ACCA Paper F8 Auditiing and Assurance F8AA(Int)RQB Qs d08

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Question 1 AUDITORS AND AUDITING STANDARDS

Auditors and Auditing Standards are controlled and regulated in a number of different ways. Required:

(a) Explain how International Standards on Auditing (ISAs) are developed by the International Auditing and Assurance Board (IAASB), and explain the role and

authority of ISAs. (8 marks)

(b) Explain the role of Professional Bodies in the regulation of auditors. (8 marks) (c) Describe how ISAs and national auditing standards in individual countries influence

each other. (4 marks)

(20 marks)

Question 2 JUMPER & CO

You are the audit manager of Tela & Co, a medium sized firm of accountants. Your firm has just been asked for assistance from Jumper & Co, a firm of accountants in an adjacent country. This country has just implemented the internationally recognised codes on corporate governance and Jumper & Co has a number of clients where the codes are not being followed. One example of this, from SGCC, a listed company, is shown below. As your country already has appropriate corporate governance codes in place, Jumper & Co have asked for your advice regarding the changes necessary in SGCC to achieve appropriate compliance with corporate governance codes.

Extract from financial statements regarding corporate governance

Mr Sheppard is the Chief Executive Officer and board chairman of SGCC. He appoints and maintains a board of five executive and two non-executive directors. While the board sets performance targets for the senior managers in the company, no formal targets or review of board policies is carried out. Board salaries are therefore set and paid by Mr Sheppard based on his assessment of all the board members, including himself, and not their actual performance.

Internal controls in the company are monitored by the senior accountant, although detailed review is assumed to be carried out by the external auditors; SGCC does not have an internal audit department. Annual financial statements are produced, providing detailed information on past performance. Required:

Write a memo to Jumper & Co which:

(a) Explains why SGCC does not meet international codes of corporate governance

(b) Explains why not meeting the international codes may cause a problem for SGCC, and

(c) Recommends any changes necessary to implement those codes in the company.

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Question 3 CORPORATE GOVERNANCE

You are a recently qualified Chartered Certified Accountant in charge of the internal audit department of ZX, a rapidly expanding company. Turnover has increased by about 20% p.a. for the last five years, to the current level of $50 million. Net profits are also high, with an acceptable return being provided for the four shareholders.

The internal audit department was established last year to assist the board of directors in their control of the company and to prepare for a possible listing on the stock exchange. The Managing Director is keen to follow the principles of good corporate governance with respect to internal audit. However, he is also aware that the other board members do not have complete knowledge of corporate governance or detailed knowledge of International Auditing Standards.

Required:

Write a memo to the board of ZX that:

(a) Explains how the internal audit department can assist the board of directors in fulfilling their obligations under the principles of good corporate governance. (10 marks) (b) Explains the advantages and disadvantages to ZX of an audit committee. (10 marks) (20 marks)

Question 4 FRAUD AND COMPLIANCE SEMINAR

During a seminar on fraud and compliance with laws and regulations, with particular reference to the implications of:

ISA 240 The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements

participants were invited to offer experiences for consideration by the seminar. Amongst the experiences considered were the following.

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(d) Scrutinising the unclaimed wages book of a medium sized business it was apparent that the same employee regularly failed to collect her pay. The book showed that the wages were always collected on her behalf by the department supervisor. The total amount was not material so further investigation by the auditors was considered unnecessary. (3 marks) Required:

For each situation, comment on the implications for the audit and discuss further actions the auditors should take.

(20 marks)

Question 5 STONE HOLIDAYS

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) (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 6 MANLY

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Mary is unhappy with the situation for the following reasons:

(a) She is reasonably certain that, if she issues a qualified opinion, the directors of Manly will recommend appointment of another firm as auditors.

(b) Her firm supplies many other non-audit services to Manly such as tax and consultancy which bring in twice as much revenue as the audit and are more profitable. It is highly unlikely the firm would continue to be asked to provide these services if the audit is lost. In total, fees paid by Manly for the audit and these other services amount to 9% of the audit firm’s revenues.

(c) She has been the engagement partner for ten years and has no reason to doubt the integrity of the chief financial officer with whom she has worked closely over that period of time. She is prepared to believe his assertion that the debt will be repaid. However, she also accepts that evidence in the audit file is equally persuasive that the customer is, currently, in financial difficulty.

She calls the chief financial officer to advise him that she will have no option but to issue a qualified opinion if the financial statements do not contain a provision against the debt.

Required:

(a) In connection with the threat of removal from office:

(i) Discuss problems that can arise when accepting audit engagements where appointment and removal from office are controlled by management and suggest ways of overcoming them. (5 marks) (ii) Explain how an audit committee can provide additional safeguards to audit independence in such a situation. (3 marks) (b) Point (b) in the scenario raises the issue of providing non-audit services to audit clients.

(i) State the requirements of the ACCA’s “Rules of Professional Conduct” relating to the supply of non-audit services to audit clients. (4 marks) (ii) Explain why the provision of non-audit services to audit clients might be seen as a problem and why it is sometimes suggested that auditors should not

provide such services. (4 marks)

(c) Point (c) in the scenario raises the issue of “audit rotation”. What is meant by audit rotation and what are its supposed benefits and drawbacks? (4 marks) Where appropriate, your answers should be illustrated by reference to the situation described.

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Question 7 INTERNAL AUDITOR

(a) You are a Chartered Certified Accountant and the newly appointed internal auditor of a company that is experiencing financial difficulties. As a condition for obtaining bank loans, the company has agreed to maintain specified liquidity ratios, asset to liability ratios, and gross profit margins. The draft financial statements for the period-end appear to show that the company has not succeeded in complying with some of these requirements.

The profit figures are significantly affected by the calculation of bad debt and depreciation charges. There has been a suggestion to the effect that these could be changed, in order to meet the bank’s conditions. There is a real danger that if the bank withdraws its funding, the company will become insolvent and will have to cease trading. The chief financial accountant has asked you to sign certain internal records that have been altered in order to show that the bank’s conditions have been met.

