Audit and Internal
TUESDAY 13 DECEMBER 2005
This paper is divided into two sections
ALL THREE questions are compulsory and MUST
TWO questions ONLY to be answered
Do not open this paper until instructed by the supervisor
This question paper must not be removed from the examination
Section A – ALL THREE questions are compulsory and MUST be attempted
1 You are the audit manager in the firm of DeCe & Co, an audit firm with ten national offices.
One of your clients, Rocks Forever, purchases diamond jewellery from three manufacturers. The jewellery is then sold from Rocks Forever’s four shops. This is the only client your firm has in the diamond industry.
You are planning to attend the physical inventory count for Rocks Forever. Inventory is the largest account on the balance sheet with each of the four shops holding material amounts. Due to the high value of the inventory, all shops will be visited and test counts performed.
With the permission of the directors of Rocks Forever, you have employed UJ, a firm of specialist diamond valuers who will also be in attendance. UJ will verify that the jewellery is, in fact, made from diamonds and that the jewellery is saleable with respect to current trends in fashion. UJ will also suggest, on a sample basis, the value of specific items of jewellery.
Counting will be carried out by shop staff in teams of two using pre-numbered count sheets.
(a) List and explain the reason for the audit procedures used in obtaining evidence in relation to the inventory
count of inventory held in the shops. (10 marks)
(b) Explain the factors you should consider when placing reliance on the work of UJ. (5 marks)
(c) Describe the audit procedures you should perform to ensure that jewellery inventory is valued correctly. (5 marks)
2 You are the senior manager in the internal audit department of Octball, a limited liability company. You report to the chief internal auditor and have a staff of six junior auditors to supervise, although the budget allows for up to ten junior staff.
In a recent meeting with the chief internal auditor, the difficulty of staff recruitment and retention was discussed. Over the past year, five junior internal audit staff have left the company, but only two have been recruited. Recruitment problems identified include location of Octball’s head office in a small town over 150 kilometres from the nearest major city and extensive foreign travel, often to cold climates.
Together with the chief internal auditor you believe that outsourcing the internal audit department may be a way of alleviating the staffing problems. You would monitor the new outsourced department in a part-time role taking on additional responsibilities in other departments, and the chief internal auditor would accept the post of Finance Director (FD) on the board, replacing the retiring FD.
Two firms have been identified as being able to provide the internal audit service:
– The NFA Partnership, a local firm specialising in provision of accountancy and internal audit services. NFA does not audit financial statements or report to members, and
– T&M, Octball’s external auditors, who have offices in 75 countries and employ in excess of 65,000 staff.
(a) Discuss the advantages and disadvantages of appointing NFA as internal auditors for Octball. (8 marks)
(b) Discuss the issues T&M need to consider before they could accept appointment as internal auditors for
Octball. (7 marks)
(c) Assume that an outsourcing company has been chosen to provide internal audit services.
Describe the control activities that Octball should apply to ensure that the internal audit service is being
maintained to a high standard. (5 marks)
3 (a) International Standard on Auditing 300 (revised) Planning an Audit of Financial Statements, states that an auditor must plan the audit.
Explain why it is important to plan an audit. (5 marks)
(b) You are the audit manager in charge of the audit of Tempest, a limited liability company. The company’s year end is 31 December, and Tempest has been a client for seven years. The company purchases and resells fittings for ships including anchors, compasses, rudders, sails etc. Clients vary in size from small businesses making yachts to large companies maintaining large luxury cruise ships. No manufacturing takes place in Tempest.
Information on the company’s financial performance is available as follows:
2005 Forecast 2004 Actual
Non-current assets (at net book value) 3,600 4,500
The industry that Tempest trades in has seen moderate growth of 7% over the last year.
– Non-current assets mainly relate to company premises for storing inventory. Ten delivery vehicles are owned with a net book value of $300,000.
– One of the directors purchased a yacht during the year.
– Inventory is stored in ten different locations across the country, with your firm again having offices close to seven of those locations.
– A computerised inventory control system was introduced in August 2005. Inventory balances are now obtainable directly from the computer system. The client does not intend to count inventory at the year end but rely instead on the computerised inventory control system.
Using the information provided above, prepare the audit strategy for Tempest for the year ending
31 December 2005. (15 marks)
Section B – TWO questions ONLY to be attempted
4 (a) International Standard on Auditing 560 Subsequent Events explains the audit work required in connection with subsequent events.
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)
(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:
15 August 2005 Bankruptcy of major customer representing 11% of the trade receivables on the balance sheet.
21 September 2005 Financial statements approved by directors.
22 September 2005 Audit work completed and auditor’s report signed.
1 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.
For each of the following three dates:
– 15 August 2005;
– 1 November 2005; and
– 30 November 2005
(i) State whether the events occurring on those dates are adjusting or non-adjusting according to IAS 10
Events After the Balance Sheet Date, 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.
5 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 balance sheet is the plant and machinery used in the construction of buildings. Due to the variety of different assets used, four different sub-classes 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.
(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.
(a) Explain the additional audit procedures you should take regarding the accidental underpayment of sales tax. (7 marks)
(b) Explain the additional audit procedures you should take regarding the possible underprovision of
depreciation. (7 marks)
(c) 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 do not intend to take any action regarding the under-provision 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.
Explain the procedures that the directors must follow in order to remove your company as the auditors of
LALD. (6 marks)
6 (a) Computer-Assisted Audit Techniques (CAATs) are used to assist an auditor in the collection of audit evidence from computerised systems.
List and briefly explain four advantages of CAATs. (4 marks)
(b) Porthos, a limited liability company, is a reseller of sports equipment, specialising in racquet sports such as tennis, squash and badminton. The company purchases equipment from a variety of different suppliers and then resells this using the Internet as the only selling media. The company has over 150 different types of racquets available in inventory, each identified via a unique product code.
Customers place their orders directly on the Internet site. Most orders are for one or two racquets only. The ordering/sales software automatically verifies the order details, customer address and credit card information prior to orders being verified and goods being despatched. The integrity of the ordering system is checked regularly by ArcherWeb, an independent Internet service company.
You are the audit manager working for the external auditors of Porthos, and you have just started planning the audit of the sales system of the company. You have decided to use test data to check the input of details into the sales system. This will involve entering dummy orders into the Porthos system from an online terminal.
List the test data you will use in your audit of the financial statements of Porthos to confirm the completeness and accuracy of input into the sales system, clearly explaining the reason for each item of data. (6 marks)
(c) You are also considering using audit software as part of your substantive testing of the data files in the sales and inventory systems of Porthos.
(i) List and briefly explain some of the difficulties of using audit software; (4 marks)
(ii) List the audit tests that you can program into your audit software for the sales and inventory system in
Porthos, explaining the reason for each test. (6 marks)