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Answer 1 EXTERNAL AUDIT SERVICES Value of an audit Corporate society is sometimes described as an awesome social invention whereby the

savings of millions are channelled into the hands of corporations to the mutual benefit of investors and management, thus ensuring that investment capital is managed by those most skilled in the process. However, the process requires that individuals entrust their savings into the hands of strangers notwithstanding concern that their interests may not be adequately safeguarded. The external audit plays a vital role in facilitating this process by protecting investors against the risk that management might use investors funds in their own self-interest and not in the investors interests. Without the work of auditors, companies would not have access to the capital they need to engage in profitable projects. The way in which the role of the auditor protects investors can be explained in a number of different ways. Information risk In order to invest capital investors need reliable information as to the financial position and performance of the companies in which they are planning to invest. Reliance must necessarily be placed on management for the provision of such information because of the risks of allowing outsiders access to confidential information about the business. However, investors would be naturally suspicious of such information. By allowing independent auditors access to the companys records, investors may obtain the required assurance as to the reliability of the information provided by the company from the auditors assurance as to its truth and fairness. Society also benefits in that, through such information, securities markets can assess the relative values of shares in each company and an active market in shares becomes possible. In this way capital is attracted to those entities whose business is likely to be the most profitable thus ensuring that capital is invested in those activities generating the greatest satisfaction to their customers. Agency theory Under the information risk hypothesis it is usually assumed that audits must be required by law for companies issuing risk-bearing securities to the public. This is normally recognized by the presence of a statutorily required audit for most incorporated entities. Agency theory, however, predicts that it is management who have an incentive to engage an independent auditor since investors are unlikely to be sufficiently reckless as to invest money in companies without such assurance. The theory derives its name from the depiction of the relationship as one whereby company management act as agents for shareholders, the principals, in investing their money in profitable projects. Agency risk is the risk that the agents act in their own self-interest. An agency contract is one offered by the agent to reassure principals that they will act in the principals interests (eg agreeing to provide information enabling the principal to monitor their performance). With companies, audited financial statements constitute the information provided by management to prove that they have acted in the shareholders interests. Insurance hypothesis A further explanation of the role of an audit is that it protects investors by insuring them against the risk of loss through relying on false information. This arises through their right to recover such losses from the auditor. This last hypothesis also exposes some of the limitations in the benefit of an audit to society. The right to recover losses applies only where the auditor has been negligent. At present there are limitations in the auditors duty to detect fraud and other illegal acts. Arguments that the auditors duty be extended are countered by concern that the cost to the auditor of performing additional procedures and accepting greater risks does not justify the increased benefit to society. ATC-Adding Value To Your Future 1

Tutorial note: This answer indicates the type of answer that was acceptable based on the (former)examiners article. Equally acceptable answers could refer to stewardship and accountability(particularly where the privilege of limited liability is extended to an entity), professional advice,credibility and independent opinions, potential investors, loans and finance, assurance and otherservices, etc. Answer 3 ISA 200 (a) Managements and auditors responsibilities The management of an entity is responsible for: the preparation and presentation of financial statements which give a true and fair view (or are presented fairly) in accordance with the financial reporting framework and statutory requirements. This responsibility includes: selecting suitable accounting policies and applying them consistently; making judgements and estimates that are reasonable and prudent; stating whether applicable accounting policies have been followed; preparing the financial statements on a going concern basis. maintaining accounting records and implementing adequate internal controls for safeguarding the assets and to minimise the risk of fraud or other irregularities. The auditors are responsible for forming an independent opinion (eg in true and fair terms in accordance with an identified financial reporting framework) based on their audit and for reporting that opinion to the addressees of the auditors report. (b) Inherent limitations facing an auditor The inability to examine each transaction and each item making up an account balance within normal time and cost constraints. This results in the necessity to rely on evidence from samples and the consequent risk of sample error. The inherent limitations of internal control systems such that any reduction in substantive procedures based on the assessed level of control risk is dependent on inherent limitations of control not exceeding reasonable levels. Even given reasonable professional scepticism the inability of the auditor to detect fraudulent misstatements carefully concealed by collusion or deliberate misstatement by senior management. The fact that audit evidence, mostly relating to past events, is rarely wholly conclusive and the necessity for reliance on judgement as to the persuasiveness of evidence. (c) Significant types of judgements made by auditors (i) In gathering evidence Assessing inherent and control risk and determining the appropriate audit strategy to be adopted. This includes assessing: the nature and degree of risk of misstatement at both the financial statement level and the level of the account balance or class of transactions; the design of internal controls and the effectiveness of the control environment in determining the nature and extent of possible misstatements. Planning tests of controls and evaluating the results of tests as to whether they confirm the preliminary assessment of control risk. Given the assessed levels of inherent and control risk, planning substantive procedures as to their nature, timing and extent. Planning substantive procedures such that sufficient appropriate evidence is obtained. In turn this requires judgements as to: the materiality of the items concerned the reliability of the evidence obtained relevance of evidence as to each financial statement assertion. ATC-Adding Value To Your Future 2

(ii) In arriving at an opinion In drawing conclusions and forming an opinion auditors need to consider whether: they have sufficient appropriate evidence to express an opinion on the financial statements taken as a whole and, if not, whether to report: limitation on scope qualified opinion; or limitation on scope disclaimer of opinion; having sufficient appropriate evidence to form an opinion, the financial statements as a whole show a true and fair view and, if not, whether to report: disagreement qualified opinion; or disagreement adverse opinion. Answer 4 FRAUD AND COMPLIANCE SEMINAR (a) Missing share certificates The auditors must treat this matter as extremely serious. Not only has a senior executive perpetrated an illegal act, he has also been guilty of deliberately attempting to mislead the auditors. The auditors must report the matter immediately to the audit committee, if there is one, or otherwise to the full board of directors (ISA 240). A criminal offence has been committed in the theft of the shares and in attempting to mislead the auditors. The auditors would expect appropriate action to be taken. Any further course of action depends on the action taken by the directors. If the directors do not take appropriate action, such as reporting the matter to the police, the auditors must consider the desirability of continued association with the company. Failure to take action would make the directors a party to the wrongdoing involving, as it does, money for which they have a responsibility to the shareholders. In most jurisdictions the auditors do not normally have any responsibility for reporting the matter to third parties except in the public interest or where there is some direct legal duty imposed on auditors. Their duty of confidentiality prevents their taking further action. However, on resigning, they can take the opportunity to reveal their concerns in any communication accompanying their resignation. They may also respond appropriately to professional enquiries from auditors nominated to replace them. However, they need to obtain legal advice on the form of such communication to avoid the risk of action for breach of confidence by the company or even defamation by the finance director. If the directors do take appropriate action, the auditors must consider their position with respect to the current audit engagement. The finance director is a key person with respect to representations on which the auditors would have relied. Now that the credibility of that officer is in doubt, the necessary level of professional scepticism becomes much greater. Such an official has the authority to override almost any control and is in a position to conceal such actions. The control environment must be regarded as being wholly ineffective and inherent risk assessed as high. Extended substantive procedures will now need to be performed in all areas that could have been manipulated by the chief financial officer. Providing sufficient appropriate evidence is available then there would be no effect on the auditors report. It is possible, under the circumstances, that the auditors may be unable to reassure themselves that further misstatements are not present. In this case they would need to issue an except for scope limitation qualified auditors report. (b) Product safety The auditors have no duty to search for all instances of non-compliance with all applicable laws and regulations. However, in addition to laws and regulations directly pertaining to financial reporting, the auditors also have a duty (ISA 250) to become familiar with any particular laws and regulations breaches of which might result in the company no longer being a going ATC-Adding Value To Your Future 3

concern. Moreover, in this case, they have already become aware of the possible breach. Their suspicions are aroused and they are under a duty to investigate the matter further. The finance director may be right in claiming the matter is of no consequence, but the fact of attempting to conceal the evidence from the proper authorities must arouse suspicions that the matter is serious. The auditors need to obtain independent expert advice on the implications of the matter. If the company denies access to an independent expert the auditors may consider, at the very least, issuing an except for scope limitation qualified auditors report. If the expert confirms suspicions and the effect is potentially material, at the very least the auditors would require full provision to be made, failing which an except for disagreement qualified auditors report would be necessary (ISA 250). If the auditors suspicions are confirmed and the effect is material, the auditors would normally report the matter to the board of directors. In this case, however, the board is implicated in the attempt to cover up the evidence. Again legal advice needs to be sought on whether the actions of the board are illegal. If so, then they may consider it desirable to resign from the audit. Moreover, consideration must be given to the consequences of the continued supply of unsafe goods. It is likely the auditors have a case for alerting the appropriate authorities in the public interest which overrides their duty of confidentiality to the client. (c) Understatement of royalties This suspected fraud differs in being perpetrated by the company and not by employees against the company. The auditors duty of confidentiality to the company prevents them from communicating their suspicions to the authors. However, the company has a liability under the terms of the royalty agreements which must be provided for until extinguished by the statute of limitations or other limitation on the rights of creditors to sue for amounts due. The auditors would possibly seek legal advice on whether the companys action was illegal, such as a conspiracy to defraud the authors or false accounting to obtain a pecuniary advantage. If the directors actions are illegal the auditors would expect the directors to pay the amounts due in full. If the directors refuse, the auditors should consider resigning. If the action is not illegal, it is certainly unethical, and the audit will be affected in two ways. Firstly, if the amounts are material and the company fails to make adequate provisions within the financial statements, the auditors must issue an except for disagreement qualified auditors report (ISA 240). Secondly, the auditors will need to revise their assessment of inherent risk at the entity level. They would need to increase the tolerable level of detection risk and perform a higher level of substantive procedures than previously would have been considered necessary (ISA 240). (d) Unclaimed wages If there is no immediately apparent explanation, such as an employee on long-term sick leave, the circumstances arouse suspicions that the employee is fictitious possibly a former employee whose resignation the supervisor has deliberately withheld from the personnel department. If the amount is wholly immaterial, the auditor has no duty to investigate the matter further. However, the auditor does have a duty to communicate suspicions promptly to an appropriate level of management and to see that the matter is properly investigated (ISA 240). If the auditor is not satisfied that a proper investigation is performed, it is possible that the level of management to which the suspicions are communicated is also implicated in the fraud. The matter becomes more serious and must be reported to the audit committee or board of directors. Answer 6 ADDITIONAL SERVICES (a) Affect on independence, benefits and safeguards (1) Taxation service ATC-Adding Value To Your Future

Generally, there should be little effect on the auditors independence in providing taxation services to the client. Most audit firms will have staff with specialised skills in taxation, so they should provide a good service. Also, there should be a cost saving compared with employing another firm for this service, as some of the procedures in preparing and auditing financial statements are helpful in calculating the corporation tax liability (eg non-current asset schedules, analysis of entertainment and some other expenses). Frequently, audit firms will have different staff responsible for audit work and taxation computations, and this will tend to increase independence. The auditors independence may be slightly compromised if a dispute arises between the company and the tax authorities, or if the auditor has made a material mistake in the Income Tax computation. The risks with preparing and negotiating directors tax liability with the tax authorities are slightly greater. A director may not have declared all benefits in kind, or the auditor may not have given the correct advice on a technical matter, or a dispute may arise with the tax authorities. These problems are likely to create a deterioration in the relationship with the director; so the auditor may back down on a contentious issue in the financial statements in order to maintain good relations with the directors and thus continue as auditor. Ideally, the taxation computations should be performed by staff independent of the audit staff, and then checked by the audit staff. (2) Accounts preparation Many small companies do not have staff with the skills to prepare the financial statements. The auditor has these skills, and there is likely to be a time (and cost) saving if the audit firm both prepares and audits the financial statements. However, if the same staff both prepare the financial statements and audit them, there is a greater risk that material errors will not be detected, as one is poor at detecting ones own mistakes. Also, staff may feel the item has been audited when preparing the financial statements, and this could lead to aspects of the financial statements not being audited satisfactorily. So, it is desirable (and recommended) that different staff should prepare the financial statements from those who audit them. Even in this situation, there is likely to be a cost saving, as the staff preparing the financial statements should prepare schedules which will help in the audit (eg schedules of additions and disposals of non-current assets, and calculation of accruals and prepayments). If the audit firm prepares the financial statements, the letter of engagement for this work should point out that the client should accept that the accounting records are the responsibility of the company, and that the financial statements are based on the companys records and explanations received from employees and the directors. The ACCAs ethical rules say that the auditor should not prepare the financial statements of listed and other public interest companies, except in emergency situations. In conclusion, the provision of accounting services is unlikely to have any significantly adverse effect on the auditors independence. (3) Internal controls The auditor may be quite good at advising on internal control systems, as this is an important aspect of audit work. However, if the auditors recommendations are implemented and the system proves to have weaknesses (which may result in serious errors or fraud), the auditor may be reluctant to criticise the system (as he would be criticising himself, so his independence would be compromised. For this reason, auditors should not say how internal control systems should be set up in client companies. However, as a result of audit work, auditors can become aware of weaknesses in internal controls in accounting systems. They should point out these weaknesses to the client, and any errors or fraud which have taken place. In addition, they can suggest how the systems can be ATC-Adding Value To Your Future 5

modified to improve controls. The auditor can suggest changes to parts of systems, but they should not say how a whole system should be set up (eg a purchases system). (b) Fees for non-audit work (i) Low audit fees There is some evidence that audit fees charged to listed companies may be reduced because of fees the auditor will receive for other services. However, it is very difficult to prove this is happening. If non-audit work is very profitable, then an audit firm may charge a lower audit fee. This is because the auditor has a greater chance of obtaining non-audit work from the listed company (ie audit firms tend to have a higher proportion of non-audit consultancy work than those firms which are not the companys auditor). So, if more high profit work is available, the auditor may be prepared to reduce the audit fee to increase the chances of obtaining the non-audit work. The reason why it is difficult to prove that audit firms are reducing audit fees is that one cannot quantify the audit fee required for a particular audit assignment. A replacement auditor may charge a lower audit fee, but this could be because the audit is carried out more efficiently, or the previous auditor had carried out more work than was necessary. (iii) Large fees for non-audit There does seem to be a greater risk that the auditor will compromise his independence if he obtains fees from both audit and non-audit work, than if he obtains fees exclusively from audit work. If the audit firm is replaced as auditor, the audit fee and most of the fees for nonaudit work will be lost. As non-audit work is likely to be more profitable than audit work, the pain to the auditor of losing the audit will be even greater, as he will lose the high profit non-audit work and the relatively low profit audit work. Risks to the audit firm of being replaced as auditor as a result of modifying the auditors report. The client may not want the auditors report to contain any form of modification (eg an explanatory paragraph in an unqualified report indicating going concern problems). So, there is a risk that the auditor will be replaced if he modifies his auditors report. Because of the substantial loss of fees, the auditor may back down and give an unmodified auditors report. If there is a serious risk that the auditor will be sued for not modifying the auditors report, he will probably not back down to pressure by the company. The auditor will want to avoid negligence claims, as they involve a lot of staff time in defending them, it adversely affects the auditors reputation, and there will be damages to pay if the auditor loses the case (or settles out of court). Although the auditor should be covered by professional indemnity insurance (PII) for legal costs and the sum paid in damages, he may have to pay an excess (eg the first $25,000 or $100,000 of the claim), and it is likely that future premiums for PII will increase following a claim. (iii) Reluctance to modify Statement (iii) is logical, as a reluctance to modify the auditors report is the outward evidence that the auditors independence has been compromised. Benefits The provision of other services by audit firms is likely to benefit both the client and the audit firm. This is because the fee charged is likely to be lower, as the audit firm already knows the client firm and does not have to spend time getting to know the companys business, its employees and systems. With the close relationship between the audit firm and the company, the companys staff should have a good appreciation of the strengths of the audit firm and be able to use these strengths in non-audit consultancy work. The higher profitability of nonaudit work, and the better chance of obtaining this work, because you are the auditor, means that ATC-Adding Value To Your Future 6

obtaining a client with a considerable amount of non-audit work is very attractive to the audit firm. Drawbacks However, from the discussion above, it appears that the provision of non-audit work could adversely affect the independence of the audit firm in carrying out the audit. Technically, the audit firm is appointed by the shareholders, and the auditor reports to the shareholders. It does seem that the provision of other work creates a conflict of interest in the auditors relationship with the shareholders. If the auditor is reluctant to modify his auditors report, the auditor is not acting in the best interests of the shareholders (and other users who rely on the financial statements). Conclusion The arguments for and against allowing auditors to carry out non-audit services for clients are finely balanced. However, listed companies have a large number of shareholders and their financial statements are relied upon by a large number of organisations. Thus, auditors of listed companies have enormous responsibilities when reporting on the financial statements. It is against the interest of these people that the auditors independence could be compromised by the provision of non-audit services. So, on balance, it appears that the final statement of the quotation, that auditors of listed companies should be prevented from providing other services to client companies should apply. Answer 8 MANLY (a) Removal from office (i) Removal by management The financial statements being reported on represent a statement of accountability by management and directors to those on whose behalf they exercise their function, that is the shareholders, in the case of an incorporated business. The ability of management to control the appointment of auditors threatens to undermine the independence of the audit. They can effectively evade an unsatisfactory auditors report by dismissing the auditor. Even where the right to appoint (and remove) auditors is in the hands of shareholders or members, management are often able to influence the exercise of that function. There are a number of safeguards available to auditors to minimise the extent of the problem. Not accepting appointment where there is reason to suspect management might seek to dismiss the auditor to evade an unsatisfactory report. Communicating with predecessor auditors to ascertain if such reasons lie behind the proposed change of auditor. Adhering strictly to professional independence rules to ensure an ability to withstand management threats of removal from office in an attempt to dissuade auditors from modifying their report. Taking full advantage of whatever statutory protection exists against removal from office such as a right to communicate with shareholders where a change in appointment is proposed by management. Adhering to professional rules relating to providing advice to non-audit clients, which might put undue pressure on their auditor. The other firm in this question appears to be acting in breach of this rule. (ii) Audit committee Public companies have many shareholders few of whom take an active interest in its affairs. If they disagreed with the directors proposed change of auditors they would probably sell their shares rather than vote against the resolution. For this reason, companies are encouraged to appoint a number of non-executive directors who are not also involved in the management of the company, and for such directors to constitute themselves as an audit committee. As a sub committee of the board they are entrusted with matters concerning the audit. As ATC-Adding Value To Your Future 7

nonexecutives they are less likely to be critical of auditors who prevent the company from presenting over optimistic financial statements. Existence of an audit committee, therefore, protects auditors against removal from office by management whom they displease. (b) Provision of other services (i) Rules of Professional Conduct An auditor should not provide accountancy services to listed or public interest company audit clients except of a purely mechanical nature such as drafting the statutory financial statements. Where accountancy services are provided to other company audit clients, the client should accept full responsibility for the records, the assistance should not extend to management decision making and a full audit must also be undertaken. In the provision of other services, care must be exercised that the service is limited to providing advice and not the exercise of management functions. This applies particularly in providing executive recruitment services. The service should be limited to identifying a shortlist and not to making the final selection. Other services should not include the making of specialist valuations, which are to be incorporated in the audited financial statements. The provision of non-audit services should not constitute recurring work which brings total fees received from that audit client to more than 15% of the firms gross fee revenues or 10% if the client is a listed or public interest company. The reasons for this are evident from the engagement partners reluctance to qualify the opinion for fear of angering the management and losing the audit. Although not over the limit, fees from the provision of non-audit services are, nevertheless, high. The engagement partners concern is unprofessional and it would be hoped that professional accountants would be more objective. Nevertheless, it illustrates concerns that would arise in the minds of users of financial statements if it is seen that the auditors are generating substantial fee income from providing non-audit services to the companies they audit. (ii) Prohibition of non-audit service provision The Rules of Professional Conduct state that, in principle, there is no objection to providing nonaudit services to audit clients. However, it is also claimed that the provision of such services impairs auditor independence. The alleged scenario is as follows: As auditors, the firm is appointed by and is responsible to the members of the company. In providing other services, the firm is appointed by and is responsible to the management. Because of the advantages of dealing with just one firm of accountants, the management tends to prefer to use the audit firm to provide these other services. If the firm loses the audit, they are likely to lose revenues from the provision of other services. This is clearly the case here and the audit partners judgement is strongly influenced by the potential loss of revenue. The auditors recognise the ability of the management to influence auditor appointment. Where auditors receive revenues from providing non-audit services, as in the case of Manly, it is alleged that management may exploit this fact in order to put pressure on the auditors. Other services often attract higher fees than audit services. Firms may seek to secure audit appointments primarily as a means of obtaining contracts for the provision of more rewarding other services. For these reasons, it is argued, firms should be forbidden to provide non-audit services to audit clients. The profession, on the other hand, argues that quarantining audit from the provision of nonaudit services denies companies the right to select their professional advisers. It also imposes costs in that the audit, necessarily, will become more expensive as will the provision of nonaudit services as the firm providing the services will not have the benefit of knowledge of the company gained through the audit. As professionals, it is argued, accountants will not allow their judgement to be influenced by such considerations and the situation illustrated in the ATC-Adding Value To Your Future 8

question is an unlikely one. Moreover, there is bound to be overlap between audit and nonaudit services such as advice on internal control and related matters contained in the management letter. (c) Rotation Rotation is the term given to limiting the number of years an individual or a firm is associated with the audit of a particular client. Professional ethics recommend that audit staff should not spend too many years associated with the same group of clients. The benefit of understanding of the clients business is outweighed by the possible loss of professional scepticism. In this case the audit partner has known Manlys chief financial officer for too long to be able to entertain ideas that he may not be trustworthy. At a further level it is argued that audit firms should only serve a fixed term of office. The benefits of securing non-audit work from clients are substantially reduced if the term of office as auditor is limited to say seven years. Similarly, efforts to maintain good relations with management possibly to the extent of condoning questionable financial statements would no longer serve a useful purpose. The argument against rotation of audit firms is that it imposes additional costs and risks. It is the first year as auditor that is most costly and also the year the auditor is at greatest risk of failing to detect misstatement through unfamiliarity with the client. Rotation of audit firms is statutorily required in some countries. Answer 9 ABEL & CO (a) Shareholding by staff member While partners are not allowed to hold shares in client companies there is no specific prohibition in the ACCAs Rules of Professional Conduct on the holding of shares in audit clients by audit staff providing the staff members concerned are not personally involved in the audit of such clients. However, some audit firms have adopted a prohibition on the holding of shares in audit clients by audit staff as an in-house rule. The argument that independence is not impaired because the holding is insignificant is incorrect. If the holding is of such a size as is likely to influence the behaviour of the audit staff member, then it is material. If the staff member was allowed to retain the shares then he or she should not have been included in the audit team. If the partner advised the staff member not to sell the shares until after the audit was completed, then this would have been unethical and possibly illegal in that it constitutes insider dealing the use of privileged information to secure a personal advantage in the trading of shares. (b) Management accounting services Preparation of accounting records on behalf of a listed or public interest company is normally prohibited. An exception to this Rule allows such work to be performed in an emergency situation which does not extend beyond the minimum period necessary and where every care was taken that management accepted full responsibility for the work of the audit firms staff member. It is more reasonable, however, to argue that the assignment of a staff member to the position of management accountant is likely to breach the rules on independence. It amounts to a staff member of the firm being engaged in making management decisions on behalf of the client. The firm will thus be reporting on a statement of financial performance in which one of its own employees had played an active part. A user of the financial statements might conclude that ATC-Adding Value To Your Future 9

the audit firm might have an incentive to conspire with management in concealing poor performance attributable, in part, to the actions of its own staff member. Tutorial note: An alternative answer could suggest that the work of the senior in winding up the priors year audit be reviewed by a manager/partner unconnected with the client to confirm that the standard of audit work was not in any way impaired by the knowledge that he was to take up a new position. It could also be considered whether the audit senior could participate in the audit of the current year financial statements (for which he has contributed to the management accounting system). It might be suggested that if the management and financial accounting systems are very independent (as is sometimes the case) then he would not be auditing his own work. However, the personal relationships which have built up over a 3 month period while he has effectively been an employee of the client alone might be sufficient grounds for his removal from the audit team. (c) Advice on controls This raises a controversial area in auditor independence. While the reporting of control weaknesses discovered during the audit is a required procedure, advising on the development of new systems to overcome those weaknesses is seen by some critics as a possible threat to independence. There is both a general and a specific issue. The general issue is that audit firms generate revenues from clients for both audit and non-audit work. However, contracts for nonaudit work are given by management. In performing the audit, the auditors may be reluctant to disagree with management for fear of losing non-audit contracts. The specific issue is that known as self-review. Since the firm designed the new internal control system, there is a presumption, when evaluating control effectiveness at the next audit, that there will be no weaknesses in the system. Rules of Professional Conduct do not prevent auditors from providing non-audit services within the overall fee limit of 15% from any one client. However, they do stress that, in advising the client, the audit firm must not make executive decisions. The implementation of advice is the responsibility of management over which the auditor has no control. At the next audit the auditor must check that the system has been properly put into operation and that it is being operated effectively. (d) Advice to non-audit clients Although Abel and Co are not threatening their own independence their action is in breach of professional rules on second opinions. By offering advice they are prejudicing the independence of the auditors of the company they are advising. This practice is sometimes referred to as opinion shopping and is carried out by companies in order to exert pressure on their existing auditors. This casts doubt about the integrity of this clients management which has implications for the inherent risk assessment of such a client. When invited to provide such advice, professional rules require Abel and Co to communicate directly with the companys auditors to ensure that their advice is based on all available facts relevant to the judgement. Abel and Co are under an ethical responsibility to decline to be nominated as auditors and to write to the company retracting the advice previously given in the light of further information. Answer 10 MELTON MANUFACTURING (a) Investigations and practical and ethical matters to be considered Eligibility the firm should be recognised to provide audit services (eg a firm of Chartered Certified Accountants) and the reporting partner should hold a recognized qualification (eg be a member of the Association of Chartered Certified Accountants and hold a practising certificate). The firm should have adequate professional indemnity insurance (PII) cover. The reason for the change in auditor whether it is just that the directors believe they do not receive a cost effective service from the existing auditor. There may be problems with the level ATC-Adding Value To Your Future 10

of the audit fee or the existing auditor may want to modify his auditors report (which the directors are trying to prevent). Previous years audited accounts. If the auditors report is modified, it indicates that the audit has a higher than normal risk. From these accounts it may be possible to assess: whether the company appears to be having going concern problems (eg by calculating appropriate ratios, eg debt/equity ratio); if there could be weaknesses in the system of internal control (because the company is small or has a dominant proprietor). With a manufacturing company there are likely to be more problems with the valuation of inventory, but there would be less risks over sales and purchases as they are likely to be on credit. There could be problems with obsolete plant and equipment. The size of the audit client and the fee compared with other clients. The Guide to Professional Ethics says that an auditors independence may be compromised if the fee from a single client exceeds 15% of the total practice income (10% for listed and other public interest companies). This does not appear to be a public company, but for a public company the auditor should not normally both prepare and audit the financial statements. For other companies, if the auditor both prepares and audits the financial statements, it is desirable that these are carried out by different staff. Independence issues in particular, shares should not be held in the client company. (Any shareholdings should be disposed before being appointed as auditor.) Close family and business relationship with any directors of the company would also impair objectivity. Fees should be sufficient to provide an acceptable return. An inadequate fee could result in insufficient audit work being carried out and thus increase the audit risk. Prior experience of the manufacturing industry and auditing companies in this industry. Without such experience the auditor may not have the skills necessary to audit inventory, impairment of plant and equipment, etc. Thus, the invitation to accept the audit appointment would need to be declined. Whether staff with special skills (eg of computer-aided manufacturing design) or external specialists may be required to carry out certain aspects of the audit. Whether Melton Manufacturing will give permission to communicate in writing with the retiring auditor. If the prospective client refuses, the nomination should be refused. With permission, the retiring auditor will be contacted and asked if there are any professional reasons why the appointment should not be accepted. If the company has not paid the retiring auditors fees, the appointment can be accepted. However, if it suggests that Melton is a bad payer it can obviously be declined. (b) Letter of engagement (i) Importance The main reason why it is important that an auditor should send a letter of engagement to the client is that it explains the duties of the auditor: and the contract, which exists between the auditor and the client. If no letter of engagement is sent, disputes and misunderstandings may arise about the auditors duties. The letter of engagement explains that the auditors duties are governed by the relevant legislation and cannot be limited by the company. Also, the auditor reports to the shareholders (and not the directors) whether the financial statements show a true and fair view. Further, it explains the directors responsibilities, particularly that they are responsible for preparing the financial statements (although the auditor can prepare the financial statements for the directors, if requested) and for ensuring there are proper systems of internal control to prevent or detect errors, irregularities and fraud. The auditors are only responsible for giving an opinion on the financial statements. They are not responsible for detecting small errors and fraud, but their audit procedures should have a reasonable expectation of detecting material errors and fraud. Finally, the engagement letter explains that the fee is based on the time spent by partners and staff in carrying out the audit. ATC-Adding Value To Your Future 11