Required:

Explain the courses of action open to you in these circumstances. (10 marks) (b) You are the external auditor of the company in financial difficulties described in (a) above. You have noted that the calculations of the bad debt and depreciation provisions have been altered in the current year and that as a result, the bank’s requirements have been met. You also note that certain accounting policy changes have been made in relation to accounting for leases and that as a result, the profit targets expected by certain investment analysts have now been met. If the changes had not been made, the targets would not have been met. You have asked to speak to the internal auditor but you have been told that he is on long-term sick leave. The chief financial accountant is away on holiday and will not be back until shortly before the audit is due to be completed.

Required:

In relation to the facts above, explain the:

(i) implications for the audit of the financial statements;

(ii) potential effect, if any, on the auditor’s report on the financial statements;

(iii) implications for the continuing relationship between the audit firm and the

client. (10 marks)

(20 marks)

Question 8 CLIENT CONFIDENTIALITY

Client confidentiality underpins the relationship between Chartered Certified Accountants in practice and their clients. It is a core element of ACCA’s Rules of Professional Conduct.

Required:

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(b) A waste disposal company has breached tax regulations, environmental regulations and health and safety regulations. The auditor has been approached by the tax authorities, the government body supervising the award of licences to such companies and a trade union representative. All of them have asked the auditor to provide them with information about the company. The auditor has also been approached by the police. They are investigating a suspected fraud perpetrated by the managing director of the company and they wish to ask the auditor certain questions about him.

Required:

Describe how the auditor should respond to these types of request. (12 marks) (20 marks)

Question 9 MELTON MANUFACTURING

The directors of Melton Manufacturing have asked your firm to act as the company’s statutory auditor for the year ending 31 March 2009. They will be asking their existing auditors to resign as they say they do not provide a cost effective service.

Required:

(a) Describe the investigations you would carry out and the practical and ethical matters you would consider before you can:

(i) accept the appointment as the company’s auditor; and

(ii) be appointed the company’s auditor. (11 marks) (b) (i) Explain why it is important that an auditor should send a letter of engagement

to the client prior to undertaking the audit.

(ii) Briefly describe the main contents of a letter of engagement which you would send to the directors of Melton Manufacturing. (9 marks) (20 marks)

Question 10 BONDI

You are a partner with a firm of Chartered Certified Accountants that has been invited, by the board of directors, to accept nomination as external auditors to Bondi, a company listed on a recognized stock exchange. Bondi operates a number of car dealerships and has grown rapidly over the past two years through an aggressive take-over strategy.

You are aware that the company’s existing auditors, a much smaller firm, qualified their last auditors’ report. Over lunch with a number of your firm’s partners, the company’s finance director maintained that their existing auditors could not cope with the audit of a company their size and, in particular, were not equipped to audit the recently installed sophisticated computer accounting program. He also suggests that they need a firm of your reputation in order to reassure the market as they intend to seek a public listing within two years.

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(i) Insufficient consideration has been devoted by management to developing the accounting system in line with the expanding business. In particular there is a lack of concern as to control. They detected a number of petty employee frauds as a result of control weaknesses. No action was taken against the employees identified as engaged in fraud. The attitude seems to be to encourage risk taking employees who, if they make money on the side whilst securing good deals for the company, that is seen as a legitimate bonus.

(ii) The newly installed computer accounting system is unreasonably complicated. Bondi claims this is necessary because of the need to maintain records to justify the company’s claims for volume rebates, and bonuses under the complex incentive schemes by which car manufacturers reward dealers.

(iii) They have no evidence of deliberate misrepresentation by the directors but audit staff were hindered in their audit work by a less than helpful attitude by senior management who adopted an aggressive stance whenever a query was raised.

The finance director was constantly on the phone to the partner claiming the audit staff were incompetent and accusing them of wasting his time asking unnecessary questions.

At a partner’s meeting a majority of partners accepted the story that the existing auditors were out of their depth and that their complaints were merely an attempt to cover up their own shortcomings. Your firm accepted nomination and was duly appointed as auditors.

Required:

(a) State factors the partners should have considered for and against accepting nomination. (7 marks) (b) Detail the matters to which you should pay particular attention in obtaining the

required knowledge of the business and in developing your audit plan. (7 marks) (c) During the first audit your firm discovers that the reason for the complexity of the computer

system is to falsify records in order to reduce the amount of tax payable to the government. Describe the action you would take on discovery of the fraud. (6 marks)

(20 marks)

Question 11 PLANNING DOCUMENTATION

“The auditor should develop and document an audit program setting out the nature, timing and extent of planned audit procedures required to implement the overall audit plan.”

Required:

(a) Distinguish between the “overall audit plan” and “audit program” (6 marks)

(b) Discuss the advantages and disadvantages of using standardized audit programs.

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You are the audit senior responsible for the audit of Viewco for the year ending 31 December 2008. Together with a junior member of staff, you will be attending Viewco’s physical inventory count.

Required:

State, with reasons, what information the working papers relating to this attendance

should contain. (8 marks)

(20 marks)

Question 12 BESTWOOD TRADING

The Senior Partner has asked you to explain the contents and importance of audit working papers to unqualified audit staff who have recently joined your audit firm.

It has been explained that audit working papers are divided into: (a) the permanent audit file, and

(b) the current audit file

Your audit firm has a standardized method of organizing and referencing working papers within each audit file.

Required:

(a) (i) List and briefly describe the contents of the Permanent Audit File and the Current Audit File.

(ii) Suggest a system for referencing the different sections of the audit working papers and explain why it is important the audit firm should use a standardized referencing system.

(iii) Describe three types of checklist (excluding audit programs) and three types of specimen letter which are commonly included in audit working papers.

