Answers

Part 2 Examination – Paper 2.6(INT)

Audit and Internal Review (International Stream) June 2003 Answers

1 (a) Performance
(i) The company has increased its revenues by 12% and its gross profit by 16% which in a competitive market is very
good (if not entirely credible) however, increased operating expenses have resulted in a reduction in operating profits of
20%.
(ii) The gross margin is very high; this is not abnormal in this sector, especially for software (although the margin is high
for hardware), but it may also be the result of errors, because the information has been produced very quickly. This is
also true of the other figures.
(iii) Total expenses as a percentage of revenue have increased substantially with the result that operating profit as a
percentage of revenue has reduced by around a third.
(iv) The increase in the selling expenses as a percentage of revenue may reflect the need for the company to spend more
on advertising.
(v) The increase in the distribution costs as a percentage of revenue may reflect inefficiencies in the method of distribution
in an industry that separates these functions.
(vi) The administrative expenses as a percentage of revenue have halved although they do not represent a significant amount
in absolute terms.
(vii) The reduction in operating profits has been partially offset by increased net interest receivable but profit before tax is still
down 10%.
(viii) The reduction in profit before tax and the increased tax charge have resulted in a reduction in profit after tax of over
40%.
(ix) Total dividends have been increased, despite the lower profits.
(x) The reduction in earnings per share is partly due to the reduction in profits but there is insufficient information to state
whether it is also attributable to an increase in the number of shares, although this seems likely.

(b) Higher risk areas and audit procedures

Gross margin and operating expenses
(i) I would obtain a detailed schedule of revenue and cost of sales showing the opening and closing inventory figures for
both software and hardware and I would perform a detailed review of changes on, say, a monthly, quarterly and half-
yearly basis.
(ii) I would ascertain the accounting policies for revenue recognition for both software and hardware and ensure that they
were in accordance with relevant International Accounting Standards. I would then test the application of these policies
to individual transactions. IAS 38 Intangible Assets requires that certain development costs be capitalised in the balance
sheet and that research costs and costs that do not meet the criteria for capitalisation be expensed.
(iii) I would seek to establish why all three categories of operating expenses have changed so dramatically, by enquiry and
by obtaining a schedule of operating expenses and a breakdown of the cost of sales figure.
(iv) I would perform detailed analytical procedures on operating expenses and cost of sales/gross margins, on a quarterly
and monthly basis and I would also perform detailed testing of transactions in these areas in order to ensure that
misclassifications have not occurred.
(v) Audit evidence provided by balance sheet work on the inventory figures (such as analytical procedures performed on
the inventory levels and attendance at the inventory count) will also provide evidence in relation to cost of sales.
(vi) It is possible that some reclassifications or even errors have been made – some costs appearing as operating expenses
might properly belong in cost of sales. It certainly seems odd that whilst sales have increased by 12%, the cost of sales
figure has hardly increased at all. The reduction in administrative expenses should also be investigated.
(vii) I would obtain schedules relating to non-current assets and establish the extent to which these had contributed to an
increase in depreciation costs. I would enquire as to the nature of the additions and their purpose. Additional non-current
assets would also be expected to contribute to revenues. If the change in the earnings per share figure is (partly) a result
of a new issue of shares, it may be that the cash generated has been used for investment in non-current assets.
(viii) Because of the possibility of errors, I would increase my sample sizes during tests of controls over the recording,
processing and posting of transactions that are posted to revenue, cost of sales and operating expense accounts.
(ix) I would perform detailed substantive testing on samples of transactions in these areas from source documentation (such
as licensing documentation, payroll records, purchase invoices for components etc.) through to the daybooks, ledgers,
and schedules supporting the income statement (for completeness), and vice versa.
(x) The extent of substantive procedures will depend on the extent to which controls are shown to be effective and I would
be particularly careful to follow up any errors discovered in both tests of controls and substantive testing. I would also
pay particular attention to any unauthorised, substantial or late adjustments.