It is important that the auditor obtains the directors agreement of the letter of engagement and that a revised letter is sent when there are significant changes to the terms of the existing letter. (ii) Main contents The letter is written on the auditors headed paper and is addressed to the directors of Melton Manufacturing. It states the directors responsibilities for keeping proper accounting records and for preparing financial statements which show a true and fair view. The directors must make available to the auditor all the records he may reasonably require, and provide answers to the auditors questions. The auditor has a duty to report on whether the financial statements show a true and fair view and comply with any relevant legislation. Normally, the auditor would report if the financial statements do not comply in any material respect with accounting standards (IASs). The audit is conducted in accordance with Auditing Standards (ISAs). Oral or written representations may be asked from the directors concerning various matters in the financial statements. The directors are responsible for preventing and detecting irregularities and fraud. The audit procedures would be designed so there is a reasonable expectation of detecting material misstatements in the financial statements: However, the audit should not be relied upon for detecting all irregularities and fraud that may exist. As auditor, we may provide additional services. For example: Preparing financial statements; Lodging returns with the Registrar of Companies; Investigating irregularities and fraud; Providing taxation services. Fees are based on the time spent by partners and staff and on the levels of skill and responsibility involved. The letter ends by saying that it remains effective until it is replaced, and it asks the directors to agree the terms of the letter in writing. Answer 11 BONDI (a) Arguments against acceptance of nomination Rapid growth is often accompanied by inadequate accounting systems and weak internal controls. Of itself this is not sufficient reason to decline an audit but it increases inherent risk. Rapid growth through aggressive take-overs implies a management philosophy that is willing to accept risks and this is likely to apply to controls as well. Again this increases inherent risk. Failure to take action against employee fraud brought to their notice by the auditors is more serious. This fosters a visible culture of unethical behaviour that is likely to permeate the company and to be shared by all employees. This will result in a weak control environment. Introduction of a new computer system must be undertaken very carefully. In addition, an unnecessarily complicated system is one of the warning signs of fraud. Such a computer system may be difficult to audit. Aggression against audit staff is a well known device for concealment of top management fraud. There are many documented examples of audit failure through fear of the audit staff to query management explanations. The impending public listing means that the company is under pressure to show an improving performance but also means that the work of the auditor will come under increasing scrutiny. There are always significant risks in accepting an audit under such terms. Arguments for accepting nomination ATC-Adding Value To Your Future 12

As a larger firm your firm is likely to have the capability of influencing the directors of Bondi and persuading them of the benefits of a more ethical style of business. This will benefit the companys shareholders. If your firm rejects the audit they are likely to appoint a less reputable firm. This will not be in the shareholders interest and may discredit the profession. (b) Matters relevant to obtaining knowledge for development of the audit plan Employee frauds More information is needed about the alleged employee frauds. In particular the specific control weaknesses that were exploited and whether any changes have since been made to the accounting and internal control systems. The current positions held by the guilty employees and whether they have access to assets and accounting records. Also, whether they are adequately supervised especially if a lack of segregation of duties is apparent. Computer system Particular attention should be given to the control environment relating to computer systems and to the evaluation of general (IT) and application controls. The audit team should include sufficient computer audit specialists. Tests of controls could include the use of test data or other computer assisted audit techniques. Contracts with manufacturers Examine the terms of contracts and the strategies adopted by the company for securing maximum benefit from them. An industry specialist may provide evidence regarding the problems encountered by manufacturers and dealers in confirming compliance with these contracts. As the incentive schemes may have accounting implications (eg 0% finance) the commercial substance as well as the legal form of the transactions with the manufactures must be understood and the impact on the financial statements assessed. (c) Misstatement As this appears to be a fraud against the government through falsification of accounting records, the evidence that the falsification of the records is deliberate and not an accidental consequence of a poorly designed computer system, must be documented. The matter must be discussed with management. Management must be asked to: correct the fictitious records; make full provision for all taxes including any penalties for which they are potentially liable; and make a full disclosure to the taxation authorities. If management refuse, the audit opinion should be qualified if the amount of taxes not provided for, if material. (However, the auditors report should not, for example, accuse the directors of impropriety.) The auditors duty of confidentiality prevents the auditor from raising the matter with the taxation authorities. Therefore, it may be most appropriate to resign from the audit if management refuse to put a stop to the malpractice. Any written statement of circumstances required on ceasing to hold office could allude to the matter but would need to be carefully ATC-Adding Value To Your Future 13

worded, probably with legal advice, to avoid accusing the directors of fraud and exposing the firm to a charge of defamation. Answer 12 PLANNING DOCUMENTATION (a) Overall audit plan v Audit program These documents are prepared during the planning process. The general strategy to the audit assignment is first set out in the overall audit plan. The detailed approach for the nature, timing and extent of the audit procedures is set out in the audit program. The overall audit plan considers those factors which underlie the conduct of the audit as a whole such as the nature and location of the business, whether systems are computerised, risk and materiality, and use of the work of others (eg internal audit and experts). The plan typically contains significant information such as: Terms of engagement scope of the audit and any other services to be provided; Key figures, ratios and indicators and the basis on which materiality is determined at the financial statements level; Client assistance including preparation of working papers, branch visits, etc; Audit approach extent to which reliance is likely to be placed on tests of control, analytical procedures and tests of detail; Timetable, including attendance at physical inventory counting, direct confirmation dates and reporting deadlines. Staffing requirements with time budget and estimate of audit fee. The audit program is more specific and concerns the principal audit areas. Fore example, tangible assets, inventory, revenue cycle (ie sales, receivables and cash receipts), etc. A program typically contains: Audit objectives eg To ensure inventory is materially correctly stated; Audit procedures eg attendance at physical inventory count; Timing of tests of control (usually interim audit procedures) and substantive procedures (usually at the final audit). The audit program has to be much more detailed than the overall audit plan in order to serve as a set of instructions. (b) Standardized audit programs Tutorial note: The Q refers only to the use of standardized AUDIT PROGRAMS and not working papers in general. Thus references to the use of standard letters and documentation other than programs are not relevant to answering the question set. Advantages Their use can lead to more efficient planning in identifying the audit objectives and adopting an approach based on these objectives. Greater assurance as to the completeness of the audit approach is obtained than if it were started from scratch. Planning can be undertaken by less senior staff. Standardised programmes facilitate delegation to junior staff and help to instruct in basic audit techniques. They help to ensure that all assignments are planned and conducted to a consistent quality. A standardised approach makes the review of audit working papers easier. Programmes may include sections to be completed, thereby reducing the need for separate supporting working papers. ATC-Adding Value To Your Future 14

Disadvantages Standardisation may lead to an overly mechanical approach. This may stifle initiative because an alternative, more efficient approach may not be considered. No account is taken of the particular circumstances of the individual enterprise. This decrease in the use of professional judgement for a particular assignment might result in over-auditing low risk or immaterial areas. There is a risk that sufficient, relevant and reliable audit evidence may not be obtained. For example, where alternatives to tests not applicable to a particular client, are not considered. Conclusion Standard audit programmes may be useful on certain assignments to improve audit efficiency but they cannot replace the need for professional judgement. (c) Information in working papers relating to attendance at physical inventory count Viewcos physical count arrangements and instructions should be obtained before attending the count: to assess the adequacy of the clients planned procedures; and to ascertain whether clients staff are carrying out their instructions properly. Pre-selected (eg high value) items chosen to ensure that an adequate proportion of the final inventory value is tested (to conclude satisfactorily on the population). Results of test counts (ie serial/component references and quantities) provide evidence as to the completeness and accuracy (or otherwise) of the count records (ie rough count sheets). Test counts also enable the auditor to assess whether the clients count procedures and controls are working properly. The sequence of rough count sheets issued and used will detect any additional items being included subsequent to attending the count. Inventories identified as damaged, obsolete or slow-moving must be detailed to assess the adequacy of allowances/provisions for items with net realisable value less than cost. Items owned by third parties must be recorded to ensure exclusion from the final inventory valuation sheets. Last goods movement document references for 31 December 2003 (ie goods received note, stores requisition, despatch note/sales invoice) are needed to check the accuracy of the yearend cutoff. Movements, if any, during physical inventory counting to ensure items are not omitted or double-counted in error. Other points A floor plan (sketch) of central warehouse should ensure complete coverage (by management and auditor) of the physical inventory count. Details (eg serial numbers) of finished goods held by third parties are required to confirm the validity of their inclusion in the final inventory value. The degree of assembly of incomplete TVs and VRs must be noted to assess appropriateness of stage of completion used in valuing WIP. Instances where the clients procedures have not been satisfactorily carried out (eg damaged items not set aside) will be required for the report to management with recommendations for improvements (eg in standing instructions for physical counts). ATC-Adding Value To Your Future 15

Answer 13 BESTWOOD TRADING (a) Audit working papers (i) Contents The permanent audit file contains information which is relevant to many years audits. Its contents can include: the letter of engagement; the memorandum and articles of the company; a history of the company, a description of its business and details of directors and senior staff; copies of previous years financial statements with ratio analysis and comment on the figures; AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1027 details of the companys accounting systems, flowcharts of those systems and completed Internal Control Evaluation Questionnaires (ICEs) or Internal Control Questionnaires (ICQs); copies of significant documents, including minutes of significant board meetings. The current audit fire contains documents which are relevant to the current years audit. This information includes: evidence of planning of the audit including the audit planning memorandum; copies of board minutes, significant management reports, management accounts, the trial balance and draft financial statements. There should be a reconciliation of any difference in profit between the draft financial statements and the management accounts; consideration of audit risk for each area of the audit. This could include notes on high risk areas of the audit and decisions on sample sizes; copies of flowcharts and completed ICQs or ICEs if they are not included in the permanent audit file; Tutorial note: It may be preferable to include flowcharts and ICEs or ICQs in the current audit file when there are changes to the systems in the year. the results of evaluation of controls supporting the assessed level of control risk; records of the audit work done, problems encountered and conclusions reached (see below); by whom the schedules have been prepared and reviewed (as evidenced by their initials) and when (ie date); a section for the managers and partners attention which lists significant problems encountered in the audit. This will include a summary of unadjusted errors. This section will direct the partner to these important areas, and to decide whether the financial statements need amending or a qualified auditors report should be given. (ii) Referencing system Recording audit work in working papers is usually divided into sections which have a reference letter or number. For instance, the letter R could be used for Sales and Receivables work. Thus, for any audit carried out by the firm, any member of staff wanting to look at audit work on Sales or Receivables can go to the section with the letter R. Within each section, there will be a sub-division whereby verification of receivables will be in pages Rl to 099 and audit work on the sales system will be on pages R100 to R199 (ie tests on balance sheet items will be on pages 1-99 and tests on accounting systems will be on pages 100-199 these numbers will be preceded by a letter which signifies the area of the audit, with R being for sales and receivables). The front page of the R section of the audit file will show the value of receivables in the balance sheet, and references on the make-up of receivables will be to the pages where details of verification of these items is included in the working papers. For instance, the total value of receivables will be broken down into: verifying the gross value of trade receivables (eg on page R2 of the audit file); checking the bad and doubtful debt provision (eg on page R5); audit of sundry receivables and prepayments (eg on page R10). ATC-Adding Value To Your Future 16

AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1028 By using this standardized procedure for referencing audit files, all members of the firms audit staff, including managers and partners can review each section of the audit in a systematic manner. This should enable them to come to an appropriate conclusion on the audit work done and the form of auditors report which should be attached to the financial statements. If no standardized procedure is used. the partner would find it time-consuming to find a particular matter in the audit file. By standardizing audit files, the audit work should be carried out in a more systematic manner which should ensure a high quality audit is carried out. Particularly important sections in audit files include: conclusions reached in each area of the audit and notes of any significant problems detected; matters for consideration by the partner and the summary of unadjusted errors (which should include significant uncertainties). (iii) Types of checklists Internal control evaluation questionnaires (ICE) and internal control questionnaires (ICQ) for evaluating controls in accounting systems. Physical inventory count checklists which are used to record work done and to ensure all aspects are covered. Companies Act and International Financial Reporting Standards checklists to ensure the financial statements comply with relevant statutory and professional requirements. Audit completion checklists to help the auditor ensure all material audit work has been performed and matters considered. Checklists are important, as they are a means of ensuring that all aspects of the audit work are carried out. A standard ICE on the sales system would be better than one prepared for each audit, as the standard ICE will be tried and tested so there will be a lower risk of a matter being omitted than if the checklist was prepared by the auditor at each audit. Types of specimen letters The engagement letter which the auditor should send to the client (and get agreed by the client) before the audit is accepted. The contents of this letter should be reviewed and a new one issued and agreed when there are significant changes in the auditors responsibilities. Management letters which are letters sent by the auditor to the company recording weaknesses found in the audit. Management representation letter which is a letter drafted by the auditor, but on the companys letter heading and signed by the directors. It is used to enable the directors to confirm to the auditor certain matters where the auditor cannot obtain adequate evidence from other sources. Bank letter, where the bank states the balances on the companys bank accounts and other matters. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1029 Direct confirmation letters from customers. The circularisation letter asks customers of the company to confirm (or otherwise) the balance on the sales ledger. (b) Reasons why auditors have working papers As a record of work performed on the audit, and to ensure a consistent, logical and reasoned approach to audit work by following an audit plan and recording work performed as the audit progresses. To assist the manager in reviewing the audit work, and the partner in coming to an audit opinion. The audit working papers will provide evidence to the partner of work done. From the working papers it may become apparent that insufficient work has been carried out in certain areas and more work is required. To provide evidence of work done if there is a threat of or action taken against the auditor for negligence. The audit working papers should provide evidence that ATC-Adding Value To Your Future 17

appropriate audit procedures have been carried out and conclusions reached, In the case of a material doubtful debt, should show the evidence the auditor has obtained and the matters he has considered in deciding whether the companys estimate of the bad debt provision is reasonable. Generally, all audit work should be recorded in the audit working papers. Work performed on some immaterial items may not be included. However, as is noted in part (c) below, it is desirable that all audit work is recorded, as an item which may appear to be immaterial may subsequently become material. For instance, an item which is checked in a test of controls may not in itself be material, but an error detected in a test will probably be material in terms of the conclusion reached on the population (using statistics). To a certain extent, audit working papers are a summary of work done. So a check performed in a test of control may be signified by an audit tick against the item, and the tick will be explained at the bottom of the schedule. If some audit work is thought to be unimportant (and thus there is the possibility of it not being recorded) the auditor should consider whether it is necessary to carry out that work. It is important to record audit work as, if legal action is taken against the audit firm, it may be necessary for the firm to demonstrate that items have been checked and support the conclusions reached. (c) Late banking of cash receipts If the late banking of receipts of $7,000 was a fraud at 31 October 2002, this is 4.4% of profit before tax, so it is unlikely to be material. When the fraud was found in May 2003, it amounted to 11.25% of profit before tax which is probably material. If the auditor did not report the late banking to the company which he found at 31 October 2002, then he could be held (partially) responsible for the loss between 31 October 2002 and when it was found in May 2003. The loss during this period is $11,000, or 6.9% of profit before tax, which may be material. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1030 (i) Reported in the management letter It appears the auditor is not negligent. The only matters which might be unsatisfactory in the auditors work are: it appears he has not determined whether a fraud was being carried out at 31 October 2002; and the company should have been informed immediately at the time the discrepancy was found, rather than leaving it to the management letter. However, both of these criticisms of the auditor appear to be relatively minor. It may not be possible at todays date to determine whether there was fraud at 31 October 2002, as the $7,000 of late banking could have been held by the cashier (although this seems unlikely). In conclusion, the auditor is probably not liable for negligence in this situation. The company has been warned of the risk of a fraud but appears to have taken no action until May 2003. (ii) Not mentioned in the management letter In this situation, the auditor may have some liability for negligence. The late banking of deposits should have been reported to the company both verbally and in the auditors management letter. Also, the auditor should have been put upon enquiry by the delay and investigated the matter further as at 31 October 2002 (or at the date he checked the bank reconciliation). Thus, the auditor has some liability for negligence for not reporting the matter to the companys management and not carrying out further procedures. The auditor could argue the possible fraud at 31 October 2002 was immaterial as it is 4.4% of profit before tax, but by taking no action on the matter it has increased to 11.25% of profit before tax, which is material. The auditor should not be held wholly responsible for the extra loss of $11,000 (between 31 October 2002 and May 2003) as it is probable that the companys control procedures were inadequate. As the cashier was recording cash received and preparing the bank reconciliation as well as having custody of the cash received there was an inadequate division of duties, so another person in the company should either have prepared the bank reconciliation or checked it. It is apparent that either this check was not being performed or it was not performed competently. As the auditor was aware of the late ATC-Adding Value To Your Future 18

banking of $7,000 of cash receipts and he should have been aware of the weakness in control over the cashier, the auditor should have reported these problems to the company, even though the fraud was immaterial at the time of the audit. Thus, in this situation, the auditor has some liability for the fraud continuing but this is mitigated by the fact that there was a clear weakness in the division of duties with the cashier, and the company should have established an effective system of internal check over the cashiers work. This was either not being performed or not being performed competently. Thus, the company must accept some liability for the fraud developing. If the case came to court, reference will probably be made to the audit working papers as one factor in determining the extent of the auditors liability for negligence. Answer 15 PHONES ANYWHERE (a) Risks associated with the audit There appear to be considerable risks associated with undertaking the audit. In particular; Phones Anywhere appears to have a very high inherent risk. The low coverage of the country will be a disincentive to new subscribers. Initially, subscribers will only be those who operate in the town with a population of 1,000,000. The service will not be available when the subscribers are outside that town. There will be serious doubts about going concern if the company does not have the financial resources for future developments (to towns with a population of 250,000 in the next year and its planned developments to the year 2006). The companys plans for extending the network do not appear to be realistic, as many mobile phones are used on motorways and trunk roads. Motorways will not be covered until the year 2006, and coverage of other roads is not mentioned. These plans are likely to be a serious disincentive to new subscribers joining the system, when competitors cover most of the country. The risk of business failure appears to be high. The central computer is pivotal to the organization, as it relays the calls and calculates the bills for subscribers. Will this computer and its software be reliable? The consequences of a breakdown of the computer will be very serious. Ideally, there should be more than one computer running the system, and the system should be able to continue if one of the computers fails. What is the capacity of the main computer? With the planned expansion, it is probable that it will run out of capacity in the near future. Is it possible to expand the capacity of the computer? Has the cost of upgrading the computer been included in future forecasts? Will the current software be able to process a large increase in subscribers, or will it have to be re-written (at substantial cost)? Is it reasonable to amortise the cost of the relay stations and main computer over six years? Six years may be realistic for the buildings part of capital expenditure, but it may be too long for electronic components including the main computer and transmitters. Is the discount paid to retailers for the purchase of the phones recoverable? It is capitalised and amortised over four years. Do subscribers remain connected to a single operator for as long as four years (if many change in less than four years, this amortisation period is too long), and are subscribers likely to change their phones within four years (to update to a more advanced model)? Paying the executive directors a bonus based on the number of subscribers of the system could encourage them to obtain as many subscribers as possible (by offering discounted prices) rather than charging a realistic price which will ensure the long term future of the company. However, the executive directors should be concerned with the long-term future of the company, as this will ensure they continue to be paid (rather than have to find a new job when the company fails). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1035 In view of the planned high borrowings, and future trading losses, there is a very serious risk the company may not be a going concern. This increases the risk of the ATC-Adding Value To Your Future 19

audit firm being sued for negligence. Also, Phones Anywhere will put severe pressure on the audit firm to give an unmodified auditors report. This pressure will increase because the audit firm is small and Phones Anywhere is a relatively large and rapidly growing company. As an alternative to the company not being a going concern, there is the risk that other investors may purchase more shares in the company (to provide additional equity finance) or purchase the company outright from the existing directors (or the administrator/liquidator). If this occurs, recent financial statements will be subject to close scrutiny. The standard of audit work will have to be high, and the problems mentioned above (eg complex computer systems and depreciation rates which may be inaccurate) could lead to undetected material errors in the financial statements. Thus, there is a high risk that legal action for negligence could be taken against the audit firm following a take-over or purchase of shares. Flotation of the company on the Stock Exchange is a further risk. Immediately prior to the flotation, audit work carried out will be subject to close scrutiny. The increase in audit risk must be reduced by an increase in audit work (to reduce detection risk) increasing the cost of the audit and reducing its profitability. Also, when the company becomes quoted on the Stock Exchange, it is probable the audit firm will be replaced as being too small. The majority of companies quoted on recognised Stock Exchange are audited by one of the big 5 firms. This is a high technology industry. The technology or customer requirements may change, which could make parts of the equipment obsolete. Alternatively, it could be expensive to modify the equipment or software to meet the demands of subscribers. Is the company currently providing a similar range of facilities to other mobile phone companies. If its service is not as comprehensive as other mobile phone companies, it may not be successful in breaking into the market. This appears to be a very competitive industry. Are the competitors profitable, or are they making losses to keep prices low to prevent other companies entering the market? Establishing Phones Anywhere as a major company in the market will probably require large expenditure on advertising and offering new subscribers a service at a lower price than competitors. Both of these factors will tend to make Phones Anywhere unprofitable (as note (j) in the question suggests). The reputation of the three major shareholders and the executive directors should be assessed. If they have been directors of companies which have failed, or been involved in financial or other wrongdoings, this will increase the inherent risk. The reputation of the financial director and the quality of the accounting records should also be considered. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1036 (b) Professional and ethical matters The size of the audit fee. The Association of Chartered Certified Accountants (ACCA) rules of professional conduct say the fees for audit and other recurring work paid by one client should not normally exceed I5% of the gross practice income (and 10% for listed and other public interest companies). If the planned audit fee is over 15% of the current practice income, the audit should not be accepted. However, the rate of expansion of Phones Anywhere will probably be much greater than the increase in practice income, so the 15% rule may become a problem in the next few years. When Phones Anywhere becomes a listed company in the year 2006, the audit fee from Phones Anywhere must be less than 10% of the fees of the practice. It seems probable that this limit of 10% will be exceeded. In practice, it is undesirable for the audit fee to approach 15% of the practice income, as reliance on such a large audit fee could be seen to affect the firms independence. The audit firm may be able to audit Phones Anywhere at its current size. However, when the system covers all towns with a population of over 250,000, on occasions audit work will probably have to cover all areas of the country, and it is most unlikely that the audit firm will have sufficient staff to perform this work. ATC-Adding Value To Your Future 20

Whether the firm is technically competent to perform the audit, and whether the size of the firm being audited is too large for the experience of the practice. Mobile telephone companies are very complex and have specialised accounting procedures; both in terms of the accounting system and the ways matters are treated in the financial statements (eg the advance payment of $200 given towards the purchase of phones purchased by new subscribers). The firm will probably not have experience in auditing the computerised accounting system which controls calls and generates bills for subscribers. This requires specialised computer auditing techniques. The firm may also be unfamiliar with many of the accounting treatments for non-current assets and may not be able to determine whether the lives given to non-current assets are reasonable. This lack of experience will probably mean that the audit will be too high a risk for the audit firm (ie the firms relative inexperience will mean that a satisfactory audit cannot be carried out, so there will be a high risk of material misstatements in the financial statements, which increases the risk of litigation being brought against the firm). The audit firm must have adequate professional indemnity insurance (PII) cover. This is unlikely in view of the size of Phones Anywhere, so there will be an increased cost of obtaining more PII cover. The insurance company may refuse to increase the PII cover if it perceives this to be a high risk audit which is exacerbated by the small size of the firm. Other matters The audit partners must have no family or personal relationships with the directors of Phones Anywhere. These relationships also apply to any staff involved in the audit. Ideally, none of the firms staff should have relationships with the directors of Phones Anywhere. No one in the audit firm should own shares or any investments in Phones Anywhere. No one in the audit firm should be a beneficiary or trustee of a trust which holds shares in Phones Anywhere. The ACCAs rules of professional conduct do allow employees of the audit firm to be a beneficiary of shares in an audit client, but that employee must not be employed on the audit of that client. For trustees, the trust should hold less than 10% of the shares of the company, and the value of the shares should be less than 10% of the total assets of the trust. Employees and partners of the audit firm must not vote on the appointment, removal or remuneration of a firm which is an audit client. The audit firm should not make a loan to or accept a loan from an audit client (exceptions to this rule apply where the audit client is a bank or other financial institution which does not appear to apply in this case). The audit fee has been considered earlier in this section. However, the audit fee should be sufficient for the firm to perform the audit to a satisfactory standard. Thus, it would not be acceptable to offer a very low fee (often called lowballing) in order to obtain the audit, as this would impose pressure on the time allowed to carry out the audit. This could lead to inadequate audit work being carried out which would increase the risk that material misstatements in the financial statements may not be detected. Other matters covered by the ACCAs rules of Professional Conduct When the audit firm is asked to accept the audit appointment, the clients permission to communicate with the existing auditor must be sought. If this permission is refused, the firm should decline to accept appointment as auditor. The audit firm should write to the existing auditor requesting all the information which ought to be made available to decide whether or not to accept the audit appointment. The audit firm should consider the reply from the existing auditor. If the existing auditor makes adverse comments, further consideration should be given whether or not to accept the audit appointment. If the existing auditor does not reply to the letter, a further letter should be sent ATC-Adding Value To Your Future 21

giving notice (eg seven days) that if no reply is received in that time, it is understood that there are no professional or other reasons preventing the firm from accepting the audit appointment. Before finally accepting the audit, a letter of engagement should be prepared and the directors of Phones Anywhere asked to sign it. (c) Conclusion From the discussion above, the firm should not offer itself nor accept the appointment as auditor of Phones Anywhere. The main reasons for this decision are: Phones Anywhere appears to be too large a company for the firm to audit, and it is likely to grow faster than the audit firm. The audit fee will probably exceed the ACCAs limit of 15% of the practice income, and if this is not exceeded now, it is likely to be exceeded in the next few years. Phones Anywhere is a specialised company with complex computer systems. It is possible the firm will not have the skills to perform this work. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1038 The accounting conventions for Phones Anywhere may be unfamiliar to a small firm, particularly the treatment of the $200 given to new subscribers to purchase the phones and the lives of the non-current assets. If the firm doe not have the skills to consider whether these treatments are satisfactory this could lead material misstatements in the financial statements being undetected. Phones Anywhere appears to be undercapitalised. Currently, leverage is 20% but this will increase substantially with expansion of the network and losses in early years of trading. Thus, there is a serious risk that Phones Anywhere will fail or be taken over, which could result in the firm being sued for negligence. The large size of Phones Anywhere and the small size of the audit firm could compromise the firms independence. Third parties (including shareholders) will perceive that the firm is not independent (on the relative size criteria), and Phones Anywhere could bring severe pressure on the firm which would be hard to resist (ie they will ask for an unmodified auditors report to be given when either a qualified opinion should be given or an emphasis of matter paragraph included). The potential listing of the company on the Stock Exchange increases the audit risk, as there will be greater scrutiny of the financial statements prior to listing, which could highlight problems in the financial statements. Finally, because of the large size of Phones Anywhere and the large audit fee, Phones Anywhere may attempt to squeeze the audit fee. Accepting a reduced audit fee (rather than losing altogether such a large audit fee) could result in a reduction in the time to perform the audit and thus increase the risk of not detecting material misstatements in the financial statements. Answer 16 BRIDGFORD PRODUCTS (a) Importance of planning ISA 300 Planning requires that The auditor should plan the audit work so that the audit will be performed in an effective manner. It goes on to say that planning means developing a general strategy and a detailed approach for the expected nature, timing and extent of the audit. As this is a continuing audit, the general strategy will probably be similar to last years audit. However it will be modified by problems experienced in last years audit and significant events which have taken place in the company since last years audit. The timing of the audit work is important, as time will be wasted if it is planned to carry out audit work when the appropriate information is not available from the company. The timing of the audit work will influence the make-up of the audit staff during the audit (ie the balance between junior and experienced audit staff). It will be necessary to agree a timetable with the company of when information will be available and this will determine ATC-Adding Value To Your Future 22

when the audit work is carried out. Also, the following dates will be important: the inventory count when the full financial statements are available for audit when the financial statements are agreed and signed by the directors and the auditor the date of the annual general meeting when the financial statements are approved by the shareholders. The extent of the audit work in each area will have to be considered. This will be based on a number of factors, including the materiality of the item and the audit risk based on experience in previous years audits. A budget will be prepared which suggests the time which should be spent on each aspect of the audit and the completion dates of each part of the audit. During the audit, progress will be compared with the audit plan. Any adverse (and favourable) variances against the plan will be investigated, and the plan amended if it is considered appropriate. Planning an audit is important. One would not build a house without a plan, so one should not carry out an audit without a plan. The requirement to plan an audit ensures senior audit staff have considered the work which is required to complete the audit, and the timing of that work so that it fits in with the dates information is available from the company and the planned completion date when the financial statements are approved by the directors and the auditor. By having a plan, the auditor should take a more considered approach to the audit which will improve the quality of the audit, and thus both minimise the time spent on the audit and the overall audit risk. When the audit is carried out, the progress can be monitored against the plan, and action taken when the audit starts to take more time than expected, both in terms of staff time and in reaching deadlines. (b) Matters to be considered and further action (i) Sales and profits The companys sales for 10 months are $130 million, which given an annualised sales of $156 million, is a 41.8% increase over the previous years. The annualised profit before tax is $4.8 million, compared with $8 million last year, which is a fall of 40%. It appears the company is increasing sales at the expense of profits. If profits are falling, the actual profit for the 10 months to 30 November 2003 may be even less than the $4 million shown by the monthly accounts. The fall in profit indicates problems which may not be fully reflected in the monthly accounts (ii) New computerised inventory system Audit work will have to be carried out on the new computerised inventory control system. Computer audit specialists within the audit firm will probably have to be used. It may be appropriate to carry out this work before the year end, so that any problems with the system can be highlighted and either overcome or allowed for at the year end. The company says it will not be carrying out an inventory count at the year end, so as auditor I will have to place considerable reliance on the accuracy of the inventory quantities reported by the inventory control system. I will have to determine from the company how frequently they count the inventory, the proportion of the inventory counted at each inventory count, and the checks they make to the inventory quantities on the computerised system. If there are a large number of differences between the physical inventory quantities and those on the computer, inventory counts should be carried out more frequently and on a larger proportion of the inventory than if differences are infrequent. This information will have to be determined before the year end, as, if differences are frequent, it may be necessary to carry out a full inventory count at the year end. Otherwise, there is a high risk the auditors report will have to be modified. (iii) Product reliability Reliability problems with the companys products could result in the following: Certain inventory being unsaleable, and thus worth less than cost (or even being worth only scrap value); ATC-Adding Value To Your Future