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Required:

Explain whether the auditor is negligent in each of the following situations:

(i) the auditor reported the late banking of cash receipts in the management letter and explained the risk of fraud;

(ii) the auditor did not mention the late banking of cash receipts in the

management letter. (6 marks)

(20 marks)

Question 13 WORKING PAPERS

The preparation of working papers is an important part of the audit process. You have been asked to prepare a session introducing new recruits to your firm of Chartered Certified Accountants to the use of working papers. Two of the topics you have been asked to cover are:

(a) the design and use of audit programs; and

(b) the concept of an audit trail with respect to the conduct of the audit itself. Required:

(a) Explain the design and use of audit programs and discuss the merits of standard and

tailored audit programs. (7 marks)

(b) Explain the importance of recording details of the actual evidence examined in the course of the audit on which the conclusions are drawn. Your answer should include consideration of the details of evidence to be recorded in the working papers and of the audit trail to be left in the books and records of the entity being audited. (5 marks) (20 marks)

Question 14 PHONES ANYWHERE

You are the partner in charge of a four-partner firm of Certified Accountants. Your firm has been invited to tender for the audit of Phones Anywhere for the year ending 31 December 2008.

Phones Anywhere was established two years ago, and it provides a mobile phone service for individuals and businesses. The system being established by the company comprises:

(a) small portable mobile phones, which allow subscribers (users) to contact or be contacted by any other telephone

(b) the mobile phones can be used within range of a local relay station, which receives calls from and sends calls to the mobile phones

(c) the local relay stations are linked to a central computer which connects the calls to other users. Frequently, this is through a competitor’s telephone network

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(e) the cost of the relay stations and central computer are capitalised and are written off over six years

(f) the mobile phones are manufactured by other companies and sold through retailers. Phones Anywhere does not sell the phones, but it pays $200 to the retailer for each phone sold and subscription signed by the customer to Phones Anywhere. This payment is capitalised in the financial statements of Phones Anywhere and written off over four years

(g) subscribers are invoiced monthly with a fixed line rental and a variable call charge. Other operators are charged for the time spent by their customers contacting Phones Anywhere’s subscribers (customers). These charges are logged and calculated by the company’s main computer

(h) all the shares are owned by three wealthy individuals who are non-executive directors. They will receive a fixed salary. They do not plan to make any further investment in the company (i) establishing the network of relay stations and subscribers will result in the company making

losses for at least three years. Current borrowings are about 20% of shareholders’ funds. Because of the substantial capital expenditure and trading losses, it is expected the company will be highly geared by the year 2011.

(j) as the company will not be profitable, the non-executive directors have decided that executive directors should receive a basic salary and a bonus based on the number of subscribers to the system

(k) the owners plan to float the company on a recognised Stock Exchange in the year 2011. The flotation will involve:

(i) issuing new shares to the general public to provide funds for the company; and (ii) the three non-executive directors selling some of their shares

You are aware that Phones Anywhere has a number of very large competitors, each of which has a large number of users and comprehensive coverage (ie over 90% of the population are within range of a relay station).

Required:

(a) Identify and explain the business risks associated with the audit of the financial statements of Phones Anywhere. (8 marks) (b) Describe the ethical and other professional matters you should consider in deciding whether your audit firm should accept the audit. (8 marks)

(c) Come to a conclusion on whether you would advise your firm to accept or decline the audit, giving your principal reasons for coming to this decision. (4 marks)

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Question 15 BRIDGFORD PRODUCTS

Your firm has been the auditor of Bridgford Products, a listed company, for a number of years. The engagement partner has asked you to describe the matters you would consider when planning the audit for the year ended 31 January 2009.

During a recent visit to the company you obtained the following information:

(i) the management accounts for the 10 months to 30 November 2008 show sales of $130 million and profit before tax of $4 million. Assume sales and profits accrue evenly throughout the year. In the year ended 31 January 2008 Bridgford Products had sales of $110 million and profit before tax of $8 million

(ii) the company installed a new computerised inventory control system which has operated from 1 June 2008. As the inventory control system records inventory movements and current inventory quantities, the company is proposing:

to use the inventory quantities on the computer to value the inventory at the year end; and

not to carry out an inventory count at the year end

(iii) you are aware there have been reliability problems with the company’s products, which have resulted in legal claims being brought against the company by customers, and customers refusing to pay for the products

(iv) the sales increase in the 10 months to 30 November 2008 over the previous year has been achieved by attracting new customers and by offering extended credit. The new credit arrangements allow customers three months credit before their debt becomes overdue, rather than the one-month credit period allowed previously. As a result of this change, receivables age has increased from 1·6 to 4·1 months

(v) the chief financial officer and purchasing manager were dismissed on 15 August. A replacement purchasing manager has been appointed but it is not expected that a new chief financial officer will be appointed before the year end of 31 January 2009. The chief accountant will be responsible for preparing the financial statements for audit.

Required:

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Question 16 FIVE DOCK

As part of the process of planning the external audit of Five Dock, a public listed company, for the year ending 31 July, you have reviewed the minutes of meetings of the Board of Directors for the year to date. You have identified the following items likely to have a bearing on the assessment of audit risk and the design of audit procedures when drawing up the audit plan.

(1) On the recommendation of its non-executive Chairman, Five Dock has invested a substantial amount in the shares of Burwood, a private company, of which the Chairman is managing director and major shareholder.

(2) Development project 21A is behind schedule. Unexpected problems have emerged which will substantially increase the cost of the development and the production cost of the new product. $120,000 of development cost was recognised as an asset in the statement of financial position last year. A further $50,000 has been spent this year. The original budget was $130,000.

(3) In order to encourage performance, a bonus scheme has been introduced for senior management. In total, 25% of the company’s reported profits before tax in excess of the previous period’s profits will be set aside to provide for bonuses. No bonus will be paid if profits do not exceed the previous period.

(4) An internal audit department has been established.

