer hardware and investments, and there have been additions to these during the year The company is experiencing increasing competition from rival companies, most of which specialise in hardware or software, but not both There is pressure to advertise and to cut prices You are the audit manager You are planning the audit and are conducting a preliminary analytical review and associated risk analysis for this client for the year ended 31 May 2006 You have been provided with a summarised draft statement of comprehensive income which has been produced very quickly and certain accounting ratios and percentages You have been informed that the company accounts for research and development costs in accordance with IAS 38 Intangible Assets STATEMENT OF COMPREHENSIVE INCOME Revenue Cost of sales Gross Profit Distribution costs Administrative expenses Selling expenses Profit from operations Net interest receivable Profit before tax Income tax expense Net profit Retained profits Dividends paid Year ended 31 May 2006 2005 $000 $000 15,206 13,524 3,009 3,007 –––––– –––––– 12,197 10,517 3,006 1,996 994 1,768 3,002 274 –––––– –––––– 5,195 6,479 995 395 –––––– –––––– 6,190 6,874 3,104 1,452 –––––– –––––– 3,086 5,422 –––––– –––––– 1,617 3,983 –––––– –––––– $1,469,000 $1,439,000 AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK Accounting ratios and percentages Earnings per share Performance ratios include the following: Gross margin Expenses as a percentage of revenue: Distribution costs Administrative expenses Selling expenses Operating profit 0·43 1·04 0·80 0·78 0·20 0·07 0·20 0·34 0·15 0·13 0·02 0·48 Required: (a) Using the information above, comment briefly on the performance of the company for the two years (8 marks) (b) Use your answer to part (a) to identify the areas that are subject to increased audit risk and describe the further audit work you would perform in response to those risks (12 marks) (20 marks) Question 16 KNITS Knits is a small company which manufactures and sells high quality knitwear Its customers are mainly fashion boutiques Knits has two directors, one of whom is non-executive The other is involved in the day-to-day administration of the company There are ten other employees Six of these work in the factory, one works in the warehouse, one is a sales representative and two are accounts staff The accounts staff are Miss Jones, who is responsible for processing sales and accounts receivable, and Mrs Singh, who is the purchases and wages clerk Mrs Singh works part-time, five mornings a week The company’s sales representative visits shops throughout the region He takes orders from customers which he records on a pre-numbered two-part order form He passes the completed forms to the accounts department Miss Jones files one copy of the order form in numerical sequence and passes the other to the warehouse The completed order is despatched from the warehouse by carrier, accompanied by one copy of a despatch note The other copy is sent to Miss Jones, who prepares an invoice based on the information it contains and on the company’s price list She sends one copy of the invoice to the customer, and a second copy of the invoice is retained Each Friday, Miss Jones inputs the week’s invoices to the computerised sales ledger She then files the invoices alphabetically by customer name Despatch notes are not retained because filing space is limited Miss Jones opens the post daily and lists remittances received from customers Every Friday, she inputs the information listed to the sales ledger Cheques received are banked daily by the executive director Miss Jones reviews the sales ledger balances every month and writes to customers who have not paid within 90 days of receiving goods The sales ledger is printed out annually for year-end purposes Otherwise no hard copy is printed and Miss Jones reviews the sales ledger on the VDU screen 10 AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK Question 48 COMPANY A (a) Company A has a number of long and short-term payables, accruals and provisions in its statement of financial position Required: Describe the audit procedures you would apply to each of the three items listed below, including those relating to disclosure (b) (i) A 10-year bank loan with a variable interest rate and an overdraft (a bank account with a debit balance on the bank statement), both from the same bank (5 marks) (ii) Expense accruals (4 marks) (iii) Trade payables and purchase accruals (6 marks) Company B has a provision in its statement of financial position for claims made by customers for product defects under 1-year company warranties Required: Describe the matters you would consider and the audit evidence you would require for the provision (5 marks) (20 marks) Question 49 WELFARE AND HELP FOR THE AGED TRUST (WHAT) Welfare and Help for the Aged Trust (“WHAT”) has recently commenced operating from a community centre in your locality, by providing facilities for the well-being of senior citizens in the area WHAT has been granted a licence by the local authority to occupy the community centre free of charge, although all maintenance and running costs are being borne by the trust WHAT receives income from the following sources: (1) Donations under deeds of covenant entered into by individuals (2) Postal donations of cheques and cash (3) Door-to-door collections by volunteers with boxes and workplace collections (4) Other donations (several mini-buses have been given, either new or second hand, by large businesses) (5) Grants from local authorities (6) Sales of refreshments at the community centre (7) A variety of fund raising events organised by voluntary helpers The trustees have appointed your firm as auditors You are the accountant in charge of the audit for the year ending 31 December 2005 32 STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) You have made an appointment with the finance executive of WHAT, who was appointed in March 2005, to obtain the further information you will require, and to discuss outline plans for the audit You have already been supplied with