Question 1 INTERNATIONAL AUDITING
The International Audit and Assurance Standards Board1 (IAASB) is authorised to issued International Standards on Auditing (ISAs).
Required:
(a) Define an audit. (2 marks)
(b) State the general principles of an audit. (5 marks)
(c) Describe the authority attaching to International Standards on Auditing. (5 marks) (12 marks) Question 2 AUDIT COMMITTEE
The objective of a system of corporate governance is to secure the effective, sound and efficient operation of companies. This objective transcends any legislation or voluntary code. Good corporate governance embraces not only making the company prosper but also doing business in a legal and ethical manner.
A key element of corporate governance is the audit committee. In many countries the audit committee is a committee of a single board of directors and is of a voluntary nature regulated by voluntary codes. In other countries there are committees which are of a supervisory nature and these are regulated by statute. For example in Germany all large public companies must have a supervisory board which contains non-executive directors who elect the board.
Required:
(a) Explain how an audit committee could improve the effectiveness of the external
auditor’s work. (10 marks)
(b) Discuss the problems of ensuring the “independence” of the members of the audit committee where the membership is regulated by a voluntary code of practice. (5 marks) (c) Discuss the view that the role of the audit committee should not be left to voluntary codes of practice but should be regulated by the law in all countries. (5 marks) (20 marks) Question 3 FRAUD AND ERROR
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 4 ISA 200
ISA 200 Objective and General Principles Governing an Audit of Financial Statements deals with, amongst other matters, the responsibility for financial statements and the concept of reasonable assurance.
Paragraph 8 of the Statement states that:
“An audit in accordance with ISAs is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement. Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole.”
“Reasonable assurance relates to the whole audit process.”
The effect on the audit is explained in paragraph 9:
“However, there are inherent limitations in an audit that affect the auditor’s ability to detect material misstatements.” and paragraph 10:
“Also, the work undertaken by the auditor to form an opinion is permeated by judgement ...”
Required:
(a) State the respective responsibilities for financial statements of the management of the
entity and of its external auditors. (6 marks)
(b) Describe the inherent limitations facing auditors in undertaking their work. (6 marks) In answering part (b) candidates are warned not to confuse inherent limitations with inherent risk.
(c) Describe the significant types of judgements made by auditors:
(i) in gathering evidence; (4 marks)
Question 5 PROFESSIONAL ETHICS
Professional ethics are relevant to both external auditors and internal auditors.
You work for a medium-sized firm of Chartered Certified Accountants with seven offices and 150 employees. You firm has been asked to tender for the provision of statutory audit and other services to Billington Travel, a private company providing discounted package holiday services in the Mediterranean. The company is growing fast and would represent a substantial amount of fee income for your firm. The finance director has explained to you that the company would like the successful firm to provide a number of different services. These include the statutory audit and assistance with the preparation of the financial statements. The company is also struggling with a new computer system and the finance director considers that a systems review by your firm may be helpful. You firm does not have much experience in the travel sector.
Required:
(a) Explain why it is necessary for external auditors to be and be seen to be independent of
their audit clients. (3 marks)
(b) With reference to the ACCA’s Rules of Professional Conduct, describe the ethical matters that should be considered in deciding on whether your firm should tender for: (i) the statutory audit of Billington Travel (4 marks) (ii) the provision of other services to Billington Travel (4 marks) You are a student Chartered Certified Accountant and you are one of four assistant internal auditors in a large manufacturing company. You report to the chief internal auditor. You have been working on the review of the payables system and you have discovered what you consider to be several serious deficiencies in the structure and operation of the system. You have reported these matters in writing to the chief internal auditor but you are aware that none of these matters have been covered in his final report on the system which is due to be presented to management.
Required:
(c) List the actions you might take in these circumstances. (6 marks) (d) Explain the dangers of doing nothing in these circumstances. (3 marks) (20 marks) Question 6 EASTFIELD DISTRIBUTORS
Your firm is the external auditor of Eastfield Distributors, a listed company, which has sales of $25 million and a profit before tax of $1·7 million. The company operates from a head office at Eastfield and has sales and inventory holding centres in different parts of the country. The directors have decided the company has reached a size when it needs an internal audit department. As is becoming increasingly common, the directors have asked your firm to provide this service to the company as well as being the statutory auditor of the company’s annual financial statements. In answering the question, you should consider:
(i) the effects of the Association of Chartered Certified Accountants’ Rules of Professional Conduct in relation to providing an internal audit service to Eastfield Distributors
(iii) the arrangements over control of the work and reporting of the internal audit staff:
−
the extent to which the internal audit staff should be responsible to EastfieldDistributors, and who should control their work
−
the extent to which the internal audit staff should be responsible to a manager or partner of the external audit firm, and whether the same manager and partner should be responsible for both the internal audit staff of Eastfield Distributors and the external audit.Required:
(a) Describe the matters you should consider and the action you will take to ensure your firm remains independent as external auditor of the annual financial statements.
(8 marks) (b) Describe the advantages and disadvantages to Eastfield Distributors of your firm
providing an internal audit service. (7 marks)
(c) Describe the advantages and disadvantages to your audit firm of providing an internal
audit service to Eastfield Distributors. (5 marks)
(20 marks) Question 7 ABEL & CO
Abel & Co, Chartered Certified Accountants, recently held a staff training session on quality control. The session concluded with staff being invited to raise matters from their experience relating to the ethical rules on independence. Some of these matters are given below.