(5) In order to finance investment in new projects Five Dock has taken out a substantial bank loan. The loan agreement states that the company’s gearing ratio (the proportion of loan capital to equity capital) must not exceed 30%. Last year’s financial statements had a gearing ratio of 20% and the latest monthly management accounts show a gearing ratio of 25%. Required:

For each of the items (1) to (5) above:

(a) explain how it might affect the assessment of inherent or control risk. (8 marks) (b) consider how it might affect the design of audit procedures specific to that item.

(12 marks)

(20 marks) Note: Assume each item is potentially material. Consider each item separately.

Question 17 PARKER

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In the next year, the directors plan to expand the range of goods sold through the Internet division to include toys, garden furniture and fashion clothes. The directors believe that when one product has been sold on the Internet, then any other product can be as well.

The accounting system to record sales by the mail order division is relatively old. It relies on extensive manual input to transfer orders received in the post onto Parker’s computer systems. Recently errors have been known to occur, in the input of orders, and in the invoicing of goods following despatch. The directors maintain that the accounting system produces materially correct figures and they cannot waste time in identifying relatively minor errors. The company accountant, who is not qualified and was appointed because he is a personal friend of the directors, agrees with this view.

The directors estimate that their expansion plans will require a bank loan of approximately $30 million, partly to finance the enhanced web site but also to provide working capital to increase inventory levels. A meeting with the bank has been scheduled for three months after the year end. The directors expect an unmodified auditor’s report to be signed prior to this time.

Required:

(i) Identify and describe THE MATTERS that give rise to audit risks associated

with Parker. (10 marks)

(ii) Explain the enquiries you will make, and the audit procedures you will perform to assist you in making a decision regarding the going concern status of Parker in reaching your audit opinion on the financial statements. (6 marks)

(20 marks)

Question 18 CLEANCO

Internal auditors often assist management in performing internal review assignments covering, for example, human resources, procurement (purchasing), marketing and treasury activities. Such reviews involve:

(i) the identification of risks;

(ii) the identification of control systems and procedures implemented to manage those risks; (iii) tests of controls to ensure that internal controls are operating effectively;

(iv) an evaluation of the overall effectiveness of the design and operation of controls in managing the risks identified.

You are the internal auditor for a private company, Cleanco. Cleanco provides cleaning services to shops and offices and has a reputation for high quality work. You have been asked to review the human resources, procurement and marketing functions within the company.

Cleanco employs about 500 cleaning staff, all of whom are on the payroll, and most of whom work part-time. Cleanco does not employ sub-contractors. Cleanco has a high turnover of staff.

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The company has recently decided to out-source its marketing to a large, aggressive, third party company that will advertise Cleanco’s services by means of direct mail, sometimes by offering discounts; this company has been criticised in the past for breaching advertising regulations. There is growing price competition in Cleanco’s market. Cleanco is struggling to maintain its profitability and would like to expand its client base.

Cleanco has three main functions: (i) human resources; (ii) procurement; (iii) marketing. Required:

For each of the three main functions at Cleanco describe the:

(a) risks that you expect the company to face;

(b) controls you expect to be in place to manage the risks you have identified in (a), above;

(c) tests of control you should perform to check that the controls you have identified in (b) above are operating properly.

Marks will be awarded as follows:

(i) Human resources. (8 marks)

(ii) Procurement. (6 marks)

(iii) Marketing. (6 marks)

You may present your answer in tabular format, if you wish.

(20 marks)

Question 19 BUSINESS RISK

(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

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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.

Required:

(b) Classify the risks relating to the four categories of trade receivables as high, medium or low and 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)

(20 marks)

Question 20 GRINDSBROOK CLOTHING COMPANY

The Grindsbrook Clothing Company is a family-owned company that manufactures and sells high quality clothes by mail order. It has been in business for nearly ten years and has made a small profit during the last five years.

The company has a small, modern factory and employs some 150 staff including clerical staff who take orders over the telephone and prepare the accounting records. The accounting hardware and software are out of date and slow. Credit management and management of receivables and payables generally is poor.

The company does not yet have a presence on the Internet. The company’s chief buyer, who is the managing director’s son, buys high quality fabrics all over the world. He is an expert in fabrics but he pays too little attention to either the consistency of supply or the cost. As a result, budgeting is difficult and some lines of clothing are made and sold at very little profit, or even a loss.

The company out-sources the production of the company catalogue and does not spend a significant amount on other advertising because the managing director does not consider that it is necessary. He has consistently refused to employ a professional marketing manager. There are an increasing number of competitors in this profitable market and despite the fact that the market is growing overall, the company’s market share is declining, although turnover is rising slowly.

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The company’s accounts have been prepared and audited by a series of firms of auditors. The managing director has refused to employ a qualified accountant. The company’s budgets and statutory financial statements have been of poor quality and have often been produced late.

You are a very busy Chartered Certified Accountant working in practice on your own and the managing director’s wife is your sister. You have considerable experience of providing advice to this type of business because you were once employed as internal auditor to a similar, but larger, clothing company. Your sister has decided that if the business is to prosper, outside professional help is needed.

The managing director’s wife, your sister, considers that your previous experience as an internal auditor may be useful to the Grindsbrook Clothing Company. She has asked you to assess the risks facing the business and to make suggestions as to how these risks should be managed.

Required:

(a) List the factors you will take into account in deciding whether or not to accept the

assignment from your sister. (6 marks)

(b) List the specific issues facing the business under appropriate headings such as external risks, financial risks, operational risks, and compliance risks. Describe the actions that could be taken by the company to deal with each issue you identify.

NB: You may use headings other than those suggested in the question. (14 marks) (20 marks)

Question 21 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;

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(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; (4 marks) (ii) describe how materiality affects the audit work performed by auditors;

(4 marks)

(iii) give an example of qualitative materiality. (2 marks) (20 marks)

Question 22 CONCEPT OF MATERIALITY

Amongst matters required to be considered by the auditor when planning the audit in accordance with the requirements of ISA 300 Planning an Audit of Financial Statements is “materiality”. Materiality is further the subject of ISA 320 Audit Materiality.

