Audit and Internal
TUESDAY 12 JUNE 2007
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
The Association of Chartered Certified Accountants
Section A – ALL THREE questions are compulsory and MUST be attempted
1 Green Co grows crops on a large farm according to strict organic principles that prohibits the use of artificial pesticides and fertilizers. The farm has an ‘organic certification’, which guarantees its products are to be organic. The certification has increased its sales of flour, potatoes and other products, as customers seek to eat more healthily.
Green Co is run by two managers who are the only shareholders. Annual revenue is $50 million with a net profit of 5%. Both managers have run other businesses in the last 10 years. One business was closed due to suspected tax fraud (although no case was ever brought to court).
Green Co’s current auditors provide audit services. Additional assurance on business controls and the preparation of financial statements are provided by a different accountancy firm.
Last year, a neighbouring farm, Black Co started growing genetically modified (GM) crops, the pollen from which blows over Green Co’s fields on a regular basis. This is a threat to Green Co’s organic status because organic crops must not be contaminated with GM material. Green Co is considering court action against Black Co for loss of income and to stop Black Co growing GM crops.
You are an audit partner in Lime & Co, a 15 partner firm of auditors and business advisors. You have been friends with the managers of Green Co for the last 15 years, advising them on an informal basis. The managers of Green Co have indicated that the audit will be put out to tender next month and have asked your audit firm to tender for the audit and the provision of other professional services.
(a) Using the information provided, identify and explain the ethical threats that could affect Lime & Co.
(b) In respect of the going concern concept:
(i) Define ‘going concern’ and state two situations in which it should NOT be applied in the preparation of
financial statements; (3 marks)
(ii) Explain the directors’ responsibilities and the auditors’ responsibilities regarding financial statements
prepared on the going concern principle. (4 marks)
(c) List the audit procedures that should be carried out to determine whether or not the going concern basis is
appropriate for Green Co. (5 marks)
2 ISA 500 Audit Evidencerequires that auditors ‘should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion’.
(a) List and explain the factors which will influence the auditor’s judgement concerning the sufficiency of audit
evidence obtained. (4 marks)
(b) You are the audit senior in charge of the audit of Metcalf Co, a company that has been trading for over 50 years. Metcalf Co manufactures and sells tables and chairs directly to the public. The company’s year end is 31 March.
Current liabilities are shown on Metcalf Co’s balance sheet as follows:
Trade payables 884,824 816,817 Accruals 56,903 51,551 Provision for legal action 60,000 – –––––––––– –––––––– 1,001,727 868,368 –––––––––– ––––––––
The provision for legal action relates to a claim from a customer who suffered an injury while assembling a chair supplied by Metcalf Co. The directors of Metcalf Co dispute the claim, although they are recommending an out of court settlement to avoid damaging publicity against Metcalf Co.
List the substantive audit procedures that you should undertake in the audit of current liabilities of Metcalf Co for the year ended 31 March 2007. For each procedure, explain the purpose of that procedure.
Marks are allocated as follows:
(i) Trade payables; (9 marks)
(ii) Accruals; (3 marks)
(iii) The provision for legal action. (4 marks)
3 Rhapsody Co supplies a wide range of garden and agricultural products to trade and domestic customers. The company has 11 divisions, with each division specialising in the sale of specific products, for example, seeds, garden furniture, agricultural fertilizers. The company has an internal audit department which provides audit reports to the audit committee on each division on a rotational basis.
Products in the seed division are offered for sale to domestic customers via an Internet site. Customers review the product list on the Internet and place orders for packets of seeds using specific product codes, along with their credit card details, onto Rhapsody Co’s secure server. Order quantities are normally between one and three packets for each type of seed. Order details are transferred manually onto the company’s internal inventory control and sales system, and a two part packing list is printed in the seed warehouse. Each order and packing list is given a random alphabetical code based on the name of the employee inputting the order, the date, and the products being ordered. In the seed warehouse, the packets of seeds for each order are taken from specific bins and despatched to the customer with one copy of the packing list. The second copy of the packing list is sent to the accounts department where the inventory and sales computer is updated to show that the order has been despatched. The customer’s credit card is then charged by the inventory control and sales computer. Bad debts in Rhapsody are currently 3% of total sales.
Finally, the computer system checks that for each charge made to a customer’s credit card account, the order details are on file to prove that the charge was made correctly. The order file is marked as completed confirming that the order has been despatched and payment obtained.
(a) In respect of sales in the seeds division of Rhapsody Co, prepare a report to be sent to the audit committee of Rhapsody Co which:
(i) identifies and explains FOUR weaknesses in that sales system; (ii) explains the possible effect of each weakness; and
(iii) provides a recommendation to alleviate each weakness.
Note: Up to 2 marks will be awarded for presentation. (14 marks)
(b) Explain the advantages to Rhapsody Co of having an audit committee. (6 marks)
Section B – TWO questions ONLY to be attempted
4 (a) ISA 700 The Independent Auditor’s Report on a Complete Set of General Purpose Financial Statements
indicates the basic elements that will ordinarily be included in the audit report.