(a) Shortly before commencing the final audit of a large listed company, a junior staff member on the audit team inherited a substantial number of shares in that company. No action was taken because, although representing a large investment for the staff member concerned, the number of shares was totally immaterial with respect to the company. Moreover, the partner knew that, when the company’s results were announced, the share price would rise and he did not think it was fair to require the staff member to sell them now. (5 marks) (b) The management accountant of another listed company client had an accident and was away from work for three months. At the time of the accident the audit senior was winding up the prior year’s audit and, because of his familiarity with the company’s management accounting system, it was agreed that he would take over as management accountant for the three months.
(5 marks) (c) In its management letter to another audit client, Abel & Co warned the company that their computer system lacked essential controls. The company decided to install a totally new computer system and Abel & Co’s management consultancy department was appointed to
design the new system. (5 marks)
Required:
Discuss the possibility that Abel & Co had impaired their independence or otherwise acted unprofessionally in each of the situations described.
(20 marks) Question 8 VISWA
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.
Required:
(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) (20 marks) Question 9 LALD
You are the auditor of LALD, a limited liability company. The main activity of the company is the construction of buildings ranging in size from individual houses to large offices and blocks of flats.
Under the laws of the country LALD operates in, LALD must add sales tax to all buildings sold and they pay this tax to the government at the end of each month.
The largest non-current asset on LALD’s statement of financial position is the plant and machinery used in the construction of buildings. Due to the variety of different assets used, four different sub-classes of plant and machinery are recognised, each with its own rate of depreciation.
You are now reaching the end of the audit work for the year ended 30 September 2005. There are two specific matters where additional audit work is required:
(ii) The complicated method of calculating depreciation for plant and machinery appears to have resulted in depreciation being calculated incorrectly, with the result that depreciation may have been under-provided in the financial statements.
You have determined that the under-provision is material to the financial statements and therefore need to modify the audit report. The directors have informed you that they do not intend to take any action regarding the underprovision of depreciation. They also disagree with your action and have threatened to remove your company as the auditors of LALD unless you agree not to modify your report.
Required:
Explain the procedures that the directors must follow in order to remove your company as the auditors of LALD.
(6 marks) Question 10 WORKING PAPERS
“Working papers” according to ISA 230 Documentation are “designed and organised to meet the circumstances and the auditor’s needs for each individual audit”.
Required:
(a) Describe the working papers which would be of particular assistance to you as a newly appointed senior in charge of a recurring audit at the final audit stage (the previous senior having left the firm after the interim audit):
(i) in familiarising yourself with the client company;
(ii) when you are planning the current year’s final audit. (12 marks) (b) Identify and explain the criteria which you would use to judge the quality of working
papers. (8 marks)
(20 marks) Question 11 PLANNING DOCUMENTATION
“The auditor should document the overall audit strategy …. to record the key decisions considered necessary to properly plan …. and the audit plan …. setting out the planned nature, timing and extent of risk assessment procedures …. ”
Required:
(a) Distinguish between the “overall audit strategy” and “audit plan” (6 marks) (b) Discuss the advantages and disadvantages of using standardised audit programs.
(6 marks)
(c) Viewco, a limited liability company, is a manufacturer of TVs and video recorders. It carries out a full physical inventory count at its central warehouse every year on 31 December, its financial year end. Inventories of finished goods are normally of the order of $3 million, with inventories of components and work in progress normally approximately $1 million.
Required:
State, with reasons, what information the working papers relating to this attendance
should contain. (8 marks)
(20 marks) Question 12 NORBERT
Norbert is a local company which designs and builds racing yachts. It has a small yard 400 kilometres away which it purchased recently. Most of the yachts are built to customer specification. However, as trade has been slack recently, the company is building some yachts without orders in the hope of obtaining buyers when the market picks up. Most of the company’s output is for export and it quotes its prices in Euros2.
You are been asked to act as senior in charge of the audit. The company has a year end of 30 September. It is apparent from the previous year’s audit file that the company has always had weak internal controls.
The company is currently amending its designs to take advantage of new technology and has invested a considerable amount of time and money in this. Consequently it is heavily indebted to the bank. The bank overdraft facility is to be reviewed in November and the bank manager has requested that the latest audited accounts be available for that review.
The chief executive has asked you to complete the audit by 31 October as he wishes to ensure the continuing availability of the overdraft facility before attending a major trade fair in late November.
Required:
(a) Describe the matters that you should consider when planning the audit of Norbert. (7 marks)
(b) Explain why each matter must be taken into account. (7 marks) (14 marks) Question 13 AUDIT RISK
It is important for an auditor to consider audit and business risk when planning, carrying out and coming to an opinion on the financial statements of a company. Risks that a business will not be able to achieve its objectives mostly translate into a risk that a material error or misstatement will be in the financial statements.
The auditor should plan and perform the audit to reduce audit risk to an acceptably low level. Whilst there are many audit risk models used by auditors, ISA 200 Objective and general principles governing an audit of financial statements has categorised audit risk into:
(1) inherent risk (2) control risk; and (3) detection risk.
Required:
(a) Define the following terms: (i) audit risk
(ii) inherent risk (iii) control risk (iv) detection risk.
(4 marks)
(b) Explain the factors which affect inherent risk in an audit. (6 marks) (c) Describe the work you will carry out to quantify the control risk in a purchases system. (5 marks)
(d) In relation to detection risk:
(i) explain the effect on the detection risk of the inherent risk and control risk, if the auditor requires a particular value of audit risk;
(ii) briefly describe the audit checks you will perform in verifying trade payables and accruals, and how these tests are affected by the value of the detection risk. (5 marks)
(20 marks) Question 14 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;
(b) The concept of materiality is fundamental to the work of auditors. Matters that are immaterial
(iii) give an example of qualitative materiality. (2 marks) (20 marks) Question 15 PLANNING ANALYTICAL REVIEW
You have been presented with the following draft financial information about Hivex, a very successful company that develops and licences specialist computer software and hardware. Its non-current assets mainly consist of property, computer hardware and investments, and there have been additions to these during the year. The company is experiencing increasing competition from rival companies, most of which specialise in hardware or software, but not both. There is pressure to advertise and to cut prices.