Required:

Explain the concept of materiality and how materiality is assessed when planning the audit. Your answer should include consideration of materiality at the overall financial statement level and in relation to individual account balances.

(12 marks)

Question 23 LENTON TEXTILES

As a member of the internal audit department of Lenton Textiles you have been asked to undertake a review of the sales system.

Lenton Textiles sells textile products to shops. Most of its sales are made on credit, but very small customers who do not have a sales ledger account can collect their purchases and pay in cash. For these cash sales:

(1) the customer orders the items from the sales department, which raises a pre-numbered multi-copy advice note;

(2) the dispatch department make up the order and give it to the customer with a copy of the advice note;

(3) the customer gives the advice note to the cashier who prepares a hand-written sales invoice; (4) the customer pays the cashier for the goods by cheque or in cash;

(5) the cashier records and banks the cash.

For credit sales, cheques and cash are received in the post. The post is opened by two people, who record cash and cheques received. The cheques and cash are given to the cashier who records them in the cashbook and pays them into the bank. The cashier reports the cheques and cash received to the sales accounting department which posts the items to the sales ledger.

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Required:

(a) (i) State the weaknesses in the cash sales system.

(ii) Describe the systems-based tests you would carry out to check there is no material fraud or error in this system. (7 marks) (b) (i) Briefly explain why two people should open the mail which contains cheques

and cash from customers.

(ii) Describe the audit work you would carry out when you attend the opening of the mail and follow through the process to banking of the cheques. (6 marks) (c) (i) List the reasons why credit notes may be issued.

(ii) Describe the audit work you would perform to check that all credit notes have been authorised and issued for a valid reason. (7 marks) (20 marks)

Question 24 BESTWOOD ENGINEERING

Bestwood Engineering, a privately owned incorporated business, manufactures components for motor vehicles and sells them to motor vehicle manufacturers and wholesalers. It has sales of $10 million and a profit before tax of $400,000.

The company has a new chief financial officer who has asked your advice on controls in the company’s purchases and accounts payable system.

Bestwood Engineering has separate accounts, purchasing and goods received departments. Most purchases are required by the production department, but other departments are able to raise requisitions for goods and services. The purchasing department is responsible for obtaining goods and services for the company at the lowest price which is consistent with the required delivery date and quality, and for ensuring their prompt delivery.

The accounts department is responsible for obtaining authorisation of purchase invoices before they are input into the computer which posts them to the accounts payable ledger and the general ledger. The accounting records are kept on a microcomputer and the standard accounting software was obtained from an independent vendor. The accounting software maintains the accounts payable ledger, accounts receivable ledger, general ledger and payroll. The company does not maintain inventory records, as it believes the costs of maintaining these records outweigh the benefits.

The chief financial officer has explained that services include gas, electricity, telephone, repairs and short-term rental (hire) of equipment and vehicles.

Required:

(a) Describe the procedures which should be in operation in the purchasing department to control the purchase and receipt of goods. (8 marks)

(b) Describe the controls the accounts department should exercise over obtaining authorisation of purchase invoices before posting them to the accounts payable ledger.

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(c) Explain how controls over the purchase of services, from raising the purchase requisition to posting the invoice to the accounts payable ledger, might differ from the procedures for the purchase of goods, as described in your answers to parts (a) and (b)

above. (6 marks)

(20 marks)

Question 25 SMALL FIRM INTERNAL CONTROLS

Internal controls over non-current assets are designed to ensure the orderly and efficient running of the business, adherence to management policies, safeguarding of assets, the prevention of fraud and error and the completeness and accuracy of the accounting records.

Required:

List the internal controls that a small printing company with office equipment, motor vehicles and plant and machinery should have in place to achieve the objectives described above.

(10 marks)

Question 26 COTSGROVE DISTRIBUTORS

You are the senior in charge of the audit of Cotsgrove Distributors which is a large privately owned incorporated business. A junior member of your audit team has asked you the controls which you would expect to see in the company’s accounts receivable system. Cotsgrove Distributors purchases products from manufacturers and sells them to retailers. It operates from a single warehouse where the products are received from suppliers, stored and sent to customers. You understand that there should be sufficient staff to ensure that there are strong internal controls in the accounts receivable system. The company’s accounts receivable ledger is maintained on a computer, and it is integrated into the perpetual inventory system so that goods are deducted from the inventory records when they are dispatched to customers.

You are aware that the following departments or individuals are involved in the accounts receivable system and receipt of cash from customers:

(a) the sales department (b) the credit controller (c) the cashier

(d) the dispatch department.

All sales are made on credit and there are no cash sales.

You are aware that the documents in the accounts receivable system include: (a) customer purchase order

(g) accounts receivable ledger (h) cash records

(i) remittance advice

(j) statements sent to customers.

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Required:

Describe the controls which you would expect to be in operation to ensure that:

(a) goods are only sent to authorised customers:

(i) who have placed an order with the company; and

(ii) who the company expects to pay for those goods (ie they will not be a bad debt) (10 marks) (b) cash is received promptly from customers and accurately recorded in the company’s

accounting records. (10 marks)

(20 marks)

Question 27 DINKO

A proper understanding of internal controls is essential to auditors in order that they understand the business and are able to effectively plan and execute tests of controls and an appropriate level of substantive procedures.

You are the auditor of a small manufacturing company, Dinko, that pays its staff in cash and by bank transfer and maintains its payroll on a small stand-alone computer.