Legal claims against the company; Customers not paying for the products. Tutorial note: These last two points are mentioned in the question. Further details will have to be obtained about legal claims against the company and customers refusing to pay their outstanding balances. Information can be obtained for this by inspecting correspondence with customers and discussing the matter with the companys staff, including the company secretary, sales director and the credit controller. The audit risks with these problems include: The difficulty in estimating the costs (ie the costs of defending legal claims and damages which may have to be paid, and the cost of the bad debts). The risk that there may be more claims and bad debts, which relate to the year under review, but may not become apparent until after the auditors report is signed. The value of the faulty inventory held at the year end. The selling price of inventory sold between the year end and the audit will have to be checked to ensure it is valued at the lower of cost and net realisable value. There may be problems determining the value of year-end inventory which is still held at the time of the audit. (iv) Extended credit The large increase in receivables age will have resulted in a large increase in receivables, from $14.7 million at 31 January 2003 to an estimated $53.3 million at 31 January 2004. The increase of $38.6 million will probably have come from increased borrowings. Thus, the increase in the credit period and sales to new customers will result in the following audit risks: New customers tend to have a higher risk than existing ones, thus increasing the risk of bad debts Increasing the credit period tends to attract customers who are a poor credit risk. This is for two reasons: (1) the longer credit limit will reduce the customers cash flow problems; and (2) it attracts customers who already have cash flow problems, as these customers are unable to pay other vendors within the shorter credit period (eg the one month credit period previously allowed by Bridgford) A potential bad debt, or dispute about a faulty product, may not become apparent until after the credit period is being exceeded. Thus, it will probably take at least three months before the doubtful receivable becomes apparent, rather than the one month with the previous credit period. So, doubtful receivables from sales immediately prior to the year end may not become apparent until after the auditors report has been signed. In addition, the actual age of receivables is 1.1 months in excess of the current credit limit (of three months) compared with 0.6 months over the credit limit in the previous year. This indicates there may be problems with collection of receivables from customers and thus an increase in bad debts. With the large increase in receivables, the company is probably experiencing liquidity problems. Are the companys borrowing facilities adequate, and is there a risk the company may not be a going concern? (v) Staff dismissals The reasons for the dismissal of the chief financial officer and purchasing manager will have to be ascertained. Were they carrying out a fraud (separately or together)? or were they contravening financial procedures? If this was happening, what are the financial consequences? Is it possible for this type of fraud to recur? Could our audit firm be liable for not detecting these events? If the dismissed employees are claiming unfair dismissal and compensation from the company, the likely outcome from these claims would have to be investigated and an appropriate provision included in the financial statements. This could be a high risk area of the audit. In addition, I will have to consider the consequences of the company being without a purchasing manager from IS August until the new purchasing manager was appointed. There ATC-Adding Value To Your Future 24

is the risk that controls during this period will have been weaker than normal, thus increasing the risk of a fraud. The new purchasing manager will take time to become effective in his post, which could increase the risk of fraud. Also, the wrong products may be purchased, or products may be purchased at an inflated price. This could mean that some products in inventory at the year end may be worth less than cost. The effect of there being no chief financial officer between 15 August and the year end may mean that financial records and controls may not be as effective as in previous years. The chief accountant will probably be much busier than when there was a chief financial officer which could mean that, with less time to prepare the financial statements, the annual accounts are less accurate and less complete. If the chief financial officer prepared the annual draft financial statements in previous years, does the chief accountant have the skills and experience to prepare this years financial statements? Answer 17 ISA 400 RISK ASSESSMENTS (a) Inherent risk at the entity level At this level inherent risk relates to factors affecting the susceptibility to misstatement of all account balances or transactions classes. In assessing inherent risk at the entity level the auditors will consider factors such as: the integrity of management that might predispose them to misstate the financial statements or creates a culture within which misstatement is likely to occur; management experience and knowledge such as in making necessary estimates and judgements affecting the financial statements; pressure on management that might predispose them to misstate the financial statements such as a failure to achieve announced profit targets; the nature of the entity, such as the technology of its products or processes, its capital structure or its geographical spread that complicates the process of identifying truth and fairness in financial reporting; factors affecting the industry within which the entity operates that, in turn, could magnify the effect of the above factors such as increased competitiveness, regulatory requirements, etc. Inherent risk at the account balance and class of transactions level Inherent risk at this level relates to factors peculiar to that account balance or transaction class that affect its risk of misstatement relative to other account balances and transactions classes. The auditors will consider factors such as: account balances susceptible to misstatement such as those requiring adjustment in the past or involving a high degree of estimation; complexity of underlying transactions which might require using the work of an expert; degree of judgement involved; susceptibility of assets to loss or misappropriation, notably cash and attractive assets which are highly desirable; completion of unusual or complex transactions particularly at or near period end; transactions not subject to ordinary processing. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1043 (b) Factors affecting extent of substantive procedures (i) Preliminary assessment of control risk mix of control and substantive procedures The auditor uses the understanding of the accounting and internal control system together with other information to form a preliminary assessment of inherent and control risk. If these are assessed as high then all of the evidence needed to reduce audit risk to the level required for the expression of an opinion on the financial statements must be derived through substantive procedures. Where the assessed level is less than high the auditor may tolerate a higher level of detection risk in performing substantive procedures. In order to substantiate the assessment of control risk as less than high, however, the auditor will need to perform tests of the controls to confirm that they are operating satisfactorily. Since tests of controls are generally less costly ATC-Adding Value To Your Future 25

to perform than substantive procedures, this is normally a preferred strategy. The assessment is made for each account balance or transaction class assertion and only applies to substantive procedures relevant to that assertion. For example, control risk as to the occurrence of purchase transactions is usually low. This also means that control risk over the existence of accounts payable is low. Control risk as to completeness of purchase transactions and thus over the accounts payable balance is often high. In testing cutoff of purchases at the year end, auditors usually perform more extensive substantive tests of details in verifying that all goods delivered before the year end are recorded than verifying that recorded transactions relate to deliveries received before the year end. (i) Preliminary assessment of control risk Effect on design of substantive procedures In tolerating a higher level of detection risk the auditor may alter the nature, timing or extent of substantive procedures. In altering their nature the auditor concentrates on less expensive procedures. Typically this involves more reliance on analytical procedures and less on tests of details. In altering the timing it can involve performing procedures other than at the year end when the auditor is under less time pressure. For example, the auditor could observe a physical inventory count other than at period end and rely on controls over perpetual records in verifying inventory on hand at the period end. The most obvious reduction, however, is in reducing the extent of testing such as circularising fewer accounts receivable. (ii) Other factors affecting the mix Preliminary assessment of inherent and control risks as less than high does not require the auditor to perform tests of controls. The auditor may still decide to rely predominantly on substantive procedures where they are more cost effective. This applies where: there are few transactions (eg additions to property, plant and equipment); the balance at the year end can be verified with an independent custodian (eg share capital records maintained by a registrar and transfer agent). Timing of audit visit(s). For example, if there is only one (ie final) visit a wholly substantive approach to balances may be appropriate. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1044 (c) Control environment Definition The control environment can be defined as the overall attitude, awareness and actions of management regarding the importance of controls. This is reflected in the existence (or absence) of procedures that reinforce their importance, eg: the establishment of an internal audit department; and the operation of budgetary controls. Control procedures are more likely to be effective in an environment in which it is known that they are held to be important. Factors contributing to the control environment The function of the board of directors and its committees. Managements philosophy and operating style. The organisational structure and methods of assigning authority and responsibility to ensure that it is only given to those capable of exercising it effectively (and with due regard to segregation of duties). Managements control system including the internal audit function and personnel policies and procedures (eg for investigating new employees). Effect on assessment of control risk The control environment provides the background against which control procedures are operated and has the potential to affect the effectiveness of all control procedures. A strong control environment supports the auditors assessment of control risk as less than high while a weak control environment reduces control effectiveness and increases the assessed level of control risk. ATC-Adding Value To Your Future 26

Answer 19 NEPCO (a) Risks ISA 400 Accounting and Internal Control Systems states that audit risk is the product of inherent risk, control risk and detection risk. Inherent risks include: The competition from Asian and Far Eastern companies, and rising raw material prices. This means that there is pressure on profits and the ability to reward employees and pay dividends to institutional shareholders which increases the pressure to manipulate the financial statements to show good returns. The potentially volatile market (computer components) in which new technology can render hardware obsolete in a very short time. This means that there is an ongoing risk to the business as a whole (a potential going concern risk) the company must be adaptable. The risk that regulators may reject a product which has taken many months or years to develop. The pressures for returns from institutional investors which means that there may be a temptation to manipulate the financial statements. The possible sale of shares, increasing the pressure for returns in order to get the best possible price, which increases the pressure to manipulate the financial statements. The inherent risks in diversification into unknown areas (the supply of other customers) but these are not current risks. Control risks: there are apparently very few except for the performance-related payment, including share options, which provides an incentive to produce acceptable figures. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1047 Detection risk: this is the firms first year as auditors and there are tight controls on audit costs, which may lead to inadequate audit evidence unless the audit is properly directed, supervised and reviewed. This is compounded by the firms lack of experience in this area. It is important that those with experience are employed on this audit, at least in a review capacity. (b) Matters to which attention should be paid and work to be performed The good accounting records and internal control combined with the need to keep audit costs down means that a compliance approach, rather than a substantive approach will be necessary wherever possible. Audit work will need to be directed towards inventory (despite the fact that it is well controlled) because it is material to the accounts. There is no year-end inventory count, and inventory is relatively easy to manipulate. It is likely that there will be a substantial amount of work-in-progress and its valuation will need to be reviewed carefully. It may be possible to rely on any interim or cyclical inventory counting. The projects on which compliance problems have arisen should be examined carefully as the costs may be significant and there may be a temptation to understate them. Overall profits and any unadjusted errors should be examined carefully because of the inherent risks noted above and the performance-related pay. The companys going concern status should be reviewed by examining its financial status, financial support and likely future developments in high risk areas. Answer 20 CONCEPT OF MATERIALITY Concept Financial statements are materially misstated when they contain errors or irregularities whose effect, individually or in the aggregate, is important enough to prevent the statements from being fairly ATC-Adding Value To Your Future 27

presented. In this context, misstatements may result from misapplication of applicable Accounting Standards, departures from fact, or omissions of necessary information. ISA 320, Audit Materiality, requires auditors to consider materiality when determining the nature, timing and extent of audit procedures. In complying with this requirement ISA 320 recommends that auditors make preliminary judgements about materiality levels in planning the audit at the following two levels: the financial statement level (overall materiality), because the auditors opinion on fair presentation extends to the financial statements taken as a whole; the account balance level (testing materiality), because the auditors verify account balances in reaching an overall conclusion that the financial statements are fairly presented. The overall level of materiality and the nature of account balances enable auditors to determine which account balances to audit and how to evaluate the effects of misstatements in financial information as a whole. Materiality at the account balance level assists auditors in determining what items in a balance (or transactions class) to audit and what audit procedures to undertake (eg whether to use sampling or analytical procedures). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1048 Overall financial statement level There may be more than one level of materiality relating to the financial statements. For the income statement, materiality could be related to revenue or to profit (usually before tax). For the balance sheet, materiality could be based on shareholders equity, assets or liability class totals. In making a preliminary judgement about materiality, auditors initially determine the aggregate level of materiality for each financial statement. For example, it may be estimated that errors totalling $100,000 for the income statement and $200,000 for the balance sheet would be material. For planning purposes, the auditors should use the smallest aggregate level of misstatement considered to be material to any one of the financial statements. This decision rule is appropriate because the financial statements are interrelated and many audit procedures pertain to more than one statement. For instance, the audit procedure to determine whether year-end credit sales are recorded in the proper period provides evidence about both accounts receivable (balance sheet) and sales (income statement). ISA 320 offers no guidance for determining this relationship but, where an item has an effect on profit, a widely used rule of thumb states that: an amount which is equal to or greater than 10% of profit is presumed to be material; an amount which is equal to or less than 5% of profit may be presumed not to be material; to determine whether an amount between 5% and 10% is material is a matter of judgement. Other commonly used bases, and materiality thresholds expressed as a percentage of that base, are as follows. Base Materiality threshold (%) ATC-Adding Value To Your Future 28

Sales 05 Gross profit 20 Total assets 05 Equity 10 Qualitative considerations The emphasis in planning materiality is on quantitative considerations. ISA 320 acknowledges that in designing the audit plan, the auditor establishes an acceptable materiality level so as to detect quantitatively material misstatements. Since the errors are not yet known, their qualitative effect can be considered only during the testing phase of the audit, as evidence becomes available. Qualitative considerations relate to the causes of misstatements or to misstatements that do not have a quantifiable effect. A misstatement that is quantitatively immaterial may be qualitatively material. This may occur, for instance, when the misstatement is attributable to an irregularity or an illegal act by the entity. Discovery of either occurrence might cause the auditors to conclude there is a significant risk of additional similar misstatements. Although it is suggested that the auditors should be alert for misstatements that could be qualitatively material, it ordinarily is not practical to design procedures to detect them. Account balance/class of transactions level Account balance materiality is the minimum misstatement that can exist in an account balance for it to be considered materially misstated. In making judgements about materiality at the account balance level, the auditors must consider the relationship between it and financial statement materiality. This consideration should lead the auditors to plan the audit to detect misstatements that may be immaterial individually but that may be material to the financial statements taken as a whole when aggregated with misstatements in other account balances. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1049 When the auditors preliminary judgements about financial statement materiality are quantified, a preliminary estimate of materiality for each account may be obtained by allocating financial statement materiality to the individual accounts. The allocation may be made to both balance sheet and income statement accounts. However, because most income statement misstatements also affect the balance sheet and because there are fewer balance sheet accounts, many auditors make the allocation on the basis of the balance sheet accounts. Allocating overall materiality to accounts is heavily dependent on the subjective judgement of the auditors. The auditors judgement may be influenced by qualitative considerations. Materiality in auditing cash balances may be set at a much lower level than materiality in auditing intangible assets. Cash is known to be capable of precise determination and is critical to the ATC-Adding Value To Your Future 29

liquidity of the entity. Intangible assets, on the other hand, are known to be incapable of precise valuation and users are unlikely to be misled by a relatively large misstatement in the reported amount. Answer 22 SPONDON FURNITURE (a) Weaknesses It is apparent that the Managing Director and book-keeper are responsible for a significant number of actions in the purchases system, which result in serious weaknesses in the system of internal control. Purchase orders It appears that only hand written orders for purchases are made to the buying manager from user departments. There should be a system whereby user departments raise pre-numbered purchase requisitions; signed by the department manager, and send them to the buying manager. The duties of the buying manager over obtaining suitable suppliers are not clear. The buying manager should obtain the best quotation in terms of price, delivery date and quality. These quotations need to be checked by a responsible official before the order is sent to the supplier. The buying manager should sign the purchase order as well as the Managing Director. The Managing Director can ask for goods or services to be supplied and approve purchase orders, which is a weakness in the system of internal control. In addition, the Managing Director authorises purchase orders, purchase invoices and signs the cheques paying suppliers. There needs to be a system to overcome these serious weaknesses in the system of internal control. However, this is difficult to achieve without an internal auditor, as all staff will eventually report to the Managing Director, so he will be able to ensure his requests are carried out. A control could be exercised by appointing an internal auditor who reports to the non-executive directors. Orders are not raised for all goods and services received by the company however, they should be raised for all these items. All purchase orders should be sequentially numbered. Goods received notes The system for checking goods received appears to be satisfactory. However, the goods received notes (GRNs) should be sequentially numbered, and signed by the storekeeper. Where goods are not in accordance with the advice note, a discrepancy note should be produced, a copy of which should be sent to the book-keeper and buying manager. There should be a system for recording receipts of other goods and services. Ideally, the goods received department should have copies of purchase orders and it should refuse receipt of goods where there is no purchase order. The system should ensure there is a GRN and purchase order for every purchase invoice where goods and services are received (orders and GRNs will not be required for provision of such services as gas, electricity, telephone and insurance). Ideally, the purchase order should include the price of the item being ordered, so this can be checked to the purchase invoice. The purchase invoice should include a slip: where the book-keeper acknowledges it has been checked to the order and GRN, and calculations on the invoice have been checked where the invoice expense is analysed. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1054 Purchase invoices The Managing Director both authorises the purchase order and the purchase invoice. To overcome this weakness, I would suggest that the user department signs the slip acknowledging the goods or services have been received. Where this would be the Managing Director, another member of staff should perform this function. Then, ATC-Adding Value To Your Future 30

the Managing Director can be the second person who authorises posting the invoice to the purchase ledger There is no check over the book-keeper posting invoices and cash to the purchase ledger. This should be checked on a test basis by the internal auditor (see below). The Managing Director should sign the list authorising payments to suppliers, before the book-keeper processes these transactions Payments The system should prevent anyone, other than the Managing Director, from signing cheques, so only payments for authorised purchases should be made. However, there is little control over the Managing Directors actions, and he could make fraudulent payments to suppliers, as he can order goods and he approves posting of the invoices to the purchase ledger. Evidence should normally be presented to the Managing Director when he signs the cheques. For normal suppliers (eg telecom company for payment of telephone costs) it seems probable that no evidence is necessary, apart from the remittance which shows the invoices being paid. However, for little known suppliers the Managing Director should request and inspect the invoices being paid. Also, for larger value cheques, a second signatory could be required. The non-executive directors could be shown a list of payments, prepared by the book-keeper, at the periodic Board Meetings There is no reference to a purchase ledger control account being maintained. This can be prepared by the book-keeper, but should be checked by an independent person (not the Managing Director). Also, the purchase ledger cash payments should be agreed to the cash book, and the bank reconciliation checked by an independent person. The cash balance in the general ledger should be checked as agreeing to the cash book each month. There should be a check of the months expense in the general ledger to the budget and previous periods and any significant differences should be investigated. (b) Internal audit work The internal auditor should highlight the weaknesses, as described above, and suggest amendments to improve controls in the system. In particular, a system of purchase requisitions should be instigated, which are prepared by the user department (and not the Managing Director). These should be sent to the buying manager to prepare the purchase order, which will be authorised by the Managing Director. A second person; in addition to the Managing Director, should authorise purchase invoices before they are posted to the purchase ledger (eg the buying manager). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1055 Checks to be performed on a test basis Check there is a properly authorised purchase order and goods received note for each invoice posted to the purchase ledger. The internal auditor should verify that the checks in (a) above have been performed on the purchase invoice. He should check the expense analysis on the invoice is appropriate and that it has been correctly posted to the purchase ledger and general ledger. The internal auditor should record cases where there is no purchase order or no GRN for an invoice, so that the system can be made to cover receipt of all goods and services. The internal auditor should consider whether the expense is for the benefit of the company, and record cases where a fraud is suspected. Check that purchase ledger payments relate to invoices posted to the purchase ledger, and that they are correctly recorded in the cash book. Check the reconciliation of the purchase ledger control account to the balances on the purchase ledger each month (and prepare this statement if it is not done by another member of staff). The purchase ledger payments in the month (from the purchases day book) should be checked as agreeing with the total of the payments in the cash book. Suppliers statements should be reconciled to the balances on the purchase ledger. Any differences should be explained (eg cash or goods in transit) and corrected the ATC-Adding Value To Your Future 31

following month. The internal auditor should test check these reconciliations. The internal auditor should scrutinise the list of payments to suppliers and investigate any which appear to be unusual. The internal auditor should investigate any debit balances on the purchase ledger (usually they are for payments where no invoice has been posted to the purchase ledger). (c) Responsibility for detecting fraud and error Essentially, the Caparo decision limits the people who can sue an auditor for negligence to the company and the shareholders as a body. ISA 240 The Auditors Responsibility to Consider Fraud and Error in an Audit of Financial Statements essentially says that auditors are not responsible for detecting immaterial frauds or error. However, they should design their audit tests so that they have a reasonable expectation of detecting material fraud and error. So the auditor could only be liable for failing to detect material fraud and error. As the ownership of Spondon is divorced from its management and two people own all the shares, it seems probable that the two shareholders could take action against the auditor if he failed to detect a material fraud (this is much more difficult if there are a larger number of shareholders). These two shareholders are then acting as shareholders as a body. Also, it appears that the two shareholders are placing some reliance on the external auditor to detect any material fraud and error when the audit is carried out. It seems probable that the external auditor will only be able to allocate a small amount of responsibility for negligence to the Managing Director, as the Managing Director does not own any shares in the company. However, as a Director, the Managing Director is responsible for instigating a system of internal control which detects fraud and error. If the main shareholders had asked the auditor to carry out work to detect material fraud or error, then the auditors liability for negligence will increase (provided the auditor has agreed to this additional responsibility). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1056 A different situation arises if the Managing Director owns all the shares. If the Managing Director is carrying out the fraud, the auditors liability for negligence should be reduced (because of contributory negligence). Also, it seems probable that the Managing Director will have tried to conceal the fraud and may have made false representations to the auditor. In this situation, it is unlikely that the Managing Director will take legal action against the auditor. If the fraud has been perpetrated by an employee, the Managing Director should take some responsibility for not detecting the fraud (contributory negligence), and this will reduce the auditors negligence. So, in conclusion, I would agree that the auditor has a greater responsibility for detecting error and fraud in Spondon Furniture than would be the case if all the shares were owned by the Managing Director. Note: Candidates may produce different arguments, and come to different conclusions. They will be awarded marks based on the quality of the points they make, their discussion and the conclusions they reach. Answer 23 EASTWOOD ENGINEERING (a) Starters and leavers test Select two payrolls, the first at the start of the companys financial year and the second a recent payroll and note: employees not on the first payroll who are on the second payroll. These are starters; employees on the first payroll who are not on the second. These are leavers. For both starters and leavers, I will go to the personnel department and find the date each employee started or left. For starters I will check to the relevant payrolls that they were not paid before they started employment. For most employees, the first payment should be at the end of the week or month they started work and not for the previous week or month. For manufacturing employees, the first payment should be made the week after they started work and they should ATC-Adding Value To Your Future 32

not be paid at the end of the week they started work. For leavers I will check to the relevant payrolls that they were not paid after they ceased employment. For most employees, they should be paid at the end of the week or month they finished work but not for the subsequent week or month. For manufacturing employees, the last payment should be the week after they left employment and they should not be paid in the following weeks payroll. An alternative way of performing this test is to start from the personnel records of staff who have started or left during the period. I will check that starters have not been paid before they started employment and leavers have not been paid after they left employment in the same way as that described in the two paragraphs above. If I find any problems, I will discuss them with the companys management. If I detect a fraud, this will require further investigation and I should report it to the companys management and include it in my management letter. This will suggest there should be greater controls over preventing frauds over starters and leavers, such as the personnel department periodically checking the wages department are treating these types of employee correctly. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1057 (b) Wages pay-out Before the wages are paid, I will take a copy of the payroll and check there is a pay packet for each employee. If the pay packet is transparent, it may be possible to test check the money in the pay packet agrees with the net pay on the payroll. When the employee is given his wage, he should sign for it. The signature should be test checked to the employees signature kept by the personnel department. I will mark on my list when each employee collects his wage. I will check that no employee receives more than one pay packet or one for another employee. I will note if this is happening. At the end of the wages payout, I will check that there is a wage packet for each employee who has not collected his wage. These will be the unmarked items on my payroll list. These are unclaimed wages. I will check that these unclaimed wages are recorded in the unclaimed wages book. The information recorded in the unclaimed wages book should include the payroll date (and payment date, if different), the employees name and number, and the net wage. I will note cases where unclaimed wages are not recorded in the unclaimed wages book. This is not unusual, as frequently wages collected in the day of payment are not recorded in the unclaimed wages book, and the unclaimed wages book records only those wages which are unclaimed at the end of the day. This creates a weakness in the wages payment system (although it is minimised by the employees signing for their wages). (c) Unclaimed wages I will have checked procedures for recording unclaimed wages in the unclaimed wages book (as above). To qualitatively check that the same procedures are carried out in the weeks when I did not attend the pay-out, I will check the number of unclaimed wage packets is about the same each week. If they are significantly less in other weeks, this indicates that some unclaimed wages are not recorded-in the unclaimed wages book. If I am concerned that proper procedures have not been followed in other weeks, I will ask the companys staff if the procedures are different in other weeks and I may attend another pay-out of wages. I will report the matter to the companys management and include it in my management letter I will check there is a wage packet for each unclaimed wage recorded in the unclaimed wages book. Where employees have collected their wages, I will check that they have either signed for the wage or there is a letter from the employee authorising another person to collect the wage packet (eg when the employee is ill). I will check the employees signature to the personnel records. The company should pay into the bank wage packets which have been unclaimed ATC-Adding Value To Your Future 33