You are the audit manager. You are planning the audit and are conducting a preliminary analytical review and associated risk analysis for this client for the year ended 31 May 2006. You have been provided with a summarised draft statement of comprehensive income which has been produced very quickly and certain accounting ratios and percentages. You have been informed that the company accounts for research and development costs in accordance with IAS 38 Intangible Assets.
Accounting ratios and percentages
Administrative expenses 0·07 0·13
Selling expenses 0·20 0·02
Operating profit 0·34 0·48
Required:
(a) Using the information above, comment briefly on the performance of the company for
the two years. (8 marks)
(b) Use your answer to part (a) to identify the areas that are subject to increased audit risk and describe the further audit work you would perform in response to those risks.
(12 marks)
(20 marks) Question 16 KNITS
Knits is a small company which manufactures and sells high quality knitwear. Its customers are mainly fashion boutiques.
Knits has two directors, one of whom is non-executive. The other is involved in the day-to-day administration of the company. There are ten other employees. Six of these work in the factory, one works in the warehouse, one is a sales representative and two are accounts staff. The accounts staff are Miss Jones, who is responsible for processing sales and accounts receivable, and Mrs Singh, who is the purchases and wages clerk. Mrs Singh works part-time, five mornings a week.
The company’s sales representative visits shops throughout the region. He takes orders from customers which he records on a pre-numbered two-part order form. He passes the completed forms to the accounts department. Miss Jones files one copy of the order form in numerical sequence and passes the other to the warehouse.
The completed order is despatched from the warehouse by carrier, accompanied by one copy of a despatch note. The other copy is sent to Miss Jones, who prepares an invoice based on the information it contains and on the company’s price list. She sends one copy of the invoice to the customer, and a second copy of the invoice is retained.
Each Friday, Miss Jones inputs the week’s invoices to the computerised sales ledger. She then files the invoices alphabetically by customer name. Despatch notes are not retained because filing space is limited.
Miss Jones opens the post daily and lists remittances received from customers. Every Friday, she inputs the information listed to the sales ledger. Cheques received are banked daily by the executive director.
The company’s computer package includes the facility to produce a sales day book and sales ledger control account. These are not used because Miss Jones considers that the low volume of transactions (10 – 15 invoices per week) makes them unnecessary.
Required:
(a) State, with reasons, what you consider to be the potential weaknesses in Knits’ present system of accounting for sales and receivables. (12 marks) (b) Describe controls that a small firm such as Knits could feasibly adopt to overcome the
weaknesses you have identified. (8 marks)
(20 marks) Note: You are not required to consider the system for dealing with returns and credit notes.
Question 17 IBSON
You work in the newly established internal audit department of Ibson, a limited liability company which supplies frozen seafood to supermarkets. The accountant has provided you with the following information about the purchases system. Your enquiries about the system indicate that there are no relevant procedures other than those described.
Requisition and ordering
Salesmen raise 2-part purchase requisitions (PRs). The buying department raises three-part, pre-numbered purchase orders (POs). These are authorised by the buyer. The first copy is sent to the supplier, the second to stores and the third is filed in the buying department.
Receiving
On receipt of goods the quality and quantity is checked immediately and, if unacceptable, the whole consignment is refused. If accepted, a two-part goods received note (GRN) is raised. If the goods received match the PO, the top copy of the GRN is filed in numerical sequence with the PO attached. The bottom copy is sent to the accounts department and filed pending receipt of invoice. In the event of a part-consignment the GRN (both parts) is kept with the PO until the order has been fulfilled.
Recording
All invoices received for goods are matched against GRNs before recording details in the purchase day book. The invoices, with GRNs attached, are kept in a “pending payment” file, until the month end, in alphabetical order.
Payment
Every month end, a bought ledger clerk prepares a cheque requisition (CR) for each supplier. The invoices and GRNs are stapled to the CRs which are then authorised for payment by the buyer. A pre-list of cheques to be drawn, prepared by the clerk, is checked and signed by the buyer.
Required:
(a) List the procedures which should be in operation in the purchases system to exercise control over:
(i) the purchase and receipt of goods; and
(b) Comment on specific weaknesses which might exist in Ibson’s purchases system and give
recommendations for improvement. (10 marks)
(20 marks) Question 18 EASTWOOD ENGINEERING
Your firm is the external auditor of Eastwood Engineering, a listed company, which has annual sales of $100 million. The head office site includes the manufacturing unit, the accounting functions and main administration. There are a number of sales offices in different parts of the country. Eastwood Engineering does not have an internal audit department.
At the interim audit you have been assigned to the audit of the wages system. This will involve obtaining an understanding of the wages system; testing the controls and performing substantive procedures in order to verify wages transactions.
The wages records are maintained on a computer and all the wages information is processed at the head office. Some of the employees in the manufacturing unit are paid in cash and all other employees have their wages paid directly into their bank account.
Manufacturing employees are paid their wages a week in arrears. All other employees are paid at the end of each week or month.
There is a personnel department which is independent of the wages department. The personnel department maintain records of the employees, including their starting date, grade, current wage rate and leaving date (if appropriate).
Previous years’ audits have revealed frauds by wages department staff which have been facilitated by weaknesses in controls in the wages system. These frauds have included:
(i) paying employees after appointment but before they commenced work (ii) paying employees after they have left; and
(iii) paying fictitious employees.