a detailed description of its accounting systems Required: (a) Describe the further information, excluding that relating to the accounting system, that you will require from the finance executive at your meeting, in order to plan your audit, and explain the relevance of this information to your audit planning (10 marks) (b) Describe the controls over the above income which you would expect WHAT to operate (10 marks) (20 marks) Question 50 AUDIT OF SMALL BUSINESSES “Small businesses possess a combination of characteristics which make it necessary for the auditor to adapt his audit approach to the circumstances surrounding the small business engagement.” Required: (a) State the meaning of a “small business” (b) Describe the characteristics of small businesses and their consequences (c) Describe the audit procedures you would employ, in addition to the routine vouching of sales and cash, to verify that all income due to the company has been recorded and included in the accounts, and the problems you may experience in so doing, in the following cases: (i) (ii) (2 marks) (10 marks) a small manufacturing company which purchases and sells goods on credit; a small retail store which purchases goods on credit and sells them for cash Assume in each case that the company keeps proper accounting records (8 marks) (20 marks) Question 51 ISAs International Standards on Auditing (ISAs) apply equally to the audit of all entities, whatever their size However, the manner in which ISAs are applied differs from entity to entity and depends on the use of the auditor’s judgement The characteristics of smaller entities may include: (a) Common ownership and management; (b) A control framework that is different to the control framework for larger entities; (c) The use of standardised computer packages; (d) Reliance on the auditor for accounting expertise; (e) A lack of sufficient appropriate audit evidence to support financial statement assertions relating to income from cash transactions 33 AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK These characteristics have an effect on the way the audits of smaller entities are approached, how audit risk is assessed, how the audit is conducted, the auditor’s report and the relationship between auditor and client Required: Describe the nature and effect of each of the five characteristics listed in (a)–(e) above on the audit of smaller entities and on the relationship between auditor and client NB: The five characteristics (a)–(e) carry equal marks (20 marks) Question 52 CALVA You are an audit manager in an audit firm with ten offices and 250 staff Your firm is the auditor of Calva, a chain of supermarkets Your firm has been the auditor of this client for many years All of the planning work and tests of control have been completed for Calva for the year ended 31 December 2005 Staff are still working on substantive procedures The company operates a continuous inventory checking system with good records and you have tested this system and will be relying on the records for the year-end figure The company is intending to invest a substantial amount in opening new stores during the next year and it has been negotiating with both banks and property companies in relation to leases Required: (a) Describe the objectives of the following and how these objectives will be met in the audit of Calva: (i) (ii) (b) overall review of financial statements; review of working papers (4 marks) (6 marks) Describe the: (i) (ii) auditor’s responsibilities with regard to subsequent events; (6 marks) procedures that should be applied during the subsequent events review at Calva (4 marks) (20 marks) Question 53 OILRAKERS (a) International Standard on Auditing 560 Subsequent Events explains the audit work required in connection with subsequent events Required: List the audit procedures that can be used prior to the auditor’s report being signed to identify events that may require adjustment or disclosure in the financial statements (5 marks) 34 STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) (b) You are the auditor of OilRakers, a limited liability company which extracts, refines and sells oil and petroleum related products The audit of OilRakers for the year ended 30 June 2005 had the following events: Date Event 15 August 2005 Bankruptcy of major customer representing 11% of the trade receivables on the statement of financial position 21 September 2005 Financial statements approved by directors 22 September 2005 Audit work completed and auditor’s report signed November 2005 Accidental release of toxic chemicals into the sea from the company’s oil refinery resulting in severe damage to the environment Management had amended and made adequate disclosure of the event in the financial statements 23 November 2005 Financial statements issued to members of OilRakers 30 November 2005 A fire at one of the company’s oil wells completely destroys the well Drilling a new well will take ten months with a consequent loss in oil production during this time Required: For each of the following three dates: – 15 August 2005; – November 2005; and – 30 November 2005 (i) State whether the events occurring on those dates are adjusting or nonadjusting according to IAS 10 Events After the Reporting Period, giving reasons for your decision; (6 marks) (ii) Explain the auditor’s responsibility and the audit procedures that should be carried out (9 marks) Note: Marks are allocated evenly across the three dates (20 marks) 35 AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK Question 54 AUDIT SCOPE Auditor’s reports include a description of the scope of an audit in order to reduce misunderstandings of the nature of audited financial statements Our responsibility is to express an opinion on these financial statements based on our audit We conducted our audit in accordance with International Standards on Auditing Those standards require that we comply with ethical requirements and plan and perform our audit to obtain reasonable assurance about whether the financial statements are free of material misstatement