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 Interest receivable
(xi) I would ask for a breakdown of, and explanation for, the increase in net interest receivable. I would perform further
analytical procedures on the interest costs and income and ensure that these are in line with current interest rates and
the types of investments held by the company.
Taxation
(xii) It seems strange that the tax figure has increased so dramatically. I would ask for copies of the tax calculations for
detailed review, and to corroborate explanations provided by management.
Dividends and earnings per share
(xiii) I would enquire as to why dividends had increased, despite the lower profits, and establish whether this trend can be
maintained in the face of falling profits. I would also enquire as to whether the company has any plans to restructure in
line with trends in the industry, what the company intends to do about the competition, and whether there is any
possibility of a take-over.
(xiv) I would establish whether there had been any share issue during the year that had affected the calculation of the
earnings per share and, if there had been, what was the purpose of the share issue.

2 (a) Importance of inventory counting

(i) Inventory counting is important to auditors of manufacturers, wholesalers, retailers and many service organisations.
Inventory counting is the best way to establish quantities for valuation purposes and it assists management in making
appropriate provisions against obsolete, slow moving and damaged items.
(ii) Inventory counting provides the only direct evidence in relation to the existence of inventory. Performed properly,
counting also provides evidence on cut-off, certain frauds and on the quality of internal controls over inventory.
(iii) Auditors should attend inventory counts where inventory is material to the financial statements (balance sheet or income
statement).

(b) Perpetual inventory system

(i) The purpose of a perpetual inventory system in practice is to control inventory. Such a system involves cyclical counting
procedures during the year. Such procedures avoid the need for reliance on a year-end count. If auditors wish to rely on
the records rather than a year-end count for the purposes of the financial statements they must ensure that the cyclical
counting procedures are adequate and are being properly and consistently applied, particularly in a large dispersed
organisation.
(ii) I would ensure that all inventories had been counted at least once a year and that the records had been kept up to date
and were promptly corrected for any discrepancies discovered as a result of counting.
(iii) I would assess the risk attaching to the different locations and seek to visit those locations where the value or volume
of inventory is substantial, and where controls are weak (i.e. where risk is greater).
(iv) It may be necessary to involve other offices of my firm, or to engage staff from another firm to attend counts, and to
co-operate with internal audit, who may wish to conduct their own counts (on which I may wish to rely), or who may
lend staff to my firm.
(v) If using other firms of external auditors, and relying on internal audit work, it is particularly important that I am satisfied
with the quality of that work and that my involvement is sufficient for my firm to be able to justify its audit opinion.
(vi) My firm may perform visits on a rotational basis throughout the year to ensure adequate coverage of all locations.

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 (c) Weaknesses in counting instructions – why they are difficult to overcome

Weaknesses Why difficult to overcome

The date of the count may be inappropriate – These problems are difficult to overcome
staff (and auditors) will not wish to work because the shop and warehouse are open
on a public holiday and given that there seven days a week and because it is
is a high level of staff turnover, there is a expensive and difficult to obtain others (who
possibility that staff will not arrive or will may not be appropriately experienced) to
complete the work too quickly without perform the count.
properly counting the inventory. This is It might be suggested that the count be
compounded by the fact that staff are conducted, say, a week before or a week later
working individually and may make errors and that a roll-forward or roll-back be
or attempt to cover up misappropriations. performed, but this will cause additional
There may be insufficient time allowed to staffing problems and problems with the
prepare the inventory for counting and it is movement of inventory. It may be difficult for
likely that the shop and warehouse will be the company to change its year-end because
untidy because the business has been busy. of local regulations. Some of the managers
might be asked to come and help.
Too much responsibility is in the hands of This is difficult to overcome because family
Mr Sneg (a lack of segregation of duties). owned companies, (even large ones) often
He is responsible for the assets (the place a substantial amount of trust in valued
inventory), the records, the staff and the employees who would be offended if it were
adjustments to the records. suggested that it were necessary to ‘check’
their work in some way.
It may be necessary for Mr Sneg to be
involved with the count but he should be
responsible together with another
representative of management who is not
involved with the day-to-day control of
inventory (such as the finance director). It
will be too easy for Mr Sneg to hide errors or
falsifications in the inventory records to cover
up errors or misappropriations.
It would be particularly easy for him to falsify
records in relation to, for example, inventory
in stock but already sold and inventory
delivered but not yet paid for.
The add-back of inventory delivered but not
yet paid for appears to be wrong, as a matter
of principle, even if the related invoices are
removed from the revenue accounts.