A check of current controls in the wages system has revealed that the company has failed to instigate controls to prevent these types of fraud recurring. So, the audit programme requires extensive substantive procedures to be carried out to ensure that recorded wages transactions have not been mis-stated by similar frauds taking place in the current year.
The existence of employees at the head office site can be verified by physical inspection. from a cost effectiveness point of view, only a small sample of sales offices will be visited. The audit manager has asked you to consider the audit procedures you would carry out to obtain sufficient appropriate evidence of the existence of employees at sales offices not visited by the audit staff.
The audit manager has explained that “unclaimed wages” arise when manufacturing employees are not present to collect their wages when they are paid out. The unclaimed wage packets are given to the cashier who records their details in the unclaimed wages book and is responsible for their custody. Any employee who has not received his wage package at the payout can obtain it from the cashier. You have ascertained that there is no system of checking the operation of the unclaimed wages system by a person independent of the cashier and the wages department.
Required:
(b) Describe the audit procedures you would carry out in connection with attending a payout of wages in cash to manufacturing employees. (5 marks) (c) Describe the substantive checks of transactions you would carry out on the unclaimed
wages system. (5 marks)
(d) Describe the evidence you would obtain to verify the existence of employees whose wages are paid directly into their bank account, including those at sales offices. (5 marks) (20 marks) Question 19 CLIFF
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.
Required:
(a) Describe the problems that you might expect to find at Cliff resulting from poor internal
controls. (8 marks)
(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)
(20 marks) Question 20 FAIRLIGHT
XY Co, Chartered Certified Accountants, have recently been appointed as the first external auditors to Fairlight on its incorporation after trading as a partnership for several years.
(i) department managers order goods and services for their own departments;
(ii) suppliers’ invoices are sent directly to the department managers who approve them for payment and pass them to the cashier to be paid;
(iii) the cashier enters the invoices in the purchase journal and then files them by supplier ;
(iv) no accounts payable ledger is maintained. When suppliers’ statements are received the invoices are attached to the statement. There are always a few invoices missing, mostly more recent ones, so, to avoid harming Fairlight’s credit rating, suppliers are always paid the balance on their statement.
The chief executive officer also advises David that he intends to hire an experienced purchasing officer but he is not sure how best to use such a person. On further investigation, David discovers that the general ledger shows a debit balance for accounts payable.
David tells the chief executive officer that there are three types of problem with the existing purchases system.
(a) Occurrence: such as paying for goods Fairlight has not ordered.
(b) Completeness: for example, not all invoices for goods and services received may be recorded in Fairlight’s accounting records, (which probably accounts for the debit balance currently recorded as accounts payable).
(c) Measurement: such as suppliers’ invoices being incorrectly entered in the purchase journal.
David agrees that, as a matter of urgency, the audit firm will advise the chief executive officer of control weaknesses in the purchasing system and their consequences and will recommend changes, including how best to use the purchasing officer.
Required:
Draft paragraphs for inclusion in the section of a management letter to the chief executive officer dealing with the purchasing system, under three headings:
(a) Occurrence; (11 marks)
(b) Completeness; (5 marks)
(c) Measurement. (4 marks)
Notes:
Do not draft the whole letter. Only draft those paragraphs dealing with the purchasing system.
If one of your recommendations deals with matters under two or more of the headings it need not be repeated but reference should be made to the recommendation.
Question 21 INTERNAL CONTROLS
There are many reasons for maintaining internal control systems. These include the need to ensure that:
(i) transactions are properly authorised
(ii) transactions are promptly and accurately recorded
(iii) access to assets and records is properly authorised
(iv) recorded assets represent actual assets.
In the absence of internal controls, errors, omissions and misappropriation of assets are likely and external and internal auditors pay particular attention to both the design and operation of internal control systems.
Receivables is an area in which most organisations expect internal controls to be operating effectively.
Required:
(a) In the context of receivables, list and describe the types of error, omission and misappropriation of assets that can occur in practice where internal controls are weak
or non-existent. (4 marks)
(b) Explain why even a good system of internal control will not necessarily prevent or detect errors, omissions and the misappropriation of assets in a receivables system, and explain why a good system of internal control is important to auditors. (4 marks) (c) List the main internal controls that you would expect to be in operation in the receivables system at a small manufacturing company with a computerised accounting
system. (9 marks)
(d) Explain why external auditors seek to rely on the proper operation of internal controls
wherever possible. (3 marks)
(20 marks) Question 22 BETTERHOME
You are the auditor of Betterhome, a company which sells building and do-it-yourself products from ten large stores throughout the country. Its business is roughly equally divided between credit sales to the building trade and cash sales to retail customers.
The company has used microcomputers, linked to the sales tills, at each store to record and control inventory, and two microcomputers at its head office to handle all the other financial records. Traditionally the company’s systems of control have been good.
During the year ending 31 December 2005, Betterhome has installed a minicomputer at its head office, and new software has connected the microcomputers at each store on-line to the new minicomputer. All sales data are now input direct from the stores.
The finance director, Mr Wright, has indicated that, since the new system is fully integrated, he expects that you need to do less audit checking for the year ended 31 December 2005, and that, as a result, he will be looking for a reduction in the audit fee.
Required:
Write a formal letter to Mr Wright explaining:
(a) the internal controls you expect to see in place in relation to the new computer system; (10 marks) (b) what impact the installation of the new computer system will have on the extent of your audit testing for the year ending 31 December 2005. (10 marks) (20 marks) Question 23 INTERNAL AND EXTERNAL AUDITORS
There are similarities and differences between the responsibilities of internal and external auditors. Both internal and external auditors have responsibilities relating to the prevention, detection and reporting of fraud, for example, but their responsibilities are not the same. Both internal and external audit are part of an organisation’s overall corporate governance arrangements. Sometimes, the responsibilities of internal auditors are out-sourced to external organisations.