for more than a month. The date the wages were banked should be recorded against details of each wage packet in the unclaimed wages book. For a sample of bankings of unclaimed wages, I will check that the amount banked (per the cash journal) agrees with the total net wages of the employees as recorded in the unclaimed wages book. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1058 If there is a long delay before the wage packets are banked (eg over three months), I will report it to the companys management and I may include it in my management letter. I will report any weaknesses I find to the companys management. The unclaimed wage packets should be kept in a secure place (eg a safe). Ideally, unclaimed wages should not be dealt with by employees in the wages department, and there should be an independent check (probably by the accounts or personnel department) to ensure that proper procedures are carried out and there is no fraud. (d) Existence of employees To verify the existence of employees, I will select a sample of employees from the most recent payroll. The procedures I will use for checking the existence of the employees will include: for employees at head office and at sales branches my audit firm visits, I could go and see them, and ask for a signature which would be checked to the personnel records. employees could be checked to the personnel records, as being currently employed by the company. The personnel department is independent from the wages department. department managers could be asked to sign a list of employees who work for them and return it direct to me. if the employees are paid by cheque, the cheques could be inspected before they are given to the employee or sent to their bank. In some countries the bank is sent a list of employees to be paid. The name of the employee on the list should be the same as on the payroll. other evidence of employees will include expense claims signed by the employee and records of tax and health insurance. For instance, there could be notifications from the Tax authorities of changes in tax allowance, and there may be an annual return to the Tax authorities (at the end of the tax year) which lists each employee. Based on the results of these tests, I will decide whether all the employees on the payroll actually work for the company. It should be noted that the checks above are the variety of methods which can be used to verify employees on the payroll, and in practice not all of them would be used. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1059 Answer 24 FAIRLIGHT (a) Occurrence Ordering Weaknesses. At the moment there is no control over ordering. Managers may not be ordering goods and services at the most advantageous terms and conditions. They may be ordering goods already held by another department. They could even be ordering goods for their own personal use. Consequences. The company may be paying too much for its goods and services and may even be being defrauded by its managers. Recommendations. We suggest that the following procedures be instituted. A separate purchasing department should be established under the newly appointed purchasing officer. Managers should requisition the purchase of goods and services through the purchasing department. The requisitioning authority of each manager should be laid down and the ATC-Adding Value To Your Future 34

purchasing officer required to check each managers requisitioning authority before placing orders. Only the purchasing department may issue orders, which should be made on official pre-numbered forms. Copies of the orders should be sent to the requisitioner, the goods received department and the accounts payable department. Receiving Weaknesses. At the moment, reliance is placed entirely on managers to ensure that goods and service are received before invoices are approved for payment. Consequences. In the absence of a formal system, managers may not always be sure whether or not goods have been received and may even accept delivery of goods that have not been ordered. Lack of segregation of duties makes it easier for managers to order goods for their private use. Recommendations. We suggest that the following procedures should be instituted. Purchase orders should require suppliers to deliver goods to a centralised receiving area. The receiver should be responsible for checking that the goods are in agreement with the order and are in a satisfactory condition. The receiver should issue a pre-numbered goods received note with copies to the requisitioning department, purchasing department and accounts department. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1060 Recording Weaknesses. At the moment reliance is placed on managers to approve invoices for payment. Consequences. In the absence of a formal system managers may not always ensure that invoices they approve relate to goods and services properly ordered and received. Lack of segregation of duties makes it easier for managers to approve payment for goods for their private use. Recommendations. We suggest that the following procedures should be instituted. Purchase orders should require suppliers to send invoices directly to the accounts department. The post room should also be instructed to deliver all invoices to the accounts department. Before recording invoices the accounts department should check them against copies of the order and goods received notes. For the supply of services it may continue to be necessary to forward invoices to managers for approval. Payment Weaknesses. At the moment payments are based on amounts recorded on suppliers statements. Consequences. Payment could be made for invoices incorrectly entered on the statement due to error by suppliers. Recommendations. We suggest that the following procedure be instituted. Suppliers statements should be checked against invoices recorded before being paid and any differences other than for goods in transit be queried with the supplier. If all of the above procedures are adopted, the risk of paying invoices for goods or services improperly ordered or that have not been ordered and received will be significantly reduced. (b) Completeness Recording Weaknesses. At the moment there is no certainty that all invoices are recorded in the purchase journal. Consequences. Managers may lose or misplace invoices or delay their transmission to the accounts department so that they are recorded in the wrong accounting period. Managers may deliberately fail to pass on invoices for goods for private use especially if they know that payment is based on suppliers statements. The debit balance in accounts payable probably arises from unrecorded invoices. The difference between the balance in accounts payable in the ledger and the true amount owed to suppliers represents an understatement of liabilities and expenses and an overstatement of profit. Recommendations. We suggest that the following procedures be instituted. ATC-Adding Value To Your Future 35

All invoices should be numbered on receipt and, after approval, recorded in the purchase journal in numerical sequence. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1061 A record should be maintained of invoices for services sent to department managers for approval and such invoices chased to ensure their prompt return. The purchase journal should be independently scrutinised to confirm the numerical continuity of recorded invoices. The accounts department should check the numerical continuity of copies of orders and goods received notes. Any that are not matched with invoices within a reasonable period of time should be investigated as they may represent invoices that have been lost. Unpaid invoices should be agreed with invoices listed on the suppliers statements. Invoices on suppliers statements not recorded in accounts payable should be investigated as possibly representing unrecorded purchases. If the above procedures are adopted, the risk that purchase records might not record all purchase transactions will be significantly reduced. (c) Measurement Recording Weaknesses. At present there is no internal check on the accuracy of recording of purchase invoices. Consequences. This could mean that the financial statements are incorrect due to undetected errors in the books. Recommendations. We suggest that the following procedures be instituted. A separate accounts payable ledger should be established with an account for each supplier. This should be entered directly from invoices by an employee other than the one responsible for entering the purchase journal. A total should be recorded of the total of invoices in each batch entered separately in the purchase journal and accounts payable ledger. The totals should be independently compared, any difference representing an error in recording invoices in one of the two records. Each month there should be an independent comparison of the general ledger accounts payable balance which has been posted from the purchase journal and the total of the list of balances in the accounts payable ledger. Any difference probably represents an error in totalling columns or balances or in posting, and needs to be investigated. The balance for each supplier in the accounts payable ledger should be reconciled with the balance on the suppliers statement. Any difference may be due to an error in the amount recorded in the accounts payable ledger. Used this way, subsidiary ledgers, such as the accounts payable ledger, represent the use of double entry in ensuring that no mistakes have been made. If these procedures are adopted, the risk of errors in recording the invoice amounts will be significantly reduced. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1062 Answer 25 SINFIN WHOLESALE (i) Purchase invoices and credit notes It is important that only authorised purchase invoices/credit notes are posted to the purchase ledger as unauthorised invoices could result in incorrect or fraudulent payments. Also, if the value posted to the purchase ledger is wrong, an overpayment could result which could take time to recover. To ensure that only authorised purchase invoices and credit notes are correctly posted to the purchase ledger: The individual posting the purchase invoice/credit note should check that it is addressed to Sinfin and has been initialled (where appropriate) in respect of: agreement to a goods received note (GRN) and/or purchase order (PO); checking and agreeing prices (eg to a price list) and arithmetic accuracy; ATC-Adding Value To Your Future 36

authorisation by a responsible official. The individual responsible for posting purchase invoices/credit notes should be sufficiently independent of other functions to ensure proper segregation of duties. For example, the individual should not have custody of inventory, access to cheques or be responsible for ordering goods and services. Purchase invoices should be batch processed, with sequential numbering by the computer. The value and number of invoices in each batch should be predetermined manually and agreed to the totals processed to the purchase ledger. Details of each batch should be logged (eg in a batch control book) and the sequence reviewed by a responsible official. Credit notes should be processed in separate batches (to reduce the risk of credit notes being processed as invoices and vice versa). When a purchase invoice/credit note is posted to the purchase ledger, the operator should check that the suppliers name and address on the computer are the same as that on the input document (and investigate any differences). Ideally, only purchase invoices for authorised suppliers should be posted to the purchase ledger. A sundry purchase account could be used for unauthorised suppliers. This should be reviewed at least once a month by the chief accountant. The value of actual expenses should be compared, periodically to individual departmental budgets and significant variances investigated. Suppliers statements should be reconciled monthly to the amounts per the purchase ledger account balances. The reconciliations should be independently reviewed by the chief accountant. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1063 (ii) Standing data Effective controls are required over the addition, amendment and deletion of suppliers to reduce the risk of errors or fraud occurring. (For example, a fraud could be perpetrated by creating a fictitious supplier, posting invoices to the account, obtaining payment and then deleting the supplier to help conceal the defalcation.) To ensure that only authorised suppliers are on the standing data file: Additions to/amendments of/deletions from purchase ledger standing data should be authorised (eg by the chief accountant) on a standard form, before being input to the computer. Changes to supplier details should be input in sequentially numbered batches and recorded in a batch control book. (If there are numerous changes they could be input in separate batches for new suppliers, amendments and deletions.) The computer should print out accepted data for one-to-one checking against input details. The computer should be programmed to reject any deletion where there is any balance (whether debit or credit) on the suppliers account A responsible official (eg chief accountant or internal auditor) should periodically check a sample of changes to ensure that they have been properly authorised. The buyer (buying department manager) should periodically review the list of authorised suppliers and recommend deletions of those which are no longer being used (as dormant accounts increase the risk of error or fraud). The computer should print out a monthly exception report of suppliers with whom there have been no transactions for six months (say). The chief accountant (or internal auditor) should review this to ensure that dormant accounts are being deleted. (iii) Cheque payments To ensure cheque payments are authorised: Each of the three types of cheques should be labelled (in some way) to denote payment: under $500; $500 $5,000; ATC-Adding Value To Your Future 37

over $5,000. For cheques between $500 and $5,000 there should be a heading beside the space where the authorised initial is required. Cheques over $5,000 should not include a printed authorised signature. Cheque payments should be run in three separate batches so that the appropriate cheque stationery can be loaded into the printer. Cheques should be sequentially numbered by the computer (when they are printed) and the bank kept informed of numbers used. Cheques should be printed in a script (ie font) which is easily identified by the bank, but not easily copied. The cheque should be printed in indelible ink. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1064 All cheques should be crossed A/C payee and not negotiable so that they can only be paid into the bank account of the named supplier. A responsible official should make periodic test checks on printed cheques, before they are posted to the supplier to ensure that the correct type is being used for the amount authorised for payment. Persons initialling cheques between $500 and $5,000 and signing cheques over $5,000 should be aware that the supplier is authorised. Cheques should be posted to suppliers accompanied by a remittance advice. The cashier should check that cheques on the bank statement appear in the cash book and investigate any apparently unauthorised cheques. The balance per the bank statement should be reconciled monthly to the balance per the cash book and the reconciliation reviewed by a responsible official (eg internal auditor). Paid cheques could be obtained from the bank (possibly at a fee) for independent checking (eg by the internal auditor), on a test basis, to ensure that: cheques are not negotiated; payee names and amounts of payments agree to the purchase ledger account and cash book; cheques have the required authorisation. To ensure the safe custody of cheques: Unprinted cheques, especially those for payments under $500 should be kept in a safe and only taken out when required. Cheques taken out of the safe for processing should be logged in a register and authorised by a responsible official. All spoilt cheques should be cancelled (by writing cancelled across them) and filed as evidence of not having been issued. Tutorial note: The following general controls (over the computer installation) are also relevant: Restricted access to the computer (ie limited to authorised personnel). Password protection of software (to prevent unauthorised amendment). Different passwords for those entitled to read (eg a recommended supplier) and those allowed to update (eg process an invoice). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1065 Answer 26 BESTWOOD ENGINEERING (a) Purchase and receipt of goods Tutorial note: The question specifically refers to controls to be exercised in the purchasing department. For all goods ordered, there should be a purchase requisition from a user department. The purchasing department should not be permitted to raise purchase requisitions; as this would create a weakness in the division of duties. For goods required by the purchasing department, they should request another department (eg the accounts department) to raise a purchase requisition. Before raising the purchase requisition, the accounts department should ensure it is for goods the ATC-Adding Value To Your Future 38

purchasing department require and are authorised to order. The purchasing department should check the purchase requisition is for goods the user department is authorised to buy or consume. If the value of the order is substantial, the purchasing department should ensure there is a need for such a large order, by checking current inventory levels and future orders to determine whether so large a quantity or value is required. The purchase requisition should use a standard form and be signed by an authorised signatory. The purchasing department should order the goods from an authorised vendor. Where there is a choice of vendor or a new vendor is required, the purchasing department should obtain the product from the vendor who provides the product or service at the best price, quality and delivery. For audit purposes, it is desirable for staff in the purchasing department to record details of the vendors contacted, the price, delivery date and perceived quality, and the decision on which vendor was finally chosen. The purchasing department should raise the purchase order which should be signed by the purchasing manager. For large value purchases, a director may be required to sign the purchase order. The purchase order should be sent to the vendor, the goods received department, the user department and the accounts department. The purchasing department should ensure the goods are received on time. This may require them to contact the vendor a week before the expected delivery date to ensure they are received on time, and allow action to be taken if the delivery date is later than specified on the purchase order. When the goods, are received, the purchasing department should receive a copy of the goods received note (GRN) from the goods received department. They should record the goods received against the order. From this information, they will be able to take action when there are short deliveries or the goods are received late. Frequently purchasing departments file purchase orders in three types of file: none of the goods have been received; some of the goods ordered have been received; all the goods ordered have been received (ie dead purchase orders). The purchasing department may be part of the system which authorises purchase invoices. They should check the goods on the invoice are consistent with the purchase order and the price per unit is correct. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1066 The purchasing department should be informed about short deliveries (ie the quantity of goods received is less than on the purchase order or advice note) and when there are quality problems. From this information, they can contact the vendor so that corrective action is taken. Also, such details may be helpful in determining whether the vendor should be used for future orders The purchasing department should be informed of situations when goods or services are received but no purchase order has been raised. With this information, the purchasing department should contact the offending department and ensure that in future a purchase order is raised for all the goods they order. The vendor should be contacted and informed that an authorised purchase order must be received by them (the vendor) before any goods or services are provided by the vendor. (b) Authorisation of purchase invoices Tutorial note: The question calls for control procedures in the accounts department before the purchase invoice is processed. The accounts department will receive the purchase invoice, which they should record in a register. The invoice expense will be included on the invoice (for posting to the general ledger). The expense analysis will be checked by an independent department (eg the purchasing or user department). The accounts department will either match the purchase invoice to the goods ATC-Adding Value To Your Future 39

received note and delivery note or ask the goods received department to check and authorise the purchase invoice. the purchasing department will be asked to confirm the goods are as described on the purchase order and the price per unit is correct. The user department may be asked to authorise the purchase invoice. An appropriate responsible official will be asked to authorise the purchase invoice. Provided these checks are satisfactory, the accounts department should input the invoice details into the computer which will post it to the accounts payable ledger and the general ledger. Where there is a problem with the invoice (eg concerning the quantity, quality or price of the goods received) the accounts department should put the invoice in a hold file. They should contact the vendor (sometimes with the help of the purchasing or user department) and try to resolve the problem. When either a credit note is received or the correct quantity and quality of goods have been received, the accounts department will get authorisation (eg from the purchasing department) that the situation is resolved and they should input the purchase invoice into the computer (and credit note if this is required). Periodically, an independent person should check vendors statements against the balances on the accounts payable ledger. Differences between these two balances should be recorded. If the transaction which created the difference is close to the date of the check, it is probable that no action will be taken. However older items should be investigated to ensure that action is being taken to resolve the problem. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1067 (c) Controls over purchase of services Frequently, procedures over receiving services are less strong and less effective than those over receiving goods. For some types of service there may be no system for raising purchase orders (eg electricity, gas, water and telephone charges). However there should be a system for reviewing these costs, by comparing them with the previous year (or period), with budget and with amounts charged by alternative vendors. In this way, the company can ensure these services are received at the most economical cost. For some of these services it may be possible to suggest ways in which these costs can be reduced (eg by turning off lights and reducing the temperature settings in winter). Costs of gas, electricity and water can be monitored by checking the meter readings monthly and determining whether the consumption is reasonable. For telephone expenses, the system should provide information on the cost for each department, and each department manager should review his departments costs. A risk with telephone systems is that they can be abused by staff, who make personal telephone calls using the companys telephone system. The department managers should be made responsible for checking this abuse is kept to a minimum. For receipt of all other services, before the service is obtained, a purchase requisition should be raised by the user department, and the purchasing department should raise a purchase order. In emergency situations, it may be acceptable to raise a purchase requisition and order after the service has been received (eg the repair of a vehicle which has broken down). There should be a system whereby action is taken when no purchase order has been raised for a service which has been received. In many situations when a service has been received, it is probably appropriate that the department receiving the service should issue a goods received note and send it to the purchases accounts and the purchasing departments. In this way, the same system can be used for processing receipt of services as for receipt of goods. Answer 28 SIGHTHILL SUPERMARKETS (a) Effectiveness of internal audit Tutorial note: ISA 610 Considering the Work of Internal Auditing lists four important criteria in assessing the work of internal audit. (i) Organisational status ATC-Adding Value To Your Future 40

The internal audit departments status in the organisation and the effect this has on its ability to be objective. Sighthill Supermarkets is a listed company, and it may have an audit committee. If it does, ideally the internal audit department should report to them (or be able to report to them). In practice, it is probable that much of the work of the internal audit department will be controlled by the Chief Financial Officer. However, there should be some input from the Board (and audit committee, if it exists) to ensure that all important aspects of the companys operations are covered by the internal auditors. As stated earlier, the internal audit department should have the right to report to the audit committee, and the audit committee should review copies of reports by the internal auditors. Also, the internal auditors should be free to communicate with the external auditors. The independence of the internal audit department is important, and I will consider whether it has adequate independence both in terms of the work it carries out and the reports it makes. (ii) Scope of function I will check what action is taken by the company as a result of the internal auditors work. Action should be taken by the company when the internal auditors detect significant weaknesses in the accounting systems or errors in processing transactions. The internal auditors should re-test the systems to check that the problems have been corrected. The internal auditors working papers showing weaknesses and errors and subsequent correction will provide me with evidence of whether action is taken following adverse reports by the internal auditors. (iii) Technical competence I will check the qualifications and experience of the internal auditors. If the internal auditors have appropriate qualifications (eg a member of the ACCA) their work is likely to be more reliable than if they are unqualified. Experience in auditing is important. They could have qualified with a firm of professional accountants and have performed audits of private and listed companies, or they may have experience of internal audit in other companies. They should attend courses to keep up to date and learn about new developments. Unqualified staff should be studying for the exams of a professional body. I will check these matters by discussing them with the head of the internal audit department and obtaining appropriate evidence. (iv) Due professional care The work of the internal auditors should be properly planned, supervised, reviewed and documented. I will scrutinise the working papers of the internal auditors. I will check the work they have carried out is appropriate and that the conclusions they reach are consistent with the results of the tests they have carried out. I will assess the work programme of the internal audit department and check it provides adequate coverage of the companys operations and that it is carried out at an appropriate frequency. For instance, checks should be carried out when new accounting systems are installed, and tests should be re-performed at a later date when serious errors or weaknesses in controls are found. There should be appropriate audit manuals for the internal audit staff. (b) Extent of reliance The existence of an internal audit department will improve controls in the company. Firstly, this is because of the policing effect, in that the existence of an internal audit department will make employees aware there is an increased risk the internal auditors will detect fraud or errors in their work. Thus employees will be more careful to minimise and correct any errors and they will be deterred from perpetrating a fraud. In addition, the internal auditors should improve the effectiveness and extent of controls as a result of the tests they carry out and the recommendations they make. Thus, the existence of an internal audit department reduces control risk. So, with an internal audit department, the external auditor should be able to carry out fewer tests of controls and/or substantive procedures in order to achieve the planned level of audit risk. (i) Recording accounting systems It is likely that I will rely almost entirely on the internal auditors work. Ideally, they should have the same system and use the same symbols for recording accounting systems as my audit ATC-Adding Value To Your Future 41

firm. I will check the accounting systems have been recorded correctly by performing walk through tests using a sample of transactions. If the systems have been recorded accurately, I can use the flowcharts in my audit working papers. Evaluation of controls The internal auditors internal control evaluation questionnaire (ICE) (or internal control questionnaire ICQ) should be the same or similar to my firms. If they are the same or similar to my firms, I will check to the flowchart that the questions have been answered correctly. If there are significant differences with my firms questionnaires, I will check that the internal auditors ICE or ICQ asks appropriate questions. I may fill in my firms ICE or ICQ rather than use the internal auditors as this will make it easier for the partner to review, and it would minimise the risk of missing weaknesses in the internal auditors ICE or ICQ. As my firm is likely to be the external auditor for a number of years, it is desirable that the internal auditors should use my firms ICEs or ICQs rather than their own. (ii) Tests of controls I will review the internal auditors work and check they are testing appropriate controls. In this area, the external auditor should not rely entirely on the internal auditors work. I will perform additional tests, either on the same items as were checked by the internal auditor, or on a different sample of items. If I find the results of my tests are similar to the internal auditors (particularly in terms of frequency and types of error found) then I will be able to place reliance on the internal auditors work and I will reduce the number of items I check. If my checks detect either different types of error or at a higher frequency than the internal auditors, I will have to perform further work by increasing the number of items I test and I will probably ask the internal auditors to perform more checks (iii) Substantive procedures to verify assets and liabilities These are likely to include: Checking the existence of non-current assets; Attending inventory counts; Checking receivables including carrying out circularisation of receivables (in a supermarket, there are likely to be very few receivables, so a circularisation of receivables may not be carried out); Checking bank reconciliations; Counting cash in tills and petty cash; Checking accounts payable ledger balances to vendors statements. I should not rely entirely on the internal auditors work. I will check the internal auditors work by either re-performing their tests, or performing tests on a different sample of items. Provided my test results are similar to the internal auditors, I can reduce the number of items I check (compared with what I would check if there was no internal auditor). Where the internal auditors find weaknesses or errors, I will check the internal auditors have rechecked the systems at a later date to ensure the weakness has been corrected. I may perform more checks in areas where the internal auditors have found weaknesses or an unacceptable error rate. (iv) Computer systems using CAATs I will look at the programme and results of their work. The programme should ensure that new computerised accounting systems and significant changes to existing systems are tested by the internal auditors. I will check that any weaknesses or errors found as a result of these tests are acted upon and re-tested by the internal auditors. I will inspect the CAAT work carried out by the internal auditors and consider whether it is appropriate and checks all the significant aspects of the computerised accounting systems. If certain aspects have not been covered, I will either ask the internal auditors to carry out the work or I will perform the tests myself. Audit of the computer systems should not be limited to using CAATs. The reliability of the ATC-Adding Value To Your Future 42

computer system is vitally important; as any serious failure could create major operational and financial problems. Thus, the internal auditors should have carried out procedures to check the reliability of the system. For instance, there should be no bugs in the software which either result in the system crashing or data files being corrupted. As most large computer systems contain some bugs, the system should be tolerant so that it can continue to operate when such problems occur. The internal auditors should have carried out tests of controls over access to the computer. The system should be able to detect errors in transmission of data (particularly over telephone lines to head office) and ensure the data is re-transmitted. I will check the internal auditors work and consider whether it is sufficient for the purposes of my audit: If I believe it is inadequate, I will either ask the internal auditors to carry out the work or I will carry it out myself. (v) Supermarket visits The internal auditor is likely to carry out a substantial number of visits to supermarkets. Visits to supermarkets are supposed to be carried out more frequently to large supermarkets and to those where problems have been found. I will inspect their work and check the frequency of their visits to supermarkets to confirm this is happening. I will check that all supermarkets are visited at least once a year. It would not be possible for my staff to visit all the supermarkets at every audit, so I will visit the large supermarkets on every audit and smaller ones on a rotational basis. I will compare the results of my tests with those of the internal auditors. If the results of the tests are similar, I will be able to place more reliance on the internal auditors work than if there are significant differences. The audit procedures carried out at supermarkets will include checking balance sheet items (eg inventory quantities and cutoff details). Also they should include checking controls (eg receipt of goods, procedures at the cash check-outs, custody and banking of cash and the existence of employees). Checking procedures over employees is important, as the supermarkets are likely to have a large number of full-time and part-time employees, who work different hours. There should be evidence of their existence and the hours they have worked. It is apparent there is a high risk of a fraud being committed by: creating fictitious employees; or inflating the employees hours and misappropriating the wage for the overstated hours (where the employees are paid in cash). The internal audit department will be very helpful at the year end, as, with their assistance, it will be possible to visit a greater proportion of the supermarkets at the year end to attend the inventory count and obtain details of purchases cutoff (sales cutoff should not be a problem with a supermarket). Provided the work of the internal auditors is reliable, the external auditors may be able to reduce the number of supermarkets they visit -at the year end and at the interim and final stages of the audit. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1074 Answer 29 GLEBE (a) Evaluation of internal audit The external auditor must first carry out a preliminary assessment of internal audit. ISA 610 Considering the Work of Internal Auditing , suggests that this review cover the following areas: (i) Organisational status We would need to review the organisational status of the department both in theory and, as far as practicable, in practice. We would need to satisfy ourselves that the internal audit department is reasonably independent of management whose work is being assessed and is free from operational responsibility. In practice this requires that internal audit report to the highest level of management, preferably the audit committee, and is free to communicate fully with the external auditors. The department should also have a reasonable degree of freedom in determining the scope of its work. (ii) Scope of function We would need to be satisfied that the findings of internal audit carry an appropriate degree of weight by selecting a few recent reports and sighting evidence that their recommendations were fully acted upon. ATC-Adding Value To Your Future 43