An audit involves performing procedures to obtain evidence supporting the amounts and disclosures in the financial statements The procedures selected ……… An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion Required: Explain the meaning of the phrases underlined above, giving reasons for their inclusion in the auditor’s report and state their significance to the reader of financial statements (20 marks) Question 55 THETA In January 2005, the head office of Theta was damaged by a fire Many of the company’s accounting records were destroyed before the audit for the year ended 31 March 2005 took place The company’s financial accountant has prepared financial statements for the year ended 31 March 2005 on the basis of estimates and the information he has been able to salvage You have completed the audit of these financial statements Required: (a) Draft, for inclusion in the auditor’s report, wording appropriate to Theta (5 marks) Note: You are not required to reproduce the auditor’s report in full (b) Explain the reasons for your audit opinion (c) Explain and distinguish between the following forms of modified report: (i) (ii) (iii) (iv) emphasis of matter qualified opinion disclaimer of opinion adverse opinion (3 marks) (8 marks) (16 marks) 36 STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) Question 56 HOOD ENTERPRISES You are the audit manager of Hood Enterprises a limited liability company The company’s annual turnover is over $10 million Required: (a) Compare the responsibilities of the directors and auditors regarding the published financial statements of Hood Enterprises (6 marks) (b) An extract from the draft audit report produced by an audit junior is given below: Basis of Opinion “We conducted our audit in accordance with Auditing Standards An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements It also includes an assessment of all the estimates and judgements made by the directors in the preparation of the financial statements, and of whether the accounting policies are appropriate to the company’s circumstances, consistently applied and adequately disclosed.” “We planned and performed our audit so as to obtain as much information and explanation as possible given the time available for the audit We confirm that the financial statements are free from material misstatement, whether caused by fraud or other irregularity or error The directors however are wholly responsible for the accuracy of the financial statements and no liability for errors can be accepted by the auditor In forming our opinion we also evaluated the overall adequacy of the presentation of information in the company’s annual report.” Required: Identify and explain the errors in the above extract NOTE you are not required to redraft the report (c) (10 marks) The directors of Hood Enterprises have prepared a cash flow forecast for submission to the bank They have asked you as the auditor to provide a negative assurance report on this forecast Required: Briefly explain the difference between positive and negative assurance, outlining the advantages to the directors of providing negative assurance on their cash flow forecast (4 marks) (20 marks) Question 57 MOWBRAY COMPUTERS You are responsible for the audit of Mowbray Computers, a trading company whose financial year end is 30 September 2005 The company assembles microcomputers in a local factory from components purchased from the Far East and sells them to major retailers, and to individuals and businesses by mail order 37 AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK In the current year, there has been a recession and strong competition which has resulted in a fall in sales and gross profit margin This has led to a trading loss and the company experiencing cash flow problems The company’s management has recently prepared forecast information at the request of the company’s bankers Required: (a) State, with reasons, the circumstances particular to Mowbray Computers which may indicate that the company is not a going concern (6 marks) (b) Describe the audit work you would undertake in order to ascertain whether Mowbray Computers is a going concern (8 marks) (c) Explain the effect on your auditor’s report on the financial statements of Mowbray Computers for the year ended 30 September 2005 if: (i) the financial statements give sufficient disclosure of the going concern problems; (ii) there is no disclosure of the going concern problems in the financial statements and there is a serious risk that the company will fail in the foreseeable future (6 marks) (20 marks) Question 58 EWHEELS Your firm has recently been appointed as external auditor to EWheels EWheels is a private “dot.com” company that operates an internet auction service for the sale of used motor vehicles You are planning the audit of the financial statements The company has been in existence for four years and has grown rapidly It was founded by three individuals who are a former car auctioneer, an internet specialist with an interest in cars, and an accountant The company now has three offices and some 100 employees The on-line car auction market is very competitive The company is the biggest provider of the service in the south of the country, but the directors have ambitious plans which include an aggressive marketing campaign, the take-over of a number of target competitors and additional office space and staff, all of which will require considerable additional finance The company is financed partly by private capital brought in by the three founders, and partly by bank loans The three founders were all directors, but the accountant resigned six months ago and has commenced a legal action against the company for a considerable amount of money, claiming that he has effectively been excluded from management by the other two directors The company’s statement of financial position shows net liabilities The company has not yet made a profit although preliminary figures indicate that it has reached break-even point in the current year Your firm has discovered that the previous auditors