3 (a) Managing conflicts of interest

(i) ACCA’s Rules of Professional Conduct state that auditors should avoid conflicts of interest (both conflicts between the
firm and clients, and conflicts between clients) wherever possible. In some cases, such as these, they are unavoidable.
(ii) Full disclosure is important – both companies should be fully aware that the firm is acting for the other party.
(iii) One or both companies may object to the firm acting for the other company and the auditor may be forced to make a
decision as to which company to resign from. However, this is not an attractive course of action because the audits may
already have commenced and it may be difficult for one of the companies to find a new auditor, quickly.
(iv) The auditor should probably not, therefore, resign unless forced to do so – this might be prejudicial to the interests of
one of the clients.
(v) It is important in such cases that different teams of staff, and different engagement partners work on the respective
audits.
(vi) Internal procedures within the firm should be set up to prevent confidential information from one client being transferred
to the other and the interests of one firm damaging the interests of the other. Such procedures are sometimes known as
‘Chinese Walls’.
(vii) If two completely separate offices could work on the two engagements, so much the better.

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(b) Main requirements of IAS 37

IAS 37 Application

IAS 37 states that a provision is a liability of If the firm can obtain sufficient appropriate
uncertain timing or amount. It should only be audit evidence to show that Tourex and/or
recognised when there is a present obligation Pudco are likely to have to make a payment,
(legal or constructive) arising from past and that the amount can be reliably
events and it is probable that a transfer of estimated, a constructive obligation seems to
economic benefits will be required to settle exist and provision should be made.
the obligation and a reliable estimate of the
amount can be made.
IAS 37 states that a contingent liability is If Tourex and/or Pudco are uncertain as to
either a possible obligation arising from past whether a payment will have to be made, or
events whose existence will be confirmed by if they are certain but the amount cannot be
uncertain future events outside the control of estimated, a contingent liability should be
the entity or, a present obligation arising from disclosed in the accounts.
past events that is not recognised because a
transfer of economic benefits is not probable,
or because the amount of the obligation
cannot be measured with sufficient certainty.
IAS 37 states that a contingent asset is a This might apply to Tourex in its claim
possible asset arising from past events whose against the food company. It seems unlikely
existence will be confirmed by uncertain that there is sufficient certainty relating to the
future events ouside the control of the entity. claim and therefore no disclosure should be
Contingent assets should only be disclosed made.
where an inflow of economic benefits is
probable. If they are virtually certain, a
contingency does not exist at all and the
income may be accrued.
It also states that expected re-imbursements If either Tourex or Pudco hold insurance
(such as those arising from insurance against such events, and it is probable that
contracts) should be recognised only where the insurance claim will be met, a contingent
they are virtually certain and treated as asset may need to be disclosed. If there is
separate assets. The net expense may be any uncertainty, there should be no
recognised in the income statement. disclosure. If it is virtually certain that the
claim will be met, a separate asset should be
recognised.
A brief description of the nature of each class
of contingent liability should be made unless
the possibility of the transfer of benefits is
remote. Where practical, an estimate of the
financial effect, an indication of the relevant
uncertainties, and the possibility of any
reimbursement should be disclosed. Similar
provisions apply to contingent assets.