Required:
(a) Explain the difference between the responsibilities of internal auditors and external auditors for the prevention, detection and reporting of fraud and error. (5 marks) (b) Explain the role of internal audit in the context of:
(i) corporate governance; (ii) risk management;
(iii) organisational control. (10 marks)
Your answer should include one example of how an internal audit department in a manufacturing company might fulfil its role under each of the headings above.
(c) Outline the issues that should be considered when an organisation decides to out-source
the internal audit function. (5 marks)
(20 marks) Question 24 RISK MANAGEMENT
Risk management involves the classification of risks. Internal auditors sometimes classify risks as:
(ii) high impact, low likelihood – such as the risk of the non-availability of a basic element of production such as sugar, for a biscuit manufacturing business, or, that there will be significant damage to property or injury to employees as a result of an earthquake in Northern Europe;
(iii) low impact, low likelihood – such as the risk that minor damage to property will be caused by snow in Australia;
(iv) low impact, high likelihood – such as the risk that drivers may be involved in vehicle accidents that will leave the business temporarily without the vehicle, or, that production employees may be ill and unable to work temporarily.
Companies may transfer, reduce, or accept risks, or adopt some combination of these approaches to risk.
Required:
(a) For each of the examples given above, describe how the business might transfer, reduce
or accept the risk. (12 marks)
(b) Explain how the work of internal auditors on the classification of risks, as described
above, could be used by external auditors. (8 marks)
(20 marks) Question 25 ROXY HOTELS
Roxy Hotels is a listed company which runs a chain of some 40 hotels. The company has an established internal audit department which is based at the head office and which makes regular visits to the hotels.
The hotels provide business and tourist class accommodation. They also provide restaurants, bars, and conference and leisure facilities which are open to the general public as well as residents. The company operates a computerised central booking and billing system and an inventory and asset control system, both of which can be accessed via terminals in the hotels. Access to the system is restricted by the use of passwords and all significant expenditure is authorised through head office. The payroll is operated through head office. Hotel and regional managers are actively involved in the setting of budgets and cash flow forecasting. On average, throughout the year, the chain has a 65% occupancy rate.
Required:
(a) Describe the role of internal audit in ensuring that organisations achieve their corporate
objectives. (5 marks)
(b) List the types of activities normally carried out by internal audit department. (5 marks) (c) Describe SIX areas in which the internal audit department at Roxy Hotels might check
detailed transactions and balances. (6 marks)
Question 26 SIGHTHILL SUPERMARKETS
Your firm is the external auditor of Sighthill Supermarkets, a listed company. The company has a head office; central warehouse and a large number of supermarkets which sell food to the general public. The company’s Chief Financial Officer has suggested the audit fee could be reduced if your firm was prepared to place greater reliance on the work of the internal audit department.
The Chief Financial Officer has explained that the duties of the internal audit department include:
(1) testing and reporting on the effectiveness of internal controls by maintaining up to date descriptions of the company’s accounting systems and evaluating the effectiveness of controls in those systems. Recommendations are made of improvements in controls, and proposed changes in controls are assessed.
(2) checking the operation and reliability of the computer systems. The department uses the computer assisted audit techniques of test data and audit software (computer audit programs). Particular attention is paid to controls over access to the computer and checking payment of vendors and wages, and receipt of cash at supermarkets.
(3) visiting the central warehouse to check operation of the systems and the effectiveness of controls. Procedures are checked at the periodic inventory counts.
(4) visits to supermarkets. All supermarkets are visited at least once a year with more frequent visits to larger supermarkets and those where serious weaknesses have been detected. At the supermarkets, the internal auditors check the effectiveness of controls and carry out cash counts and test counts of the inventory. Visits are made to supermarkets to attend the periodic inventory counts and check procedures.
The Chief Financial Officer says the internal audit department would be willing to amend the timing of its work, so as to fit in with the external auditor’s work. The results of the internal auditor’s work can be reported directly to the external auditor.
Required:
(a) Describe the matters you should consider at the planning stage to assess the effectiveness
of the internal audit department: (6 marks)
(b) Consider the Chief Financial Officer’s proposals, namely the extent to which you can rely on the work of the internal auditors and thus reduce your audit work in:
(i) recording accounting systems and evaluating the effectiveness of the recorded controls.
(ii) performing tests of controls.
(iii) carrying out substantive procedures to verify assets and liabilities in the statement of financial position.
(iv) auditing the computer systems, including using computer assisted audit techniques.
(v) visiting supermarkets.
(14 marks)
Question 27 SOURCES OF AUDIT EVIDENCE
“The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion.
“Sufficiency is the measure of the quantity of audit evidence; appropriateness is the measure of the quality of audit evidence and its relevance to a particular assertion and its reliability.”
ISA 500 Audit Evidence Required:
Discuss the extent to which each of the following sources of audit evidence is appropriate and sufficient:
(i) oral management representations in respect of the completeness of sales where the majority of transactions are conducted on a cash basis;
(ii) flowcharts of the accounting and control system prepared by a company’s internal audit department;
(iii) year-end suppliers’ statements;
(iv) physical inspection of a tangible fixed asset by an auditor;
(v) comparison of items of income and expenditure for the current period with corresponding information for prior periods.
