Professional Documents
Culture Documents
P7 Summary Notes 2015 PDF
P7 Summary Notes 2015 PDF
+2348039399907,teshocki@gmail.com
2015
FOR MORE INFO FOLLOW OUR GROUP ON FACEBOOK AT ACCA NAIJA LOADED
CONSIDERATION OF LAWS AND REGULATIONS IN AN AUDIT OF FINANCIAL
Non compliance
Non compliance refers to acts of omission or commission by the entity, either intentional
Company law
Employment law
Labor law
Management
The following policies and procedures may be implemented by the management in order
1. Maintain a register of significant laws with which the entity has to comply.
Auditor
As with fraud, the auditor is not, and cannot be held responsible for preventing non
compliance but they should aim to be aware of those that could materially affect the
Financial Statements. There is unavoidable risk that some material misstatements in the
financial statements go undetected even though the audit is properly planned and
performed.
1. The auditor should obtain general understanding of the laws and regulations
Use the auditors existing understanding of the entitys industry, regulatory and
2. The auditor should obtain sufficient appropriate audit evidence of compliance with
other laws and regulations such as entitys license to operate (non compliance
may doubt going concern) that may have a fundamental affect on operations of
the entity.
3. The following procedures may indicate the instances of non compliance such as:
Reading minutes
4. The auditor should obtain written representation from management and those
charge with governance that they have informed auditor about all known and
suspected non compliance.
Audit procedures when non compliance is identified:
1. An understanding of the nature of the act and the circumstances in which it has
occurred.
When evaluating the possible effect on the financial statements the auditor should
In exceptional cases the auditor may consider whether withdrawal from the engagement
is necessary.
When non compliance is material and not adequately disclosed in the financial
When the auditors is precluded by the management and those charged with
governance from obtaining sufficient appropriated audit evidence than the auditor
of scope.
shall express a qualified opinion or disclaim an opinion on the financial statements on the
The auditor may conclude that withdrawal from the engagement is necessary when the
entity does not take the remedial action that the auditor considers necessary in the
management
MONEY LAUNDERING
Money laundering is the process by which criminals attempt to conceal the true origin
and ownership of the proceeds of their criminal activity. In order to be able to spend
money openly, criminals will seek to ensure that there is no direct link between the
A pattern that after a deposit, the same amount is wired to another financial
institution.
Placement;
Layering.; and
Integration
The firm must gather know your client information (KYC) to assist in spotting suspicious
2. Who controls it
In the UK, the basic requirements are for accountants to keep records of clients identity
and to report suspicions of money laundering to the Serious Organized Crime Agency
(SOCA).
2. Train the individuals to ensure that they are aware of relevant legislation, know
how to deal with potential money laundering, how to report suspicions to MLRO.
3. Establish internal procedures such as know your client and client acceptance
4. Verify the identity of new and existing clients and maintain evidence of
identification.
5. Maintain records of identification, and any transactions undertaken for or with the
client.
Note:
1. Concealing and tipping off (MLRO or any individual discloses something that
This is needed because there is a clear conflict between the following two situations:
business, and
as required by law.
they report in good faith their knowledge or suspicions of money laundering to the
appropriate authority.
Disclosure without reasonable grounds would possibly lead to the accountants being
A) Comment on the need for ethical guidance for accountants on money laundering.
(4 marks)
B) The Financial Action Task Force on Money Laundering (FATF) recommends
preventative measures to be taken by independent legal professionals and accountants
(including sole practitioners, partners and employed professionals within professional
firms).
Required:
Describe FOUR measures that assist in preventing professional accountants from
being used for money laundering purposes.
(8 marks)
Ans
A)
1) Accountants (firms and individuals) working in a country that criminalises money
laundering are required to comply with anti-money laundering legislation and failure to
do so can lead to severe penalties. Guidance is needed because:
for example:
reporting to regulators;
3) Professional accountants are required to communicate with each other when there is
a change in professional appointment (i.e. professional etiquette). Additional ethical
guidance is needed on how to respond to a clearance letter where a report of
suspicion has been made (or is being contemplated) in respect of the client in question.
4) Accountants need ethical guidance on matters where there is conflict between legal
responsibilities and professional responsibilities. In particular, professional
accountants are bound by a duty of confidentiality to their clients. Guidance is needed
to explain:
How statutory provisions give protection against criminal action for members in
B)
3) Performing customer due diligence. Firms should verify the identity of their
customers, when:
ACCA members are expected to carry out their work with due skill and care while giving proper
regards to technical and professional standards.
Auditors are not only required to be ethical but they must be seen to be ethical. It is on this note
that ACCA publishes rules of professional conduct which all members and students must adhere
to.
Threats to the fundamental principles (AFISS). These are situations that make auditor not
to adhere to the fundamental ethical codes.
This may create self interest and familiarity threat. The IESBA code of ethics states that when a
firm or a member of the assurance team accepts gift and hospitality, unless the value is clearly
Possible safeguards:
Going by IESBA code of ethics, provision of actuarial service and other valuation services may
give rise to self review threat.
If the service involves evaluating matters that are material to the financial statement and the
valuation involves a high degree of subjectivity, the threat to objectivity and independence cannot
be reduced to an acceptable level by applying appropriate safeguards. The service should
therefore not be provided, or the audit firm should withdraw from the engagement if it wants to
carry out the service.
Possible safeguards:
Audit firm should ensure that members doing the valuation work are not part of the audit
team
Auditor should obtain managements acknowledgement that it is responsible for the result
of the valuation
Audit work done for the client should be reviewed by an independent accountant
Audit firm offering internal audit services to client
Offering of this service may result in self review threats to objectivity. To reduce the threat to an
acceptable level, the firm should ensure that management is ultimately responsible for the control
Possible safeguards:
The client should acknowledge that it is responsible for establishing and monitoring the
system of internal controls
The scope of work to be done should be set by the clients management
The audit firm should ensure that members responsible for the internal audit service are
Contingent fee
This is a situation whereby the auditors fee depends on the outcome of uncertain future event.
IESBA code of ethics outrightly prohibit contingent fee for audit engagement. It creates self
interest threat to objectivity. No level of safeguards will be adequate in this regards, contingent
fee arrangement should be rejected by audit firm.
This may lead to familiarity threat. The auditor may not see anything wrong in what the client is
doing now because it has always get things right in the past. This makes the auditor to lose his
professional skepticism as a result of the close relationship. It may equally lead to self interest
threat because the auditor does not want to lose a source of income.
Safeguard
For listed clients, the IESBA code requires the key audit partner to be rotated after 7 years and
Provision of this service is not prohibited by the IESBA code. It could however lead to the
following threats:
Self interest threat. This is because the firm will want to protect its fee income from the
recruitment. The firm may compromise quality in order to earn its own fee
service will amount to making management decision. If the staff recruited is responsible
for the financial statement, this will amount to the firm auditing its own work.
Familiarity threat. The interaction made during the process of interview will create
familiarity with the staff. The firm may be less critical of the work of such employee based
on the impression created by the employees during the interview.
Possible safeguards:
The firm should only make recommendation, the selection should be made by the
management
The fee charged should be disclosed to the audit committee
This is a situation whereby staffs of audit firm are temporarily assigned to work in a client. This
arrangement will lead to the following threats to objectivity and independence:
Depending on the seniority of staff and the position they are assigned to work, the
assigned staffs may be making management decision. In no way should auditor be
making management decision. It will lead to self review threat because the auditor will be
part of the system he set out to audit.
Self review threat. The seconded staffs will be auditing the work they help to prepare and
may never want to fault their own work. The other staffs of the firm on the audit team may
and as a result the team may not be performed the audit with required level of
professional skepticism.
Possible safeguards:
The firm should ensure the seconded staffs do not take on management role or take any
managements decision.
Seconded staffs should not be included in the audit team to the client
Question DEPECHE
You are a manager in Depeche, a firm of Chartered Certified Accountants. You have
specific responsibility for undertaking annual reviews of existing clients and advising
whether an engagement can be properly continued. The following matters arose in
connection with the audit of Duran, a company listed on a stock exchange, for the
year to 31 December 2008:
(1) The audit team included a manager, two supervisors, two qualified seniors
and six trainees. The final audit, which lasted approximately five weeks, was
very time-pressured and the team worked late into the night towards the end
of the audit. Durans staffs were very supportive throughout and paid for
evening meals that were brought in so that the audit team could work with
minimum disruption.
(2) Durans chief finance officer, Frankie Sharkey, was so impressed with the
commitment of the audit staff that he asked that Depeche pay them all a
bonus through an increase in the audit fee. In April 2009, Depeche paid all
the members of the team below manager status a bonus amounting to a
weeks salary. The bonus was processed through Depeches payroll, in the
same way as overtime payments, and recharged to Duran as part of audit
expenses.
(3) One of the points initially drafted for possible inclusion in the report to the
companys audit committee concerned the illegal dumping of drums,
containing used machine oil, on nearby wasteland. Notes of discussions
between the audit manager and Frankie show that it is the companys
unwritten policy to disregard the local environmental regulations and risk
incurring the fines, which are only small, as it would be costly to use the
nearest licensed disposal unit. The matter is not referred to in the final report.
Required:
(a)Comment on the ethical and other professional issues raised by each of the above
matters. (10 marks)
(15 marks)
Ans
(1) Hospitality
That the bonus was not accepted at the manager level suggests
that this was considered to be a threat to objectivity. This
consideration and the decision to accept the bonus for other
staff should have been documented.
(3) Client/auditor integrity
Available safeguards
Fraud involves the use of deception to obtain an unjust or illegal financial advantage and
categorized as below:
Management responsibilities
Clients management and those charged with governance are primarily responsible for the
detection and prevention of fraud. The management of the client is responsible for establishing
strong system of internal controls to be able to detect and prevent fraud.
Auditors responsibility
Auditor is not primarily responsible for detecting fraud. Rather ISA 240 requires auditor to be
aware, when planning and performing their audit, that fraud may have taken place. Auditor is
only responsible for detecting fraud to the extent that it is material to the financial statements.
On discovering fraud by auditor, ISA 240 the auditors responsibility relating to fraud in an audit
of financial statements prescribes the following:
The auditor should consider the effect of the fraud on the audit opinion
Error
Error is an unintentional mistake. Auditors have the following duties regarding detection and
reporting of error:
material in aggregate
The records of all errors discovered by the auditor should be communicated to the
management as soon as possible
Auditors have a duty of care to the body of the shareholders (not to individual shareholder) and
Generally, auditors do not owe a duty of care to third parties and cannot be liable to them. For
auditor to be held liable to a 3rd party, the followings must be established:
There was duty of care at the time of the audit owed by the auditor to the 3rd party
The duty of care was breached by performing negligent audit by the auditor
The audit firm may use insurance to limit exposure to claims from third party
The firm may operate as a limited liability partnership
The report should contain a statement that management is responsible for the
underlying information
The auditor should clearly state in the report that it is only the intended recipient that can
rely on the report
Firm should develop a robust client acceptance procedure. This should ensure that only
auditor may not be conscious of quality anymore, knowing that arrangement exist to limit
his liability, and leading to poor quality audit. This may reduce the overall value placed
on the auditors opinion.