(iii) Technical competence We would need to be satisfied that the department is staffed by appropriately qualified personnel. We would need to review the personnel files of existing internal audit staff for evidence of their qualifications and experience. We would also need to see evidence of company policy with regard to the employment, training and promotion of internal audit staff members. (iv) Level of resources We would need to consider the level of internal audit resources relative to the extent of work we would be relying on. In particular we would need to obtain firm assurance that internal audit would perform the procedures on which reliance would be placed, particularly visits to branches. (v) Due professional care We would need to examine manuals, work programs and working papers to ensure that the work performed meets appropriate standards of planning, review and documentation. (b) Reliance on the work of internal audit Where the external auditor intends to use the specific work of internal auditing, ISA 610 requires the external auditor to evaluate and test that work to confirm its adequacy for the external auditors purpose. Procedures and other considerations applicable to each of the areas is detailed below. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1075 (i) Accounting and internal control systems If we are to place reliance on internal audit prepared documentation of the accounting and internal control systems we would need to: review procedures followed in obtaining the understanding and in documenting the results to ensure that they are sufficiently thorough, such as through confirmation by walk-through tests; take a sample of such documentation, consider the adequacy of the level of detail recorded and perform a walk-through test in order to satisfy ourselves as to its accuracy and relevance for our purposes; see that the documentation is reasonably current and that there is evidence that staff members undertaking the documentation were properly supervised and that the work has been properly reviewed. (ii) Tests of control We would probably be able to rely on tests of controls performed by internal audit staff at branches. In relying on the results of these tests we would need to: to be satisfied as to the timing and extent of the tests; sight evidence that the tests were properly planned, performed, documented and reviewed; ensure that the conclusions were consistent with the results of the tests; compare the evidence obtained with the results of similar tests performed by us at head office and at the principal store. (iii) Assessment of inherent and control risks It is unlikely that we would be prepared to rely on the assessment of inherent risk by internal audit. Neither would we rely solely on the assessment of control risk by internal audit as this is critical to the development of an appropriate audit strategy. However, in forming our assessment of control risk we would consider the role of internal audit and the results of tests of control undertaken by internal audit. (iv) CAATs The use of embedded audit facilities is much more efficient than test data. Embedded facilities, such as an integrated audit test facility, test live data as it is processed by the system. Although external auditors may be consulted, such facilities are usually installed for use by internal audit. Moreover, the use of such facilities is an ongoing activity and cannot always be conveniently performed during the limited period of external audit attendance at the premises. Furthermore, internal audit may have more expertise in operating the particular facilities ATC-Adding Value To Your Future 44

available than our own computer audit specialists. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1076 For all of these reasons it makes sense to accept the co-operation of internal audit in performing CAATs. However, we would need to: perform tests to ensure that the facilities are properly installed and operating; evaluate general controls over computer operations to ensure that the audit facilities are secure and can only be accessed by internal audit staff; be involved in the design of the tests to be performed; review the working papers to ensure that the tests are properly conducted, supervised, documented and reviewed and that the conclusions are consistent with the evidence. (v) Substantive procedures It would be reasonable to place reliance on routine substantive procedures performed by internal audit at branch stores. Such procedures could include surprise cash counts, attendance at periodic inventory counts, year end cash and inventory counts including follow up procedures such as cut-off tests and checking count sheets to final inventory listings. However, we would need to perform similar procedures at the main store and at least one other store so that we can compare our experience with the evidence obtained by internal audit. The locations that our firm and internal audit visit should be rotated annually. As in previous situations, we would need to review the work performed by internal audit. We would probably also perform additional procedures if the work of internal audit reveals material misstatements or other unusual matters. Answer 31 WICKET (i) Weaknesses Collection of data Hours worked are not authorised. (ii) Consequences Employees may be paid for work not done (eg by their clocking each other in and out at earlier and later times). (iii) Recommendations Mr Lamb should authorise hours to be paid by initialling the clock cards. He should observe the clocking-in procedure regularly to ensure it is not being misused. The calculation of hours worked and the split between basic and overtime for each employee is not subsequently checked. Employees may be overpaid if hours are over calculated or too many are attributed to overtime. Employee goodwill may be lost if underpayment arises from error in the determination of hours worked and the element of overtime. All hours worked and the overtime element, should be calculated and recorded before the clock cards are given to Mrs Gooch. This could be done manually by Mr Lamb or by a new facility to the clocking-in system. Mrs Gooch should countersign clock cards as evidence of having checked the hours calculated. Processing ATC-Adding Value To Your Future


No controls exist over the accuracy of the total, basic and overtime hours input to the computer. Employees may be paid for hours not worked or at the wrong hourly rate. Mrs Gooch should calculate batch totals of basic, overtime and total hours and record these before passing the cards to Mrs Smith. The payroll should be reviewed (for reasonableness of amounts) by one of the cheque signatories (Mr Lewis or Mr Stewart). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1080 (i) Weaknesses (ii) Consequences (iii) Recommendation No controls exist to ensure that all (and only) valid clock cards are processed in the correct period. If a clock card is lost: it may not be possible to verify the hours worked; employee goodwill may be lost; it will be administratively timeconsuming to make individual payments. Mrs Gooch should batch the clock cards and record the total number to be processed. Miss Smith should agree/ reconcile this to a computer-generated total at the end of the payroll run. Security/confidentiality Only one password is used to access the computer for all functions. Unauthorised access could result in: corruption of standing data; data loss. The hierarchical password facility should be used and passwords changed periodically. Backup procedures are inadequate as the zip disk copy is not kept secure and could be lost/ damaged. If the hard disk data is lost/damaged, its retrieval would be costly and timeconsuming in the absence of the zip disk. The zip disk should be stored securely, in a fireproof safe, outside the accounts office. Review/maintenance of standing data Standing data is adjusted for starters and leavers without authorisation. Financial loss could result if: new employees are taken on when idle time/ spare capacity is available; leavers are not removed and subsequently paid. ATC-Adding Value To Your Future


Mr Lambs list of starters and leavers should be signed, as authorised, by Mr Lewis. Mr Lewis should review all standing data amendments logged by the computer. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1081 Other points Collection of data Mrs Gooch is not notified promptly of starters and leavers and may therefore write up inaccurate clock cards. A new starter may work without a clock card making it impossible to check their hours. A leavers clock card may be used by another employee causing a leaver to be paid. A copy of the authorised list of starters and leavers should be given to Mrs Gooch weekly before she prepares clock cards. Review/maintenance of standing data There is no overall supervision of the payroll function. Financial loss may result from: undetected (and therefore uncorrected) overpayments; absence of monitoring of hours worked, idle time, overtime, numbers of employees etc. The number of each category of employee should be budgeted by Mr Lamb and Mr Stewart. The actual monthly costs should be reviewed by Mr Lewis, compared with budget and variances followed up. No independent personnel records are kept outside the payroll function. Payroll errors may go undetected if personnel records are not kept up to date and checked (eg if a leaver is not removed from the payroll). Personnel records and notifications and changes should be kept by Mr Lewis. He should check periodically the computer standing data against these records. No controls exist to obtain the necessary documentation from starters and to prepare documentation for leavers. If the correct tax forms are not obtained, incorrect deductions may be made from a starters wages. The company would be liable for any underpayment of tax. Standard checklists of documents required from starters and for leavers should be used. Security/confidentiality ATC-Adding Value To Your Future


Personnel records are kept by the payroll clerk in a filing cabinet which also contains other records. Staff looking for other records may gain unauthorised access to confidential details relating to other employees (eg details of maintenance payments). Personnel records should be kept by Mr Lewis, not with files in the payroll office. Answer 33 TWO COMMUNICATIONS (a) Letter of representation (i) Purpose During the course of the audit many representations are made by management to the auditors. Some of these are in response to direct enquiries by the auditors, others are implicit in the preparation of financial statements that give a true and fair view. Most of these representations will be confirmed during the course of the audit by more reliable evidence such that reliance no longer need be placed on management representations. For other representations, however, there will be no independent corroboratory evidence available. The letter of representation, therefore, provides formal confirmation of the representations made. In so doing, management may be encouraged to reflect more fully on the completeness of the representations made and provide further information that may earlier have been overlooked. Reliability Failure, by the auditors, to confirm such representations in writing would constitute negligence. However, it is important that auditors do not place reliance on representations where more reliable evidence would be expected. The absence of corroboratory evidence would, in itself, be suspicious and should lead to further audit enquiry. Moreover, written representations do not necessarily constitute sufficient evidence. The auditor must consider all available evidence and its reliability in forming an opinion. For example, in a small business where significant audit reliance must be placed on management representations, auditors may occasionally form the view that, even with written representation by management, there is insufficient evidence on which to form an opinion. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1086 (ii) Matters included Disclosures of contingent liabilities and assertion of completeness of disclosure. Identification of related parties and assertion of completeness of disclosure of related party transactions. Assumptions underlying accounting estimates where sufficient other evidence cannot reasonably be expected to be available (eg projecting the outcome of longterm contracts). Unusual contract terms such as purchases with reservation of title and assertion of completeness/adequacy of disclosure. Managements plans that may significantly alter the carrying value or classification of any of the entitys assets or liabilities (eg managements intention to settle a matter out of court or sell a division). Occurrence of specific subsequent events. Tutorial note: Only three are required. Other matters may also be considered relevant. (iii) Effect of refusal on audit If management refuse to provide written representation as requested, the reasons would need to be enquired into and the effect on the overall sufficiency of evidence considered. If refusal is due to managements uncertainty about the factual accuracy of an earlier verbal representation then additional procedures should be undertaken, if possible, to obtain sufficient evidence. Generally, if a matter were sufficiently important as to warrant a request for its inclusion in the letter, a failure to obtain written representation would normally constitute a scope ATC-Adding Value To Your Future 48

limitation. This would result in the issue of an audit opinion which is either qualified except for or for which a disclaimer of opinion is given. In this case it should be reported by exception that in this respect all information and explanations necessary for audit purposes have not been received. (b) Management report (i) Procedures Timeliness Communication of control weaknesses is normally made shortly after completion of the audit. On larger engagements where control risk was assessed during an interim visit, a letter should normally be sent after that visit as well as on completion of the audit. Occasionally the matter may be sufficiently serious that it warrants more timely communication, such as where the exposure to risk is great or where there is reason to suspect that fraud or failure to comply with laws or regulations may already have occurred as a result of the weakness. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1087 Method As is implied in the title commonly given, the communication is normally made in the form of a letter. Often, however, a preliminary meeting is held with management directly responsible in order to confirm the understanding and to discuss the most appropriate form of changes to the system. The letter is, therefore, more likely to be accepted and its recommendations acted upon. Oral communication may also be appropriate for weaknesses that are in urgent need of correction followed up by a written communication. Level of management It is common to discuss the detailed recommendations with line management before issuing the letter. The letter would normally be addressed to the finance director. The letter may refer to minor matters in brief with more detailed recommendations being sent to financial officers of divisions or subsidiaries. More serious matters may be communicated directly to the Board of Directors or, if the entity has one, the audit committee. These would include such matters as previous recommendations that have not been implemented where the auditors believe the risks to the entity are material. (ii) Auditors responsibility The auditors are not primarily responsible for evaluating the effectiveness of all internal controls and reporting all weaknesses. In the letter of weakness and in the engagement letter the auditor should make it clear that the assessment of control effectiveness is restricted to those controls on which reliance is intended to be placed for audit purposes. If auditors intend to place reliance for particular financial statement assertions wholly on substantive procedures, they have no responsibility for controls over those assertions. Where the auditors do become aware of internal control weaknesses, however, there is an expectation that they will warn management where the risk of loss or misstatement is considered material. Awareness of control weaknesses may come about from procedures other than those directed specifically at testing controls. For example, in obtaining an understanding of the system the auditor may become aware of major control weaknesses. Also, in performing substantive procedures, investigation of errors may alert the auditor to the presence of control weaknesses. The auditors duty to report on the effectiveness of internal controls, under auditing standards, is confined to the management of the entity. They have no responsibility to report to other parties. The letter of weaknesses normally carries a disclaimer of responsibility to any other persons to whom the letter might be shown. Auditors may accept engagements to report on control weaknesses, either to managers, to regulators or to third parties. However, such engagements are not part of the audit of the ATC-Adding Value To Your Future 49

financial statements. Answer 35 THIRD PARTY EVIDENCE (a) Reliability (i) Valuation of land and buildings Provided the valuation comes from an independent, qualified and experienced valuer; this evidence is obtained from a well qualified and competent individual. However, valuation of land and buildings is very difficult and can be subject to considerable error. It is easier to value properties if there are a large number of similar properties available (eg small industrial units and small shops), as the valuer should be aware of how much similar properties are selling for and he can use these valuer to estimate the value of the clients property. If the property is large or of a specialised nature the valuation may be unreliable. With a specialised property (eg a car manufacturing plant) there is the question of whether the purchaser wants to use the property for the same use, or he may decide to demolish it to construct a building for a different purpose. If the buyer wants to demolish the property, the value of the land and buildings will be no more than the value of the land (ie it could be worth the value of the land less the cost of demolishing the buildings). During the recession in many countries in the early 1990s there were few sales of properties, and the selling price of the properties depended on whether there was a willing purchaser and how quickly the seller wanted to dispose of the property. Thus, a normal sale will achieve a much higher price than a forced sale (eg arising from a liquidation). An example of this is that repossessed houses sold for much lower prices than other houses where the seller was in no hurry to sell the property. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1090 (ii) Replies to a circularisation of accounts receivable These are moderately reliable. The limitations are that some customers agree every reply to a circularisation, when it is apparent that there are disputed invoices. Also, some customers may disagree the clients balance, and I, as auditor, will have to check whether the differences are validly goods and cash in transit, or whether they are disputes. Goods in transit are goods sent to the customer shortly before the year end, the invoice of which has not been posted to the customers purchase ledger. Cash in transit is cash paid by the customer, which is not received by the client until shortly after the year end. A practical problem is that many customers do not reply to the circularisation (many companies never reply to any circularisation) and some customers say they cannot confirm the balance. As the replies to these circularisations are sent direct to the auditors office by the customer, it is impossible for the company to amend the customers reply. A significant weakness of a circularisation of accounts receivable is that it does not confirm whether the debt is good (ie the customer can reply agreeing the balance but he may be unable to pay the sum due). So, alternative audit procedures have to be carried out to check whether the debt is good. As far as the quality of audit evidence is concerned, in carrying out such a circularisation one is checking the customers purchase ledger. In practice, purchase ledgers tend to be less reliable than sales ledgers, as there are often delays between receiving the goods and the purchase invoice and in checking the purchase invoice. These delays mean that most purchase ledgers have some cutoff errors (ie goods have been received before the year end but the purchase invoice has not been posted to the purchase ledger before the year end). Sales ledgers tend to be more accurate as the dispatch of goods, preparation of the sales invoice and posting it to the sales ledger are under the clients control and they are usually carried out within a day. Also, sales ledgers have to be accurate to ensure the company receives cash from sales promptly, and thus minimise cash flow problems. (iii) Bank reports for audit purposes The letter from the bank is excellent audit evidence, as banks are a very reliable source of evidence, and the letter is sent direct to the auditor, thus preventing the client from ATC-Adding Value To Your Future 50

manipulating figures. With any bank, the reported overdraft should be correct, but, if the bank is in financial difficulties, the balance of cash at the bank may not be recoverable. Although it is unusual for balances of cash at the bank to be doubtful, this did arise for depositors in BCCI (ie an example of a bank which failed). In conclusion, the valuation from a valuer is probably the least reliable form of audit evidence because of the difficulty in valuing properties (as described in the answer). The replies to a circularisation of accounts receivable are less reliable than the letter from the bank which is the most reliable form of third party audit evidence. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1091 (b) Valuations In order to check the accuracy of the valuation, I would check the independence, qualifications and experience of the valuer. On independence, the valuer should work for (or be a partner of) a firm of valuers and he should not be an employee of the audit client or related to the directors of the audit client. On qualifications, he should be a member of a professional body. The valuer should be experienced in valuing similar properties to the clients and in the same geographical area. For instance, the valuation would be unreliable if the valuer was only experienced in valuing domestic properties and the client owned industrial properties. Also, the valuer should have experience in valuing properties in the same geographical area as the client, as, for instance, properties in London have a different value from those in Paris. The basis of the valuation should normally be an existing use valuation. It would not normally be appropriate to use the rebuilding cost of the property as a valuation base (except for insurance purposes). In order to check that the value of the property is reasonable, I would inspect the property and check that its value is consistent with the value of similar properties. I may have had experience of clients buying similar properties recently, so this will give me a guide to the propertys value. Also, the price properties are advertised by estate agents is a guide, although the estate agents asking price is likely to be higher than the finally agreed sale price. (c) Bank balances In order to check the accuracy of the cash book balance in the companys accounts, I will have to check the bank reconciliation. I will obtain a copy of the bank reconciliation from the client and: Check the additions on the bank reconciliation. Check receipts and payments from the bank statement to the cash book for the month before the year end. Note uncleared items at the year end from the cash book (and the previous months bank reconciliation) and agree them to the bank reconciliation. Check the clearance of the items after the year end. Most cheque payments should have cleared within a week of the year end. If there are a significant number of cheques uncleared two weeks after the year end, it is an indication that the cheques were not posted to suppliers until after the year end. So, these payments should be reversed in the cash book and added to payables at the year end (ie a payment is normally treated as a payment when the cheque is sent to the supplier) Lodgements should be cleared within two banking days of the year end. If there is a longer delay, it indicates there may be a teeming and lading fraud. To check if there is a teeming and lading fraud, I will check that yesterdays cash receipts were banked either yesterday evening or today (by checking the entry in the cash book and the date stamped by the bank on the copy of the paying-in slip). If there is a delay, I should be able to count the unbanked cheques and cash if they are missing, a teeming and lading fraud is taking place. Agree the balance per the bank on the bank reconciliation to the bank letter and the bank statement AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1092 Agree the cash book balance on the bank reconciliation to the cash book and draft ATC-Adding Value To Your Future 51

accounts. If there is more than one bank account, the reconciliation of all the bank accounts should be checked. The number of bank accounts should agree to the number in the bank letter (or if the accounts are held at more than one bank or branch, I will check them to letters received from all the banks where accounts are held). I will check the validity of all accounts opened and closed in the year, by checking the last statement for accounts closed and the first for accounts opened. Answer 36 ISA 500 (a) Procedures for obtaining audit evidence Inspection The physical examination of records, documents or tangible assets. Observation Looking at procedures being performed by others. Inquiry and confirmation Inquiry consists of seeking information of knowledgeable persons inside or outside the entity. The information may be new to the auditor or may corroborate evidence from other sources. Confirmation is the response to an inquiry to corroborate information contained in the accounting records. Computation Checking the arithmetical accuracy of source documents and accounting records or performing independent calculations. Analytical procedures The analysis of significant ratios and trends and investigation of fluctuations and relationships that are inconsistent with other relevant information or deviate from predicted amounts. (b) Audit tests of plant and equipment Tutorial note: The tests in this answer are illustrative only. Other tests using each procedure would be equally satisfactory. Inspection Physically inspect additions to plant and equipment agreeing details (eg model number and serial number) with the purchase invoice and fixed asset register. Observation Observe entity staff comparing the physical existence of plant and equipment with the items recorded in the fixed asset register. Inquiry and confirmation Obtain written confirmation of the existence of plant and equipment recorded as being leased to customers. Computation Check the computation of depreciation for the year. Analytical procedures Compare the total depreciation charge for plant and equipment with the comparable charge for the previous year and consider the reasonableness of any difference. (c) Reliability of evidence Inspection With the inspection of documents the reliability of evidence depends on: the nature and source of the documents with the least reliable being documents created by and obtained from the entity and the most reliable being documents created by and obtained directly from third parties; whether documents are originals or photocopies or facsimiles. With the inspection of tangible assets, as in the test in (b) above, the reliability depends on the ability of the auditor to be certain the asset examined is the one recorded in the records. Reliability may be increased by obtaining the services of an expert in identifying the asset. Observation The reliability of the evidence depends on whether: entity staff were warned in advance that their performance was to be observed by the auditors; performance is likely to be affected by the knowledge that it is being observed. Where observation is of the nature of a sample test, as in observing ATC-Adding Value To Your Future


comparison of fixed assets to the records for only a sample of the entitys plant and equipment, the reliability of the evidence depends on the auditors judgement as to whether the performance of procedures by entity staff might differ when they are not being observed. Inquiry and confirmation The reliability of the evidence depends on; the independence of the other party, whether the reply is written or oral. Confirmations from customers as to the existence of plant and equipment on hire to them is highly reliable as, being third parties, they are independent of the entity and as the response is written. Computation Being entirely auditor created, computational evidence (eg verifying the calculation of the depreciation charge) is highly reliable. Analytical procedures As auditor created evidence analytical procedures are reliable but limited by the ability of the auditor to assess its reasonableness. In comparing the total depreciation charge for the year, the effect of additions and disposals of assets with different depreciation rates can only be approximated unless a full computation is performed. Where the procedure involves non-financial data or data from outside the entity, reliability is limited by the reliability of the other data. Answer 37 MILDRAIN (a) Potential problems of unrestricted Internet access Many companies are now offering services on the Internet. These services include limited banking facilities, loan advice, tax advice, share dealing and advertisement of company products. It is possible to buy and sell goods via the Internet. Thus an unauthorised official with access to the Internet could notionally: pay for goods of a personal nature by using a corporate credit card number; sell the companys assets; buy goods/services on behalf of the company; disseminate confidential information (eg financial data); give advice to customers which may prove to be negligent. The common practice of putting a disclaimer at the bottom of public messages is not a fail safe shield in this matter. Obviously these possibilities are always likely in a company but the Internet gives staff more opportunity to carry out these acts. Thus an unauthorised official could cause significant disruption in the companys operations by gaining access to the Internet. The question as to whether the contracts made via the Internet in this fashion are legally binding is a separate question depending upon the circumstances of the case. However, it can be seen that access controls are essential to prevent problems being created by unauthorised access to this powerful medium. (b) Controls to prevent unauthorised Internet access There are several controls which a company could use to prevent unauthorised access to the Internet system. Identity recognition procedures can restrict access to the system. Access may require the use of passwords, identity tokens or other security devices. Access controls will involve the use of a card, badge or key system, personal identification numbers (PINS) or a combination of these methods. These systems, however, control access and not the personnel. It is possible to gain unauthorised access to the system by using an authorised persons identity recognition device. Care must be taken to ensure that the system for issuing badges, keys, tokens or PINs is secure. Systems may also operate by voice reference, fingerprint recognition, signature or other personal characteristics. Additionally it is normal for passwords to be encrypted in order to prevent unauthorised use of the password. A physical control could be the removal of the relevant hard disk from the computer ATC-Adding Value To Your Future 53

hardware. This would obviously prevent the user from gaining access to the Internet. Thus it can be seen from the above that it is important that the entry points to the system are shielded and protected. Additionally procedural controls can be set up whereby information/transactions to be processed by the Internet are only dealt with by authorised personnel. Essentially there would be segregation of duties between the user department and the data input/output section. Also the company could set up a formal fraud/error control project. In a risk based analysis of the areas of corporate operations which are most at risk, the Internet system would obviously come under close scrutiny. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1095 (c) Validity of audit evidence Audit evidence assists auditors in their judgements concerning the relevance and reliability of the accounting assertions. It is the means by which the auditor achieves assurance about the reporting quality and is the basis for the auditors opinion: Evidence should be valid and relevant. ISA 500 Audit Evidence states that the reliability of audit evidence can be judged by using certain criteria, as follows: external evidence is more reliable than internal evidence; evidence from the companys records is more reliable when internal controls are satisfactory; evidence obtained by the auditors is more reliable than that obtained from the entity; written evidence is more reliable than oral representations Evidence collected from the Internet system could be valid audit evidence but the quality may vary. For example, a customer could confirm a balance outstanding via the Internet using the customers ID. This could be construed as good audit evidence if there is no possibility for example of altering the customers reply. Again if the procedural controls over access to the Internet are good then the quality of the audit evidence derived from it is enhanced. The auditor may set up his own access code on the Internet and test the information set up by the client on the Internet system. This audit evidence will then have some validity depending upon the quality of the clients initial input to the Internet system. For example if property loan quotations are made by the company via the Internet, the auditor could select a sample of these quotes as the base documents for his compliance tests. Evidence generated by the Internet can be printed out by the client and thus is in documentary form but the quality of the evidence will be determined by the validity of the source of the information. (d) Additional work on audit exceptions Credit notes A formal letter should be written to this supplier together with a detailed statement setting out the make-up of the outstanding balance in the clients records. The letter should ask for confirmation of the outstanding balance and/or a reconciliation of any difference between the amount in the suppliers records and that in the clients records. The reply should be sent directly to the auditors offices. Additionally the whole payables ledger should be scrutinised to see if there are any similar cases. If the auditor is suspicious then a suppliers circularisation should be performed and purchases cutoff further scrutinised and tests extended. Also the credit notes could be traced to specific purchase transactions/invoices and the truthfulness of the proposition that these were issued for overcharging can be examined. The existing audit evidence can be further reviewed by looking at the Internet address from which the credit notes had been issued. The company should have a list of addresses of company suppliers and the source of the credit notes can be agreed to this listing. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1096 Insurance policies and property loans A sample of the new clients who had taken out insurance policies and loans could be taken and direct confirmation techniques used to verify the authenticity of the transaction. Additionally the auditor could write to the insurance company or loan company stating the ATC-Adding Value To Your Future 54

amount of the outstanding balance due to the client company and asking for direct confirmation of the balance outstanding to be sent to the auditor. Again the auditor could look at the source address on the Internet for these transactions and try and determine the independent nature or otherwise of the audit evidence. Again the auditor could scrutinise this evidence for any related party involvement. (e) Resolving differences of opinion Differences of opinion between members of an audit team are quite common because of the subjective nature of many of the judgements made by auditors. The matter should be resolved by open discussion between the members of the audit team and the audit senior should take responsibility for any decisions made. Audit assistants are often reluctant to express an opinion for fear of the effect it may have on their career. However, if the audit assistant is convinced that material error could occur there is an ethical obligation to bring this to the attention of the audit manager. The audit assistant may feel that a note disassociating himself from the decision should be placed on file. However, the decision as to the notes inclusion in the audit working papers will be made by the audit manager or partner and in reality, it is unlikely to be included in the file. The audit manager is likely either to disagree with the audit assistant in which case no note will be filed or agree with the assistant in which case additional work will be performed. The limited extent of an audit assistants experience often leads to disproportionate significance being given to certain matters. However, in this particular case, it is likely that the audit manager will agree with the audit assistant and that the additional work will be performed. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1097 Answer 40 JUST CRUST (a) Nature and purpose of analytical procedures Analytical procedures involve: the analysis of significant ratios and trends; the investigation of fluctuations and relationships that are inconsistent with other relevant information (or which deviate from predicted amounts). Analytical procedures include the consideration of: comparisons of the entities financial information with, for example, similar industry information; relationships between financial and non-financial information. Procedures may involve simple comparison of current with prior years or a review of variance accounting. They are used: to assist in audit planning the nature, timing and extent of other audit procedures; as substantive procedures (when more effective or efficient than tests of detail); as an overall review. (b) Extent of use At the planning stage, analytical procedures assist in understanding the entitys business and identifying potential risk areas. Substantive procedures, such as test in total, may be effective in reducing detection risk for specific financial statement assertions (eg regarding rental income, interest payable, depreciation, etc). Conclusion drawn from analytical procedures as part of the overall review of financial statements should corroborate conclusions drawn on individual audit areas. Substantive analytical procedures Analytical procedures can themselves provide sufficient audit evidence where an item can be verified directly by reference to another (valid) item. Analytical procedures may be effective in testing for understatement (ie completeness). For example, in predicting sales from purchases and known margins. Where sufficient substantive evidence is not obtained by analytical procedures alone, some tests of detail will also be required. ATC-Adding Value To Your Future 55

AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1104 Greatest use of substantive analytical procedures is where: existing client is well established; well known industry is stable; predictive information is available (eg budgets); accounting and internal control systems are effective. (c) Substantive analytical procedures Tutorial note: Just Crusts inventory is minimal. Sales (broken down by product and in total) Compare variations by month with the previous year. Investigate seasonal fluctuations which are inconsistent. Ascertain reasons for volume increases or decreases in sales, especially where the movement is contrary to the industry trend. Compare sales in volume terms with manufacturing capacity. Compare production with delivery records. Reconcile sales value with previous year by reference to production levels and selling price increases. Compare and explain fluctuations in the following ratios: Delivery costs : sales Discounts allowed : sales Productive labour : sales Agree/reconcile turnover to VAT (sales tax) returns. Purchases Reconcile raw material purchases (flour etc) with production records and industry averages for price increases. Compare and explain fluctuations in the following ratios: Carriage in : raw materials Discount received : raw materials. Compare costs of material consumed. Gross margin and cost of goods sold Compare with previous years. Review percentage against industry average. Compare with clients mark-up percentage. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1105 Manufacturing overheads Compare variable production overheads (eg lighting and heating) with previous year by reference to production levels and general price increases. Compare fixed production overheads with previous year by reference to general price increases. Compare output per production worker (each baker) with corresponding figures for previous year. Salaries and wages Compare, explain and substantiate fluctuations in the following: Social security expense : payroll Pensions scheme expense : payroll Holiday pay : wages. Schedule payroll expense by week or month and explain fluctuations by reference to staff changes, pay rises, holiday pay, etc. Compare total with comparative figures and rationalise by reference to overall staff levels and pay rises (proof in total). Other profit and loss expenditure Compare where relevant: rent with annual rent per rental agreement; rates with previous year and known rate increases; other items related to activity level (eg advertising) with price increases ATC-Adding Value To Your Future 56

and changes in relevant level of activity; other items not related to activity with general (or specific) price increases; vehicle running expenses to number of vehicles; vehicle running expenses (excluding wages) to mileage. Balance sheet Compare and explain fluctuations in the following: Solvency ratios (1) Current assets : current liabilities (2) Liquid assets : current liabilities (3) Collections period Capital ratio (gearing). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1106 Other Make comparisons using significant accounting ratios, in particular those relating to: profitability liquidity capital gearing. Compare items with budgets or forecasts, and with previous periods. Specific comparisons should include: breakdown of sales into products; costs of productive labour compared with sales; costs of variable overheads compared with sales; returned and unsold goods compared with production; fixed assets, depreciation, and vehicle running costs. Determine monthly trends, using management accounts, and take into account: changes in the expected direct relationship between raw materials purchases, production, and sales (minimal inventory being held in the bread industry); changes in the buying habits of the public (eg moving from processed to wholemeal bread); any unexpected variations in capital expenditure on vans, which might indicate an expansion or contraction (actual or anticipated) in sales; labour unrest in the bakery industry on a national level; and any undercutting of the companys prices by imports of frozen bread or cakes. Answer 42 KILLARA (a)(i) Effect of factors on sample size Tests of controls (Tests 1 & 2) Population size It is generally accepted that population size has no effect where populations are over 5,000 and little effect, even, on populations over 500. The fact that Test 2 involves a larger population of transactions, therefore, does not mean that a larger sample size will be required. Assessed level of control risk Assuming it is intended to take maximum advantage of controls in determining the extent of substantive procedures, more reliance would be sought from the effective operation of the control in Test 1 than in Test 2. This is because fewer substantive procedures result in there being less chance of discovering errors if control procedures are not as effective as believed. A relatively larger sample is therefore needed for Test 1. Deviation rate A deviation indicates that a control is not operating and increases the chance that an error could occur. In practice, tolerable deviation rates are determined by reference to the level of control risk to be confirmed. Therefore, the effect on sample size is that a larger sample is required for Test 1 than Test 2. A larger sample enables the results to be projected to the population with greater precision. Tutorial note: The deviation rate is the proportion of transactions not processed in ATC-Adding Value To Your Future


accordance with laid down procedures, whether or not the invoices are still correctly recorded. Expected deviation rate In Test 1, even if the sample deviation rate is significantly greater than expected, it could still be within tolerable limits. For Test 2, however, it is more important that sample deviation rate closely reflects actual deviation rate as there is less margin for sampling error. A relatively larger sample size will, therefore, be required for Test 2 than for Test 1. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1111 Substantive procedures (Tests 3 & 4) Inherent and control risk The higher the risk, the greater the likelihood that controls have failed to detect or prevent errors and, therefore, the greater the likelihood of errors in the data being tested. To achieve a consistent level of audit risk for both tests, a relatively larger sample will be needed for Test 3 on inventory than in Test 4 on trade receivables. Tolerable error This relates to materiality. Although other factors enter into the determination of tolerable error, the balance on inventory is probably substantially larger than trade receivables such that a much smaller percentage error will be material to the financial statements as a whole. In order that sample results may be interpreted with the required precision, a larger sample of inventory items would be needed for Test 3 than of trade receivables balances for Test 4. Expected error In Test 4, even if the sample error rate is significantly greater than expected, it will still be within tolerable limits. For test 3, however, it is more important that sample error rate closely reflects actual error rate as there is less margin for sampling error. A relatively larger sample size will, therefore, be required for test 3 than for Test 4. (ii) Results of tests of controls The results indicated a deviation rate for Test 1 greater than the tolerable rate. The intended reliance on controls is, therefore, not supported. It is possible, however, that some reliance could still be placed on controls. The results of the sample would need to be re-evaluated and, possibly, the extent of testing increased to determine the actual deviation rate and revise the control risk assessment. Sample deviation rate in Test 2 is much better than is necessary to support the assessed level of control risk. However, it does not support control risk being assessed as less than moderate. Assessment of control risk is principally determined by the design effectiveness of controls, not operating effectiveness as tested by this procedure. (b) General control objectives over computer information systems Operations The principal objective of controls over computer operations is that functions are properly assigned to competent individuals and to achieve an effective segregation of duties. System development The objective of controls over systems development and maintenance is to provide reasonable assurance that systems are developed and maintained in an authorised and efficient manner. In particular the controls must ensure the reliability of new systems and of changes to existing systems and the availability of adequate documentation describing systems in use. Access The objectives of access controls is to provide reasonable assurance that computers are properly used for authorised purposes only and that neither the computers themselves nor the data held within the information system can be accessed by unauthorised persons. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1112 Other The principal objective of other controls is to ensure the continuity of operations by guarding against malfunction and through the provision of back-up facilities for both data and operations. Answer 43 NEWTHORPE ENGINEERING ATC-Adding Value To Your Future 58

(a) Audit work on estimates Obtain a schedule identifying the assets and employees who are being made redundant as a result of closure of the factory. It will be easier to identify these items if the whole factory is being closed: plant and equipment should be identified in the fixed asset register; and employees should be either on a separate payroll or otherwise separately identified. (i) Net realisable value plant and equipment Obtain a schedule of the fixed assets and the estimated or actual disposal proceeds. In most cases there is likely to be a loss on disposal, unless the fixed asset is fully written off. To check completeness of the population being examined, agree (or reconcile) the cost and depreciation on the fixed asset register to the figure in the companys accounting records and the draft financial statements. Obtain separate schedules of plant which is sold and plant which is unsold. Test check the completeness of plant and equipment on the schedules by selecting items of plant from the fixed asset register and checking they are on either the plant sold schedule or the plant unsold schedule. For selected items of plant which have been sold, agree the sale proceeds to sales invoices and cash book receipts. There may be costs of disposal (eg unfixing or dismantling the plant) which will have to be deducted from the sale proceeds if Newthorpe has agreed to pay these costs. If the item has not been sold, obtain details of the plant and its estimated sale proceeds. If the sale proceeds are small (eg scrap value) confirm that this is reasonable (eg in relation to the age and condition of the asset). If estimated proceeds are substantial, ask the companys staff why they are so large and whether potential buyers have expressed interest in purchasing them. Inspect correspondence or other evidence of interest by buyers (eg in response to sale advertisements). Further consider whether estimated sale proceeds are reasonable by comparison with actual proceeds received from the sale of similar assets. Increase the sample of items to be checked if the companys estimates are unreliable. Discuss any significant differences with the directors. If they refuse to change the figure in the financial statements to reflect apparent impairment losses, include the difference in the schedule of unadjusted errors. (The auditors report should be qualified if the total of the unadjusted errors is material.) AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1113 (i) Net realisable value inventory Obtain a schedule of the actual and estimated proceeds of sale of the inventory. Tutorial note: The question clearly states that the physical count was carried out at the year end and that inventory quantities have already been determined to be accurate. Using details of year-end inventory from the inventory sheets (as a basis for identifying the inventory which is sold after the closure) select a sample of inventory of inventory, probably using monetary unit sampling. For inventory which has been sold, agree sale proceeds to sales invoices and cash book receipts. For some items, it may not be possible to identify the selling price as a number of products may have been sold in a single transaction. If this has happened, the allocation of sale proceeds against the inventory sold should be reviewed for reasonableness. For inventory which is unsold, consider whether the companys estimates are realistic. Confirm that the disposal proceeds of clearly slow-moving or obsolete items are estimated to be only small (if any). For items where the estimated sale proceeds are large, ask Newthorpes staff the reasons for such a high price being used. Obtain corroborative evidence such as ATC-Adding Value To Your Future 59

offers received from potential customers. Use judgement, based on knowledge of the products and experience in other audits, to assess reasonableness (eg an estimate of valuable material, such as lead, could be obtained from a scrap metal merchant). For items which are unsold, net realisable value is sale proceeds less costs of sale. Confirm the reasonableness of such costs (eg that costs of advertising and possibly delivery to the customer are taken account of). _____Unsold work in progress is likely to have a low value (if any) so should be investigated if a high value has been attributed to it. If the value of unsold inventory is significant, compare the ratio of net realisable value to cost for unsold inventory against that for inventory sold. For example, if inventory has been sold at 20% of cost, then it is unlikely that the remaining inventory will be sold for 25% of cost, but a figure of 15% of cost for the unsold inventory would probably be realistic. As for plant and equipment, discuss any significant differences with the directors (and include, as necessary, on schedule of unadjusted errors). (ii) Redundancy cost Obtain a schedule of the redundancy costs. Agree the basis for the redundancy payments (as stated in the question), for example, to: documented company policy; contractual terms of employment; terms minuted by the Board and announced to the workforce. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1114 Confirm that employees on the payroll just before the factory closed appear on the list of employees being made redundant. For employees on the payroll who are not on the list, verify that they have been transferred to another factory (eg they should appear on a current payroll for that factory). Discuss with management any employees on the list of those being made redundant who do not appear on the factorys payroll at the year end. For most employees, redundancy pay will be the weekly pay times the number of years service. For a sample of employees, agree the number of years service from the start date recorded in their personnel records. Ask what is meant by one weeks pay (eg basic pay (excluding overtime) or a weekly average (including overtime)) and agree it (eg to the weekly payroll). Recalculate redundancy payments and compare with amounts paid. For a sample of employees under a service contract, recompute the amount due under the terms of their contract. Test check the payments to the cash book to ensure they are the same as on the companys schedule. Check the addition of the employees redundancy pay and agree it to the provision in the financial statements. Ask if there are any disputes with employees over the amount they are to be paid (or have been paid). Review correspondence with employees and Newthorpes legal advisers for evidence of disputes. Discuss with management their opinion of the final outcome, and consider the materiality of any additional amount that might have to be settled (including legal costs). Tutorial note: The last point could be expanded on, for external confirmation from legal advisers and written management representation, but this part of the question carries only 4 marks. (b) Unfair dismissal (i) IAS 37 disclosure requirements for contingent liabilities If the possibility of the obligation is remote no disclosure is required in the financial statements. Where the probability of the obligation is possible but not probable (ie < 50%), a ATC-Adding Value To Your Future 60

note about the contingent liability should be included in the financial statements indicating: the nature of the contingent liability; an estimate of its financial effect (where practicable); the uncertainties relating to the amount or timing of any outflow; and the possibility of any reimbursement. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1115 Where there is a probable obligation, as a result of past events, the liability should be provided for in the financial statements (unless a reliable estimate of the amount cannot be made). In this situation the financial statements are required to make disclosures about the provision also. (ii) Audit work Tutorial note: To determine whether the company will have to pay damages depend on whether the likelihood of settlement is remote, possible or probable. The amount of damages and costs which should be included in the financial statements will depend on the sums the company may have to pay if it is successful or unsuccessful in defending its action in dismissing the Managing Director. To determine the likelihood of the Managing Director being successful in his claim: Obtain a copy of his service contract and consider whether, under its terms, he could be entitled to two years salary. If so, this would probably be the maximum sum he could claim under this contract. Scrutinize the contract for any circumstances which would prevent him making this claim (eg being dismissed for gross misconduct). Obtain a transcript of the companys disciplinary hearing held on 17th March and discuss with management the details of the allegations of gross misconduct. Inspect any evidence supporting these allegations (eg an internal report on fraud) and consider whether the Managing Director has at any time agreed or refuted the companys findings. Ask about any developments since 17th March which could quantify the companys potential liability relating to this claim. Read correspondence between the company and the Managing Director (or between their solicitors). If the company has agreed to make an out-of-court settlement, a provision for the payment should be included in the financial statements. It seems probable that the company will incur legal costs in defending the claim by the Managing Director and these should be accrued in the financial statements. An estimate of these costs should be obtained from the companys solicitor (with the clients permission). External confirmation from the companys solicitor should be sought regarding the likely outcome of the case. In the unlikely event that the amount of damages claimed is very material (eg so as to threaten the companys existence), further independent legal advice should be sought. Review Newthorpes insurance policy documents for any cover against such claims and the legal costs. Obtain external confirmation from the insurance company (with the clients permission) to confirm that it will reimburse any agreed settlements. The insurance company may pay the legal costs, but not any damages awarded against the company. Any reimbursement through insurance cover should be separately disclosed in the financial statements (and not merely offset against the liability). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1116 The reasonableness of the companys omission of any provision or disclosure in the financial statements should be assessed based on the findings of the above investigations. Although the company will probably want to avoid mentioning dismissal of the director in the financial statements (because of the associated bad publicity), if the likelihood of the company having to concede the Managing ATC-Adding Value To Your Future 61

Directors claim is less than remote (ie at least possible) there should be some disclosure in the notes (whether a contingent liability or provided for). Also, the company will probably have to pay its own legal costs, and these should be provided for. Answer 47 SOUTHWELL ENGINEERING (a) Test data In using test data to check the operation of the companys accounting computer programs, first I would either prepare some test files or copy the clients standing data and transaction data files. Then I would print out these files, including the balances on each sales ledger account and the total of the sales ledger balances. The purpose of printing the contents of the files at this stage is to enable me to check that after input of the test data, the changes in the contents of the files are correct. Test data comprises valid and invalid data. Valid data should be processed correctly and with invalid data either a warning should be given (for minor errors) or the data should be rejected. First, I will input valid sales data comprising: a valid account number the current day for dispatch various items to dispatch with the part number and quantity of each item. I will check that the computer produces a dispatch note and a sales invoice in accordance with these details, and updates the sales ledger. I will check that the correct prices have been used on the sales invoice and that the calculations on the sales invoice are correct. Invalid data will include: an invalid account number. If the account number is not on the standing data file, the computer should reject the data input. However, the computer will not reject an account number which is for a valid customer, so the computer should display the customers name and address on the screen so that the user can check that it agrees with the details on the record from which data is being input an invalid date could be input. If it includes alphabetic letters it should be rejected. If it is for a date earlier than the current date, the computer should give a warning and allow the data to be input again. If the date is some time in the future, a warning should be given (ie it should accept a date up to a week in the future, if it is up to a month in the future a warning should be given and if it is more than a month it should be rejected) AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1125 an incorrect part number can be input. This is similar to inputting an invalid account number, as it should be rejected if it is not on the file. The computer should display details of the part on the screen so that the user can check that it is in accordance with the part number which has been input (ie the computer will not be able to detect an incorrect part number, which is on the standing data file). The part number may have a check digit to minimise the risk of an invalid number being input. Also, it may comprise a letter followed by five numbers, and the computer can have a format check to ensure the first character is alphabetic followed by five numeric characters this format check can be tested by inputting invalid characters (eg numbers where alphabetic characters are expected and vice versa) the computer should not accept any alphabetic characters when the quantity is input, and it should not accept zero or negative quantities. For most items it should only accept whole numbers (as one cannot have half of a car!) but for liquids and solids measured by weight or volume it may allow decimal figures. For some items, there may be a limit of the quantity the computer will accept. The test data will be designed to check these controls. Following the input of this data, the listing of the invoices will be printed out, as well as the sales ledger accounts updated and the total of the balances on the sales ledger. I will check that the sales ledger accounts have been updated correctly and that the closing balance after inputting the data is equal to the opening balance plus the value of the invoices posted to the ATC-Adding Value To Your Future 62

ledger. I will check that sales income has been recorded correctly and posted to the nominal ledger. (b) Computer audit program A computer audit program can be used to select accounts for circularisation from the sales ledger file using a random statistical sampling method. The most appropriate method to use is monetary unit sampling, where the probability of an account being selected is proportional to its value. A computer audit program can be used to perform this task. The procedure for selecting accounts using monetary unit sampling is as follows. If the total of the sales ledger balances is $1 million, and 50 accounts are to be circularised, one account is circularised for every $20,000. First, the accounts are listed in account number order, and a random number between 0 and 20,000 is selected (say 13,199). The following example illustrates how this method is used: Account name Balance Total b/fwd Total c/fwd Select? $$$ 1 AGJ 4,663 0 4,663 No 2 AHG 10,925 4,663 15,588 Yes 3 AKD 13,524 15,588 29,112 No 4 APD 17,236 29,112 46,348 Yes 5 ASG 241 46,348 46,589 No Account 2 is selected because its balance straddles $13,199 (ie $13,199 straddles the b/f balance of $4,663 and the c/f balance of $15,588), and account 4 is selected because its balance straddles $33,199 (ie 13,199 + 20,000). The computer audit program can be used to check the ageing of the account balances (as described below), print out old outstanding balances and those over the credit limit. I will circularise a sample of these balances which look doubtful. These will include accounts where I am aware the company is in financial difficulties, and those where there are old unpaid items. In addition, I may circularise a few zero value balances and credit balances. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1126 Using the list of accounts receivable I have decided to circularise (arrived at from the procedures described above), the computer audit program will be used to write the letters to send and include the balance in the letter. Also, a copy of the statement at the year end may be included in the letter to enable the customer to identify the reasons for the difference between his purchase ledger balance and the clients sales ledger balance. In addition, the computer can send out second letters to customers who have not replied, analyse the results of the circularisation and produce a statistical conclusion to this test (ie provide a quantitative measure of the accuracy of the sales ledger). (c) Year-end receivables A computer audit program can be used on the sales ledger transaction file to: add up the individual items on each sales ledger account and check that the total agrees with the total balance on that account (normally, the computer stores the individual items and the total balance on an account in separate data files) check the ageing of sales ledger accounts and compare this ageing with that produced by the companys normal accounting program add up the balances on each sales ledger account and agree it to the total of the balances on the sales ledger. The computer audit program can add up the individual ageing of each account and check it to the total ageing, and it can calculate the number of accounts with a balance and the total number of accounts on the standing data file. The total number of accounts will be checked to the number printed by the companys accounting computer program the computer can print out sales ledger accounts where the customer is over the credit limit or the debts are overdue. It can print out credit balances and those with unallocated cash (ie where cash received has not been matched to sales invoices) select accounts for circularisation, write the letters to the customers and analyse the results (as described in (b) above). Any differences between the figures calculated using the computer audit program and those ATC-Adding Value To Your Future 63

printed out by the companys normal sales accounting computer program would be investigated. The checks above will assist the auditor in the following audit tasks: checking of the additions will be more comprehensive than the auditor could perform manually. Once the computer audit program is set up, it will take very little time to carry out with a consequent time saving in future years checking the ageing of debts provides confidence that the companys age analysis provides a reliable source of audit evidence the overdue debts and those over the credit limit can be investigated to see if they are doubtful debts. Credit balances often arise through errors (eg where invoices are not posted to the sales ledger) and unallocated cash indicates weaknesses in the companys system of control (as they should contact the customer and ask which invoices are being paid and if there are any disputes). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1127 Answer 50 NEWTHORPE MANUFACTURING (a) Valuation of land and buildings Obtain the letter from the valuer stating the value of the property (ie land and buildings). This should be the original letter sent by the valuer to the company (and not a photocopy). Check there has been no amendment to the valuation and that the letter is signed by the valuer. Confirm the existence of the valuing firm by checking its name to the telephone directory. Independence of the valuer To confirm that the valuer is not an employee, confirm that the name of the valuer is not on the companys payroll. Carry out further investigations if an employees name is found to be the same as the valuers (this seems unlikely). If the valuer has the same surname as a director or senior employee of Newthorpe Manufacturing, determine whether the valuer is related to that employee. If they are related, it could prejudice the independence of the valuer. If the valuation has been by a firm of valuers, check that none of the surnames of the partners are the same as directors or senior employees of the company. Ask the directors if they are connected to the valuer, either by a blood relationship or by being directors or partners in a common business. Make the same enquiry of the valuer. Include a statement that the directors have no business or blood relationship with the valuer (or partners in the firm of valuers) in the letter of representation. Ideally, the valuer should not own shares in Newthorpe. This can be checked against the register of members (shareholders). If the valuer does own shares in Newthorpe Manufacturing, this should not be a problem provided the number and value of the shares is small (but it could be a problem if the valuer owns a substantial number or value of shares of Newthorpe Manufacturing). Consider whether the fee for the valuation is a substantial proportion of the fees of the valuer. This may be apparent from my local knowledge of the firm of valuers. Obtain external direct confirmation from the valuer if the valuation fee appears to be is a substantial proportion of the valuers income. Qualifications and experience Confirm the qualifications of the valuer by inspecting his qualifications on the headed paper with the valuation (it will either be given in the list of partners, or when he signs the letter). If there are no qualifications given on the letter, contact the valuer to enquire. If there are any concerns that qualifications may not be valid, contact the valuers professional body. If being a valuer requires the member to have a practising certificate (like members of the ACCA); check with the professional body that the valuer has a current practising certificate. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) ATC-Adding Value To Your Future 64

Accountancy Tuition Centre (International Holdings) Ltd 2004 1134 Consider whether the valuer is experienced in valuing properties like those owned by Newthorpe Manufacturing. Ask the valuer for details. If the valuer normally values houses and has little experience of valuing industrial properties, then his valuation will be less reliable than if he commonly values industrial properties. Newthorpe Manufacturings properly is likely to be quite large, and it may be specialised, so the valuer needs to have experience in valuing this type of property. The valuer should have experience in valuing properties in the same geographical area as Newthorpe Manufacturings property. If the valuer is a local firm, then it is more likely to produce an accurate valuation than from a valuer in a different area where there are large differences in property prices (eg a London valuer valuing properties in Madrid). Terms of reference Ask the company for a copy of the letter appointing the valuer. This should show the terms of reference set for the valuer. Consider whether there have been any limitations placed on the valuers work. The letter by the valuer which includes the valuation is likely to include any limitations placed on the valuers work, assumptions concerning the valuation and the basis of valuation used. Basis of valuation and current value The property should have been valued on an existing use basis (or similar basis). A basis like development value would probably not be appropriate as it is likely to be anticipating future profits. If development use is used, discuss the matter with the directors and seek further evidence and consider whether it is appropriate. A replacement cost valuation would not be appropriate, as the cost of replacing the building will probably be more than its current (second hand and used) value. As it appears that the property may be over-valued, ask the valuer the basis he has used to value the property (eg land and buildings on a $ per square metre basis). Review any documents the valuer has used in the valuation (to check their authenticity and reliability). Review the prices being asked for similar properties at other industrial estate agents and see if they are consistent with the value placed on Newthorpe Manufacturings property. The rental value of a similar property could be used to estimate the current value, as with rentals at (say) 5% of capital cost, a rent of $100,000 a year would indicate a capital cost of $2 million. If local or national statistics are available which provide indices of property prices, use these indices to determine whether the increase in the value of the freehold land and building is reasonable. Based on this work, decide whether the value of $5 million is reasonable. As valuation of properties can be subject to considerable error, quite a large difference between my estimated figure and that estimated by the valuer maybe acceptable. However, if there is a material over-valuation of the property, the directors should be asked to reduce the value (or obtain another valuation which gives a lower value). If they refuse, the auditors report should be qualified (except for disagreement). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1135 (b) Existence and completeness of plant and equipment Agree the opening balances (cost and accumulated depreciation), closing balances, additions, disposals and depreciation charge on the non-current asset register agree with the accounting records and the draft financial statements. Before deciding on the number of items to check, enquire how frequently the company checks the existence of plant in the non-current asset register and review the documents recording details of the companys checks. Select a larger sample of non-current assets if they are checked infrequently, or if only a small proportion of non-current assets are checked by the company or a large number of discrepancies are found in the companys tests. ATC-Adding Value To Your Future 65

To check existence Select items from the non-current asset register weighted towards larger value non-current assets. Ideally, some statistical sample selection method should be used (eg monetary unit sampling or stratified sampling) probably based on the net book value of the non-current asset. Ask the production manager the location of each non-current asset selected (if not given in the asset register). Physically check the existence of each non-current asset selected and confirm that they appear consistent with the description in the noncurrent asset register, and agree the serial numbers (if any). Check that the age of the non-current asset given in the asset register should give, appears reasonable. Assess the condition of assets (and how much they are being used) by physical inspection. The check from the non-current asset register to the non-current asset confirms the existence of non-current assets in the non-current asset register. To check completeness Select a sample of plant and equipment from the factory (including their serial number and a description) and check they appear in the non-current asset register. It is probably not possible to use a statistical basis for selecting these items, but a pseudo monetary unit sampling basis could be used by biasing the sample towards newer and higher value items. It is important the serial number is recorded, as this is unique. This test checks that non-current assets which exist appear in the noncurrent asset register (ie completeness of plant and equipment in the non-current asset register). If tests highlight discrepancies in the non-current asset register, either perform more checks or ask the companys staff to perform more checks (and test check their work). If serious problems are highlighted, include the matter in the management letter, and consider whether the financial statements should be amended (to correct errors) or an audit modification given (eg if the error is material). (c) Capital versus revenue expenditure Consider whether the companys treatment is consistent with the IAS 1 definition of a noncurrent asset, namely that it is expected to yield future economic benefit and is intended to be retained for use in the business. Also consider whether the companys treatment of additions to non-current assets and charging items as an expense is consistent with previous years. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1136 In checking additions to non-current assets in the year, vouch the purchase invoice to the general ledger and non-current asset register. The value of the invoice should agree to the amount posted to the general ledger and non-current asset register. The description of the non-current asset per the purchase invoice should agree to that in the non-current asset register, and the serial number of the asset should be correctly recorded in the non-current asset register. (i) Additions to non-current assets Consider whether it is validly an addition to non-current assets or should have been an expense in the year. This can be quite difficult to decide. A repair of a non-current asset should not be included in additions to non-current assets (as this would overstate non-current assets and profit for the year). If this has occurred, include details of the items which should be included in repairs in the list of unadjusted errors. Discuss these with the directors. If they are material, ask the directors to amend the financial statements, and if they refuse, consider whether the auditors report should be modified. (ii) Expense of capital items Confirm with the directors and last years audit file that items of under $500 are not capitalised. With the limit of $500, there may be a large number of items under this value, and not capitalising them may materially understate the value of non-current assets in the financial statements. If this is happening, assess whether the financial statements need amending. ATC-Adding Value To Your Future 66