(c) Sufficient audit evidence and audit reports

(i) The main problem for the auditors will be gaining sufficient evidence to determine whether any amounts should be
provided for and/or disclosed in the financial statements of the two companies.
(ii) The lawyers refuse to provide anything other than informal evidence and this will almost certainly not be sufficient to
form an audit opinion.
(iii) Unless audit evidence can be obtained elsewhere – a qualified opinion, ‘except for’, on the basis of a limitation in the
scope of the audit may be needed for both companies as the amounts involved are material.
(iv) However, it may be possible to take the view that there is a significant uncertainty, the resolution of which is dependent
on future events that are outside the direct control of the entity, and that an ‘emphasis of matter’ paragraph is therefore
appropriate, rather than a qualification to the auditor’s opinion.
(v) It may be possible for the auditors to suggest to the companies that it would be very helpful for the lawyers to provide
some indication as to their view of the likely outcome and the amounts involved, in order to avoid a qualified opinion.
(vi) The auditors should also take note of the progress of any legal proceedings and any proceedings that may be instigated
by the public health authorities as such authorities might impose significant fines, and they might even close the
businesses down, which has implications for the going concern status of both.

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4 (a) Reliance on work of internal auditors
(i) As requested, the external auditors will seek to rely on the work of internal audit to the maximum extent possible. This
might cover planning, risk assessment, tests of controls and substantive testing.
(ii) In all cases, the external auditor should be aware that the purpose of internal audit’s work will not be primarily directed
towards the financial statements.
(iii) In relation to the cyclical audit of internal controls, it may be possible to rely on the work of internal audit in relation to
all of the areas noted, but only if the internal controls audited affect the financial statements. It may be that internal
audit’s work on operations and customer support is less relevant than its work in other areas.
(iv) In relation to the four-year review of internal controls – the extent of reliance will depend on how long ago the last review
was conducted. If it was conducted recently, it will provide help in relation to the external auditor’s assessment of the
accounting and internal control systems.
(v) In relation to risk management – the relevance of internal audit work depends on the extent to which risks in relation to
reporting in general, and the financial statements in particular, have been addressed separately by management. This
work will be relevant to the external auditor’s risk assessment and planning.

(b) Information required

(i) The information required to determine the extent of external audit reliance on internal audit’s cyclical audit will be:
– internal audit’s systems documentation (the work on information systems and finance may include documentation
of the company’s accounting and internal control systems);
– internal audit’s planning documentation which may cover a risk analysis, tests of controls and sustantive
procedures;
– the results of tests of control and substantive procedures;
– documentation on the four-year review of internal controls, particularly in relation to the finance and information
services functions.
(ii) The external auditors should ask to see all documentation relating to the work performed by internal audit on information
services restructuring during the year because the external auditor’s assessment and testing of systems will be split into
two parts, pre- and post-restructuring.
(iii) Other documentation requested will include internal audit’s operating procedures manuals and documentation relating
to the recruitment, training and development of internal audit staff, and management responses to internal audit
recommendations. This information is required to enable the external auditor to form an opinion on the competence and
effectiveness of the internal audit function.

(c) Circumstances in which it would not be possible to rely on the work of internal audit
(i) It may not be possible to rely on the work of internal auditors if they:
– are not competent (this relates to experience as well as qualifications);
– lack integrity;
– do not properly plan or document their work, or if management does not act on (or at least respond to)
recommendations made;
– do not perform work relevant to the external auditor.
(ii) It will also not be possible to rely on internal audit if internal audit is insufficiently independent within the organisation,
i.e. where internal auditors have insufficient operational freedom, where they are reporting to those who control the
functions that they work on, or where they are reporting on their own work.

(d) External auditor work

(i) External auditors will wish to perform work independently, regardless of internal audit work, in all areas that are material
to the financial statements. For immaterial areas in which internal audit work can be shown by testing and review to be
adequate, it may be possible to rely on the work of internal audit without performing any other work.
(ii) Areas material to the financial statements are likely to be long and short-term leasing receivables and inventory. Leases
may be complex and the auditors will wish to ensure that accounting policies are appropriate and that they have been
properly applied. The valuation of inventory will have a direct effect on the profit for the period. This is an area that is
easy to manipulate and external auditors will wish to ensure that this has not happened.
(iii) External auditors will also wish to perform their own risk analysis and final review of financial statements in order to
ensure that no high risk areas have been overlooked.