Question T U R N A L S
Turnals is an unlisted manufacturing company with 120 employees, projected sales of $12
million, and estimated profit before tax of $1.5 million. During the current year the
directors attention had been brought to a recently discovered fraud perpetrated by Mr
Jones, the purchasing manager: He had set up a fictitious business that had invoiced
Turnals for goods that had never been supplied. The fraud had been going on for over two
years. Mr Jones was immediately suspended from all duties and the police informed. During
their investigation, Mr Jones admitted to the police that he had perpetrated a similar fraud at
his previous employers, who had not informed the police. When Mr Jones had been
employed, no reference had been sought from his previous employers.
Mr Jones had responsibility for obtaining competitive quotes, checking and initially
approving new suppliers. Final approval was authorised by the Managing Director but in
practice this was a formality. Mr Jones also raised most of the purchase requisitions based
on information supplied by the storekeeper and approved any requisitions made by other
members of staff.
The fraud took place during the storekeepers holidays (4 weeks each year). It was
discovered when the cashier had to query one of the fraudulent invoices with the
storekeeper because Mr Jones was absent on company business.
Subsequent investigation revealed that approximately $50,000 had been misappropriated by
Mr Jones.
Garner & Co has been the auditor of Turnals for many years. The firm has 12 partners
and 60 audit staff. The internal control over Turnals purchase system was recorded and
tested for the first time during last years interim audit. In previous years a fully substantive
approach to purchases had been applied and no review of the internal controls over the
purchase system had ever been carried out.
No comments were made to management by the auditors on their findings from the interim
work on the purchase system.
Garner & Co had also acted as management and systems design consultants during the
implementation of Turnals purchase system at the beginning of last year. As a result the
directors believe that Garner & Co should be liable for the losses suffered by Turnals as
they employed the audit firm in a dual capacity.
Required:
(a) Describe the regulations and other audit practices that are designed to avoid conflicts of
(b) Discuss why the following audit procedures may have failed to detect the above fraud:
(10 marks)
(c) Discuss the bases on which Turnals believe they have a claim against their auditors and
(20 marks)
Ans
The provision of non-audit work will increase the amount of the fees from
this client. However it is debatable whether the consultancy is a recurring
fee. If it is not it would be disregarded. In any event it is unlikely that the
15% figure would be exceeded (although the question gives no guidance
on this).
Loss of independence
But, the auditors have not followed the requirements of ISA 315. They
have not fully understood the entitys internal control and may not have
sufficiently assessed the risk of fraud (ISA 240) to enable them to
appropriately plan their audit.
In addition, they did not report to management any weaknesses within the
system. It is clear from the scenario that weaknesses did exist (e.g. use of
Mr Jones to cover during holiday periods, the lax approach of the
Managing Director to authorising new suppliers, the failure to obtain
references from previous employers).
The design of the internal control system should have specified that during
the holiday periods of the storekeeper a deputy, other than Mr Jones,
should be appointed and a more rigorous suppliers authentication
procedure should have been undertaken.
These weaknesses should have been noted by the auditors and
communicated to management.
Auditing standards do not appear to have been followed.
The importance of having good quality control procedures in place is to ensure quality of audit
work is maintained and to ensure the auditor complies with his duty of professional competence
and behavior. Lack of quality audit work will generally bring the audit profession to disrepute and
increase litigation risk against the auditor.
Management of the firm should establish internal culture that promotes quality.
A staff with appropriate level of authority should be appointed as the quality control
manager. This person will ensure quality is maintained within the firm
Firm should ensure it has sufficient staff with required competence and capabilities
The engagement partner should ensure that the team is appropriately qualified and
experienced. staff assignment should be based on competence and capabilities
All assignments should be adequately directed, supervised and reviewed
Advertising
Advertising is not prohibited for audit firm. However, the content of the advertisement or the
medium used should not bring accounting profession to disrepute. The following principles on
advertising should be followed:
If a fee is included in the advertisement, the basis of calculation should also be included
Unsubstantiated claims should be avoided
Audit Fees
Audit fee constitute expense and companies may perceive it to be too high. The auditor must
therefore ensure that they can provide a quality audit for the price charged.
Auditors may use any suitable method to calculate fees, but the basis upon which the fee is
calculated should reflect the level of work done. Contingent fee arrangement is however
When companies want to appoint auditors, they normally invites tender for their audit work. This
will give them the opportunity to obtain a competitive rate. The tender give opportunities to each
audit firm to showcase what they have in their fold to give them competitive hedge against
others.
This is a situation where firms charge less than market rate for an audit. This practice is
While Lowballing is not considered ethically wrong, the firm must ensure the following conditions
are strictly upheld:
The auditors must ensure they carry out an audit of required quality as dictated by
international standards of auditing
The auditors must ensure that the low audit fee does not create a situation where their
independence will be compromised.
Ethics of appointment
Ethics of appointment is divided into two phase, procedures to follow before accepting a
nomination and procedures to follow after accepting nomination.
The firm must ensure that there is no any conflict of interest with the potential client
The firm must ensure it is professionally qualified to act for the potential client
Communicate with the incumbent auditor to learn of the reason for the change of auditor
and some other issues the new auditor should be aware of. The firm must seek for
permission from client before making any contact with the incumbent auditor. In the
The firm should ensure that the removal of the outgoing auditor is legally done
The new auditor should request for a copy of the resolution passed at the general
Question AGNESAL
(a) Quality control policies and procedures should be implemented at both the level of the
audit firm and on individual audits. ISA 220 Quality Control for Audit Work
Describe the nature and explain the purpose of quality control procedures appropriate to the
(b) You are the manager responsible for the quality of the audits of new clients of Signet , a
firm of Chartered Certified Accountants. You are visiting the audit team at the head office of
Agnesal Co. The audit team comprises Artur Bois (audit supervisor), Carla Davini (audit senior)
and Errol Flyte and Gavin Holst (trainees). The company provides food hygiene services which
include the evaluation of risks of contamination, carrying out bacteriological tests and providing
advice on health regulations and waste disposal.
Agnesals principal customers include food processing companies, wholesale fresh food
markets (meat, fish and dairy products)and bottling plants. The draft accounts for the year
ended 30 September 2008 show turnover $19.8 million (2007 $13.8 million) and total assets
$6.1 million (2007 $4.2 million).
(1) Against the analytical procedures section of the audit planning checklist, Carla has
written not applicable new client. The audit planning checklist has not been signed off as
(2) Artur is currently assigned to three other jobs and is working from Signets office. He last
visited Agnesals office when the final audit commenced two weeks ago. In the meantime, Carla
has completed the audit of tangible non-current assets (including property and service
equipment) which amount to $1.1 million as at 30 September 2008 (2007 $1.1 million).
(3) Errol has just finished sending out the requests for confirmation of accounts receivable
balances as at 30 September 2008 when trade accounts receivable amounted to $3.5 million
(2007 $1.6 million).
(4) Agnesals purchase clerk, Jules Java, keeps $2,500 cash to meet sundry expenses. The
audit program shows that counting it is outstanding. Carla has explained that when Gavin was
sent to count it he reported back, two hours later, that he had not done it because it had not
been convenient for Jules. Gavin had, instead, been explaining to Errol how to extract samples
using value-weighted selection. Although Jules had later announced that he was ready to have
his cash counted, Carla decided to postpone it until later in the audit. This is not documented in
(5) Errol has been assigned to the audit of inventory (comprising consumable supplies)
which amounts to $150,000 (2007 $90,000). Signet was not appointed as auditor until after the
year-end physical count. Errol has therefore carried out tests of controls over purchases and
issues to confirm the roll-back of a sample of current quantities to quantities as at the year-end
count.
(6) Agnesal has drafted its first Report to Society which contains health, safety and
environmental performance data for the year to 30 September 2008. Carla has filed it with the
Required:
Identify and comment on the implications of these findings for Signets quality control policies
and procedures.(18 marks)
Ans
(a) QC procedures
Quality controls are the policies and procedures adopted by a firm to provide
reasonable assurance that all audits done by a firm are being carried out in
accordance with the objective and general principles governing an audit (ISA 220).
The audit has been inadequately planned and audit work has commenced before
the audit plan has been reviewed by the audit supervisor. The audit may not be
carried out effectively and efficiently.
Supervisors assignments
The senior has performed work on tangible non-current assets which is a less
material (18% of total assets) audit area than trade receivables (57% of total assets)
which has been assigned to an audit trainee. Tangible non-current assets also
appear to be a lower risk audit areas than trade receivables because the carrying
amount of tangible non-current assets is comparable with the prior year ($1.1m
at both year ends), whereas trade receivables have more than doubled (from
$1.6m to $3.5m). This corroborates the implications of (1).
The audit is being inadequately supervised as work has been delegated
inappropriately. It appears that the firm does not have sufficient audit staff with
relevant competencies to meet its supervisory needs.
Direct confirmation
It is usual for direct confirmation of accounts receivable to be obtained where
accounts receivable are material and it is reasonable to expect customers to
respond. However, it is already more than 2 months after the end of the reporting
period and, although trade receivables are clearly material (57% of total assets),
an alternative approach may be more efficient (and cost effective). For example,
monitoring of after-date cash will pr ovide evidence about the collectability of
accounts receivable (as well as corroborate their existence).
This may be a further consequence of the audit having been inadequately planned.
Alternatively, monitoring of the audit may be inadequate. For example, if the audit
trainee did not understand the alternative approach but mechanically followed
circularisation procedures.
Depending on the reporting deadline, there may still be time to perform a
circularisation. However, consideration should be given to circularising the most
Cash count
Although $2,500 is very immaterial, the clients management may well expect the
auditor to count it, albeit routinely, to confirm that it has not been misappropriated.
Monitoring of the trainee may have been inadequate. For example, Gavin may
not have understood the need to count the cash immediately the request was made
of the client . However, the behaviour of Gavin also needs to be investigated in that
he failed to report back to the audit senior on a timely basis and allowed himself to
be unsupervised.
The trainees do not appear to have been given appropriate direction. Gavin
may not be sufficiently competent to be explaining sample selection methods to
another trainee.
Although it is not practical to document every matter, details should have been
recorded to support Carlas decision to change the timing of a planned
procedure. (Carlas decision appears justified as it is inappropriate to perform a
cash count when the client is ready for it). Also, if some irregularity is discovered
by the client at a later date (e.g. if Jules is found to be borrowing the cash),
documentation must support why this was not detected sooner by the auditor.