List SIX basic elements of an auditor’s report. Briefly explain why each element is included in the report.
(b) You are the audit manager in charge of the audit of MSV Co for the year ended 28 February 2007. MSV Co is based in a seaside town and hires motor boats and yachts to individuals for amounts of time between one day and one week. The majority of receipts are in cash, with a few customers paying by debit card. Consequently, there are no trade receivables on the balance sheet. The main non-current assets are the motor boats and yachts. The company is run by four directors who are also the major shareholders. Total income for the year was about $10 million.
The following issues have been identified during the audit: Issue 1
Audit tests on sales indicate a weakness in the internal control system, with a potential understatement of income in the region of $500,000. The weakness occurred because sales invoices are not sequentially numbered, allowing one of the directors to remove cash sales prior to recording in the sales day book. This was identified during analytical procedures of sales, when the audit senior noted that on the days when this director was working, sales were always lower than on the days when the director was not working. (8 marks) Issue 2
During testing of non-current assets, one yacht was found to be located at the property of one of the directors. This yacht has not been hired out during the year and enquiries indicate that the director makes personal use of it. The yacht is included in the non-current assets balance in the financial statements. (6 marks)
For each of the issues above:
(i) List the audit procedures you should conduct to reach a conclusion on these issues;
(ii) Assuming that you have performed all the audit procedures that you can, but the issues are still unresolved, explain the potential effect (if any) on the audit report.
Note: The mark allocation is shown against each of the two issues.
5 ISA 230 Audit Documentation (Revised)establishes standards and provides guidance regarding documentation in the context of the audit of financial statements.
(a) List the purposes of audit working papers. (3 marks)
(b) You have recently been promoted to audit manager in the audit firm of Trums & Co. As part of your new responsibilities, you have been placed in charge of the audit of Specs4You Co, a long established audit client of Trums & Co. Specs4You Co sells spectacles; the company owns 42 stores where customers can have their eyes tested and choose from a range of frames.
List the documentation that should be of assistance to you in familiarising yourself with Specs4You Co. Describe the information you should expect to obtain from each document. (8 marks)
(c) The time is now towards the end of the audit, and you are reviewing working papers produced by the audit team. An example of a working paper you have just reviewed is shown below.
Client Name Specs4You Co Year end 30 April Page xxxxxxx
Working paper Payables transaction testing
Prepared by Date
Reviewed by CW Date 12 June 2007
Audit assertion:To make sure that the purchases day book is correct.
Method:Select a sample of 15 purchase orders recorded in the purchase order system. Trace details to the goods
received note (GRN), purchase invoice (PI) and the purchase day book (PDB) ensuring that the quantities and prices recorded on the purchase order match those on the GRN, PI and PDB.
Test details: In accordance with audit risk, a sample of purchase orders were selected from a numerically
sequenced purchase order system and details traced as stated in the method. Details of items tested can be found on another working paper.
Results:Details of purchase orders were normally correctly recorded through the system. Five purchase orders
did not have any associated GRN, PI and were not recorded in the PDB. Further investigation showed that these orders had been cancelled due to a change in spectacle specification. However, this does not appear to be a system weakness as the internal controls do not allow for changes in specification.
Conclusion:Purchase orders are completely recorded in the purchase day book.
Explain why the working paper shown above does not meet the standards normally expected of a working paper.
Note: You are not required to reproduce the working paper.
6 You are an audit manager in Ron & Co. One of your audit clients, MistiRead Co, is a specialist supplier of crime fiction with over 120,000 customers. The company owns one large warehouse, which contains at any one time about 1 million books of up to 80,000 different titles. Customers place orders for books either over the Internet or by mail order. Books are despatched on the day of receipt of the order. Returns are allowed up to 30 days from the despatch date provided the books look new and unread.
Due to the high inventory turnover, MistiRead maintains a perpetual inventory system using standard ‘off the shelf’ software. Ron & Co has audited the system for the last five years and has found no errors within the software. Continuous inventory checking is carried out by MistiRead’s internal audit department.
You are currently reviewing the continuous inventory checking system with an audit junior. The junior needs experience in auditing continuous inventory checking systems and some basic knowledge on ACCA’s Code of Ethics and Conduct.
(a) Explain the advantages of using a perpetual inventory system. (4 marks)
(b) List the audit procedures you should perform to confirm the accuracy of the continuous inventory checking at MistiRead Co. For each procedure, explain the reason for carrying out that procedure. (6 marks)
(c) Explain the fundamental principles set out in ACCA’s Code of Ethics and Conduct of integrity, objectivity and
independence to accountants. (6 marks)
(d) During your preliminary audit planning you note that the engagement letter has been returned un-signed by the directors of MistiRead. When asked to explain their action, the directors indicate that they cannot allow you access to information on the company’s new website development as this contains various trade secrets. You will not, therefore, be able to perform audit procedures on the research and development expenditure incurred on the website and included in non-current assets.
Briefly explain the actions you should take as a result of the directors not signing the engagement letter.
End of Question Paper