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5 (a) Information in internal audit reports
(i) Cover page: this normally deals with the subject matter, the distribution list, date, and authors.
(ii) Executive summary: this normally includes an introduction, summary terms of reference, outcome of the work, key risks
identified, key action points/recommendations, further work required.
(iii) Main report contents: this normally includes findings and action points or recommendations (including alternatives), it
gives details of responsibility for actioning the points, costs and time-scales.
(iv) Appendices: these may contain the full terms of reference, tables, questionnaires used, tests performed and any other
relevant information.

(b) Contents of external audit reports

External audit reports include:
(i) A title and addressee, and the signature of the auditor and the date.
(ii) A paragraph detailing the financial statements audited, and the responsibilities of directors and auditors.
(iii) A paragraph explaining the basic procedures involved in an audit and the fact that the audit is conducted in accordance
with International Standards on Auditing.
(iv) A paragraph stating the auditors’ opinion on the truth and fairness (or fair presentation) of the financial statements and
identifying the financial reporting framework.

(c) Differences – internal and external audit reports

(i) The wording of the external audit report is set out by in ISA 700 The Auditor’s Report on Financial Statements (and
national standards) and includes references to the financial statements audited, the auditing standards applied, a
summary of the procedures applied and the audit opinion in terms of truth and fairness and compliance with an
identified financial reporting framework.
(ii) The main difference between external and internal audit reports is that external reports are highly summarised, and do
not contain recommendations or action points in respect of internal controls or other matters. Internal and external audit
reports are similar to the extent that they all state what has been done, the overall parameters (law and accounting
standards in the case of external reports, the terms of reference in the case of internal reports) and the overall findings.
But the subject matter (internal controls for internal reports, financial statements for external reports) are different.
(iii) External audit reports are normally produced because of legal requirements and are therefore heavily regulated. Internal
audit reports are produced because management commissions them for control and corporate governance purposes.

(d) Common characteristics

(i) Both internal and external auditors draft their reports on the basis of the findings of their work (in the case of external
auditors this will relate to weaknesses in the structure and operation of controls encountered during the audit).
(ii) The report will be split into three main sections – the issues, the consequences or implications, and the
recommendations. There will usually be a split between major and minor matters and some sort of summary or overall
evaluation of the more important matters.
(iii) The draft report will often be discussed with management, partly to confirm the findings, and partly to establish
management’s likely responses – these can be incorporated into the report itself.
(iv) Reports will usually go through several redrafts (particularly in large organisations) and the report will then be issued. If
management have not commented at an earlier stage, some sort of response may be expected at a later stage.
(v) It is normal to follow up on recommendations or agreed action points at a later stage in order to establish how the issues
have been dealt with.

6 (a) Internal controls

(i) Controls contributing to the orderly and efficient running of the business, safeguarding the assets and adherence to
management policies would include the following:
– physical controls over access to the assets such as the locking of doors and the maintenance of an appropriate fire
and flood resistant environment;
– insurance against disaster and contingency plans;
– the use of passwords for access to computers and plant and equipment;
– the numerical or other tagging of all equipment, referenced to an asset register;
– performing periodic asset audits;
– internal regulations requiring staff who take equipment such as laptops and motor vehicles home to ensure that
they are secure, and prohibiting staff from using their own software on company equipment;
– the maintenance of firewalls and virus checking software.