Inventory
Inventory is almost as immaterial as the cash in (4) from an auditing perspective,
being less than 2.5% of total assets (2007 2.1%). Although it therefore seems
appropriate that a trainee should be auditing it, the audit approach appears highly
inefficient. Such in-depth testing (of controls and details) on an immaterial area
provides further evidence that the audit has been inadequately planned.
Again, it may be due to a lack of monitoring of a mechanical approach being
adopted by a trainee.
This also demonstrates a lack of knowledge and understanding about Agnesals
business the company has no stock-in-trade, only consumables used in the supply
of services.
Question VALDA
As manager responsible for prospective new audit clients you have received a telephone
call from an acquaintance of a client. The caller, Richard Stone, has asked for your assistance
concerning Valda Co, a supplier of electrical alarm equipment. Business has boomed over
the last two years due to reported increasing crime rates. Turnover has nearly doubled and
the company is very profitable.
Mr Stone asks you for an estimate of the cost of a cheap and cheerful review of the
companys accounting systems and internal controls and of a new computer installation. The
new computer is to be supplied next month, by R S Office Equipment, subject to board
approval. He suggests that you could spend a few days looking at the systems flowcharts
and documentation. He wants you to tell him anything else that could be significant to the
boards decision to adopt his proposals.
Although you are keen to gain the business, you inform him that you will write after giving the
matter further consideration.
Required:
(a) Identify and comment on the issues raised as they affect your decision to gain the
business. (10 marks)
(b) State what procedures you would adopt to clarify and agree the basis on which your
firm would undertake this work. (5 marks)
Ans
Future business
Timescale
As for all professional work, it should be carried out with a proper regard for the
Access to information
Restricted access to information and explanations, which limits the scope of the
proposed review, may prevent conclusions being drawn. It may be necessary to
discuss sensitive issues including proposed business expansion, technical
obsolescence of products, product development, etc. Also, the current auditors
permission should be sought to review their management letter.
Reporting
Presumably the findings of the review will be reported, possibly to Mr Stone rather
than the board. Any opinions must be commensurate with the scope of the review
performed. In particular, the report will not recommend the boards decision.
Nature of review
Decision to purchase
The decision to purchase, or not, will be taken by the board. Matters significant
to the boards decision, which may not be included in Mr Stones proposals, could
be:
cost and availability of software support;
Fees
The assignment cannot be accepted if fees are contingent on the outcome. Fees will
be based on time spent and the level of skill of staff involved.
Resources available
The assignment will require at least one member of staff with relevant systems and
computer knowledge and experience. Some knowledge of the industry will be useful.
Such a person may not be available, at such short notice, without disturbing the
services provided to existing clients. For this reason alone, the assignment could be
declined.
(b) Procedures
current auditors;
Mr Stones interests as director/shareholder.
Audit planning
Proper planning is required in audit to avoid performing negligent audit. Overall audit plan
The followings are the aspect of the clients business which the auditor must understand:
Business risk. This is the risk that the company may not achieve its objectives. Business
risk is a good indicator of going concern problem
Internal control. Assessment of the internal control will determine the audit strategy to be
adopted
Discuss with internal audit personnel and review the internal control manual to obtain
Perform analytical procedure on the entries in the financial statements to assess risk of
material misstatement
Discuss with management to gain knowledge of the corporate structure
Audit approach
Risk-based approach
In this approach, the auditors assess the risks associated with the clients business,
transactions and systems and direct their testing to risky areas. The extent of detailed testing
Audit risk
Audit risk is the risk that the auditor may give an inappropriate opinion.
Control risk- is the risk that the system of control put in place by the management will fail to
detect material misstatement.
Detection risk- is the risk that the procedures performed by the auditor will fail to detect material
misstatements
If both control risk and inherent risks are low, the overall audit risk will be low. The auditor will
perform less substantive testing
If both control risk and inherent risks are high, the auditor needs to reduce the overall audit risk
by keeping the detection risk as low as possible as this is the only component of the audit risk
the auditor can control. To do this, the auditor will need to test more details
This approach ensures that the greatest audit effort is directed at the riskiest areas, so that the
chance of detecting misstatement is enhanced and less time is devoted to less risky areas.
It lays too much emphasis on test of details. This may make the auditor overlook other
This approach starts by considering the business and its objectives and works down to the
financial statements, instead of working up from the financial statements. The auditor will
key performance indicators and associated risks and controls; he then compares his
assessment of these factors with the position reflected in the financial statement.
This approach save auditors time and add more value to the client
Environmental risks
Increase in competition
Financial risks
Cost of maintenance
Cost of any inputs
paying fines
Compliance risks
Operational risks
Age of plants
Safety
Staff training
Hedging
Avoid unacceptable risk
Audit strategy sets the overall scope, timing and direction of the audit. The suitability of an audit
strategy depends on the risk characteristics of the audit. In other words, the strategy to be
adopted for a particular audit depends on the result of risk assessment carried out by the
auditor.
Audit plan details the specific procedures that need to be carried out in order to implement the
strategy and complete the audit. It details the step-by-procedures needed to gather evidences
for the completion of the audit.
Financial statement risks include both inherent and control risk. Financial statement risk is
generally the risk that the assertions in the financial statement may not be correct.
Business risk on the other hand is the risk that the business may not achieve its objectives. For
example, any factors capable of eroding the profit of an organization constitute business risk.
Any factors that threaten the going concern of an organization equally constitute business risk.
A highly geared company is faced with financial risk. This is because of the huge financial
commitment involved. Interest payments reduce the companys profit, and as such, it constitutes
a business risk. This may equally lead to going concern problem because some of the assets of
the company may have been used as collateral to secure the loan. Inability to meet interest
obligation or loan repayment will lead to the seizure of such assets. This cause operational
problem and could eventually lead to the company going out of business. The financial
statement risk here is possible understatement of liabilities or non disclosure of going concern
problem.
The business risk here is non-renewal of the license as a result of not meeting the attached
conditions. If the license is not renewed, the business will become inoperative. The associated
financial statement risk is non-disclosure of going concern problem in the financial statements.
A company listed on multiple stock exchanges is inherently risky to audit because the reporting
Presence in multiple locations increases control risk in that the entity system of control may not
cover all location. It equally increases detection risk in that the auditors need to attend and
obtain information from various locations.
Some companies operate in industries that make use of complex assets that are difficult to
value. This constitutes inherent risk
When you are provided with extracts of financial statements and ask to highlight business and
financial statement risks, perform analytical procedures for the followings:
Movement in revenue
Movement in finance cost
Movement in profit margin
The percentage increment or decrement of the following pair of items should ideally be fairly the
same. Compare the percentage changes in the items and explain any variance with possible
misstatement.
Tax complication as a result of the company not understanding the foreign tax system.
When customers are dissatisfied for whatever reasons, the following risks are possible
These are tests carried out to obtain audit evidence to detect material misstatement in the
financial statements.
Analytical procedures
Test of details
Substantive tests carried out to obtain evidence on financial statement assertions are described
below:
resulting investigations of fluctuations and relationships that are inconsistent with other relevant
information or which deviate from predictable amounts.
Auditor must apply analytical procedures at the planning and review stage of the audit. In
profit to sales
Those between financial information and relevant non-financial information, such as the
relationship of payroll costs to number of employees
Auditors must apply analytical procedures at the planning stage to assist in understanding the
business and in identifying areas of potential risk.
The followings are the possible sources of information about the client:
Budgets
Management accounts
Non-financial information
Industry information
Figures used are likely to be in draft form: - subsequent adjustment to these figures will
Information may not be prepared on the same basis as the previous year.
Information may not be available before the year-end accounts are produced.
To develop business understanding at the planning stage of the audit e.g. profit margin
Compare actual revenue and profits for like 3 years with projected revenue and profit.
Training cost
Property cost
ISA 520 Analytical procedures states that auditors must decide whether using available
analytical procedures as substantive procedures will be effective and efficient in reducing
detection risk for specific financial statement assertions.
The followings are the factors which the auditor should consider when using analytical
procedures as substantive procedures:
Availability of information
Reliability of the information
Proof in total test can be used to assess the reasonableness of items in the statement of
comprehensive income such as depreciation, wages and salary change.
For wages and salaries, the average numbers of employees can be taken and multiplied
by the average salary for the year to get an estimate of the salary charge for the year-
any pay rise should be factored into the calculation.
Comparisons of current year figures to prior year figures can be made for immaterial
items to form an assessment about the reasonableness of the figure. Comparison can
also be made with budget figures for the year.
Accounting ratios can be used as analytical procedures to provide audit evidence. The
ratios can be calculated for prior periods and for comparable companies.
Materiality of the item involved. Analytical procedure would be used for those items that
are not material to the financial statements. It is not suitable to use analytical procedure
on items that are material.
The accuracy with which the expected results of analytical procedures can be predicted
Analytical procedure can be use to proof in total for specific items in the accounts e.g.
depreciation, staff costs
Analytical procedures are more suited to large volume transactions. The auditor need to
test if the controls are effective to determine the extent of reliability
1. Nature
2. Value
3. Impact.
There is an inverse relationship between the risk and the materiality. The higher the risk
the lower the materiality level and vice versa. When materiality level is set at lower level
materiality).
Performance materiality is set at much lower level than the overall materiality so that
small misstatements in aggregate should not cross the overall materiality level.
Revenue 0.5%-1%
Gathering evidences
Students will be required to suggest audit procedures for specific matters raised in an
examination scenario. To be able to do this, students need strong knowledge of
accounting standards. Students must first identify the accounting issues in the questions
before prescribing procedures.
Professionals audit staff are highly trained and educated, but their experience and
therefore be necessary to employ someone else with different expert knowledge to gain
1. Valuation of certain types of assets for example land and building, plant and
machinery.
accounting.
The risk that the experts objectivity is impaired increases when the expert is:
2. Related in some other manner to the entity, for example by being financially
The auditor shall agree in writing when appropriate on the nature, scope and objectives
of that experts work. Such agreement/instruction should cover the following factors:
5. The results of the experts work in the light of the auditors overall knowledge of
The auditor shall not refer the work in an auditors report unless required by law or
regulation. The reason is that such a reference may be misunderstood and interpreted
appropriate.
You are carrying out the audit of Ravenshead Construction Inc. The companys business
includes large civil engineering contracts the construction of buildings and roads. It also owns
investment properties which are let to third parties these comprise offices and industrial
buildings.
During the year ended 30 April 2009 the company received a substantial claim for damages
from Netherfield Manufacturing Inc for faults in a building it had constructed this claim includes
the cost of repair and damages, as the customer alleges that the building cannot be used
In the year-end accounts the investment properties have been revalued by an independent
valuer and the construction contract has been valued by an employee of the company who is a
qualified valuer.