were not re-appointed because they refused to issue an unmodified audit opinion on the previous year’s financial statements, and instead made reference to the going concern status of the company in their audit report Your firm has made it clear to the directors that it may be necessary to make reference to the going concern status of the company again in the current year, but they have indicated that they would prefer an unmodified report if at all possible You are also aware that loan facilities for this type of company are becoming scarcer, as there are too many companies seeking such finance 38 STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) The director who resigned six months ago was responsible for the day to day accounting function and for the preparation of the financial and management accounts The company has been unsuccessful in recruiting a permanent replacement and has used a number of temporary accountants Your initial investigations have highlighted a number of weaknesses in the operation of the accounting and internal control systems Required: (a) Explain your understanding of audit risk (4 marks) (b) Describe the risks associated with the audit of EWheels (7 marks) (c) List the enquiries you will make and the procedures you will perform in deciding whether to make reference to the going concern status of EWheels in your audit report on the financial statements (5 marks) (d) Describe the different ways in which your audit report might refer to the going concern status of the company (4 marks) (20 marks) Question 59 INTERNAL AUDIT REPORTS Reports produced by internal auditors are different from audit reports produced by external auditors performing audits under International Standards on Auditing The reports are produced for different purposes, and are directed at different users They differ substantially in both form and content Internal audit reports often comprise the following: (i) A cover page; (ii) Executive summary; (iii) The main report contents; (iv) Appendices Required: (a) List and briefly describe the general categories of information that you would expect to find in an internal audit report under each of the four headings above (4 marks) (b) List the main contents of most external audit reports (4 marks) NB: You are not required to reproduce a full external audit report (c) Explain why the contents of external audit reports prepared under International Standards on Auditing and internal audit reports are different (4 marks) (d) Some reports produced by internal auditors are similar to the report to management (management letter) on internal controls and other matters that are produced by external auditors during the course of the audit The steps taken by internal and external auditors in drafting, issuing and following up such reports are also similar 39 AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK Required: Describe the common characteristics of the steps taken by internal and external auditors in producing reports to management (8 marks) (20 marks) Question 60 QUICK QUESTIONS Required: Answer the following questions with concise and specific bullet points Complete sentences are NOT required 60.1 What does the existence of high control risk mean? 60.2 What internal controls would help to ensure that goods cannot be delivered to a customer without an account receivable being recorded? (2 marks) 60.3 What are the principal internal control objectives in relation to the purchase of materials in a manufacturing company? (3 marks) 60.4 Why auditors perform walk-through checks? 60.5 What you consider are the main disadvantages of using internal control questionnaires to document and evaluate a company’s internal control system? (2 marks) 60.6 In a computer information system, what is an application control? 60.7 What factors would affect your assessment of the sufficiency of audit evidence collected for a particular account balance? (2 marks) 60.8 Eyeopener manufactures a range of domestic lighting products Quarterly physical inventory counts have revealed significant shortfalls compared to the perpetual inventory records Management has asked you as the company’s auditor to investigate controls in this area Identify possible control weaknesses that could have led to the inventory losses (1 mark) (1 mark) (1 mark) (3 marks) (15 marks) Question 61 JASPER, RUBY, GARNET & EMERALD You are currently engaged in reviewing the working papers of several limited liability company audit assignments recently carried out by your audit practice Each of the audit assignments is nearing completion, but certain matters have recently come to light which may affect your audit opinion on each of the assignments In each case the year end of the company is 31 December 2005 (a) Jasper (Profit before tax $150,000) On 23 January 2006 a letter was received informing the company that a customer, who owed Jasper $30,000 as at the end of the reporting period, had been declared bankrupt on 17 January It is expected that unsecured creditors, such as Jasper, will receive nothing in respect of amounts owing to them Jasper’s management refuses to change the accounts to provide for the loss, on the grounds that bankruptcy was declared after the statement of financial position date 40 STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) Total trade receivables shown in the statement of financial position amounted to $700,000 (b) Ruby (Profit before tax $500,000) On 31 October 2005 a customer sued Ruby for personal damages arising from an unexpected defect in one of its products Shortly before the end of the reporting period Ruby made an out-of-court settlement with the customer of $10,000, although this agreement is not reflected in Ruby’s financial statements as at 31 December 2005 Further, the matter subsequently became known to the press and was extensively reported Ruby’s legal advisers have now informed you that further claims have been received following the publicity, although they are unable to place a figure on the potential liability arising from such claims which have not