To locate items which were included as an expense but should have been capitalised, look at certain accounts in the general ledger including: Repairs and renewals Sundry expenses Motor and travelling expenses. Compare the charges in each of these accounts to previous years, both in terms of total value and as a percentage of the companys revenue. If the expense charge in each of these accounts is similar to previous years and audits in previous years have shown that the company has an appropriate split for capital/expense items, then the number of items to be checked can be reduced. However, if the expenses this year are significantly greater than previous years, the number of items to be checked should be increased. From these accounts, select a sample of items over the minimum capitalisation value (ie over $500) and check to the purchase invoice whether they are capital and should be included in non-current assets. Prepare a list of items which should perhaps be included in non-current assets for discussion with the companys management. Following this discussion, prepare a final list of items which should be capitalised and include their details in the list of unadjusted errors. If a large number of errors is found, either increase the sample of items check or ask the companys staff to check more items (and test check their work). As only a sample of items will be checked, extrapolate the sample results to estimate the potential error in the population. Most auditors would accept writing off certain non-current assets in the year of purchase, as this tends to understate profit for the year. Auditors are more concerned that profit is not overstated, so some understatement of profit in this way would be acceptable. Finally, based on this work, decide whether the value of additions to non-current assets in the year is reasonable. If there appears to be a material understatement or overstatement of additions to non-current assets (which has a material effect on the profit for the year) ask the directors to amend the financial statements, and if they refuse, consider qualifying the auditors report. Answer 52 SILVERHILL POTTERIES (a) Basis for valuing inventory (IAS 2) Inventory is valued at the lower of cost and net realisable value. Cost is the purchase price (including import duties, transport and handling costs and any other directly attributable costs) less trade discounts, rebates and subsidies. For work in progress and finished goods of a manufacturer, the costs of direct labour and production overheads, based on a normal level of activity, are included in the value of inventory. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1140 Net realisable value is the actual or estimated selling price (net of trade but before settlement discount) less costs to be incurred in selling, distribution and marketing (and for work in progress and raw materials, less all further costs to completion). The benchmark treatment is for a FIFO (first in; first out) or weighted average basis to be used. The LIFO (last in, first out) basis is an allowed alternative treatment for valuing inventories. (b) Types of inventory which may be worth less than cost Slow-moving and obsolete inventory. Damaged and seconds inventory. Inventory which is being sold below cost (eg in a sales promotion). Also, it is desirable to check that categories of inventory with a high value at the year end are being sold for more than cost (if they are being sold for less than cost, they should be valued at net realisable value). To identify such inventory Obtain details of such inventory as recorded on the inventory sheets at the inventory count, and in my audit working papers. Slow-moving inventory is likely to be dusty (or the packaging dusty) and it may be stored in a different area from fast moving inventory. It should be apparent if inventory is damaged. Seconds inventory may ATC-Adding Value To Your Future 67

be put in a different area, or it may be labelled seconds on the shelf where it is kept. In addition, there may be odd items of pottery (eg some cups without saucers) or incomplete sets which may be worth less than cost (some may be worthless). The computerised inventory records should note damaged and seconds inventory (ie they should be in a different inventory category from perfect inventory). I will find details of slow-moving inventory from the computerised inventory records. Some pottery inventory may be held for long periods, but I will record inventory which is over six months old as it is probably slow moving. Also, I will record apparently fast moving inventory (cheap sets of pottery) which has been in inventory for over three months, as it may be slow moving. I will inspect sales reports, management reports and board minutes for further evidence of inventory which may be worth less than cost. These reports should indicate: inventory lines which are being discontinued; inventory which is difficult to sell or slow moving; and damage to inventory. Also, they will report special offers where inventory may be being sold for less than cost. I will list details of such inventory which may be worth less than cost. I will ask the appropriate management (eg sales director, storehouse manager) and the directors if there is any inventory worth less than cost and I will record details of such inventory. In particular, I will ask them if any inventory is being sold below cost (eg in a sales promotion). I will note the inventory items which I have recorded from the work described above and I will check net realisable value as follows. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1141 (c) Determining NRV Net realisable value is: the actual or estimated selling price; less costs to be incurred in selling, distribution and marketing. As Silverhill Potteries only has goods purchased for resale, costs to completion are not relevant. Determining actual or estimated selling price If all the inventory has been sold between the year end and the date of my checks, I will check the selling price to sales invoices issued after the year end (the selling price is after trade discount but before settlement discount). If most of the year end inventory has been sold by the time of my check, then the selling price after the year end will be used for that inventory. If there have been few (or no) sales after the year end, I will check sales invoices selling the inventory before the year end. This will be the best estimate of the price the inventory will be sold for after the year end. However, if the inventory has become obsolete between the last sale before the year end and my audit check, then the selling price before the year end may be too high compared with the price the inventory will be sold for after the year end. So, I will have to consider a fair price this inventory will be sold for after the year end (this will be the estimated selling price). If there have been few sales before and after the year end, the inventory may have to be sold at a very low price to provide space for new inventory. If the value of this inventory (at cost) is significant, I will have to check the companys plans for disposing of it. Overall, it is probably wise to estimate a very low selling price. Some damaged inventory items and odd items (eg single cups without saucers) may be worth only scrap value, and I may accept that they should be included in inventory at zero value. It should be noted that it is unreliable to determine the selling price from the companys price lists, as this type of inventory is probably being sold at a lower price than that shown on the price list. I will compare my estimates of selling prices with the companys. I will discuss cases where there are significant differences between my estimates and the companys, and I will discuss with them situations where I find it difficult to estimate the selling price of the inventory (eg ATC-Adding Value To Your Future 68

for incomplete sets, and very slow-moving inventory). Based on these discussions I will consider whether the managements estimates of the selling prices of the inventory are reasonable. These checks above will have determined the actual or estimated selling price. Net realisable value is found by deducting costs to be incurred in selling, distribution and marketing from this selling price. Generally, selling, distribution and marketing expenses are small, so I will find the years selling, distribution and marketing costs and total sales from the general ledger. I will calculate the ratio of selling, distribution and marketing costs to total sales for the year (say it is equal to 4%). Using this figure, net realisable value will be 96% of the actual or estimated selling price. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1142 If it is apparent that some inventory items will incur larger selling, distribution or marketing costs, then the actual costs would be deducted from the selling price to determine net realisable value. For instance, if the items have to be exported then the carriage costs will be high. From these investigations, I will determine the net realisable value of the inventory: Assuming I have found the cost of the inventory, I will value the inventory at the lower of cost and net realisable value. Then I will compare my inventory value with the companys. I will discuss any significant differences with them, and I will note any significant disagreements in my schedule of unadjusted errors. Answer 53 OXTON PUMPS (a) Finished goods (i) Material cost Work to be performed in checking the cost of materials in a pump: Obtain details of the pumps in finished goods inventory and select a sample of pumps which each have a high value (either because they are individually expensive, or there are a larger number of lower value pumps). Obtain the specification for each of these pumps. For each specification inspect an actual pump to check that the components required for the pump are consistent with the specification. Check the cost of the major components (ie the electric motor, the body of the pump and the impeller) to purchase invoices. For small parts, such as nuts and bolts, electrical connections and pipe fittings consider whether their cost is reasonable. If their cost appears to be wrong, check it to purchase invoices. If prices of components are rising (or falling), the valuation should be on a FIFO (first in, first out) basis, or a weighted average basis, although LIFO (last in, first out) is an allowed alternative treatment. Check that the finished goods were produced recently and that Aprils purchases are similar to previous months. Check the additions of the cost of individual items to the total and record any errors found in the valuation of the pumps. The total value of the finished goods would be checked as the product of the quantity of each pump and the cost per unit. (ii) Direct labour cost I would obtain the production records, and for a sample of large value pumps calculate the direct labour time to produce each pump. The labour hours to produce a single unit of one type of pump would be found by determining the hours to produce the pumps in April (which would be found from the payroll and the break-down of hours for each type of pump) and dividing it by the quantity produced, which would be found from the production records. The rate per hour for the employees would be found from Aprils payroll, and the labour cost per pump would be the product of the hours to produce a pump and the direct labour rate. The direct labour rate may include employers taxes on wages, pension, sickness and other benefits. I would check that Aprils wages are similar to previous months and that the finished goods were produced recently. I would quantify any errors I find in these calculations, and if they are significant, I would record them in my schedule of unadjusted ATC-Adding Value To Your Future 69

errors. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1143 An alternative method of calculating the labour hours to produce a pump is to use the costing records. However, these hours may be unreliable, because there is no indication that the hours in the costing records are compared with the actual hours the employees take to produce each type of pump. As these hours are unreliable, checking the cost of labour in this way will be unreliable. (b) Level of activity (i) Operating at normal The investigations I would carry out and the matters I would consider in determining whether the company is operating at a normal level of activity would include: I would compare the level of production with previous years. If it is similar to previous years, and in previous years the company was operating at a normal level of activity, then it is operating at a normal level of activity this year. It may be difficult to assess the level of production activity, so, if there is no significant change in inventory during the year, the value of sales would be a close approximation to production activity I would compare production (or sales) with budget. If sales are similar to budget, the company is probably operating at a normal level. If sales are significantly less than budget, the company is probably operating at a lower than normal level I would look at the amount of overtime being worked by production staff (the question says no overtime is being worked, but I will check to the payroll and ask staff if overtime is being worked). If the overtime being worked is similar to previous years, then the company is probably operating at a normal level. If no overtime is being worked (and overtime was being worked in previous years) there is a risk that activity is less than the normal level. The main matter to consider is whether there is idle time. I would ask the companys directors, the production director (or manager), and the employees and check the payroll to see if there has been idle time in April. If there is idle time; then the company is working at a lower than normal level I would ask management if there have been any changes in production in the year, and, if I was on the audit last year, I should be able to assess whether there have been any changes. Also, minutes of management meetings and board minutes should record any changes. If there has been new machinery or an increase in the production capacity (eg by an increase in the production area) then it would probably not be appropriate to compare this years production with last year, as this years production should be higher. If there has been an increase in production capacity but no increase in sales, it is probable that the company is operating at a lower than normal level of activity. Based on this work, I would decide whether the company has been operating at a lower than normal level of activity. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1144 (ii) Inclusion or exclusion of labour and overhead costs Inventory should be valued at the cost of production when the company is operating at a normal level of activity. So, any inefficiencies which arise through the company operating at a lower than normal level of activity should be charged to the income statement. Therefore, the direct labour and overheads in inventory should: only include fixed overheads relating to a normal level; exclude any direct labour costs which are classed as idle time. For instance, if the company is operating at 80% of its normal level, only 80% of the fixed overheads should be included in the inventory value. Fixed overheads would include rent and property taxes of the factory. Provided variable overheads are entirely variable, all these overheads can be included in the value of inventory. If direct labour is paid entirely on the amount produced, all the direct labour cost can be ATC-Adding Value To Your Future 70

included in the value of inventory. However, if 10% of the labour cost represents idle time (or is used to increase the employees wage to a minimum level), only 90% of the direct labour cost should be included in the value of inventory. (c) Value of overheads Raw materials Work in progress Finished goods $$$ Materials 74,786 85,692 152,693 Direct labour 13,072 46,584 Analysis of April 2003 data into production and other overheads: Total Production Other costs overheads overheads $$$ Direct labour 61,320 Selling costs 43,550 43,550 Depreciation and finance costs of production machines 4,490 4,490 Distribution costs 6,570 6,570 Factory managers wage 2,560 2,560 Other production overheads 24,820 24,820 Purchasing and accounting costs relating to production 5,450 5,450 Other accounting costs 7,130 7,130 Other ad ministration overheads __2_4_,_7_7_0 _______ __2_4_,_7_7_0 _1_8_0_,6_6_0_ __3_7_,_32_0_ __8_2_,_0_2_0 Direct labour cost 61,320 Production overhead rate 61,320 37,320 100% = 60.86% AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1145 Raw Work in Finished materials progress goods Total Answer $ $ $ $ Materials 74,786 85,692 152,693 313,171 Direct labour 13,072 46,584 59,656 Production overheads 7,956 28,351 36,307 (at 60.86% of direct _______ _______ _______ _______ labour cost) 74,786 106,720 227,628 409,134 _______ _______ _______ _______ Answer 55 COTSGROVE DISTRIBUTORS (a) Controls over dispatch of goods (to authorised customers) The sales department should have received an order from the customer. Ideally this should be in writing but telephone orders may be accepted from customers. For telephone orders, the employee in the sales department should record the date and time the order is received and its details. Ideally, the company should send a sales order to the customer, which gives details of the goods ordered; the price per unit, the date the order will be dispatched and credit terms. The sales manager end credit controller should authorise this sales order. It may be acceptable to by-pass the credit controllers authorisation if the customer is on a list of customers authorised by the credit controller. This list should be updated periodically with new customers. Some existing customers may be put on stop if they become a credit risk. Before the goods are dispatched, they should be authorised by the credit controller. As the company uses a computerised accounts receivable system the computer may accept dispatches of goods to good credit risk companies (where the credit limit is ATC-Adding Value To Your Future


not exceeded) without the authorisation of the credit controller. In this situation the credit controller will authorise dispatch of goods to poor credit risk companies and those where the credit limit is being exceeded. With this system, the credit controller should ensure that the standing data file of good credit risk companies and customers credit limits are kept up to date. The goods should only be dispatched to customers when the dispatch department receives an authorised shipping document. The dispatch department should get the carrier or customer to sign a copy of the shipping document when they take the goods, as this is evidence that the customer (or carrier) has received the goods (in cases where there is a dispute over a delivery). This copy of the shipping document should be filed in the dispatch department. The computerised accounts receivable system should produce a sales invoice when the goods are dispatched. The prices on the sales invoice should agree with the sales order (or the companys authorised price list) and it should be posted to the accounts receivable ledger. There should be periodic inventory counts to check that the quantities of inventory are the same as those shown by the physical inventory records. Any differences should be investigated. This check should either prevent or detect any unauthorised dispatches of goods (or misappropriation of goods). A person independent of the dispatch, sales and accounts receivable accounting department should check that: a sales invoice is issued for every dispatch of goods; all customer orders are satisfied within a reasonable time This person should check any cases of a dispatch of goods with no invoice and any old orders where no goods have been sent to the customer. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1149 An independent responsible official (eg the chief accountant) should periodically check the gross profit margin on sales. This should highlight any cases of customers being charged the incorrect price. Also, it will highlight misappropriation of inventory and goods being dispatched without an invoice being raised (these will also be highlighted by earlier checks). The following duties should be carried out by different staff: Authorisation of the customer order, and raising the shipping document Credit control checks Dispatch of goods to the customer Processing of sales invoice. (b) Prompt receipt of cash There should be a procedure for investigating the credit worthiness of customers. For new customers the company may ask for recent financial statements of the customer, bank and other customer references. Also, a credit rating agency could be used to obtain an independent assessment of the customers credit risk. For poor credit risk customers the company should require payment in advance or cash on delivery. Initially, the credit limit of a new customer will be based on its reputation and other information obtained. For a large and financially stable company (eg IBM) a high credit limit will be allowed, but for small companies and those with liquidity problems, the initial credit limit should be small. The credit limit of existing customers should be reviewed periodically. It will be increased if the company pays its account promptly and sales are increasing. For slow payers the credit limit may be reduced; or credit may be withdrawn. The credit controller should put accounts on stop where the account is over the credit limit or in arrears. Further dispatches should only be permitted with the authorisation of the credit controller. The company should have a procedure of chasing debts. They should send ATC-Adding Value To Your Future


monthly statements to customers, and regularly telephone customers where a payment is expected or is in arrears. There should be a procedure for following up old debts. This should start with the customer being sent a reminder, then dispatch of goods should be stopped, legal action should be threatened and finally the debt should be dealt with by a debt collection agency or by a lawyer. When cash is received in the post it should be opened by two individuals, who should prepare a prelist of cash received. Any uncrossed cheques should be restrictively crossed so that they can only be paid into the companys bank account. Two employees should open the mail in order to prevent a weakness in the system of internal control (ie they have custody of the cheques and are recording the transaction). The cheques and remittance advices should be passed to the cashier who will record them in the cash records and pay them into the bank. Finally, these cheques should be recorded on the accounts receivable ledger. Periodically, an independent person should check the pre-list of cash received to the cash records to ensure all items are entered in the cash records and banked. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1150 An independent person (eg the chief accountant) should check the bank reconciliation and ensure that cash received is banked promptly, as late banking of this cash could indicate that a teeming and lading fraud is taking place. An accounts receivable control account should be maintained by a person independent of the accounts receivable department and cashier. Ideally, the totals posted to this control account should be derived from sources independent of the accounts receivable department. However, in computerised systems the only source of sales may be from the sales journal (which is not an independent source). Nevertheless, the cash posted to the control account should come from the cash records. The independent person (eg the chief accountant) should check the posting of the accounts receivable control account and that the balance either agrees (or can be reconciled) to the total of the balances on the accounts receivable ledger. Answer 57 STRATHFIELD (a) Method of selecting items for confirmation (i) Inconsistencies with sampling To be a sample, each item must have an equal chance of selection. Sarahs approach does not meet that requirement in that: all large accounts are selected; no accounts under $100 are selected; no government accounts are selected. Selecting all large accounts for testing is quite common but the basis for defining large needs explanation. The population being sampled is then defined as all receivables balances below the threshold for items selected as large. Ignoring very small balances is irregular but, in a test primarily concerned with testing for overstatement and valuation, unlikely to affect the results. However, her working paper should, again, explain the basis for determining the cutoff point of $100. Treating government accounts as a separate sub-population is acceptable providing alternative verification is performed on such accounts. Moreover, the total of government accounts in the ledger should be treated as a separate sub-population when projecting the sample results. Merely excluding them as being too difficult is not acceptable. (ii) Alternative approach to selection The two preferred methods of drawing a sample from variable populations to ensure a sufficient sample of more material balances are stratification and monetary unit sampling. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1153 Stratification divides the population into strata by value and draws relatively larger samples from higher value strata than lower value strata. Sarah has actually done this but not in a ATC-Adding Value To Your Future 73

formalised way. Statistics can enable auditors to determine the optimum stratification to obtain the required assurance from the smallest sample. In evaluating results error rates need to be projected separately to each stratum. Monetary unit sampling identifies individual $s as the sampling unit. By systematically selecting $s, the larger the account balance the larger its chance of containing a $ being selected and thus being tested. Each $ is regarded as being in error proportionately to the error in the account balance of which it forms part. (iii) Haphazard selection Haphazard selection is an acceptable method of drawing a sample but introduces the risk of unconscious bias such as neglecting the first or last items on a page. Systematic sampling overcomes this by requiring the staff member to follow a prescribed order. Selection can be replicated and any instances of failure to select the required sample detected. It is not convenient for populations in which the sampling units are not sequentially ordered. It also presents the risk that there may be a particular pattern to the population, which recurs at the same interval as the sampling interval. Random selection can be undertaken by use of random numbers generated by computer or random number tables. In both cases bias is avoided by requiring the staff member to justify reasons for not testing the sampling unit selected by computer or through use of random number tables. It is inconvenient for populations not held on a computer in that physical selection of documents in random order can be time consuming. It is also not appropriate for sampling units, which are not serially numbered, such as inventory items. (b) Qualitative analysis of errors Address unknown These affect the valuation assertion since the amount is potentially uncollectable. The extent of the error depends on whether the company does have a forwarding address. Assuming there is no forwarding address the error is one that may be projected to the population. Cutoff Since these have been established as goods or cash in transit, they are not misstatements and do not constitute errors. Invoicing errors These would appear to result from a weakness in control. The cause of discovered errors must be investigated as to whether they are consistent with the assessed level of control risk for invoice pricing. If they suggest a higher level of risk than that originally assessed the level of substantive procedures may need to be reconsidered. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1154 It may be they occurred during a particular point in time such as when the invoicing clerk was on holiday in which case further testing may be required on the subpopulation of invoices prepared at that time. Otherwise they are consistent with expected errors and must be projected to the population. Posting errors These would appear to result from control weaknesses. Although there is a slight risk of such errors resulting in accounts becoming uncollectable, the fact that the customer to whom they are wrongly charged is likely to complain means that the error is likely to be detected and corrected within a reasonable time. The auditor is not unduly concerned about controls or discovered errors in a situation where monthly statements are issued and customer queries independently investigated. Assuming that to be the case, the error would not be regarded as a misstatement. Disputed items Each dispute is likely to be unique. The auditor must investigate each one to see if it is part of a material sub-population. For example it could reveal problems with a particular product and may require a provision against all outstanding sales of that product and even against unsold ATC-Adding Value To Your Future 74

inventory. If the individual issues are isolated but symptomatic of errors that could be present in the population the error must be projected to the entire population. (c) Projected error In projecting the error material accounts selected for testing should be excluded from the population samples. In theory, balances below $100 and with government customers should be excluded. However, the former are likely to be immaterial in total and may be ignored and we have no information as to the latter. It is assumed that our qualitative analysis has determined that all errors except for cutoff differences and mispostings should be projected to the population. It is also assumed that the ratio method is appropriate. Recorded value of sample $265,450 Errors Gone away 950 Invoicing ($2,800 $2,200) 600 Dispute s ($2,800 $1,300) _1_,_5_0_0 _3_,_0_5_0 Percenta ge error 1__1_5_%_ AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1155 Total accounts receivable $2,350,000 l ess mate rial items selected ___2_0_5_,_0_0_0 Populatio n sampled _$_2_,1_4_5_,_0_0_0 Error rate ____1__1_5_%_ Projected error 24,668 Errors in material items _________0 Total pos sible error ___$_2_4_,6__6_8 Alternatively: Errors known (in 6,500) 3,050 Projected error (on 2,138,450) ____2_4_,_5_9_2 Total pos sible error ___$_2_7_,6__4_2 Sarah must consider, in the light of the total possible error, whether to conclude that accounts receivable are not materially misstated. Answer 58 GOODFOOT (a) External confirmation (i) Positive and negative confirmations. Negative confirmations request a reply from the debtor only if the debtor disagrees with the amount. Positive confirmations request a reply in any case. Negative confirmations are generally only used with a representative sample of a large number of small accounts where internal controls are strong. (ii) Positive confirmations. There are two types of positive confirmation. In the first type, the amount owed is stated by the client and the debtor is asked to agree or disagree. If the debtor disagrees, he is asked to provide an explanation of why he disagrees in the form of reconciling items. In the second type, the debtor is asked to fill in the balance. The advantage of the first type is that the debtor may perform the reconciliation. The principal disadvantage is the fact that the debtor may simply agree with any amount stated, particularly if it is understated. With the second type, the debtor is less likely to reply as more work is involved, but the amount stated represents what is in the debtors records. It is not possible for the debtor to perform the reconciliation in this case. (iii) Reconciling items. Reconciling items include: cash, goods and credit notes in transit and other timing differences, debit notes, contras, journal entries, disputed items, and simple errors on the side of either debtor or supplier. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1156 (b) Financial statement assertions receivables Assets are generally more at risk from overstatement than from understatement. There is a ATC-Adding Value To Your Future 75

risk that receivables are overstated by the under-provision for bad debts. If assets are overstated, profits are likely to be overstated and it is therefore sometimes tempting to underprovide for bad debts in order to show a better profit figure, as well as for management purposes. Bad debts can sometimes be hidden by the use of credit notes and similar devices; whilst this does not affect the overall profit figure, it can affect the presentation of the financial statements. (c) Audit work on receivables and bad debts Comfort can be taken from the proper operation of internal controls over receivables and it is therefore possible to reduce the level of substantive testing. The primary focus of substantive testing will be the external confirmation. A 50% response rate is quite adequate. All of the thirty largest accounts can be circularised together with a representative sample of the remainder, paying particular attention to old accounts, nil balances and credit balances. For those accounts where there is no reply, and for any other accounts selected for testing it will be necessary to gain comfort on the amount receivable by reviewing cash received after the period end. Where cash has not been received, it will be necessary to review signed delivery notes, contracts, the pattern of payments, etc. For accounts confirmed, any differences should be thoroughly investigated and followed up, with the help of the client if necessary. It should be remembered that where a debtor agrees that an amount is owed, it does not automatically follow that the amount will be paid. The bad debt provision should be reviewed in the light of past experience and current period conditions. Generally, specific provisions are permissible for tax purposes but not general provisions and the tax computation should be checked. The arithmetical accuracy of the ledger should be checked as should the correct presentation of the amounts in the financial statements. A review of invoices and credit notes around the period-end may highlight the need for additional provisions. Analytical procedures on the ageing of debtors by comparison with prior periods will give comfort on bad debt provisions. Sales cut-off testing should be performed to ensure that amounts have been correctly recorded in the correct period. Answer 60 VILLAWOOD COMPUTERS (a) Bank reconciliation (i) Procedures (ii) Purpose Agree the balance per bank with the bank statement and with the bank confirmation. To agree the correctness of the amount. Agree the balance per books with the trial balance and draft financial statements. To agree the correctness of the amount recorded in the reconciliation. Add the bank reconciliation. To agree the correctness of the amount arrived at. From the October bank statement trace deposits to the list of receipts in October or to the September bank reconciliation and: trace outstanding deposits on the September bank reconciliation (if any) and the October list of receipts ATC-Adding Value To Your Future


not appearing on the October bank statement to the October bank reconciliation; To verify that all outstanding deposits are recorded in the reconciliation and at the correct amount. ensure that there are no other outstanding deposits on the October bank reconciliation. To verify that all deposits recorded as outstanding are in agreement with the books. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1161 From the October bank statement trace cheques to the list of payments in October or to the September bank reconciliation and: carry forward outstanding cheques on the September bank reconciliation and the October list of payments not appearing on the October bank statement to the October bank reconciliation; To verify that all outstanding cheques are recorded in the reconciliation and at the correct amount. ensure that there are no other outstanding cheques or other payments on the bank reconciliation. To verify that all cheques recorded as outstanding October are in agreement with the books. Obtain the November 2003 bank statement and: trace outstanding deposits and cheques from the October 31 bank reconciliation to the bank statement; list outstanding items appearing on the October bank reconciliation not traced to a subsequent bank statement for follow up before the end of the audit. To verify the existence and correctness as to amount of amounts listed as outstanding on the December bank reconciliation. For returned cheques recorded on the bank statement agree the amount with the original entry recording the receipt; To verify the existence and correctness of the amount of the returned cheque. examine reversing entry for correctness. To verify that the returned item has been correctly credited to cash and debited to ATC-Adding Value To Your Future


debtors. For all other items such as bank charges, credit transfers and direct debits recorded on the bank statement trace to the entry in the companys books. To ensure that cash at bank per the books is correctly adjusted by the amount of all such items. Enquire into other items appearing on the bank reconciliation as appropriate. To ensure that there are no fictitious items that might be concealing an error or misstatement. List, for partners attention, outstanding items not cleared through the bank by the completion of the audit. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1162 (b) Reliability of bank statements as audit evidence Bank statements are moderately reliable as they are provided by a third party from a source known to maintain reliable records. The limitation is that they are obtained from the entity being audited. There is a possibility of the bank statement being altered or that it could even be a forgery. The auditor should be particularly suspicious if the entity provides a fax or photocopy for the auditors use and not the original. Where necessary their reliability can be improved by asking the audit entity to request their bank to send a copy statement directly to the auditor or, better still, for the auditor to collect a copy directly from the bank. (c) Computer audit approaches (i) Auditing around and through the computer Auditing around the computer is where the auditor traces transactions recorded on documents to the point of entry into the computer and picks up those transactions as part of the output and continues from that point to the entry in the ledger. (Or vouches transactions from the records to the output from the computer and picks them up at the point of entry to the computer back to the source documents.) Any processing performed by the computer is verified by reference to input or output documents. Auditing through the computer is where the audit verifies the processing of the transaction by the computer using computer assisted audit techniques (CAATs). (ii) Inappropriateness of auditing around the computer Auditing around the computer is inappropriate where it is: impractical; or inefficient. Impractical Source documents are not available in hard copy form. It is not possible to follow the audit trail from input to output or vice versa because: there is no hard copy of the output; the output summarises input data in such a way that reconciliation is impractical such as where sales and cash receipts data are input into the system but the output is in the form of unpaid invoices listed by customer. Control risk assessment is based on computerised application controls which cannot be verified by comparison of input with output, such as credit approval of sales orders evidenced electronically by the credit managers password. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1163 Inefficient Substantive procedures around the computer are practicable but computerised ATC-Adding Value To Your Future 78

application controls, which can only be verified by the use of CAATs could reduce control risk and the level of substantive procedures significantly. For example invoice pricing could be verified against the hard copy of the price list but it would be much easier to verify the reliability of pricing information held by the computer. Substantive procedures could be performed more efficiently through the use of CAATs. For example, we can verify completeness by testing the numerical continuity of input documents, but the use of audit software enables us to program the computer to perform this test. Answer 62 RAVENSHEAD ENGINEERING (a) Suppliers statements I will assess the system of control in the purchases system and its reliability. This will be based on the results of my tests of control, other investigations and my experience in previous years. Where the purchases system is reliable, I will check fewer items than if it is unreliable. If I find discrepancies in my audit tests, I will increase the sample of items I check. I will check fewer suppliers statements to the purchase ledger balances if a member of the companys staff regularly performs these checks and corrects discrepancies. Generally, I will check a larger proportion of suppliers where the balances are large, or where there are a large number of transactions. Where there is no suppliers statement for one of these important accounts, I will either contact the supplier to confirm the balance, or ask for a statement at the year end (this could be sent by fax). Where the balance on the suppliers statement is the same as the purchase ledger balance, I will record the agreement in my audit working papers and carry out no further work on that balance. Where there is a difference, I will divide it into: goods in transit cash in transit other differences. Goods in transit are invoices on the suppliers statement which are not on the clients purchase ledger. If these differences have been included in purchase accruals, I may perform no further checks. However, for large value items, I will check the goods received note (GRN) to ensure they were received before the year end. If there is no purchase accrual, I will check the date on the GRN. If the date on the GRN is after the year end, the treatment is correct. However, if it is4 before the year end there is a cutoff error, and the value of these goods will have to be included in my schedule of unadjusted errors. For cash in transit, I could check to the next months suppliers statement that the cheque was on the suppliers sales ledger just after the year end. An alternative is to check to the bank statement the date the cheque is cleared by the bank after the year end. If there is a significant delay in clearing the cheque (and this is common to a number of cheques issued immediately before the year end), this indicates that the cheques were sent to suppliers after the year end. If this has been happening, the value of these cheques should be deducted from the year end bank overdraft in the draft financial statements and added to payables at the year end (as the payment did not occur until after the year end). For other differences, if they are small, they can be ignored. However, if they are significant I will discuss them with the client and I may ask if I can contact the supplier to confirm the reason for the difference. The year end accounts should include an appropriate provision to allow for such differences (generally, this should be the difference between the balance on the suppliers statement and that on the clients purchase ledger). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1166 Based on these tests, I will assess whether they provide sufficient evidence that ATC-Adding Value To Your Future 79