Required:
Describe the matters you would consider and the other evidence you would obtain to enable
you to assess the reliability of the work of specialists in the following cases:
(a) Legal advice obtained from the local solicitor on the outcome of the claim by Netherfield
Manufacturing; (6 marks)
(20 marks)
Ans
Enquire into the background of the local solicitor and establish that he/she has no
connection with the company or with the officers of the company.
The auditor should investigate the experience of the solicitor ideally he should be a
counsel briefed by solicitor is also relevant in this area. Lastly the materiality of the
amount of the claim should be considered and the solicitors opinion should be read
carefully. The solicitor may only give a very pessimistic estimate of the likely outcome of
the case. This should be considered in the light of any precedence and will obviously be
relevant in examining the accounting treatment of the item in the financial statements.
The qualification of the valuer should be noted. Membership of the/a national institute for
surveyors is a recognised qualification for this purpose.
The terms of reference given to the independent valuer should be noted. There may be
important reservations with regard to how the valuation is conducted. This may obviously
affect the quality of the valuers opinion.
The basis used for valuation must be reasonable and generally acceptable. Investment
properties are valued on the basis of the future income that they generate. The
calculations for the valuation should be examined and verified by the auditor. This will
involve communicating with the experts and establishing sight of his working papers.
The auditor should also consider the valuation of other investment properties in a similar
The value of the construction contract and the degree of monetary precision which would
years.
The accounting records for the contract should be reliable and should be capable of
substantiation.
The past record of the valuer should be considered; there should be other construction
contracts which have been completed in the past and the valuation basis should have
been capable of validation with the benefit of hindsight.
The auditor should also examine the estimate of cost of completion and estimated
contract revenue. The estimates of cost completion should allow for remedial costs and
for cost escalation in the price of materials. Any fixed price contract is likely to be
exceedingly risky. The auditor should check the calculation of attributable profit and
establish that all adjusting events after the reporting period have been taken into
accounts in the valuation of the contract. Where a loss is foreseen provision should be
made in full as per IAS 11.
regarding the ability of the entity to continue as a going concern IAS 1 requires
adequate disclosures.
ISA 570 summarizes the main responsibilities of both management and auditor regarding going
concern. The going concern assumption is a fundamental principle. Readers of the financial
statements would assume the entity is viable unless it is clearly stated otherwise
Responsibilities of management
more a going concern, alternative basis of presentation should be adopted E.g. break-up
basis.
Adequate disclosure should be made in the notes to the account regarding any
Responsibilities of Auditor
The auditor should obtain sufficient, appropriate evidence about the appropriateness of
uncertainty on the entitys ability to continue as a going concern and this has been duly
disclosed by the management, there will be no need to qualify the auditors opinion,
otherwise qualified opinion will need to be issued.
The auditor shall remain alert throughout the audit for audit evidence of events or
condition that may cast significant doubt on the entitys ability to continue as a going
concern
NOTE: The auditor shall cover the same period as management in the evaluation of
managements assessment of going concern
The following range of indicators may be used by both the auditor and the management in
making assessment of going concern:
Financial indicators: Analytically compare key financial ratios. Any adverse movement could
indicate going concern problem e.g. drop in profit margin, decrease in interest cover,
decrease in current ratio.
Operating indicators: The following factors could indicate going concern problem
problem. It may equally create operational problem if there is charge on the entitys
assets.
Reliance on overdraft facilities. This is an unsuitable source of long term funding. It
is not sustainable on long term and it usually carries high interest rate.
Unusual increase in inventory level or insufficient inventory level.
working capital management if the entity do not get enough cash to settle its current
Impairment of assets
Debts going bad
Note: any of the above points constitute matters to be consider regarding going concern
If the auditor becomes aware of factor of uncertainty casting significant doubt on the entitys
ability to continue as a going concern, the auditor must carry out further procedure to obtain
The auditor should evaluate managements future plan to sustain the entitys going
concern. E.g. managements plan for the expansion of its business or invest in new
projects.
The auditor should consider the availability and sufficiency of finance available to fund
any future business expansion or new projects.
The auditor should obtain direct confirmation from the entitys bank on its readiness to
provide the needed finance for the entity.
The auditor should assess the viability of managements plan e.g. by assessing the
The followings are the implications of going concern issues on the auditors report:
Where the auditor consider that there is significant level of concern about the ability of
the entity to continue but do not disagree with managements use of the going concern
assumption in preparing the financial statements, an unqualified opinion will be issued
provided it is adequately disclosed in the notes to the account. The auditors report
would include an emphasis of matter paragraph to draw readers attention to the note.
If the use of the going concern is appropriate but there is material uncertainty on the
going concern, if required disclosures are inadequate the auditor would issue a qualified
or adverse opinion depending on the pervasiveness of the uncertainty to financial
statements.
If the auditor disagrees with the basis of preparation, an adverse opinion will be issued
because it is pervasive to the financial statements.
Where the accounts have been prepared on an alternative basis, e.g. break up basis,
and the disclosure to this effect is considered not adequate, the auditors report would
need to be modified on the ground of inadequate disclosure
If there is clear indication that the entity will be liquidating its assets and there is no
If the client is unable to obtain the loan, the financial statement must contain disclosures
regarding the material uncertainty over going concern. The auditors report should
contain an emphasis of matter paragraph discussing the uncertainty and referring to the
note.
If the financial statements do not contain the disclosures, the auditors opinion would
need to be either qualified or adverse
Audit Procedures in respect of an entity with going concern problem applying for bank loan
to fund a project
Obtain & review the forecasts and projections and assess if the assumptions used
Obtain & review the terms of the loan to see if the client can make the repayments
required.
Consider the sufficiency of the loan requested to cover the costs of the intended
project.
Review the repayment history with the clients bankers to form an opinion as to
considered.
Obtain a written representation from management stating managements opinion as
Requires that inventory should be valued at the lower of cost and net realizable value.
The method used in allocating costs to inventory need to be selected with a view to providing
the fairest possible approximation to the expenditure actually incurred in bringing the inventory
Notes:
It is permitted to value inventory at market price at year end only if the rate of turnover
and fluctuations in the market price is very high, but this is a departure from IAS 2 and
Selling price less gross profit margin is an acceptable method of approximating to cost of
inventory
Cut-off. Inventory will be undervalued or overvalued if cut-off has not been appropriately
applied.
Counting. Inventory will be undervalued if not all inventory items have been included in
count.
appropriate staff
Discuss scrap and wastage policy with the concerned staffs.
Examine details of scrap and discuss reasonability of figures with appropriate staff
Test cut-off is correct by tracing the last goods delivery notes and dispatch notes to the
invoices.
Recast additions on inventory sheets to verify accuracy.
Discontinued Operation
line of business
Disposal group: the assets of a discontinued operation are a disposal group per IFRS 5.
IFRS 5 Requires that a disposal group is recognized as held for sale where the assets are
available for sale in their present condition, the sale is highly probable and the sale should be
According to IFRS 5:
The assets in disposal group should be measured at the lower of their carrying amount
and the fair value less cost to sale.
The assets should not be depreciated.
Confirm that results of the discontinued operation are presented separately in the
The disposal should be as a result of a single coordinated effort to dispose a major line
of business.
If products are different from the products of the continued operations, then it is arguable that a
component has been closed as part of a single coordinated plan to dispose of a separate major
line of business. In this case, there should be separate disclosure in the financial statements.
If the discontinued operations are not separately identifiable either by products or geographical
location, there is no need to make separate disclosure.
IAS 8 states that a company should only change its accounting policy towards an item if
required to do so by an accounting standard or if the change in policy would give a more reliable
and relevant reflection of the substance of the transaction
In a case where there is prior year overvaluation of inventory, comparative figures should be
restated in the financial statements and adjustments should be made to the opening balances of
There should be no specific reference to the corresponding figure in the auditors report merely
because they have been restated (ISA 710). However, if the corresponding amounts have not
been properly restated or appropriate disclosures have not been made, the report should the
modified with respect to the corresponding figures.
Audit procedures
Compare prior year accounting policies with the current policies to determine if there is
The auditor should recalculate any restated figure in statement of changes in equity due
to prior period error.
The auditor should ensure adequate disclosure is made in the notes to the account
regarding any change in accounting policies and error.
Financial instrument
An entity should recognise a financial asset or liability in the statement of financial position when
it becomes a party to the contractual provisions of the financial instrument.
Financial asset:
Any asset which is not measured at amortised cost must be measured at fair value
Financial liabilities
Financial liabilities are measured at amortised cost unless held for trading
Audit Evidence
A subsequent event is any event occurring after the date of the financial of the financial
statement being audited.
Material non-adjusting events must be disclosed in the note- explaining the event and its
financial implication.
The auditor needs to consider whether the events have been properly accounted for in
accordance with the requirements of IAS 10 Events after the reporting date
Events occurring between date of the financial statement and the date of auditors report
In this period:
The auditor has an active duty to perform procedures to identify any subsequent events.
The auditor should perform procedures to identify events that might require adjustment
or disclosure in the year-end financial statements.
The auditor should consider the impact on the audit reports and whether modification is
necessary to the audit report
Events occurring after the date of auditors report but before the financial statements are issued.
In this period:
The auditor should request that management amend the account to allow for the
subsequent event
In the event that management fails to make adjustment to the account regarding the
The auditor should take necessary step to prevent reliance on the report
The auditor should speak about the event at the general meeting of members
Auditors have no obligations to perform procedures after the financial statements have been
issued.
If the auditor becomes aware of a situation that if he had known at the date of the financial
statement would have cause the auditor to give alternative audit opinion, the auditor should
On managements revision of the financial statements, the auditor should carry out further
procedures as follows:
Audit procedures for restructuring cost discovered after the year end (Non-adjusting event)
Verify that management has included a note disclosing this event in the financial
documentation
Review the details of the announcement made on the restructuring and agree the details
to the disclosures made in the financial statements.
It provides evidence about the valuation of the brand at the reporting date (the brand as
an intangible asset may be overvalued).
The net realizable value of inventory may be less than cost
The value of the brand may be impaired
Deferred tax
IAS 12 Requires that deferred tax is calculated at a rate of tax that is substantively enacted and
expected to apply to the period when the deferred tax is to be settled, it must have been passed
into law, not merely suggested or announced.
Audit concern
Check that the increase or decrease in provision will not be material to profit in order to explain
the implication for the audit
asset
Check the arithmetical accuracy of deferred tax and corporate tax computations.
Agree the figures used to any tax correspondence and financial statements.
Obtain profitability forecasts and ensure there are enough forecast taxable profits for the
losses to be offset against.