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 (ii) Controls contributing to the prevention of fraud and error, and the completeness and accuracy of the accounting records
would include the following;
– the preparation and monitoring of capital expenditure budgets together with authorisation of capital expenditure,
disposals and depreciation rates by independent persons at an appropriate level within the organisation who do
not have day-to-day responsibility for the related records or assets;
– the maintenance of an asset register that is reconciled to the general ledger and the assets themselves;
– the periodic checking and review of asset lives, and fully depreciated assets, to ensure that assets are being
depreciated correctly, over an appropriate period of time.

(b) Description
(i) Judgement and statistical sampling
Judgement sampling uses the auditor’s judgement to select the number of items to be tested, which items to be tested,
and to interpret the results. Statistical sampling uses probability theory to do the same. Some judgement is always used
in statistical sampling in the assessment of materiality and in the determination of what constitutes tolerable error, for
example.
(ii) Representative sample
A representative sample is one whose characteristics are the same as, or similar to, the characteristics of the population
as a whole. All sample selection methods attempt to select samples that are representative.
For example, a sample of invoices that have not been properly authorised in 5% of cases will be representative of all
invoices if the population as a whole also has around 5% of invoices not authorised.
(iii) Tolerable error
Tolerable error is the maximum error that the auditor is prepared to accept and still conclude that the audit objective has
been achieved.
For example, in relation to receivables, the auditor may be prepared to form the conclusion that receivables are not
materially misstated if sampling shows that the receivables population has a value that is within plus or minus, say, 5%
of the figure in the financial statements.
(iv) Different methods of sample selection
Random selection requires the use of random number tables in order to select a representative sample.
Haphazard selection may be deemed to approximate to random selection provided that no bias is displayed.
Interval (or systematic) selection involves taking every nth item, starting at random. Monetary unit sampling is also a
form of systematic selection.
Block selection methods (taking one full part of the population) will probably not result in a representative selection.
Block selection might involve obtaining confirmation of receivables from one region of the country only, for example.
NB: Only two examples are required.
(v) Extrapolation of errors
Errors found in a sample are extrapolated across the population as a whole, in order to enable the auditor to form a
conclusion on whether the population is materially misstated. It is important to remember that there is not necessarily
a direct, linear relationship between errors in samples and errors in the populations from which they are drawn.

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Part 2 Examination – Paper 2.6(INT)
Audit and Internal Review (International Stream) June 2003 Marking Scheme

Marks
1 (a) Performance
Up to 1 mark per point to a maximum of 8

(b) Higher risk areas and audit procedures

Up to 1·5 marks per point to a maximum of 12
____
Total 20

2 (a) Importance of inventory counting

Up to 2·0 marks per point to a maximum of 4

(b) Perpetual inventory system

Up to 1 mark per point to a maximum of 4

(c) Weaknesses in counting instructions – why they are difficult to overcome

Up to 2·0 marks per point to a maximum of 12
____
Total 20

3 (a) Managing conflicts of interest

Up to 1·5 marks per point to a maximum of 6

(b) Main requirement of IAS 37

Up to 1·5 marks per point to a maximum of 7
(No more than 4 marks for the requirements of IAS 37)

(c) Sufficient audit evidence and audit reports

Up to 1·5 marks per point to a maximum of 7
____
Total 20

4 (a) Reliance on work of internal auditors

Up to 2 marks per point to a maximum of 6

(b) Information required

Up to 2 marks per point to a maximum of 6

(c) Circumstances in which it would not be possible to rely on the work of internal audit
Up to 2 marks per point to a maximum of 4

(d) External auditor work

Up to 1·5 marks per point to a maximum of 4
____
Total 20

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 Marks
5 (a) Information in internal audit reports
Up to 1 mark per point to a maximum of 4

(b) Contents of external audit reports

Up to 1 mark per point to a maximum of 4

(c) Differences – internal and external audit reports

Up to 2 marks per point to a maximum of 4

(d) Common characteristics

Up to 2 marks per point to a maximum of 8
____
Total 20

6 (a) Internal controls

Up to 1 mark per point to a maximum of 10

(b) Description
Up to 2 marks per point to a maximum of 10
(NB: not more than two marks per item) ____
Total 20

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