(15 marks) Question 28 BASIS OF VALUATION
ISA 500 Audit Evidence requires auditors to obtain evidence that supports the relevant financial statement assertions. One of these assertions is that of valuation. Evidence is therefore required to ensure that assets or liabilities are recorded at an appropriate carrying value. Many audit failures are associated with difficulties experienced by auditors in verifying this assertion in the face of attempts by management to engage in creative accounting. In verifying valuation auditors need to determine that the basis of valuation is consistent with accepted accounting practice usually aided by reference to accounting standards (eg IFRSs). Additionally auditors need to obtain sufficient evidence as to the values themselves. Valuation problems likely to be encountered by auditors include those associated with determining:
(i) The appropriate amount of overhead carried forward as part of the cost of closing inventory. (ii) The written down value of property, plant and equipment having a limited useful economic life. (iii) Development costs deferred in the year and recognised as an intangible asset.
Required:
For each of the three items:
(a) State the acceptable basis of valuation. (6 marks)
(b) State with explanations the audit procedures to be performed in verifying the appropriateness of the basis of valuation and the correctness of the actual amounts.
(14 marks) Note: You are only required to consider audit procedures relevant to the valuation assertion.
Question 29 METHODS OF EVIDENCE GATHERING
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.
Required:
(a) Explain the advantages and disadvantages of each of the five methods of evidence
gathering listed above. (15 marks)
NB: You are not required to describe the methods listed above.
(b) Describe the relationship between the five methods of evidence gathering described
above. (5 marks)
(20 marks) Question 30 DELTA
Delta operates a chain of 30 shops throughout the country, dealing in car and van spare parts. It has 150 employees, of whom 30 work at its headquarters and central warehouse and the remainder at its shops. At its year end, 31 May 2006, inventory of spare parts totalled $2.2m, of which $1.4m were held at the individual shops and the remainder at the warehouse. Inventory represented 75% of Delta’s net assets.
Delta’s sales are almost entirely for cash or cheques. It has few trade receivables.
Delta operates a computerised information system. The reports which this system produces each month include a detailed statement of comprehensive income and statement of financial position for each shop, and a detailed analysis of the age and type of inventories held at each location including the warehouse. Physical inventory counts are carried out twice a year, on 30 November and 31 May, at all locations, and discrepancies between book and physical inventories are investigated.
Required:
Describe what analytical procedures might be used in the audit of Delta for the year ended 31 May 2006:
(i) at the planning stage; (8 marks)
(ii) as substantive procedures; (8 marks)
(iii) at the overall review stage. (4 marks)
Your answer should include the purpose of each procedure you identify and how it would be used in the audit.
Question 31 SAMPLING AND ANALYTICAL TECHNIQUES
Statistical and non-statistical sampling techniques are commonly used by auditors performing substantive tests on financial statement assertions. This subject is dealt with by ISA 530 “Audit Sampling and Other Selective Testing Procedures”. Analytical procedures are also used for substantive testing, as well as for planning and review purposes under ISA 520 “Analytical Procedures”.
Required:
(a) Explain how audit sampling and analytical procedures are used for substantive testing
purposes, giving examples. (9 marks)
(b) Discuss the relative merits of sampling and analytical procedures for collecting audit
evidence. (6 marks)
(15 marks) Question 32 ACCOUNTING ESTIMATES
The audit of accounting estimates is often problematic. Many estimates are material to the financial statements and involve the application of a high degree of subjective judgement. It is important that accounting estimates are adequately disclosed in the financial statements. There have been a number of cases in which auditors were accused of issuing unmodified reports on financial statements with inadequate disclosure of such estimates.
ISA 540 Audit of Accounting Estimates states that the determination of an accounting estimate may be simple or complex, depending on the nature of the item.
Required:
(a) Give examples of accounting estimates and explain why they are important to the
financial statement audit. (4 marks)
(b) Describe the approach to the audit of accounting estimates and explain the problems in
applying the approach. (7 marks)
(c) Describe the extent to which auditors may seek to rely on management representations during the course of their audit of accounting estimates in accordance with ISA 580
Management Representations. (4 marks)
(15 marks) Question 33 ESTIMATES
An accounting estimate is defined by International Standards on Auditing as “an approximation of the amount of an item in the absence of a precise means of measurement”.
Required:
(a) State the matters you would consider and describe the audit work you would perform in order to ascertain whether the following are fairly stated in the financial statements: (i) provision to meet warranty claims, made by a company which assembles a
(ii) estimate for annual depreciation charge on a compressed air system purchased by the company during the year for its assembly department. (8 marks) (b) Explain why the audit of accounting estimates is a difficult area for the auditor. (4 marks) (20 marks) Question 34 FLASHY
(a) Your client, Flashy, is engaged in the provision of management consultancy services to the manufacturing sector. It employs a core of well-qualified staff and also utilises the services of specialist manufacturing freelancers on an ad hoc basis.
Its debt/equity ratio has risen sharply over the past three years accompanied by a decline in profitability and whilst it is not currently suffering liquidity problems, its clients are taking, on average, sixty days to pay this year as opposed to thirty days three years ago. No cash flow forecast has been prepared for the coming year. You have encountered problems in the past with freelancers submitting bills late and internal controls in this area are weak. Your reporting deadline is one month after the year end and direct confirmation of accounts receivable received a poor response.
Required:
Draft three paragraphs you would expect to see in the representation letter concerning
the matters noted above. (6 marks)
(b) During the course of your audit you relied upon the work of the internal auditor Mr Mehta, a well-qualified and experienced accountant. The day you are due to sign the auditor’s report you are told that Mr Mehta “resigned” from Flashy “at short notice due to gross incompetence”.
Required:
Describe, with reasons, the action you would take. (6 marks) (12 marks) Question 35 LETTER OF REPRESENTATION
Towards the end of an audit, it is common for the external auditor to seek a letter of representation (written representations) from the management of the client company.