The fair value of an asset or a liability is the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at the measurement
date.
According to IFRS 13 fair value measurement entity should follow the following hierarchy in
order to determine the fair value of an asset:
Quoted prices in an active market for identical assets or liability that the reporting entity
can assess at the measurement date.
Quoted price for similar asset in active markets or for identical or similar assets in non-
active markets.
Using the entitys own assumptions about market exit value.
In a situation where the market is illiquid, it will be difficult to apply fair value because of
unavailability of information. This constitutes area of great audit risk.
Audit risks associated with the application of IFRS 13 will be grouped as follows:
Inherent risk
Measurements of fair value are subjective in nature because they generally involve
making estimates based on a number of assumptions, management may not be
sufficiently experienced or skilled to make these assumptions
CONTROL RISK
Making estimate for fair value is likely to fall outside the system of controls set up by the entity to
deal with regular transactions since they are likely to take place once in a year.
DETECTION RISK
There is risk that the audit team may lack the knowledge to make assessment of the fair value
measurement and may rely too heavily on the work of auditors expert.
events and from which future economic benefits are expected to flow to the entity.
For an asset to be recognized in the financial statement, it must be probable that the economic
benefit associated with the asset will flow to the entity and the cost can be measured reliably.
Initial recognition
Recognized Asset should be initially measured at cost. The cost of an asset includes the
followings:
After the initial recognition, an entity may adopt any of the following recognition models:
Cost model. This refers to the cost of asset minus the accumulated depreciation
Revaluation model. This refers to the fair value of the asset minus subsequent
accumulated depreciation and impairment losses. The revaluation model can only be
Take a sample of assets from the asset register and trace to physical location to confirm
existence
Take a sample of assets from physical location and trace to assets register to confirm
completeness.
Inspect purchase invoices to confirm the cost of assets and the dates on the invoice
should confirm the cut-off is proper.
Recalculate the depreciation
Check consistency of the depreciation policy by comparing the current rate with prior
years.
Check to confirm any disposed asset has been removed from the asset register and
Dismantling costs
Dismantling costs should be capitalized as non-current assets, and a provision created against
them.
The provisions may not have been measured correctly according to IAS
37,provisions,contigent liabilities and contingent assets
NOTE: Account should be taken care of the effect of discounting if it is material to the account,
and should be included in the statement of profit or loss to represent the unwinding of the
discount.
Verify cost of the PPE by reviewing the contract with the contractor
Agree cost of the PPE to invoice
Inspect the asset at year end to assess the stage of completion. Use this to confirm the
Agree finance cost to the terms of the finance contract and payment made
Recalculate capitalized amount to ensure accuracy
Ensure the basis of capitalization agrees with IAS 16
Discuss with management on the consideration of possible impairment
Leases
A lease is a finance lease if it transfers the majority of the risks and rewards relating to the
ownership of the asset to the lessee. If this is not, it is an operating lease.
Finance lease:
At the start of the lease, the lessee should recognize the leased asset as a non-current asset,
valued at the lower of:
Finance charge
Partial repayment of the lease obligation
Both the depreciation and finance charge should be accounted for as period charges in the
statement of profit or loss.
Operating lease
Lease payment under operating lease is treated as rental expense in the statement of profit or
loss.
The asset should not be recognized in the statement of financial position of the lessee. Also, the
leased asset should not be depreciated.
Materiality
Classification whether leases have been correctly classified as finance or operating
Note: For lease of land and building, according to IAS 17 leases, only the buildings element of
the lease can be capitalized as land is always an operating lease. The risk here is that both land
and building may be wrongly capitalized.
Copy of clients workings in relation to the amount recognized as finance lease charge.
Recalculation of the present value of the minimum lease payment and compare to fair
value.
Recalculation of operating lease expenses on a straight line basis over the lease term
If the transaction results in a finance lease, any associated profit or loss should not be
immediately recognized. The profit/loss should instead be deferred and amortised in the
If the transaction results in operating lease, the associated profit/loss should be recognized
immediately. In a case where the transaction does not occur at fair value, one of following
treatments applies:
If the sales price is above the fair value, the excess of the price over the fair value
should be deferred and amortised over the lease term to match the lease payments.
If the sale price is below the fair value, any profit/loss should be recognized immediately
Revenue
Sale should only be recognized when risk and benefit associated with goods have been
Deposits made when the customer is yet to enjoy the service is treated of deferred income and
Consignment Inventory: this refers to inventory held by one party but legally owned by another
party. Items should be accounted for according to the substance of the transaction rather than
legal form. Consignment inventory should never be recognized as a sale. It is otherwise known
as agency sale
The auditor should examine the terms of the sale in order to establish whether:
The seller has the legal right to cancel the sale and order the return of the goods
Government Grant
IAS 20 Accounting for Government Grants and disclosure of Government Assistance requires
that the Grant income is matched to the cost it is intended to compensate for
Just as we systematically allocate the cost of a non-current asset over the useful life in line with
the matching concept, IAS 20 requires that Govt. grant should be recognized as deferred
income in the statement of financial position. There is risk that this may not be done leading to
liabilities being understated and profit being overstated.
IAS 20 Requires that a grant is recognized only when there is Reasonable assurance that the
company will meet the condition attached to the grant. Where there is doubt over this, a
provision should be recognised in line with IAS 37. There is risk that this will not be done
thereby understating liabilities and overstating profits.
Obtain the grant document and review the terms to verify the amount of grant.
IAS 37 requires that a company set up a provision where there is a present obligation as a
result of past event from which it is probable that a transfer of economic benefit will be required
In a situation where the future payment is only possible but not probable, no provision is
required but there should be adequate disclosure in the notes to the account. This is called
contingent liability.
unfavourable
Breach of law and regulation which may likely lead to fines and compensation
Obligation to decommission a site after use
Audit procedures:
analytically compare currents year provision with that of prior years, obtain explanation
for any unexpected result
Note: A provision for restructuring costs (e.g. the closure of a business segment) should only
be recognized if a formal plan had been in place and there has been a public announcement
regarding the plan. If these conditions are not satisfied, the plan should only be disclosed in the
note to the account as a non-adjusting event in line with IAS 10 Events after reporting period
Intangible asset
Intangible assets are business resources that have no physical form, items that cannot be seen
Development costs may qualify for recognition as intangible assets provided the following
criteria are met:
The following recognition criteria must be met before an intangible asset can be recognized in
the financial statements:
it must be probable that the company will gain future economic benefit attributable to the
asset
If an item does not meet both the definition of intangible asset and recognition criteria given
above, the expenditure on such item should be recognized as expense in the period
to purchase invoice
Agree finance cost to loan contracts - interest rate should be agreed to finance
Intangible asset (e.g. operating license) granted at no cost can be recognized at its fair
value if the fair value can be correctly measured.
If there is a legal or constructive obligation to dismantle an asset after its useful life,
provision should be made and should be included in the cost of the asset.
Internally generated goodwill should not be recognised
Impairment
Impairment refers to a fall in the value of an asset. An asset is impaired when the recoverable
amount of such asset is less than its carrying amount.
If an asset is impaired, the value of the asset as recognized in the financial statement should be
reduced by the value of the impairment. The amount of the impairment should be debited to the
Obtain written representation that the estimate of the useful life is valid
Review board minutes for any major decision regarding the intangible asset
Assess the present value of future cash flows associated with the asset and compare
with carrying value.
Inspect board minutes to see any evidence of change in operation plan that may render
some asset obsolete
IAS 33 requires disclosure of earning per share figure. Both basics EPS and diluted EPS should
disclosed. Non disclosure will always amount to a material misstatement. This is because the
earnings per share figure are material by nature.
If there is Non disclosure of the earnings per share figure in the financial statement, the auditors
report will need to be modified.
Audit procedures
The model used to assess the fair value of the share options must comply with IFRS 2 share
based payment.
Fair value must be measured at the grant date in order to calculate expense otherwise the
financial statements will be inaccurate.
Review contractual documentation for the share-based payment scheme and agree the
following to the management calculation of the expense:
Discuss the reasonableness of the percentage staff turnover assumption with human
resources department.
Obtain written representations from management confirming that the assumptions used
in measuring the expense are reasonable and that there are no share-based payment
There is risk that its results have not been consolidated from the correct date leading to the
Goodwill
There is risk that goodwill has not been calculated correctly. The fair value of subsidiarys
assets and liabilities may not have been estimated reliably.
When a subsidiary does not prepare accounts in line with IFRS the accounts of the subsidiary
should be restated to be in line with group accounting policies.
Intra-group trading
Intra-group transactions must be eliminated during the consolidation process. There is risks this
is not done. Inventories may as a result contain unrealized profit thereby overstating revenues,
expenses, assets and liabilities.
Obtain list of directors of the companies to confirm whether the company has appointed
director(s) to the boards.
Discuss with the directors of the company the level of involvement in policy decision made at
the companies.
Obtain a written representation detailing the nature of involvement and influence exerted over
the companies.
Your firm has been approached by the managing director of Abacus Leasing to tender for the
audit. The company is a small non-listed incorporated enterprise. The previous auditors have
resigned after a loss of confidence in them by the board of Abacus Leasing. This concerned the
disapproval by the board of a qualified auditors report issued by the outgoing auditors which
referred to inadequate internal controls in Abacus Leanings systems.
The company leases equipment to building contractors, many of whom have insufficient cash
resources to purchase the equipment outright. Some lessees have been refused credit
elsewhere. Since formation three years ago Abacus Leanings sales revenues have doubled
each year and lease receivables now represent over 80% of the companys gross assets. The
company is now experiencing difficulty in collecting a substantial amount of overdue lease rental
payments. The company has no formal system for approval of new customers or any laid down
procedures for repossession of assets where the terms of the lease agreements have been
broken.
Although the terms and conditions of the leases vary considerably all of them had been treated
by Abacus Leasing as finance leases.
The company is managed by a Board of three directors with a dominant managing director who
owns 93% of the share capital. The directors and senior management are largely remunerated
by a performance bonus based on new sales. The company does not have an audit
committee.
Required:
(a) Describe the procedures an audit firm should undertake before accepting a potentially
(b) Describe the factors in relation to the audit of Abacus Leasing that would affect your
assessment of risk. (7 marks)
Ans
It should be apparent to a prospective auditor that the audit of Abacus Leasing is a high risk
audit and therefore the quality control procedures to be adopted before tendering for such an
audit would include:
A request to communicate with the previous auditor. A refusal of this would inevitably
attention being focused on the system of controls and activities of the company.
A commercial assessment must be made. The prospective client appears to have weak
controls and several high risk areas. This may entail a large amount of audit time making
the audit fee expensive. The financial position of the client may not be sound and there
may be a serious risk of non-payment of the audit fee. The risk of an incorrect audit
opinion being given increases the possibility of legal action against the auditor as well as
the possibility of bad publicity and implications for future insurance indemnity premiums.
