Audit and Internal
TUESDAY 14 DECEMBER 2004
Time allowed 3 hours
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
Section A – ALL THREE questions are compulsory and MUST be attempted
1 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.
(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)
(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)
2 You are an audit senior responsible for understanding the entity and its environment and assessing the risk of material misstatements for the audit of Rock for the year ending 31 December 2004. Rock is a company listed on a stock exchange. Rock is engaged in the wholesale import, manufacture and distribution of basic cosmetics and toiletries for sale to a wide range of stores, under a variety of different brand names. You have worked on the audit of this client for several years as an audit junior.
(a) Describe the information you will seek, and procedures you will perform in order to understand the entity and its environment and assess risk for the audit of Rock for the year ending 31 December 2004.
(b) You are now nearing the completion of the audit of Rock for the year ending 31 December 2004. Draft financial statements have been produced. You have been given the responsibility of performing a review of the audit files before they are passed to the audit manager and the audit partner for their review. You have been asked to concentrate on the proper completion of the audit working papers. Some of the audit working papers have been produced electronically but all of them have been printed out for you.
Describe the types of audit working papers you should expect to see in the audit files and the features of those working papers that show that they have been properly completed. (10 marks)
3 Day-to-day internal controls are important for all businesses to maximise the efficient use of resources and profitability. Your firm has recently been appointed as auditor to Cliff, a private company that runs a chain of small supermarkets selling fresh and frozen food, and canned and dry food. Cliff has very few controls over inventory because the company trusts local managers to make good decisions regarding the purchase, sale and control of inventory, all of which is done locally. Pricing is generally performed on a cost-plus basis.
Each supermarket has a stand-alone computer system on which monthly accounts are prepared. These accounts are mailed to head office every quarter. There is no integrated inventory control, sale or purchasing system and no regular system for inventory counting. Management accounts are produced twice a year.
Trade at the supermarkets has increased in recent years and the number of supermarkets has increased. However, the quality of staff that has been recruited has fallen. Senior management at Cliff are now prepared to invest in more up-to-date systems.
(a) Describe the problems that you might expect to find at Cliff resulting from poor internal controls.
(b) Make FOUR recommendations to the senior management of Cliff for the improvement of internal controls, and explain the advantages and disadvantages of each recommendation. (12 marks)
Section B – TWO questions ONLY to be attempted
4 ISA 500 Audit Evidence (Revised) states that management implicitly or explicitly makes assertions relating to the various elements of financial statements including related disclosures. Auditors may use three categories of assertions to form a basis for risk assessments and the design and performance of further audit procedures. The three categories suggested by ISA 500 relate to (i) classes of transactions, (ii) account balances, and (iii) presentation and disclosure. One assertion applicable to all three categories is completeness: that all transactions, events, assets, liabilities, equity interests and disclosures that should be included, are included in the financial statements.
(a) List and describe SIX financial statement assertions, other than completeness, used by auditors in the audit
of financial statements. (6 marks)
(b) Boulder is a small company that manufactures hosiery products. It employs approximately 150 staff, all of whom are paid by bank transfer.
Temporary factory staff are hired through an agency and are paid on piece rates (i.e. for the number of items that they produce or process) on a weekly basis. Supervisors at Boulder authorise documentation indicating the number of items produced or processed by agency staff. The agency is paid by bank transfer and it, not Boulder, is responsible for the deduction of tax and social insurance.
Permanent factory staff are paid on a weekly basis on the basis of hours worked as evidenced by clock cards. Administration and sales staff are paid a monthly salary. The two directors of the company are also paid a monthly salary.
Sales staff are paid a quarterly bonus calculated on the basis of sales. Directors are paid an annual bonus based on profits.
You will be performing the audit of the financial statements for the year ending 31 December 2004 and you will be responsible for the figures in the financial statements relating to payroll.
Describe the substantive audit procedures you will perform on:
(i) the payroll balances in the balance sheet of Boulder; (10 marks)
(ii) the payroll transactions in the income statement of Boulder. (4 marks)
5 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.
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.
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
6 The purpose of an external audit and its role are not well understood. You have been asked to write some material for inclusion in your firm’s training materials dealing with these issues in the audit of large companies.
(a) Draft an explanation dealing with the purpose of an external audit and its role in the audit of large companies,
for inclusion in your firm’s training materials. (10 marks)
(b) The external audit process for the audit of large entities generally involves two or more recognisable stages. One stage involves understanding the business and risk assessment, determining the response to assessed risk, testing of controls and a limited amount of substantive procedures. This stage is sometimes known as the interim audit. Another stage involves further tests of controls and substantive procedures and audit finalisation procedures. This stage is sometimes known as the final audit.
Describe and explain the main audit procedures and processes that take place during the interim and final
audit of a large entity. (10 marks)