Required:
(a) Explain why auditors seek letters of representation. (5 marks) (b) List the matters commonly included in the letter of representation. (6 marks) (c) Explain why it is important to discuss the content of the letter of representation at an
early stage during the audit. (3 marks)
(d) Explain why management is sometimes unwilling to sign a letter of representation and describe the actions an external auditor can take if management refuses to sign a letter
Question 36 PORTHOS
(a) Computer-Assisted Audit Techniques (CAATs) are used to assist an auditor in the collection of audit evidence from computerised systems.
Required:
List and briefly explain four advantages of CAATs. (4 marks) (b) Porthos, a limited liability company, is a reseller of sports equipment, specialising in racquet sports such as tennis, squash and badminton. The company purchases equipment from a variety of different suppliers and then resells this using the Internet as the only selling media. The company has over 150 different types of racquets available in inventory, each identified via a unique product code.
Customers place their orders directly on the Internet site. Most orders are for one or two racquets only. The ordering/sales software automatically verifies the order details, customer address and credit card information prior to orders being verified and goods being despatched. The integrity of the ordering system is checked regularly by ArcherWeb, an independent Internet service company.
You are the audit manager working for the external auditors of Porthos, and you have just started planning the audit of the sales system of the company. You have decided to use test data to check the input of details into the sales system. This will involve entering dummy orders into the Porthos system from an online terminal.
Required:
List the test data you will use in your audit of the financial statements of Porthos to confirm the completeness and accuracy of input into the sales system, clearly explaining
the reason for each item of data. (6 marks)
(c) You are also considering using audit software as part of your substantive testing of the data files in the sales and inventory systems of Porthos.
(i) List and briefly explain some of the difficulties of using audit software; (4 marks) (ii) List the audit tests that you can program into your audit software for the sales
and inventory system in Porthos, explaining the reason for each test. (6 marks) (20 marks) Question 37 INSURANCE BROKERS
Your firm is the auditor of Insurance Brokers which operates from a number of branches and provides insurance for the general public and businesses. The company obtains insurance from large insurance companies, and takes a commission for its services. You have been asked to audit certain aspects of the company’s tangible fixed assets for the year ended 31 March 2006.
The company’s main non-current assets comprise
(1) freehold land and buildings
(2) microcomputers, printers and related equipment which are used by staff
The company has been operating for a number of years, and it maintains details of its office equipment and motor vehicles on a computerised fixed asset register. The company uses the following depreciation rates
(1) buildings 2% per annum on cost (2) office equipment (including computers) 10% per annum on cost (3) motor vehicles 25% per annum on cost.
You are concerned that the depreciation rate for the computers may be inadequate.
Required:
(a) List the audit procedures you would undertake in order to ascertain whether the following assets are owned:
(i) freehold land and buildings;
(ii) computers and motor vehicles. (7 marks)
(b) Describe the audit procedures that you would perform in order to reach a conclusion on whether the depreciation rate of the computers is adequate. (6 marks) (c) Discuss the matters that you would consider when deciding whether to modify your auditor’s report if you are not satisfied that the depreciation of the computers is adequate. State, with reasons, what kinds of audit modification (if any) would be
appropriate. (7 marks)
(20 marks) Question 38 TRACEY TRANSPORTERS
You are the external auditor of Tracey Transporters, a public limited company (TT). The company’s year end is 31 March. You have been the auditor since the company was formed 24 years ago to take advantage of the increase in goods being transported by road. Many companies needed to transport their products but did not always have sufficient vehicles to move them. TT therefore purchased ten vehicles and hired these to haulage companies for amounts of time ranging from three days to six months.
The business has grown in size and profitability and now has over 550 vehicles on hire to many different companies. At any one time, between five and 20 vehicles are located at the company premises where they are being repaired; the rest could be anywhere on the extensive road network of the country it operates in. Full details of all vehicles are maintained in a non-current asset register.
Bookings for hire of vehicles are received either over the telephone or via e-mail in TT’s offices. A booking clerk checks the customer’s credit status on the receivables ledger and then the availability of vehicles using the Vehicle Management System (VMS) software on TT’s computer network. E-mails are filed electronically by customer name in the e-mail programme used by TT. If the customer’s credit rating is acceptable and a vehicle is available, the booking is entered into the VMS and confirmed to the customer using the telephone or e-mail. Booking information is then transferred within the network from the VMS to the receivables ledger programme, where a sales invoice is raised. Standard rental amounts are allocated to each booking depending on the amount of time the vehicle is being hired for. Hard copy invoices are sent in the post for telephone orders or via e-mail for e-mail orders.
Required:
(a) List and explain the reason for the audit tests you should perform to check the completeness and accuracy of the sales figure in TT’s financial statements. (10 marks) (b) List and describe the audit work you should perform on the statement of financial position figure for vehicles in TT’s financial statements for the year ended 31 March
2005. (10 marks)
(20 marks) Question 39 FENTON ELECTRONICS
You are the internal auditor of Fenton Electronics, which has recently installed a computerised bar code system to record goods received, sales and inventory quantities. The company is a retailer of electrical products. In this computerised system:
(1) when the goods are received, the goods received department
(i) either read the bar code on the box containing the product, or input the bar code number manually
(ii) manually input the number of items received (eg a box may contain 100 video tapes).
The quantity of items received is added to the quantity of inventory recorded on the computer.
(2) when goods are sold to the customer, the bar code of the product is either read or input manually, and the computer produces the sales invoice using the selling price of the product, as recorded on the computer’s standing data file. The quantity of items sold is deducted from the inventory quantity recorded on the computer.