The following factors would need to be considered in assessing the level of risk in Abacus
Leasing:
The suspicious circumstances in which the previous auditors resigned, particularly the
reasons for the audit qualification. It would appear that there are poor internal controls at
Abacus Leasing, and further, it seems management are reluctant to improve them.
The domination by the managing director.
The company is a new company with little history and the growth of the company is
spectacular.
There may be an element of overtrading causing the company to be over borrowed,
highly geared and experiencing liquidity problems.
The bonus incentive for management may have caused high risk sales (leases) to have
been made, or the sales revenue figure may have been falsified.
The nature of the products, building equipment, can have high associated risks. There is
frequent theft of this type of equipment and as the equipment is often abused in its use it
may not last the length of the lease, making default more likely.
The high proportion of assets in the form of lease receivables which appear to be difficult
to collect and the lack of a formal system of collection.
(i) Leases
The principal aim is to determine whether a tease falls to be treated as a finance lease or an
operating lease. IAS 17 Leases says that a finance lease occurs when substantially all the risks
and rewards of ownership are transferred to the lessee. This is deemed to occur where:
but it would be net of any trade or large quantity discounts and any grant assistance for
the purchase. The auditor must identify the specific asset being leased in the
agreements and determine its original cost by tracing the purchase invoice and the
payment made. If any grants have been received by Abacus Leasing during the year the
documentation relating to them must be inspected to determine which assets had grant
aid and how much this was.
The minimum lease payments (MLP) should be readily determinable from the
agreement. The auditor would then calculate the present value of the MLP using an
appropriate discount rate. The discount rate should be confirmed by management and
the auditor would use his experience of similar agreements and market interest rates to
confirm the appropriateness of the rate.
The results of the above tests should determine whether the agreement is a finance lease or an
operating lease (as per the definition above). If it is a finance lease the outstanding net
investment in the finance lease should be shown in receivables. The rental income should be
allocated partly to finance charges and credited to profit or loss with the balance being treated
as a repayment of the lease receivable. If it is an operating lease the assets should be shown
under non-current assets and depreciated over their estimated lives, with the rental income
If a lease has been incorrectly classified there may not be a material error in the total value of
the assets in the statement of financial position. However the presentation of the statement of
financial position would be incorrect.
The work the auditor would do to confirm the estimate of the bad debts allowance is:
Confirm the gross lease receivables by the tests above and, using an appropriate
be of greater value and at more risk of non-payment. Leased receivables differ from
normal trade receivables in that they are not receivable within a short period of time.
The auditor should check to see if any receivables contain overdue instalments: Such
receivables are more likely to be bad. Some of the lessees may be in dispute and the
The auditor should review the companys procedures for recovery of receivables which
have breached the terms of the agreements. As these procedures are known to be weak
further tests of detail (substantive procedures) should be performed to confirm the value
of the lease receivables.
The above tests should give the auditor a basis for estimating the total allowance required for
bad debts. From the information in the question this is likely to be a high figure due to the credit
standing of some of the customers and the sales policy encouraged by the bonus scheme.
Lease receivables again differ from most normal trade receivables in that Abacus Leasing
retains ownership of the related assets. Where an agreement is in default such assets could be
repossessed by the company.
If Abacus Leasing has reduced the total allowance by an estimate of the recoverable amount of
leased assets the auditor must do farther work. The auditor should try to obtain proof of the
physical existence of the assets to confirm they are still in the possession of the lessee and-to
determine their condition. This may be very difficult in practice. The auditor would then form an
opinion of the recoverable amount of the assets. This would either be an estimate of their net
selling price or their fair value if leased to another builder. The value to be used would be
The opportunity has arisen for your firm to seek appointment as auditors of Sunshine Stores, a
supermarket chain of twenty stores which operates a sophisticated computerised inventory
control and re-ordering system. You learn that Sunshine Stores has also invited four of your
Sunshine Stores has a centralised purchasing system and individual stores transmit electronic
point of sale (EPOS) information each night to the head office for processing the following day.
All other accounting functions are also carried out centrally with the exception of casual wages
and petty cash expenditure. Each days takings are banked daily to one single bank account.
Sunshine Stores is particularly anxious to establish the ability of your auditing procedures to
deal with the business risks and has asked you to set out, as part of your presentation, your
approach concerning:
(1) audit risk (that is, the degree of risk of misstatement through errors or irregularities) and
how your procedures would seek to address it in the business of Sunshine Stores;
(3) sampling, and the extent to which it might be appropriate to use this technique; and
(4) analytical procedures and its contribution to the efficiency of your audit process.
You understand the need for Sunshine Stores to have a high level of confidence in your firms
approach to highly computerised clients, and you have the task of drafting the sections of your
firms written presentation to demonstrate how your procedures would be likely to apply to this
client.
Draft the sections of the written presentation to Sunshine Stores which deal with these four
aspects of the audit approach and the inter-relationships, if any, between them.
(15 marks)
Ans
Audit risk, defined as the degree of risk of material mis-statement through errors and
irregularities, is a fundamental determinant of the sufficiency of audit evidence. It is ascertained
at:
the overall financial statement level (e.g. the knowledge that accounts are likely to be
used partly to defend a takeover bid would be considered to increase audit risk); and
at the individual account level (e.g. in many organisations, the sales/receivables/cash
cycle would be considered to have higher audit risk than, say, executive salaries).
Our approach involves assessing audit risk at both levels under the two headings of inherent (or
business) risk, and control risk. Inherent risk arises due to the nature of the companys
operations and industry within which it operates, and control risk is the risk that the accounting
and internal control system will fail to prevent or detect any errors or irregularities that do occur.
In the particular context of Sunshine Stores, inherent risk can be identified in the following
areas:
at the time of writing, the losses arising from excess inventory of eggs and poultry.
The detailed assessment of audit risk is made by using the techniques of interviews and
(we have a number of clients in this area). Control risk is assessed by obtaining a thorough
understanding and evaluation of the internal control system assisted by the use of pre- prepared
ICQs. Based on our judgement as to the likelihood of errors and irregularities arising due to
inherent risk, and the extent to which such eventualities are likely to be prevented or detected
by the internal control system, we assign numerical values to these elements based on a well
recognised model of audit risk, which leads us to the design of samples and sample size
calculations
(2) Materiality
Materiality is a concept fundamental to the auditor, the user of accounts and the preparer of
those accounts. To the preparer, the concept is applied in deciding on the applicability of IASs
(IASs are to be applied to all items which are material in determining the value of
assets/liabilities or the determination of profit/loss). To the auditor the concept is applied when
determining the areas of the financial statements to which especial effort should be devoted and
ultimately in adjudicating whether a true and fair view is shown. It is also relevant in designing
sampling plans. Finally, the user of accounts is concerned with the concept, since it is likely that
a material error, omission or mis-statement would have caused him to act differently had he
In the context of our audit approach to the financial statements of Sunshine Stores, materiality
will be assessed by the exercise of professional judgement. Our overall concern is that the
needs of users must be met, and thus materiality measures based on the critical points (e.g.
the amount that would change profit to loss, or net current assets to net current liabilities) would
be relevant. Furthermore, measures based on percentages of major elements of the accounts
Having set such a measure, we are not rigidly constrained by it. For instance, the nature of an
manner, the trend demonstrated in financial results may, on occasions, suggest that smaller
monetary amounts be viewed as material.
Finally, we would be pleased to advise you on what we view as material in any particular
context so as to assist you in applying IASs and devoting appropriate effort to the determination
of amounts appearing in your accounts.
Audit sampling can be described as the application of an audit procedure(s) to less than 100%
of an accounting population in order to draw an inference, based on the sample, about the
population from which it was drawn. Two particular factors make it an appropriate technique for
use in many modern audits, and especially the audit of Sunshine Stores.
First, the sheer volume of transactions in most modern businesses make it an essential
technique to enable the audit to be completed in a reasonable time and at a realistic fee.
Secondly, and particularly in the case of Sunshine Stores, the homogenous nature of
transactions (many transactions of broadly similar size and nature) means that entirely
justifiable conclusions about a population can be made by examining a relatively small, though
representative, sample. Thus we would intend to make extensive use of the technique in the
audit of much of your business, most notably in the audit of the transactions cycle, year-end
liabilities, inventory valuations and shop fittings.
In certain areas of your financial statements, the use of sampling would not be appropriate. For
instance the audit of freehold/leasehold premises and directors emoluments would most likely
be subjected to 100% checking, as would any other area that was small in terms of number of
items but large in value, or of statutory importance. In a similar manner, those areas of high
Our firm makes use of two techniques of sampling judgement sampling and statistical
sampling. It is most likely that we will make extensive use of the latter method, especially since
our approach integrates numerical measures of audit risk and materiality, to ensure a high level
of confidence derived from the overall audit.
Analytical procedures involve the systematic analysis of past results, budgets, trends, financial
and non-financial data and variations from predicted patterns in order to provide an efficient
in the planning of the audit since the method should serve to direct effort to critical
areas and/or those which do not conform to predictions; and
in the evidence collection stage where a degree of reliance can be placed on the results
Analytical procedures are also very relevant in the final review of financial statements where it
both serves as corroborative evidence to that gathered by other techniques and supports the
review for fairness and credibility.
Our approach involves the use of manual techniques of comparison, and on occasion we make
use of sophisticated statistical techniques such as multiple regression analysis to determine
patterns and trends and project these to the current and future accounting periods. It is likely
that, in the case of a new client, the method is used in the first audit only at the planning and
overall review stages, since the amount of reliance placed on SAPs is necessarily limited when
we have little personal experience of the major features and account relationships to build upon.
However, we would seek at the earliest opportunity to build up a profile of past trading patterns
to use as a basis in later years in order to place greater reliance on this technique. We will thus
be able to future years to further reduce the time spent on traditional audit testing.
Our overall audit approach is designed to ensure that sufficient audit evidence is obtained to
enable us to form our opinion as to the truth and fairness of financial statements in the most
efficient manner possible. To this end the various elements of approach and the particular
techniques of risk assessment, materiality and sampling (and on occasion, analytical
procedures) are integrated via well recognised and tested models. It should be clear that such
relationships exist, and our approach specifically links the elements to ensure that, in total, we
achieve a high level of confidence in our opinion. Where inherent risk is high, though control risk
is low, audit risk is medium and thus sample sizes will be manageable. Highly material areas will
dictate larger sample sizes than immaterial areas, and those in which analytical procedures
showed no unexpected variations will correspondingly have smaller sample sizes (although
perhaps not in the first year of a new audit). When the opportunity exists (as appears at this
stage to be the case in the audit of Sunshine Stores) to make use of the EDP system to extract
samples in an expeditious manner, the greatest efficiencies are realised.