Required:

(a) For the payroll department at Dinko, describe the:

(i) internal control objectives that should be in place; (4 marks) (ii) internal control environment and internal control procedures that should be in place to achieve the internal control objectives. (6 marks) (b) For the payroll charges and payroll balances (including cash) in the financial statements

of Dinko:

(i) describe the external auditor audit objectives; (4 marks) (ii) list the tests of control and substantive procedures that will be applied in order to achieve the audit objectives identified in (b) (i) above. (6 marks) (20 marks)

Question 28 ASG

(a) State the control objectives for the ordering, despatch and invoicing of goods. (5 marks) (b) Atlantis Standard Goods (ASG) Co has a year end of 30 June 2008. ASG is a retailer of kitchen appliances such as washing machines, fridges and microwaves. All sales are made via the company’s Internet site with despatch and delivery of goods to the customer’s house made using ASG’s vehicles. Appliances are purchased from many different manufacturers.

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(1) Potential customers visit ASG’s website and select the kitchen appliance that they require. The website ordering system accesses the inventory specification file to obtain details of products ASG sells.

(2) When the customer chooses an appliance, order information including price, item and quantity required are stored in the orders pending file.

(3) Online authorisation of credit card details is obtained from the customer’s credit card company automatically by ASG’s computer systems.

(4) Following authorisation, the sales amount is transferred to the computerised sales day book. At the end of each day the total from this ledger is transferred to the general ledger.

(5) Reimbursement of the sales amount is obtained from each credit card company monthly, less the appropriate commission charged by the credit card company. (6) Following authorisation of the credit card, order details are transferred to a goods

awaiting despatch file and allocated a unique order reference code. Order details are automatically transferred to the despatch department’s computer system.

(7) In the despatch department, goods are obtained from the physical inventory, placed on ASG vehicles and the computerised inventory system updated. Order information is downloaded on a hand held computer with a writable screen.

(8) On delivery, the customer signs for the goods on the hand held computer. On return to ASG’s warehouse, images of the customer signature are uploaded to the orders file which is then flagged as “order complete”.

This year’s audit planning documentation states that a substantive approach will be taken on the audit.

Required:

Tabulate the audit tests you should carry out on the sales and despatch system, explaining the reason for each test. (15 marks) (20 marks)

Question 29 MILDRAIN

Mildrain operated a number of retail outlets. These outlets were mainly large retail stores which sold food, clothing, furniture and financial services. The management of Mildrain decided that the company should join the worldwide computer network system called the Internet. The main purpose of this move was to allow potential customers to access information about their financial services operations and obtain quotations for property loans and insurance in addition to share dealing facilities.

At the final audit of Mildrain, an audit assistant noticed the following facts:

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(ii) There seemed to be a large increase in the number of clients who had purchased insurance policies or taken out property loans with the company. At the year end there was a material accrual for commission to be paid by insurance companies to the company.

(iii) In both of the above cases the only audit evidence available was hard copy evidence provided by the Internet and representations made by management.

The audit assistant pointed out the above matters to the audit senior who felt that the audit evidence already gathered was sufficient and that any costs of further work would outweigh the benefits to be obtained. The audit assistant disagreed with this view but was unsure as to how to proceed with the matter.

Required:

(a) Discuss the potential problems a company may face where it gives unrestricted access to employees to the Internet system. (4 marks) (b) Describe the controls which a company should introduce in order to prevent unauthorised access to the Internet system. (4 marks) (c) Discuss the validity of audit evidence collected from the Internet system. (4 marks) (d) Describe the additional work which the auditor ought to carry out to substantiate the two audit exceptions noted by the audit assistant. (5 marks) (e) Describe how the difference of opinion between the audit senior and audit assistant

should be resolved. (3 marks)

(20 marks)

Question 30 WICKET

You are employed in the newly established internal audit department of Wicket, a company which manufactures furniture. The company employs sixty weekly-paid employees comprising upholsterers, carpenters, joiners and general labourers. All employees are paid by credit transfer directly into their bank accounts.

The payroll is processed using a microcomputer with a hard disk which stores the payroll program, standing and transactions data relating to employees. On completion of payroll processing, the hard disk is copied onto a zip disk which is stored in one of the filing cabinets in the accounts office.

Hours worked are recorded on clock cards. Employees clock in and out on arrival at and departure from the premises. At the end of each week, the factory manager, Mr Lamb, gives the accounts supervisor, Mrs Gooch, the clock cards for that week and collects the clock cards for the following week. Each employee’s name and number is entered on the card by Mrs Gooch.

Mrs Gooch calculates for each employee the hours worked, split between basic and overtime. The cards are then passed to Miss Smith, the payroll clerk, who enters the details into the computer. The figures for gross and net pay are calculated by the program and the following reports are generated: Payroll: details per employee of gross pay, deductions and net pay; totals thereof and total hours split between basic and overtime;

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Giro list: bank account details, net pay per employee and total net pay.

The finance director, Mr Lewis, signs the cheque after agreeing it to the total net pay on the giro list and passes the cheque to the managing director, Mr Stewart, who countersigns it.

Mr Lamb gives a list detailing starters and leavers to Miss Smith who enters these changes into the computer as and when the situation arises. She uses the same password as for payroll preparation even though there is a facility within the software for hierarchical passwords. Miss Smith then files the list with the personnel records in her filing cabinet.

Your enquiries about the system indicate that there are no relevant procedures or controls other than those described above.

Required:

Draft, for inclusion in a report to management:

(i) a description of the internal control weaknesses in the wages system; (ii) the possible consequences of each weakness; and

(iii) recommendations to remedy the weaknesses.

(20 marks)

Question 31 COSMO

(a) Internal control systems are designed, amongst other things, to prevent error and misappropriation.

Required:

Describe the errors and misappropriations that may occur if purchases and capital expenditure are not properly controlled. (5 marks) (b) Cosmo is a high-quality, private motor manufacturing company. It has recently joined a consortium for the purchase of parts. Cosmo’s purchases and capital expenditure systems are not integrated.