accounts payable and purchase accruals are correctly stated at the year end. If, because of errors I have found, I believe I have not obtained sufficient reliable evidence, I will increase the number of purchase ledger balances I check against suppliers statements. (b) Purchases cutoff The best place to start a purchases cutoff test is from goods received notes issued immediately before and after the year end. Generally, the test should cover a sample of items during the period two weeks before to two weeks after the year end, concentrating on larger value items: More items are likely to be selected from before the year end than after the year end, as there is a greater risk of cutoff errors with these transactions. At the inventory count, I should have recorded the last goods received note number issued before the year end (eg number 1462). Goods received before the year end should have a goods received note number of 1462 or less and goods received after the year end should have a goods received note number of 1463 or more. I will select a sample of goods received notes issued before the year end, and follow through to the purchase invoice. For these goods I will check that: either the purchase invoice has been posted to the purchase ledger before the year end or a purchase accrual (equal to the invoice value) has been included in the accounts at the year end; if there are book inventory records, I will check that the goods have been included in the book inventory records before the year end. There will be a purchases cutoff error where either: the purchase invoice has not been posted to the purchase ledger before the year end and there is no purchase accrual; or the purchase invoice has been posted to the purchase ledger before the year end and there is a purchase accrual at the year end. For goods received after the year end, I will select a sample of goods received notes issued after the year end, and follow through to the purchase invoice. For these goods I will check that: neither the purchase invoice has been posted to the purchase ledger before the year end nor a purchase accrual been included in the accounts at the year end; if there are book inventory records, I will check that the items of goods received have not been included in the book inventory records before the year end (they should have been included in the book inventory records after the year end). There will be a purchases cutoff error where either: the purchase invoice has been posted to the purchase ledger before the year end, or there is a purchase accrual at the year end (and the purchase invoice has been posted to the purchase ledger after the year end). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1167 (c) Sundry payables and accruals I will assess the level of accruals, and the systems of control. I will perform less work on small accruals than material ones. If the companys system of determining accruals is good, I will perform less work than if controls are weak. I will compare this years accruals with last year. I will investigate cases where there was an accrual last year, but none this year, and vice versa. Also, I will investigate any large changes in accruals. The wages accrual will be checked to the payroll. As 30 September 2003 is a Friday (say), the wages accrual will be a whole weeks gross wages. The wages tax accrual will be checked back to the payroll. I will check to the cash book that the accrual is equal to the payment to the tax authorities after the year end (ie in October). The sales tax payable will be checked as being the tax on sales and purchases (from the sales and purchases day books) for the months since the end of the last tax period and tax on sundry cash receipts and payments. If the year end is the end of a tax period, I will check the tax payable at the year end is equal to the payment to the ATC-Adding Value To Your Future 80

tax authorities after the year end. Accrued interest on the bank loan and overdraft will be checked to the letter I have received from the bank, and it may be confirmed by the sum charged by the bank after the year end. For other loans, the accrued interest will be checked as being the product of the amount outstanding, the current interest rate and the time since the last charge. Other accruals will be checked to invoices received after the year end (or if no invoices have been received after the year end, then invoices received before the year end will be used). Unless there is any special reason, the charge should be apportioned on a time basis. For instance, if the electricity bill received after the year end is :$2,400 for three months and there were two months electricity accrued, the accrual should be $2,400 = $1,600. Similar checks will be made on other significant accrued expenses (eg gas, telephone, motor expenses, leasing charges etc). I will consider whether there are any circumstances which have arisen in the year which may result in new accruals, and I will check if these accruals have been included (or that the accrual is zero). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1168 Answer 66 DYLAN (a) Subsequent events In auditing terms (ie ISA 560) subsequent events means all events occurring after the period end ie both events occurring between the period end and the date of the auditors report and facts discovered after the date of the auditors report. In accounting terms (ie IAS 10) events after the balance sheet date are restricted to those events, both favourable and unfavourable, that occur between the balance sheet date (ie period end) and the date on which the financial statements are authorised for issue (which is usually the date on which the auditors report is signed) . IAS 10 distinguishes between two types of events: those which provide further evidence of conditions existing at the balance sheet date (adjusting events); and those that indicate conditions that arose subsequent to the balance sheet date (nonadjusting events). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1177 (b) (i) Information (ii) Audit procedures Tutorial note: The Q called for just FOUR areas of the financial statements to be identified. The list of FIVE which follows is not exhaustive. Inventory The ultimate sale proceeds (if any) of yearend inventory. This is relevant to establishing net realisable value (NRV). Inventory should be stated at the lower of cost and (NRV). Also, the receipt of after date proceeds provides evidence of the good condition (or otherwise) of inventory (ie an adjusting event). For major lines of inventory, compare afterdate sales invoice prices with year-end cost. Inspect condition of inventory items where no sales (eg as identified by an exception report) have occurred since the year end. If material, obtain management ATC-Adding Value To Your Future 81

representation to confirm the directors considered view (eg that NRV of slowmoving inventory against which no provision has been made will exceed cost). Trade receivables Cash received after the balance sheet date. The collectability of accounts receivable is relevant to determining the adequacy of any allowance (provision) for bad and doubtful debts. Receivable should be stated at their recoverable amount in the balance sheet. The renegotiation of amounts owed by customers or notification of their insolvency are adjusting subsequent events. For major customers, review after-date cash receipts. Review direct confirmation (circularisation) suppliers and other correspondence with customers for evidence of disputes or notification of receivership/liquidation. Review the latest available aged debt analysis to identify post year-end deterioration in the recovery of trade receivable balances. Trade payables Cutoff information concerning year-end trade payables and accrued expenses. The accuracy of inventory and payments cutoff is relevant to confirming that liabilities are not materially understated in the financial statements. Examine suppliers statement reconciliations and confirm that reconciling items have been properly accounted for (eg year-end goods received not invoiced should be accrued). Scrutinise significant after-date cash book payments and confirm the year-end account payable or that no liability existed. Review the 30 April bank statement reconciliation for unpresented cheques representing payments to suppliers withheld at the year end (ie bank/creditor cut-off error resulting in understatement of both). AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1178 Contingent liabilities The expected outcome (or further evidence of) any contingent liabilities (eg legal claims) as at the date on which the financial statements are approved is relevant to the appropriate accounting treatment (ie disclosure or provision). Review all minutes of meetings and ATC-Adding Value To Your Future


correspondence with solicitors (including bills rendered) and insurers to date to ascertain latest position. Request written confirmation from Dylans solicitors. Obtain written management representation to the effect that (say) similar claims are not expected to be received. Property, plant and equipment Impairments in the value of items of property, plant and equipment. Values impaired during the year under review may not be detected until after the year end. Impairment losses must be recognised when the recoverable amount of an item is less that its carrying amount (ie book value). Physically inspect significant assets for evidence of deterioration. Where any class of asset is measured at a revalued amount (per IAS 16 allowed alternative treatment) review any appraisals undertaken/reports issued since the balance sheet date. Obtain written management representation confirming that there have been no events since the balance sheet date which necessitate revision to the balances included in the financial statements. (c) (i) Between 31 August and 17 November Advise management how to properly account for and adequately disclose such events in the financial statements. If not amended or disclosed in the financial statements, qualify the auditors report except for on the grounds of disagreement (as the matter is material). (ii) Between 17 November and 5 December Discuss the matter with management and take action appropriate to the circumstances. For example, request that the financial statements as they currently stand and the auditors report thereon should not be issued. If the financial statements are amended Extend subsequent event review procedures to the date of the new auditors report. Provide a new auditors report dated not earlier than the date the amended financial statements are approved. If unamended financial statements are subsequently issued Take action to prevent reliance on the auditors report (eg the auditor can attend a meeting of the company). Consider taking legal advice. AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1179 Resign (in extreme circumstance) in those jurisdictions where legal rights can be exercised to bring the matter to the attention of shareholders. (iii) After 5 December Discuss with the directors how they intend to deal with the situation, in particular, whether they intend to communicate with members. If, the directors are not dealing correctly with the situation, consider taking legal advice. If revised financial statements are to be issued, issue a new report thereon including an emphasis of matter paragraph (referring to a note discussing the reason for the ATC-Adding Value To Your Future 83

revision and earlier auditors report thereon). Answer 67 REDDY (a) Subsequent event The agreement to pay a backdated pay rise is an adjusting event since it clearly relates to a prior period even though the extent of the pay rise was unknown as at the year end (IAS 10 Events After the Balance Sheet Date ). Reddy and Co should confirm the pay rise by sighting the agreement, check the computation of the amount outstanding as at the balance sheet date and assess the materiality of the effect on profit. They should recommend the directors to provide for the backdated pay for the period from 1 July to 30 September as a liability in the balance sheet as at 30 September and to adjust expense accounts in the income statement as appropriate. If the directors do not do so then it represents a disagreement. If the amount is material, the auditors report will need to be modified by way of a qualified (except for) opinion due to disagreement. (b) Other information The Chairmans statement would appear to represent a material inconsistency with the audited financial statements in accordance with ISA 720 Other Information in Documents Containing Audited Financial Information. It suggests that operating profit represents the true level of performance. IAS 1 Presentation of Financial Statements, however, requires items such as reorganisation costs and profits or losses on disposal of property, plant and equipment to be included in arriving at a measure of profit from ordinary activities for the period (also IAS 8 Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies ). Reddy and Co should advise the Chairman to amend the information in his statement to avoid the apparent inconsistency. If the Chairman refuses Reddy and Co should consider taking appropriate action. One possibility is the inclusion of an emphasis of matter paragraph immediately after the unqualified opinion paragraph in the auditors report. If the matter were considered to be more serious Reddy and Co could refuse to issue the auditors report or withdraw from the engagement subject to receiving appropriate legal advice. (c) Internal control Although advising audit clients of weaknesses discovered in internal controls is not the primary objective of an audit, various jurisdictions have held the auditor to be negligent if failure to make proper communication of such information results in losses being incurred by the company. It is generally known that potential losses from unauthorised trading of this kind can be very large (Barings Bank). Jane should review more recent dealings to see if any have been entered into speculatively it is possible that the practice has ceased even though no action has yet been taken. If such transactions are still being entered into, Jane should discuss with the chief financial officer if there has been a change in company policy. If so, this should be evidenced in board minutes and Jane should update the permanent audit file. Tutorial note: Reference could also be made that if policy has not changed, the letter point should be redrafted (and to more senior management). Since the chief financial officer appears not to have taken appropriate action Reddy and Co must, as a matter of urgency, raise the matter with the Board of Directors or, if the company has one, the Audit Committee. (d) Subsequent event This is a non-adjusting event (IAS 10). On the basis of the preliminary information it would appear to be of a magnitude to require disclosure. The disclosure should describe the nature of the event and an estimate of its financial effect (i.e. the cost of cleaning up operations and of liability to pay compensation) or a statement that such an estimate cannot be made. If the company is unwilling to disclose the event in the notes to its financial statements then Reddy ATC-Adding Value To Your Future 84

and Co are in disagreement with management and must issue a qualified opinion in their auditors report. Disclosure may be required in the directors report as well as in a note to the financial statements. Answer 68 CREMORNE (a) Inventory valuation The chief financial officers view that the write down should be reflected after balance sheet date is irrelevant. As at balance sheet date the material could not be used in road construction and, as such, its value, at the lower of cost and net realisable value, was $2 million. The issue of the report failed to change the situation. The value of inventory and operating profit should, therefore, be reduced by the amount of the write down to net realisable value, being $5 million. This amount is material being in excess of 10% of operating profit. If Cremorne fails to adjust its financial statements, the effect on the auditors report would be an except for qualified opinion as the matter affects only inventory valuation and is, therefore, not pervasive. The cause of the qualification is a disagreement with management and the auditors report would describe the nature of the disagreement and quantify the effect on the financial statements. The opinion paragraph would then express a qualified opinion using the phrase In our opinion, except for and then refer to the matters described. (b) Depreciation IAS 16 Property, Plant and Equipment requires that useful lives of assets be reviewed regularly and the depreciation adjusted where there is found to be a change in useful life. The chief financial officers claim that technological obsolescence need not be taken into consideration is not consistent with IAS 16. Depreciation for the current financial year should be adjusted so as to write off the written down value of computer controlled earth movers over their revised useful life. Year of purchase Cost $000 Depreciation to 1/1/02 $000 Written down value 1/1/02 $000 Remaining useful life in years including 2002 Required depreciation charge for 2002 based on an overall life of 5 years $000 Depreciation provided 2002 $000 Adjustment ATC-Adding Value To Your Future


required $000 1999 5,000 1,500 3,500 2 1,750 500 1,250 2002 8,000 8,000 5 1,600 800 800 2,050 The depreciation charge should be increased by $2,050,000 which would have the effect of reducing the written down value of plant and equipment and of profit from operations by that amount. If there were no other uncorrected errors I would probably accept the amount as not being sufficiently material to justify issuing a modified audit opinion if the financial statements were not adjusted. It is just over 5% of operating profit but depreciation is based on an estimate of the useful economic lives of the assets. As such it is not a precise amount and, on a qualitative basis, does not indicate the financial statements are necessarily materially misstated. If there were other detected but uncorrected errors in the financial statements then, no matter how small these other errors might be, it would probably be appropriate to qualify my opinion on the financial statements along the same lines as in the case of inventory valuation. (c) Contingent liability A threat to claim for damages might be regarded as remote but the actual issue of a claim must be taken seriously. If successful, the claim would certainly be material being in excess of the years profit. There certainly appears to be some substance to the claim and the existence of the lawsuit should be disclosed in the note on contingent liabilities. This note needs to be reasonably comprehensive as to the basis for the claim, the amounts involved, and the companys grounds for not making a provision. If the company does not disclose the existence of the lawsuit a qualified opinion is required as the amount is significant but not pervasive. The nature of the qualification is a disagreement with management as to the adequacy of disclosure. The auditors report should describe the nature of the disagreement including details of the contingency. The opinion paragraph would then commence with the phrase In our opinion, except for followed by a reference to the description of the disagreement. A further concern is that the existence of the lawsuit might constitute a significant uncertainty. Even if the company properly disclosed the contingent liability, it should be referred to in the auditors report after the opinion, as an emphasis of matter. Answer 69 THETA (a) Introductory paragraph We were engaged to audit the accompanying balance sheet of Theta as of 31 March 2003 and the related statements of income and cash flows for the year then ended. These financial statements are the responsibility of the companys management. Tutorial note: sentence stating responsibility of the auditor is omitted. Scope paragraph (extract) The evidence available to us was limited because many of the companys accounting records were destroyed by fire in January 2003. The financial statements therefore include significant amounts based on estimates. In these circumstances there were no satisfactory audit procedures that we could adopt to obtain all the information and explanations we consider necessary. Opinion paragraph Limitation on scope Disclaimer of Opinion ATC-Adding Value To Your Future 86

Because of the significance of the limitation on the evidence available to us, we do not express an opinion2 on the financial statements. (b) Reasons for audit opinion The fire has resulted in limitations in audit work and evidence necessary to form an opinion cannot be obtained. It is a matter of fact that accounting records adequate for audit purposes have not been kept and all information and explanations necessary for audit purposes have not been received. Disclaimer The effect of the limitation is so material and pervasive that it is not possible to express an opinion on the financial statements. For example, significant estimates include net book values of tangible non-current assets, inventory valuations, recoverable amounts of trade receivables, provisions for unrecorded liabilities, revenue and cost of sales. Alternatively Except for The effect of the limitation is not so material and pervasive as to require a disclaimer of opinion. For example, the extent of reconstruction facilitated and analytical procedures performed is such that uncertainty only remains in respect of unrecorded liabilities (say). 2 An except for opinion could be appropriate, ie except for the effects of such adjustments, if any, that might have been determined to be necessary had we been able to satisfy ourselves as to . . .. The choice of opinion (ie disclaimer v except for) must be justified in part (b). (c) Forms of modified audit opinion (i) Emphasis of matter An emphasis of matter is clearly distinguishable from other modifications (eg qualified opinions) in that it doe not affect the auditors opinion. An emphasis of matter paragraph highlights a matter affecting the financial statements which is discussed in note to the financial statements, for example, going concern. The paragraph is included after the opinion paragraph Without qualifying our opinion (above) we draw attention to Note X. (ii) Qualified opinion An except for opinion is expressed when the auditor cannot express an unqualified opinion but the effect of the matter (disagreement or limitation on scope) is not so material and pervasive as to require an adverse opinion or disclaimer of opinion. (iii) Disclaimer of opinion An auditor is unable to express (ie disclaims) an opinion when the effect of a limitation on scope is so material and pervasive that the auditor has been unable to obtain sufficient appropriate audit evidence (which may be reasonably expected to be available). (iv) Adverse opinion The effect of a disagreement is so material and pervasive that the auditor concludes that a qualification is not adequate to disclose the misleading or incomplete nature of the financial statements. ATC-Adding Value To Your Future 87

Distinctions There are three issues which distinguish the form of modified reports 1 EITHER the matter does not affect the auditors opinion (ie (i)) or it does (ie (ii), (iii) and (iv)) If the audit opinion is affected, then: 2 EITHER there is sufficient appropriate evidence on a matter for the auditor to disagree with the amount, treatment or disclosure in the financial statements (as in (iv)); OR there is insufficient evidence due to scope limitation (in (iii)). 3 EITHER the matter is so material and pervasive (as in (iii) & (iv)) resulting in Because of the significance of (extreme opinions); OR not so material and pervasive (as in (ii)) resulting in an except for opinion. Answer 71 ISA 570 REVISED (a) Meaning of going concern basis Assets are recorded on the basis that the company will be able to realise or recover them at or above recorded amounts in the normal course of business. Liabilities are recognised and recorded on the basis that they will be discharged in the normal course of business. The IASBs Framework defines the going concern concept as meaning that the enterprise will continue in operational existence for the foreseeable future. This means that the financial statements are prepared on the assumption that there is no intention or necessity to liquidate or curtail significantly the scale of operation. (b) Procedures for obtaining sufficient evidence Tutorial note: Evidence should be obtained sufficient to confirm or dispel whether or not material uncertainty exists. A review of forecast and budget information produced by a company, and the reliability of the systems in place for producing this information. This would include a review of the key assumptions underlying the forecasts and budgets, and a comparison actual results against budgets. A review of the evidence relating to the adequacy and period of borrowing facilities. The auditor may need to obtain written information from banks or other third parties in order to be able to assess the degree of their commitment (and the legality and enforceability of financial support). A review of the inherent risk assigned to the audit client. The sensitivity of forecasts and budgets to variable factors both within the directors control and outside their control will be scrutinised, including relevant economic factors. A review of the directors plans for overcoming any problems their company is having or resolving any matters giving rise to doubts about the appropriateness of the going concern basis. The auditor should consider the basis on which they have been prepared, whether they are realistic and whether the plans are likely to resolve the companys problems. A consideration of any professional advice obtained by the directors as to the extent of the companys difficulties and the practicalities of overcoming them. It may be necessary for the directors to obtain legal advice on: the consequences of the company continuing to trade while it is known by the directors not to be a going concern; or the existence of litigation and claims. A review of the financial records including the order book, directors minutes and an analytical review of the financial statements. Reviewing the terms of loan and overdraft agreements and determining whether they have been breached (eg late payments, exceeding limits). The nature and scope of the auditors procedures will depend upon the circumstances of the client. The extent of the procedures will be determined by the extent of the resources it ATC-Adding Value To Your Future 88

requires to continue as a going concern. (c) Factors which might cast doubt on the going concern status of a company Tutorial note: The Q only called for 6 factors. The following is not an exhastive list of the examples of the financial, operating and other events or conditions that may cast doubt on the going concern assumption. Financial An excess of liabilities over assets and/or adverse key financial ratios. Default on terms of loan agreements or inability to pay other creditors on due dates. Significant impairment in the value of assets used to generate cash flows or substantial operating losses. Significant liquidity or cash flow problems indicated by negative operating cash flows in historical or prospective financial statements. Denial of normal terms of credit by suppliers or other indications of withdrawal of financial support by suppliers (eg change from credit terms to cash-on-delivery). Major debt repayment falling due where refinancing is necessary to the companys continued existence and there are no realistic prospects of renewal or repayment. Arrears or discontinuance of dividends. Inability to raise finance for essential investment, new product development, etc. Operational Internal matters such as: loss of key management without replacement; labour difficulties; or excessive dependence upon a few product lines where the market is depressed. External matters such as: loss of key suppliers, customers or major markets; shortages of essential supplier; or technical developments which render a key product obsolete. Other Major litigation in which an adverse judgement would result in claims that are unlikely to be satisfied, imperilling the companys continued existence. Non-compliance with statute, environmental legislation, etc. Adverse effects of changes in legislation or government policy. (d) Auditors responsibilities Before the issue of ISA 570 Going Concern, professional requirements concerning going concern had a passive air about them. Where the auditor was satisfied that the financial statements had been prepared on a going concern basis, no mention of any matters relating to the going concern status would normally be required in the auditors report. The current guidance in ISA 570 (Revised) goes somewhat further. There is now a duty on the part of the auditor to plan and perform procedures specifically designed to identify material matters which might cast doubt upon the going concern status of the company. It would be possible to extend the auditors responsibilities still further. For example ISA 570 does not stipulate a strict time period beyond the balance sheet date over which the auditor should satisfy himself that the company will remain in operation. It would be possible for a revised ISA 570 to insist that the auditors report specifically includes a statement that the auditors opinion is that the company will remain in operational existence for at least the following twelve months, unless stated otherwise. This requirement would highlight the issue of going concern more than is currently the case. ATC-Adding Value To Your Future 89

Answer 72 HYSON COMPUTERS II (a) Company performance In 2002 the companys performance is good. Its profitability is very good, with a return on capital employed of 36.5% and a net profit margin of 12.7%. The liquidity ratios are normal and satisfactory (ie leverage, current ratio and acid test ratio). The inventory, receivables and payables age are reasonable. Interest cover is excellent at 8.1, and dividend cover at 1.91 is at the required level (as indicated in the question). In 2003, there has been a 10% fall in sales and the gross profit margin has reduced from 30% to 22.1%, thus confirming the Financial Directors assertion that trading has been difficult. Noncurrent assets have increased by $2.3 million (28% increase) which indicates that the company was expecting to increase sales, but sales have fallen by 10%. The increase in noncurrent assets appears to have been financed by the $2 million increase in the long term loan. Inventory has increased by $2.1 million (49%) and its age has increased from 2.93 months to 4.35 months. The increase in inventory is the main reason for the increase in the bank overdraft of $3.5 million. The leverage ratio (including bank overdraft) has increased from 0.53 to 1.19. A leverage ratio of over 1 usually indicates serious liquidity problems, as banks are reluctant to lend more money than the company holds as shareholders funds: Thus, there could be going concern problems. The interest cover of 1.5 is low, and the dividend paid is twice the profit after tax (ie only half of the dividend has been paid out of this years profit). The current ratio is satisfactory. However, the acid test ratio has fallen from a reasonable 1.06 to a low 0.66, which indicates liquidity problems (for most businesses buying and selling on credit, the acid test ratio should be about 1.0). The receivables age has fallen slightly, probably because of the reduction in sales. Similarly, payables age has fallen from a reasonable 2.59 months to 1.8 months, as a result of a fall in purchases. The fall in payables age indicates that the company has stopped purchasing materials for production, because of the fall in sales. Thus, the company is acting correctly to the fall in sales. (b) Matters to be investigated The increase in non-current assets. I would verify additions to non-current assets by vouching them to purchase invoices. In view of the reduction in the non-current asset turnover, I would consider whether the company requires all the non-current assets it has purchased, and whether some of them are surplus to requirements or obsolete and will have to be sold at a loss. The increase in inventory. In view of the trading conditions, can all this inventory be sold for more than cost, or will it have to be sold below cost? If it is sold for less than cost, it will have to be valued at net realisable value. The companys borrowings. With current leverage of 1.19 (ie over 1.0), is it possible to reduce borrowing? What is the current bank overdraft limit, is it being exceeded? If it is not exceeded, how much additional finance from the bank is available? What are the future commitments for purchasing equipment from North America and Asia? Is this greater than planned sales after the year end? Will prices have to be reduced further to reduce inventory levels, and will this result in further losses? Reducing the level of future purchases will increase the price of items purchased (as quantity discounts will be smaller), thus further eroding the future gross profit margin. Is there an exchange risk relating to currency movements between the UK, North America and Asia? Has this currency risk been hedged? What do other similar businesses do about currency risk (we are more at risk if they hedge future exchange rates and we do not). ATC-Adding Value To Your Future 90

Receivables age and payables age seem reasonable, so the normal audit work would be performed. However, I will have to check that the bad debt allowance is reasonable, as the Financial Director has said there have been a lot of bad debts in the year (so there may be more after the year end). The bank overdraft and bank loans should be verified in the normal way (eg by obtaining a bank letter and checking the bank reconciliation). I will have to find out how close the company is to its borrowing limit. There will be a limit imposed by the bank to the overdraft and the Articles of Association may define a limit. If the company is close to, or exceeding its borrowing limits, there is a risk the company may not be a going concern. In view of the fall in sales, is the company planning to make some of its staff redundant? If so, a provision for the redundancy costs should be made in the financial statements (assuming the company had decided before the year end to make the employees redundant). (c) Going concern There appears to be a serious risk that Hyson Computers may fail during the next year. The going concern problem is highlighted by: leverage of over 1.0 the bank may refuse to provide further borrowings to the company; the low profitability in 2003. If the decline in profitability has been progressive for the last year, it is probable that the company is currently making losses; if sales have continued to fall during 2003, it is probable that current sales are significantly less than 90% of 2002s monthly sales; there is an exchange risk in purchasing parts for computers from Asia and North America; the proposed reduction in purchases will increase the purchase price (due to a reduction in the quantity discount) and thus increase the cost of the computers and other equipment; falling sales will probably mean that the company will have to reduce the selling price of its products (to maintain sales); the combination of increasing costs of purchasing computers from suppliers, and falling sales and selling prices will probably lead to the company making losses in 2003. This is likely to have an adverse effect on liquidity. Investigations and considerations Ask the client for a profit and cash flow forecast for at least the year to 30 September 2003. With the clients permission, ask the bank their limit on the companys borrowings, and consider whether it is adequate for future trading. Consider whether future sales are realistic, both in terms of the quantity of equipment sold and. the selling price. It appears that it will not be possible to increase prices unless a new product is to be launched (eg a computer with a new microprocessor). Consider whether the cost of purchasing materials both from the UK and overseas is realistic. The effect of any exchange risk will have to be considered. Consider whether overheads are realistic, and whether the profit and cash flow forecasts are realistic Based on these investigations, I will decide whether there is a significant risk that Hyson Computers will fail. If the forecast shows that Hyson Computers will make a loss, there is a serious risk that Hyson Computers may fail. If the forecast shows Hyson Computers will be ATC-Adding Value To Your Future 91

profitable, and this is realistic, then the risk of Hyson Computers failing is low, and it should be possible to give an unmodified auditors report.

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