Question SELLERS
You are planning the final audit of the financial statements of Sellers, a manufacturing company.
The following events occurred shortly after the end of the reporting period:
(1) One of the companys largest customers, Bramley, notified Sellers of its intentions to go
into liquidation with an outstanding debt of $260,000. Sellers directors consider that the current
allowance for bad debts will cover any potential loss.
(2) A writ was issued against Sellers by a former sales director who is claiming $90,000 for
breach of his service agreement following his dismissal during the year under review. No
(4) Half of the sales force was made redundant and a provision has been made for
redundancy payments amounting to $400,000.
Required:
(ii) State the matters you would consider and the audit evidence you would obtain to be able
to draw a reasonable conclusion on which to base the audit opinion. (12 marks)
(20 marks)
Ans
Specific allowance, calculated on a prudent basis, should be made against the amount due from
Bramley at the end of the reporting period. The year-end general allowance should be
recalculated in accordance with Sellerss accounting policy.
However, an adjustment would not required if the amount of the specific allowance required was
found to be immaterial (e.g. if the balance at the end of the reporting period was considerably
less than $260,000 and/or the liquidator considered that a reasonable dividend would be paid
to creditors).
Steps being taken by Sellers to find new customers to lessen the impact of the loss of
this major customer (which may otherwise have implications for the appropriateness of
the going concern assumption).
Whether any goods have been manufactured to specific orders for Bramley. Such goods
should be separately identified in year-end inventory as their net realisable value may be
less than costs if an alternative customer cannot be found.
The steps which have been (are being) taken to recover the amount due (e.g. attending
the creditors meeting arranged by the liquidator).
Audit evidence
The make-up of Bramleys account balance in Sellerss receivables ledger (i.e. year- end
balance and post year-end transactions).
After-date (post year-end) cash receipts from Bramley.
Correspondence with the liquidator to establish the amount of debt (if any) most likely to
be recovered.
If settlement of the claim is probable (e.g. because the former sales directors action is
full amount of the liability (including legal costs) should be provided in the financial
statements.
If the outcome is less certain, any part of the contingent loss which is not provided for
should be disclosed by way of a note to the financial statements (IAS 37). However, as
the amount involved ($90,000) makes this the smallest of the events (in financial terms)
The reason(s) for which the former sales director was dismissed. If he was guilty
The nature of the alleged breach of the service agreement. For example, if
Sellers did not follow specified procedures for dismissal, the sales director may
have good grounds for his claim (even though Sellers may be justified in
dismissing him).
Whether the company intends to contest or counter the claim or negotiate an out-
Audit evidence
The service agreement, to ascertain whether actions of the former sales director
out-of-court settlement).
The destruction of warehouse inventory was not a condition existing at the end of the
reporting period and therefore is a non-adjusting event (IAS 10 Events After the
example, the loss was uninsured and Sellers is no longer a going concern).
However, the matter should be fully disclosed in a note to the financial statements as
the amounts involved are very material. Even if there is no financial loss in respect of
the inventory destroyed (e.g. because it is fully insured), some disruption to trading is
As non-disclosure would affect the ability of users to make proper evaluations and
destroyed;
To what extent have inventories have been replaced since the fire.
To what extent the manufacturing processes were disrupted (if at all) by the loss
of raw materials.
goods to customers.
Whether the cause of the fire was accidental or arson is suspected (in which
Audit evidence
Insurance policy to confirm the extent to which loss of inventory, trade and
warehouse fixtures and fittings were covered and on what basis (e.g.
be settled in full.
Assuming that the sales force is more than a handful of employees, making half of it
expense separately to explain the performance of Sellers (IAS 1). If the redundancies
If the decision to make personnel redundant was made after the reporting period, the
matter is a non-adjusting event (IAS 10) which should be disclosed if material. That a
provision has been recognised means that the obligation existed at the year end
(IAS37). The provision should include all related tax, social security and pension
contributions (less any statutory recoveries).
of a business segment).
Audit Evidence
Schedule showing the make-up of the provision for agreement to payroll and
personnel records.
was made.
Sales order books to establish the impact, if any, on sales levels in the wake of
the
Communicate clearly with the component auditors about the scope and timing of their
work on financial information related to components and their findings
To express an opinion whether the group financial statement are prepared, in all material
possible effect of this will result in a disclaimer of opinion, then they must not accept the
engagement.
The components.
Group-wide controls.
The consolidation process.
The risk of material misstatement in the component and group financial statement.
information of the components, whether performed by the group team or another auditor.
If significant risk of material misstatement of the group account has been identified in a
component that is audited by another auditor, the group auditor shall evaluate the
If the component it not considered significant then the group auditor shall simply performed
The group Engagement team has the right to require from auditors of subsidiaries the
information and explanations they require, and to require the group management to obtain the
necessary information and explanations from subsidiary. if The degree of corporation is limited
by factors such as the component auditor not being subject to the requirement of ISA,s, but of
different national practice.ISA 600 states that the group auditor should not accept a group audit
if there are restriction on his communication with component auditors.
Factors to be considered by the group auditor in relying on the work of component auditor
Ethics: the group auditor should consider whether the component auditor complies with required
ethical requirements. The component auditor should be subjected to the same ethical
requirements as the group auditors irrespective of the local regulations applicable.
Professional competence: The group auditor should check whether the component auditor
understand IAS and must make sure the work performed by the component auditor is in
conformity with international standards. He must make sure the component auditor understand
IFRS and have sufficient resources and skills to perform the required work.
Procedures that should be performed to determine the extent of reliance to be placed on the
work of component auditor:
Discuss the audit methodology used by the auditor and compared to international
standards
Review the quality control policies and procedures used by the auditor at firm level and
Audit procedures to carry out as part of the planning and evaluation of the work of the
component auditors
The group auditor should review the component auditors working papers to determine
the adequacy of work performed by component auditor.
The group auditors is responsible for setting the materiality level for the group financial
statements as a whole, and for components which are individually significant, this would
be set at a lower level than the materiality level of the group as whole. The component
auditor will then perform a full audit based on the component materiality level.
Depending on whether the component is significant or not to the groups financial
statements, the group auditor should review the component auditors overall audit
strategy and audit plans and perform risk assessment procedures to identify and assess
risks of material misstatement at the component level.
The group auditor should discuss with the component auditor on the components
business activities that are significant to the group, and the susceptibility of the
component to material misstatement of the financial statement due to fraud or error.
The group auditor should review the component auditors documentation of identified
significant risks of material misstatement.
The group auditor should review a questionnaire completed by the component auditor
highlighting key issues identified during the audit.
The parent and subsidiaries are seen to be a single entity, so if the group as a whole is a going
concern then this is sufficient. When a subsidiary is not a going concern, auditor may request a
support letter from the directors of the parent company. This letter represents documentary
evidence and is normally approved by the parent company board. If there is a limitation on the
time for which the support is to be provided, other evidence may be required that the subsidiary
will be able to continue as a going concern.
The auditor will need to ensure that the parent company is in a position to provide the support
which it is claiming to give in the comfort letter. The auditor should confirm this promise by
reviewing the group statement of cashflows for availability of needed finance.
Always relate your answer to the given scenario in the examination question. However, the
The revised group structure will need to be ascertained to ensure all relevant entities are
consolidated.
The issue of component auditor should be discussed. Before reliance can be placed on
the work of the component auditor, Independence and competence of the auditor need
to be assessed.
Materiality of the new company will need to be assessed in relation to the group as a
The auditor will need to assess the method used by management to obtain the fair value
The audit plan should contain a list of all the companies within the group so that
completeness of intercompany balances can be confirmed.
You are currently auditing the consolidated financial statements of the Cuckoo Group and are
scrutinising the accounting policies being used by the group for the valuation of inventories. The
group has three principal subsidiaries which are Loopy, Snoopy and Drake Retail. You are not
currently the auditor of Loopy as Cuckoo only recently acquired this subsidiary company.
Cuckoo, the holding company, carries on business as a dealer in gold bullion and other precious
metals. It purchased the three subsidiaries in order to diversify its activities. It felt that dealing in
commodities was quite risky and wished to spread the operating risk. The following are the
Cuckoo proposes to recognise the bullion and other precious metals in the statement of
financial position at the year-end market values. It does not enter into any contracts for the
forward purchase or sale of precious metals. Cuckoo does not manufacture products from the
precious metals but simply buys and sells the metals on the bullion markets.
Loopy manufactures domestic products such as cutlery, small electrical appliances and
crockery. The inventory is valued at the lower of cost or market valued applied to the total of the
inventory. Cost is determined by using the last in, first out (LIFO) method of inventory valuation.
Overhead costs are allocated on the basis of normal activity and are those incurred in bringing
the inventory to its present location and condition.
Snoopy manufactures similar domestic products to Loopy. The inventory is valued at the lower
of cost and net realisable value for the purpose of the group statement of financial position.
However, inventory is further reduced to its standard value for the purpose of the group profit or
loss. This reduction is not material in the context of the group accounts. Overheads are
allocated on the basis of normal activity levels and the costs incurred in bringing the inventory to
its present location and condition.
selling value of inventory. When computing net realisable value, an allowance is made for any
The directors of Cuckoo Group wish the following accounting policy note to be included in the
group financial statements regarding inventory: Inventories are stated at the lower of cost and
net realisable value and comprise raw materials (including bullion), work in progress and
finished goods.
Required:
(a) Describe the audit procedures which you would carry out before placing reliance upon
the work of the auditors of Loopy. (7 marks)
(b) Discuss whether you feel that the current accounting policies adopted by Cuckoo and its
three subsidiaries regarding inventory and work in progress are acceptable to you as group
auditor. (7 marks)
(c) Discuss the problems which may arise when determining which overhead costs are to
be incorporated into the inventory valuation of manufacturing companies such as Loopy and
Snoopy. (6 marks)
(d) Discuss whether you feel that the accounting policy note regarding inventory and work in
progress provides adequate information to the users of the group financial statements. (5
marks)
(25 marks)
Reliance will not be placed upon the financial statements of Huey until the audit procedures
carried out by their auditor (the component auditor) have been reviewed by the parent
companys auditor (the group auditor). Before any approach is made to the auditor of Huey plc,
the directors of Donald plc will be informed of the intention to communicate with the component
auditor. The component auditor is under a statutory duty in this case to co-operate with the
group auditor.