Purchases and capital expenditure

There are complex internal rules relating to what constitutes a purchase, and what constitutes capital expenditure and the budgets for both are tightly controlled. Problems associated with the internal rules result in a significant number of manual adjustments to the management accounts which take up an excessive amount of management time.

The system for authorising capital expenditure is not well controlled which results in some capital items being acquired without proper consideration, at the monthly meetings of the capital expenditure committee.

Purchase orders

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Some of the purchases are input into the buying consortium system which shows the optimum supplier for any combination of cost, delivery time and specification. This system has only been in operation for a few months. The system takes up a substantial amount of disk space on the company’s computers and is suspected of causing problems in other systems. It is difficult to use and so far, only two of the production controller’s junior managers are able to use it. As a result, the parts ordered through the system are sometimes of the incorrect specification or are delivered late. The remaining purchases are ordered directly from manufacturers, as before, through a reasonably well-controlled buying department.

Required:

Set out, in a form suitable for inclusion in a report to management, the weaknesses, potential consequences and your recommendations relating to the purchases and capital

expenditure systems of Cosmo. (15 marks)

(20 marks)

Question 32 BEARSWORLD

You are the auditor of BearsWorld, a limited liability company which manufactures and sells small cuddly toys by mail order. The company is managed by Mr Kyto and two assistants. Mr Kyto authorises important transactions such as wages and large orders, one assistant maintains the payables ledger and orders inventory and pays suppliers, and the other assistant receives customer orders and despatches cuddly toys. Due to other business commitments Mr Kyto only visits the office once per week.

At any time, about 100 different types of cuddly toys are available for sale. All sales are made cash with order – there are no receivables. Customers pay using credit cards and occasionally by sending cash. Turnover is over $5·2 million.

You are planning the audit of BearsWorld and are considering using some of the procedures for gathering audit evidence recommended by ISA 500 as follows:

(i) Analytical Procedures (ii) Inquiry

(iii) Inspection (iv) Observation (v) Re-calculation Required:

(a) For EACH of the above procedures:

(i) Explain its use in gathering audit evidence. (5 marks) (ii) Describe one example for the audit of BearsWorld. (5 marks)

(b) Discuss the suitability of each procedure for BearsWorld, explaining the limitations of

each. (10 marks)

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Question 33 GORDON

ISA 500 Audit Evidence provides a framework for evaluating the role of evidence in forming an opinion.

The following procedures appear in the accounts payable audit program for Gordon, a listed company. (1) Select a sample of purchase transactions recorded in the purchase journal during the year and

vouch them to suppliers’ invoices.

(2) Observe the goods received clerk accepting delivery of goods.

(3) Check the numerical continuity of a sequence of goods received notes and trace them to suppliers’ invoices and to the entry in the purchase journal.

(4) Select a sample of purchase invoices and see that they have been initialled as being agreed to the goods received note and to the purchase order.

(5) Consider the reasonableness of the relationship between the year-end accounts balance and the total of credit purchases during the year.

(6) Add the list of accounts balance balances and agree the total to the control account in the general ledger.

(7) Enquire into the procedures used to ensure the reliability of cut-off. Required:

For each procedure (2) to (7) inclusive:

(a) identify its principal objective; (3 marks) (b) explain its objective in terms of the account balance or transaction class involved and the financial statement assertion(s) to which the evidence principally relates; (8 marks) (c) discuss the reliability of the evidence obtained. (9 marks) (20 marks)

For your guidance an answer to the first procedure would be:

Test (a) Objective (b) Assertion(s) (c) Reliability 1 Substantive test of

details of purchase transactions

To verify the occurrence of purchase transactions by ensuring that each recorded purchase is supported by evidence of being invoiced by the supplier.

Suppliers’ invoices are reasonably reliable being third party documents providing the copy examined is the original and has not been altered.

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Question 34 CONFIRMATIONS

Auditors obtain several different confirmations from various sources during the course of their audit. Required:

Describe the audit evidence provided by each of the confirmations listed below, the practical

difficulties in obtaining them and the alternative audit evidence available when they are not

provided:

(a) Management representations. (5 marks)

(b) Direct confirmation of receivables. (6 marks) (c) Confirmation of inventory held by third parties. (5 marks) (d) Reports provided by auditors of third party service organisations. (4 marks) (20 marks)

Question 35 JUST CRUST

ISA 520 Analytical Procedures requires that “The auditor should apply analytical procedures at the planning and overall review stages of the audit”. The explanatory material contained within ISA 520 recognises that “Analytical procedures may also be applied at other stages”.

Required:

(a) Explain the nature and purpose of analytical procedures. (4 marks) (b) Describe the extent to which analytical procedures can be used as part of an audit.

(4 marks) (c) Just Crust bakes bread products and supplies various supermarkets. The company operates from one central bakery and uses a fleet of vans to deliver to its customers. Minimal inventories are held at any time. The company operates a small number of accounts staff but maintains detailed production and delivery records and prepares monthly accounts.

You are preparing the audit plan and considering placing greater reliance upon analytical procedures than previously.

Detail the substantive analytical procedures you might use for your audit of Just

Crust. (12 marks)

(20 marks)

Question 36 VILLAWOOD

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Ratio 2008 2007 2006 2005

(i) Days sales in accounts receivable 56 days 38 days 41 days 39 days (ii) Inventory turnover 10 times 13 times 14 times 13 times (iii) Plant and equipment depreciation expense

as a percentage of cost 11% 14% 14% 13%

(iv) Repairs and maintenance expense to turnover 4.5% 2.0% 1.5% 2.2% Initially you attempt to establish, by enquiry, whether there is any satisfactory explanation for the changes, which might not have been identified when planning the audit. Where your enquiries fail to provide a basis for predicting the change, you consider possible causes that require a modification to your planned tests of details.