(3) periodically inventory is counted and these counts are compared with those on the computer. The quantities on the computer are amended when significant differences are found.
(4) the system allows
(i) details of new products and the selling prices of products to be added or amended (ii) inventory quantities to be amended from differences found at the count
(iii) special prices to be charged to customers (eg where a product is damaged or discontinued).
The main products the company sells comprise:
(1) slower moving products, such as televisions, video recorders, video cameras and audio equipment (2) fast moving, low value products, such as batteries, video and audio tapes.
Required:
(a) Describe the control procedures (including those to be operated by computer software) that you would expect to see in operation to ensure that details of goods received are
(b) (i) Suggest how frequently physical inventory counts should be carried out. (3 marks)
(ii) Describe the procedures to be undertaken by the company in order to ensure the inventory quantities in the computer system are accurate. (5 marks) (c) Describe the controls which should be implemented to ensure that the prices of the products on the computer file and on the products in the store are correct. (6 marks) (20 marks) Question 40 CHARLTON COMPUTERS
Your firm is the auditor of Charlton Computers, which imports parts for computers from the Far East, assembles the computers and sells them to individuals, businesses and retailers. You have been asked to identify inventory which may be worth less than cost and to determine whether it has been valued accurately in the accounts.
The company maintains perpetual inventory records on its computerised accounting system, which also show the age of items. A full physical inventory count is to be carried out at the company’s year end.
The company sells three main ranges of computer (Mark I, Mark II and Mark III) which have microprocessors of increasing speed and power.
Each computer is assembled from the following components:
(1) a standard metal case, power supply and keyboard
(2) circuit boards with the microprocessor and random access memory (one type for each range) (3) up to three drives (floppy disc, CD-ROM and zip)
(4) a hard disc drive (storage capacities vary)
(5) cards providing different facilities (eg for networks, sound, modem and graphics) (6) colour VDUs, both low and high resolution.
The cards, disc drives and VDUs are also sold separately to customers.
You are aware that the company is finding it difficult to sell the Mark I computer, because of severe price competition, and it is likely to be discontinued during the forthcoming year. In addition, low resolution VDUs are becoming less popular with customers.
You are satisfied that the cost of inventory has been correctly determined. Labour costs in finished goods are small, as it takes less than an hour to assemble a computer.
Required:
Describe the matters you would consider and the audit work you would carry out: (a) to identify inventory where net realisable value may be less than cost
(i) at the physical count (6 marks)
(ii) at the final audit (8 marks)
Question 41 FIZZIPOP
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).
Your firm, which has several offices, wishes to rely on the “Stockpop” system to provide the basis of the figure to be included in the financial statements for inventories. Your firm does not wish to ask the company to conduct a year-end inventory count.
Required:
(a) Describe the audit tests that you would perform on the “Stockpop” system during the year in order to determine whether to rely on it as a basis for the raw materials and finished goods figures to be included in the financial statements. (11 marks) NB: You are not required to deal with work in progress.
(b) Describe the audit tests you would perform on the records held by Fizzipop at the year-end to ensure that raw materials and finished goods are fairly stated in the financial
statements. (9 marks)
(20 marks) Question 42 SPONDON
You are the senior in charge of the audit of Spondon, an expanding company which sells all its products on credit. Its turnover for the year ended 31 March 2005 was $25 million.
On 31 March 2005 the total value of accounts receivable on the ledger was $5.3 million. Your tests of control on the sales system have shown that there is a satisfactory division of duties in the sales system and only minor errors were found in the tests of control.
Required:
(a) Discuss the extent to which a direct confirmation of accounts receivable is reliable in providing audit evidence and in verifying the value of end of the reporting period
balances. (8 marks)
(b) Describe the audit work you would undertake when following up the replies to the direct confirmation in order to ensure an adequate test of the existence and amount of Spondon’s accounts receivable where:
(i) the customer disagrees the balance and provides a different balance;
Question 43 CAMBRIDGE
Cambridge is a company that wholesales motor car spares to a large number of retail stores. Details of trade receivables at the end of the reporting period were as follows.
Number % Value % $
Nil balances 600 9.1 – –
Credit balances 50 0.8 (120,000) (1.0) $1 to $1,000 5,120 77.8 3,072,000 22.2 $1,001 to $10,000 600 9.1 4,620,000 33.4 $10,001 to $20,000 120 1.8 1,810,000 13.1 $20,001 to $50,000 60 0.9 2,350,000 17.0 Over $50,000 ______ 35 ____ 0.5 2,120,000 ________ ____ 15.3
6,585 100.0 13,852,000 100.0 ______ ____ ________ ____ Required:
(a) State the objectives of direct confirmation of accounts receivable. (4 marks) (b) Explain the following terms:
(i) positive confirmation;
(ii) negative confirmation. (4 marks)
(c) Describe how you might select a sample for direct confirmation of: (i) balances over $50,000;
(ii) balances between $1 and $1,000. (4 marks)
(d) State what you understand by the term “statistical sampling”? How does this differ
from “judgmental sampling”? (2 marks)
(14 marks) Question 44 CROMWELL
Cromwell sells fashion accessories through approximately 500 shops and has a head office.
Each shop operates an imprest system and holds a cash float of $500 to provide change for the till and to cover sundry expenses. All cash takings are banked at the end of each working day.
You are the senior in charge of the audit and your manager has indicated that only a sample of the cash balances held by the shops will be the subject of audit tests.
Many of the fashion accessories are purchased from overseas suppliers and the company’s buyers frequently travel abroad. The cashier at head office therefore holds a substantial amount of foreign currency in her safe.