yet been received Ruby had referred to the claims received in a note to the financial statements stating, however, that no provision had been made to cover them because the claims were not expected to be material (c) Garnet (Profit before tax $250,000) Audit work revealed that an item of investment property stated in the statement of financial position at $500,000 had suffered a permanent impairment in its carrying value of $300,000 The management of Garnet admits that the decline has occurred, but refuses to write down the item on the grounds that other investment properties (not held for resale) have risen in value and are stated at amounts considerably below their realisable values (d) Emerald (Profit before tax $100,000) This client is a construction company, currently building a warehouse on its own premises, and using some of its own workforce The cost of labour and materials has been included in the cost of the non-current asset in the statement of financial position, the total figure being based on the company’s costing records The warehouse is almost complete and the cost shown in the statement of financial position includes direct labour costs of $10,000 However, during audit testing, it was discovered that the costing records, showing the direct labour costs for the warehouse in the early part of the year, had been destroyed accidentally For each assignment and using the proforma answer provided: (i) assess materiality (eg $A represents x% of profit before tax, therefore material) (ii) identify relevant accounting requirements and state compliance or otherwise with them (eg non-compliance IAS 16 (must depreciate)) (iii) state a suitable audit opinion (just one, eg modified “except for”) (a) Jasper (12 marks) Materiality IFRSs Audit opinion 41 AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK (b) Ruby Materiality IFRSs Audit opinion (c) Garnet Materiality IFRSs Audit opinion (d) Emerald Materiality IFRSs Audit opinion 42 STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) Question 62 BURTON HOUSING Your firm is the auditor of Burton Housing, a small incorporated charity and housing association Its principal asset is a large freehold building which contains a restaurant and accommodation for 50 young people The charity is controlled by a management committee which comprises the voluntary chairman and treasurer, and other voluntary members elected annually However, day-to-day management is by a chief executive who manages the full-time staff who perform accounting, cleaning, maintenance, housing management and other functions You are auditing the company’s financial statements for the year ended 31 March 2006 Draft accounts have been prepared by the treasurer from accounting records kept on a microcomputer by the bookkeeper The partner in charge of the audit has asked you to consider the audit work you would perform on income from rents and expenditure in the restaurant For income from rents: (a) the housing manager allocated rooms to individuals, and this information is sent to the bookkeeper (b) each week the bookkeeper posts the rent to each resident’s account on the sales ledger All rooms are let at the same rent (c) rents are received from residents by reception staff who are independent of the housing manager and bookkeeper Reception staff give the rents to the bookkeeper (d) the bookkeeper posts cash received for rents to the rents receivable ledger, enters them in the cash book and pays them into the bank (e) the housing manager reports voids (ie rooms unlet) to the management committee The restaurant comprises the manager and four staff, who prepare and sell food to residents and other individuals Restaurant expenditure includes only expenditure on purchasing food and wages of restaurant staff The system for purchasing food comprises: (a) the restaurant manager orders the food by sending an order to the suppliers (b) food received is checked by the restaurant manager (c) the restaurant manger authorises purchase invoices, confirming the food has been received (d) the bookkeeper posts the purchase invoices to the trade payables ledger (e) the bookkeeper makes out the cheques to pay the suppliers, which the chief executive signs The cheques are posted to the trade payables ledger and cash book The bookkeeper is responsible for paying the wages of staff in the restaurant The restaurant manager notifies the bookkeeper of any absences of staff 43 AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK Required: Using the proforma answer provided suggest FIVE control procedures (ie internal controls) and FIVE procedures for obtaining audit evidence for (i) (ii) rents received expenditure in the restaurant Control procedures Limiting direct physical access to assets/records Approving & controlling documents Controls over CIS Checking arithmetical accuracy of records (20 marks) Procedures for obtaining audit evidence Analytical procedures Enquiry Inspection Observation Computation Maintaining & reviewing control accounts and trial balances Approving reconciliations Comparing − internal data with external sources of information − results of cash/inventory counts with accounting records − financial results with budgeted results JOT DOWN ANY OTHER “PROMPTS” WHICH MAY HELP YOU TO GENERATE IDEAS HERE 44 STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) (i) Rents received * (ii) * * Expenditure in restaurant * * 45 AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK 46 ... exercise control over: (i) (ii) the purchase and receipt of goods; and the recording and settlement of liabilities (10 marks) 11 AUDIT AND ASSURANCE (F8) – STUDY QUESTION BANK (b) Comment on specific... procedure you identify and how it would be used in the audit (20 marks) 20 STUDY QUESTION BANK – AUDIT AND ASSURANCE (F8) Question 31 SAMPLING AND ANALYTICAL TECHNIQUES Statistical and non-statistical... freehold land and buildings microcomputers, printers and related equipment which are used by staff motor vehicles which are provided to directors and salesmen who visit customers 23 AUDIT AND ASSURANCE