Required:

For each ratio

(a) Suggest an explanation for the change in the ratio in the financial year just ended that

you would consider satisfactory. (4 marks)

(b) Explain how the change in the ratio could be caused by misstatements in the 30 September 2008 financial statements. (6 marks) (c) Describe substantive tests of details that would be necessary to detect possible

misstatements. (10 marks)

(20 marks)

Question 37 AUDIT SAMPLING

Audit sampling is a technique for drawing conclusions about the characteristics of a population by testing a sample drawn therefrom. Internal and external auditors use it for both tests of controls, and substantive testing.

Required:

Describe the following:

(i) Judgement sampling and statistical sampling; (ii) A representative sample;

(iii) Tolerable error;

(iv) Two different methods of selecting a representative sample; (v) The extrapolation of errors.

NB: Parts (i) – (v) carry equal marks.

(28)

Question 38 STRATHFIELD

The recorded value of Strathfield’s accounts receivable, as at 31 October, was $2,350,000. Out of the 5,350 balances, Sarah Jones selected 120 accounts for direct confirmation as part of the external audit of the company.

In selecting accounts for confirmation Sarah picked the 10 largest accounts totalling $205,000 and 110 other accounts selected haphazardly. Her working paper states that she rejected any accounts that were less than $100 as not being worth confirming and accounts with government bodies since she knew they never bother replying to confirmation requests.

Each of the 10 largest accounts was satisfactorily confirmed. Sarah analysed the responses to the confirmation of the other 110 accounts as follows:

Result of confirmation Number Recorded Amount

of amount confirmed

accounts $ $

Satisfactorily confirmed 75 245,000 245,000

Confirmation returned marked

“gone away – address unknown” 4 950 0

Cutoff differences – cash or goods in transit 8 6,800 5,750

Invoicing errors 4 2,800 2,200

Invoices posted to the wrong customer’s account 2 1,300 980 Disputed – price or quantity or quality of goods 3 2,800 1,300 Not confirmed – verified by alternative procedures 14 ___ _______ 5,800 _______ 5,800

Totals 110 ___ _______ 265,450 _______ 261,030

Sarah is about to draw up her working paper in which she reaches a conclusion as to whether the results of the confirmation of accounts receivable enables her to conclude that the recorded balance is not materially misstated. She is aware that ISA 530 Audit Sampling and Other Means of Testing requires her to:

1. consider the qualitative aspects of errors and whether any of these relate to a sub-population and not to accounts receivable as a whole; and

2. project the error results of the sample to the population from which the sample was selected. Required:

(a) Discuss Sarah’s method of selecting items to be confirmed. Your answer should:

(i) identify any aspects of her approach that might be considered inconsistent with sampling;

(ii) suggest alternative means of selecting a sample ensuring that the more material balances stand the greatest chance of selection;

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(c) Calculate the projected error in accounts receivable based on the results of the sample test consistent with the qualitative considerations in your answer to (b).

(4 marks) (20 marks)

Question 39 NEWTHORPE ENGINEERING

You are auditing the financial statements of Newthorpe Engineering, a company listed on a recognised inventory exchange, for the year ended 30 April 2008.

(a) In March 2008 the Board decided to close one of the company’s factories on 30 April 2008. The plant and equipment and inventory will be sold. The employees will either be transferred to another factory or made redundant.

At the time of your audit in June 2008, you are aware that: (i) some of the plant and equipment has been sold (ii) most of the inventory has been sold

(iii) all the employees have either been made redundant or transferred to another factory. The company has provided you with a schedule of the closure costs, the realisable values of the assets in (i) and (ii) above and the redundancy cost.

Details of the plant and machinery are maintained in a fixed asset register.

A full physical inventory count was carried out at 30 April 2008. Audit tests have confirmed that the counts are accurate and there are no purchases or sales cut-off errors.

You are aware the redundancy payments are based on the number of years service of the employee and their annual salary (or wage). Most employees were given redundancy of one week’s pay for each year’s service. A few employees have a service contract with the company and were paid the amount stated in their service contract, which will be more than the redundancy pay offered to other employees. Employees who are transferred to another factory were not paid any redundancy.

Required:

For the factory being closed, describe the audit work you will carry out to verify the company’s estimates of:

(i) the net realisable value of:

plant and equipment

inventory (7 marks)

(ii) the redundancy cost. (4 marks)

Note:

(i) In auditing inventory, you are required only to verify that the price per unit is correctly determined.

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(b) In February 2008 the directors of Newthorpe Engineering suspended the Managing Director. At a disciplinary hearing held by the company on 17 March 2008 the Managing Director was dismissed for gross misconduct, and it was decided the Managing Director’s salary should stop from that date and no redundancy or compensation payments should be made:

The Managing Director has claimed unfair dismissal and is taking legal action against the company to obtain compensation for loss of his employment. The Managing Director says he has a service contract with the company, which would entitle him to two years’ salary at the date of dismissal.

The financial statements for the year ended 30 April 2008 record the resignation of the director. However, they do not, mention his dismissal and no provision for any damages has been included in the financial statements.

Required:

(i) State how contingent losses should be disclosed in financial statements according to IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

(3 marks) (ii) Describe the audit work you will carry out to determine:

whether the company will have to pay damages to the director for unfair dismissal; and

the amount of damages and costs which should be included in the

financial statements. (6 marks)

(20 marks) Note: Assume the amounts you are auditing are material.

Question 40 TWO COMMUNICATIONS

Two important communications of matters relevant to the audit of financial statements are the “letter of representation” and the “management report” (or “letter of weaknesses”). The letter of representation is the subject of ISA 580 Management Representations and material weaknesses are considered in ISA 260 Communication of Audit Matters With Those Charged with Governance.

Required:

(a) Letter of representation:

(i) Explain the purpose of the letter of representation and the extent to which it constitutes sufficient appropriate audit evidence. (5 marks) (ii) Describe three matters you might find in a letter of representation (other than the acknowledgement by management of its responsibility for the financial

statements). (3 marks)

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