Audit and Internal
TUESDAY 15 JUNE 2004
This paper is divided into two sections
ALL THREE questions are compulsory and MUST
TWO questions ONLY to be answered
Section A – ALL THREE questions are compulsory and MUST be attempted
(a) Explain how the classification of risks into categories such as ‘high’, ‘medium’ or ‘low’, helps entities manage
their businesses. (4 marks)
You are the internal auditor of a large private company, Twinkletoes. Twinkletoes manufactures a high volume of reasonably priced shoes for elderly people. The company has a trade receivables ledger that is material to the financial statements containing four different categories of account. The categories of account, and the risks associated with them, are as follows:
(i) small retail shoe shops. These accounts represent nearly two thirds of the accounts on the ledger by number, and one third of the receivables by value. Some of these customers pay promptly, others are very slow;
(ii) large retail shoe shops (including a number of overseas accounts) that sell a wide range of shoes. Some of these accounts are large and overdue;
(iii) chains of discount shoe shops that buy their inventory centrally. These accounts are mostly well-established ‘high street’ chains. Again, some of these accounts are large and overdue; and
(iv) mail order companies who sell the company’s shoes. There have been a number of large new accounts in this category, although there is no history of bad debts in this category.
Receivables listed under (ii) to (iv) are roughly evenly split by both value and number. All receivables are dealt with by the same managers and staff and the same internal controls are applied to each category of receivables. You do not consider that using the same managers and staff, and the same controls, is necessarily the best method of managing the receivables ledger.
Twinkletoes has suffered an increasing level of bad debts and slow payers in recent years, mostly as a result of small shoe shops becoming insolvent. The company has also lost several overseas accounts because of a requirement for them to pay in advance. Management wishes to expand the overseas market and has decided that overseas customers will in future be allowed credit terms.
Management has asked you to classify the risks associated with the receivables ledger in order to manage trade receivables as a whole more efficiently. You have been asked to classify accounts as high, medium or low risk.
(b) Classify the risks relating to the four categories of trade receivables as high, mediumor lowand explain your
classification. (8 marks)
NB: More than one risk classification may be appropriate within each account category.
(c) Describe the internal controls that you would recommend to Twinkletoes to manage the risks associated with the receivables ledger under the headings: all customers, slow paying customers, larger accounts, and
overseas customers. (8 marks)
2 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.
(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)
3 Fizzipop manufactures and distributes soft drinks. Its inventories are controlled using a real-time system which provides accurate records of quantities and costs of inventories held at any point in time. This system is known within the company as the ‘Stockpop’ system and it is integrated with the purchases and sales system. Fizzipop has an internal audit department whose activities encompass inventories.
No year-end inventory count takes place. Inventories are held in several large warehouses where non-stop production takes place.
Your firm is the external auditor to Fizzipop and you have been asked to perform the audit of inventories. Inventories include finished goods and raw materials (water, sugar, sweeteners, carbonating materials, flavourings, cans, bottles, bottle tops, fastenings and packaging materials).
Section B – TWO questions ONLY to be attempted
4 Curdco is a company that runs a chain of fast food restaurants. The company has a centralised operating style and managers of individual restaurants have very limited decision-making powers on day-to-day operational matters. The company’s centralised administration is responsible for the buying of food, the payment of staff, the maintenance and cleaning of restaurants by staff employed by a national agency, and all other matters relating to the running of the business. The company has good internal controls over purchasing. Inventory counts are conducted at each restaurant at the year-end. Your firm has recently been appointed as auditor to Curdco.
(a) List the account headings you would expect to find in Curdco’s schedule of accounts payable and accrued
expenditure. (3 marks)
(b) Describe and give reasons for the audit tests you would carry out to obtain audit evidence for Curdco’s accounts payable and accrued expenditure. (12 marks)
(c) Explain the difficulties faced by auditors, and the decisions that auditors have to make, in conducting direct
confirmations of accounts payable. (5 marks)
5 Flylo is an airline. The company owns some of its fleet of aircraft. Other aircraft are leased from third parties. Flylo has an internal audit function that has recently been expanded. Your firm is the external auditor to Flylo. Your firm has been asked to investigate the extent to which it may be able to rely on the work of internal audit in the following areas:
– sales and ticketing;
– fleet acquisition and maintenance;
– trade payables and long-term debt financing (borrowings).
The company outsources its in-flight catering and payroll functions to different service organisations.
(a) Explain why the work of the internal auditors, in the three areas noted above, is likely to be useful to you as
the external auditor. (9 marks)
(b) Explain how the quality of the internal audit function is likely to influence the extent of your reliance on
internal audit work. (5 marks)
(c) Describe the audit evidence you will seek relating to internal controls over the out-sourced functions (in-flight
6 There are a number of different methods of obtaining audit evidence. Methods include:
(i) analytical procedures; (ii) audit sampling; (iii) tests of controls;
(iv) detailed testing of transactions and balances; (v) computer assisted audit techniques (CAATs).
These methods overlap and may be used for different purposes during an audit of financial statements.
(a) Explain the advantages and disadvantages of each of the five methods of evidence gathering listed above.
NB: You are not required to describethe methods listed above.
(b) Describe the relationship between the five methods of evidence gathering described above. (5 marks)
End of Question Paper