The auditors of Loopy should be informed in advance of the standard and scope of the work
required and any reporting deadlines, and the component auditor should discuss any potential
the previous and current financial statements of Loopy (including analytical procedures);
the terms of the component auditor engagement and any restrictions placed upon their
work;
the standard of the work of the component auditor and the nature and extent of their
audit examination;
the independence of the auditor of Loopy
It is unlikely that the group auditor will have dealings with the component auditors prior to taking
over the audit of Cuckoo. Therefore, the above items can best be dealt with by a meeting of the
auditors. If this is not possible, then a questionnaire may be sent to the component auditors,
covering the above areas. The questionnaire will cover such areas as the nature of the interim
audit, the audit of non-current and current assets, liabilities, profit and loss account and the
If Loopy is of material significance a review of the working papers of the component auditor may
be required. This may involve a further visit to the subsidiary company as it is important that the
group auditor is satisfied that the audit has been carried out in accordance with acceptable
auditing standards, and that the component auditor audit opinion is reasonable and reliable.
If the auditor is not satisfied with the work carried out, the auditor should arrange for additional
tests to be performed by the auditor of Loopy. Only in exceptional circumstances will the group
auditor perform more tests as the component auditor is responsible for the auditors report on
Loopys financial statements.
(i) Cuckoo
This practice is quite common place when dealing with commodities. It represents a departure
from the usual valuation rules as inventories are stated at above their cost. IAS 2 Inventories
does not deal with this issue and the requirement of the standard to show inventory at the lower
of cost and net realisable value has obviously been dispensed with. It can be argued that in the
case of commodities, it is necessary to depart from IAS 2 and apply alternative accounting
practices. The financial statements are more helpful to users if the commodities are shown at
market value and this is generally justified in order to show a true and fair view. However, it will
only be acceptable as a valuation model where the companys principal activity is the trading of
commodities, the commodities do not alter in character between purchase and sale, the
commodities can be traded on an organised market and the market is sufficiently liquid to allow
the company to realise its inventory close to the valuation price. It would appear therefore that in
IAS 2 requires that the comparison of cost and net realisable value should be done on an item
by item basis or by groups of similar items. In the case of Huey plc the comparison has been
carried out on a total inventory basis. Thus the group auditor will request the component auditor
to carry out a net realisable value test on an item by item or group basis. Further, the LIFO (last
in, first out) method of inventory valuation is not acceptable by IAS 2 and therefore inventory will
need to be revalued in order to conform with the standard if the financial statements are not to
be qualified. (This is dependent upon the materiality of the amount in the context of the group
accounts.)
(iii) Snoopy
This accounting procedure is effectively showing inventory at base inventory value in profit or
loss and at FIFO (first in, first out) valuation in the statement of financial position. Base inventory
is not an acceptable method of valuing inventory under IAS 2. Inventories should be stated at
the same value in both the statement of comprehensive income and statement of financial
position under existing accounting conventions. The presentation in the statement of financial
position takes the form of reserve accounting with the base inventory write-down presumably
being charged against retained earnings without being shown in profit or loss. It is a practice
which would be discouraged by the auditor but because the amount is immaterial, the error may
be summarised along with other errors found in order to ascertain the collective materiality of
those items. Alternatively, because the item can be adjusted easily on consolidation, the
financial statements of Snoopy may be adjusted.
This company sells high volumes of various small items of inventory. Invariably in this type of
trade, similar mark-ups are applied to groups of inventory items. In this situation, a
disproportionate amount of time can be spent determining the cost of the year end inventory.
The most practical method of valuing year end inventory is to record inventory at selling price
and convert it to cost by removing the mark-up.
Problems arise under IAS 2 with regard to how overheads are to be incorporated into inventory
valuation. IAS 2 defines costs as that expenditure which has been incurred in the normal
course of business in bringing the product to its present location and condition. Certain costs
are not costs of bringing the inventory to its present location and condition. These include
storage costs, selling costs and administrative overheads. However, in certain circumstances it
is possible to argue a case for their inclusion in inventory valuation. For example if firm sales
contracts have been entered into for the sale of inventories, the inclusion of selling costs
incurred before manufacture can be justified under IAS 2. Storage costs may be incurred prior
to further processing and these costs should be included in the cost of production. The standard
recognises that in the case of smaller organisations there may not be a clear distinction of
management functions and that this cost may be allocated to production on fair basis.
Thus it can be seen that the allocation of costs to inventory will vary from organisation to
organisation and the accounting policy of valuing inventories at cost is fraught with difficulty. It
leads to a situation where companies may ostensibly have the same accounting policy but the
overhead cost allocation may be quite different.
Another problem is that IAS 2 requires overheads to be included in inventory on the basis of a
companys normal level of activity. Normal is not defined in the standard but normal level of
activity is established by reference to the budgeted or expected level of activity over several
years. What is normal is obviously left open to subjective assessment particularly during the
initial years of a business or in a recession. The standard is unhelpful in this area and the
acceptability of the overhead allocation based on normal activity is effectively left to mutual
agreement between the auditor and the client.
IAS 2 states that the accounting policies that have been applied to inventories and work in
progress should be stated and applied consistently from year to year. The degree of detail given
by companies varies considerably. Some companies provide comprehensive and informative
information, others provide very brief statements. Companies need only state that inventories
and work in progress are valued at the lower of cost and net realisable value in groups of similar
items.
The directors of Cuckoo Group appear to have adopted the latter viewpoint as the information to
be given to users has little interpretational value. Hence the bullion inventories, retail goods and
the trading inventories should be suitably described.
Different accounting policies have been used to value the bullion, retail goods and the trading
inventories and these should be detailed in the notes to the accounts. Further it would be useful
to users if the accounting policy relating to a specific category of inventory was set out in some
Work in progress and finished goods Cost of direct materials and labour plus attributable
overheads based on a normal level of activity
Retail inventoriesCost is computed by deducting the gross profit margin from the selling value
Bullion inventoriesAssets in bullion and other metals are stated at year-end market values in
the statement of financial position.
Your firm is the auditor of Beeston Industries Inc, which has a number of UK subsidiaries (and
You have been asked to consider the work which should be carried out:
to ensure that inter-company transactions and balances are correctly treated in the
group accounts;
to check the auditors work and the accounts of companies not audited by you.
Required:
(a) List and briefly describe the audit work you would perform to check that inter-company
balances agree; state why inter-company balances should agree and the consequences of them
not agreeing. (7 marks)
(b) Describe the audit work you would perform to verify that inter-company profit in inventory
(c) List and briefly describe the audit work you would perform to verify that the work carried
out by other audit firms, who are auditors of subsidiaries of the group, is satisfactory. (8
marks)
(d) Briefly describe the effect the following would have on your review of the work of the
books.
Short-term general ledger credit balances which are loans or advances repayable within
twelve months and long term non ledger credit balances which are loans repayable after
twelve months.
There should be an agreed procedure laid down by the group accountants department for the
following matters:
Goods in transit Some companies follow the convention that the supplier companys
record is the definite record; therefore the consignee should make an accrual to agree
the inter-company balance.
Cash in transit A convention which is often adopted is that the paying companys
record is the definitive record and agreement should be made on that basis.
There should be a timetable laid down for the agreement of inter group balances and for
the publication of a return to head office so that inter-company balances are clearly
agreed.
General ledger balances described above should be confirmed in writing at the year-
end and if necessary validated by reference to an auditors certificate. There should be
that either profits or net assets could be over stated. If this is done to any material extent
the group financial statements may not give a true and fair view.
Inter-company profit from inventory must be eliminated in group accounts as this is effectively
unrealised profit in the context of the group. In order to eliminate inter-company profit from
inventory the group accounting procedures should be so designed so as to identify year-end
inventory balances which are the result of inter-group trading. If the group follows a policy of
trading at arms length these amounts of inventory will be stated at cost and there will obviously
be an element of unrealised profit in the context of the group. The procedure adopted by
companies to reduce this inventory to true cost would include the following:
invoices for the items concerned and making enquiries of the supplier companies of the
basis of cost structure. The calculations used by the group accountant or the individual
subsidiary accountant to eliminate the profit should be validated by reference to the data
should be reviewed from one year to the next and any significant variations investigated.
The inter-company inventory thus reduced to true cost should be traced to the final
inventory summary to verify that it has been included. Lastly the auditor should verify
that the provision for inter-company profit is appropriately increased or reduced in order
The audit work that would be done to verify that the work of the subsidiaries auditors has been
properly carried out would include the following:
An assessment of materiality: The group auditor should establish the materiality of the
individual subsidiary within the group context as a whole. In evaluating materiality he will
add regard to contribution towards profit for tax, net assets and turnover. Those
subsidiaries which are material or if not material which possess risk factors out of
proportion to their size will be subjected to greater audit effort that those which are not
are harmonious within the group. The key accounting policies are those on turnover,
inventories, deferred tax, depreciation, common occurrences, leasing. The most usual
way of doing this is to send the component auditors a questionnaire specifically dealing
with accounting policies and on receipt to review the questionnaire to establish that the
policies are harmonised. Where policies are not harmonised it may be necessary for the
mentioned earlier. All companies immaterial or otherwise who are audited by other firms will
receive an audit policies and procedures questionnaire from the group auditor.
This policies and procedures questionnaire will seek to examine auditing standards
employed by subsidiary company auditors. They would include consideration of the
following.
The audit strategy and the relying or otherwise on the companies system of
internal trouble.
The procedures used to verify assets (e.g. attendance to physical inventory
counting, verification of bank and cash balances, circularisation of receivables
and verification of research and development).
The procedures used to verify liabilities.
The identification of contingencies and any events after the reporting period.
The management letters sent by the component auditors to the management of
the subsidiary.
The auditors report and the scope of any qualifications. It would be necessary to
consider the scope of the qualifications in the context of the group. A review of
working papers of the subsidiary company auditors will be carried out by the
group auditor where the subsidiary is a material subsidiary or possesses risk
factors out of proportion to its size.
In considering the accounts of a subsidiary audited by another firm the following matters are
relevant.
(i) Materiality
If the auditors report of a subsidiary is qualified the qualification may be significant in the
context of the group. A material and fundamental qualification of a significant subsidiary will
almost certainly involve some form of qualification in the auditors support of the group. In many
cases where the subsidiary is not material the group context of qualification issued by the
component auditors would not need to be reflected in the group auditors report.
AUDIT REPORT
Title: The title should clearly indicates that it is the report of the independent auditor
Addressee: the report should be addressed to the legal recipient of the report
Introductory paragraph: this paragraph contains the name of entity being audited, the sets of
financial statements that have been audited, period covered by the audit, and brief statement of
accounting policy.
Section describing managements responsibility for the financial statements: This section
Auditors signature: the signature of the person signing for the firm and the name of the firm
Auditors address: the report should include the address of the auditor
The financial accounts of the audited entity give true & fair view.
The financial accounts of the entity have been prepared in accordance with the
The basis of opinion should be shown immediately above the opinion paragraph.ISA 705
requires them be headed as:
Full name of IAS should be provided in the paragraph e.g. IAS 33 Earnings per share
The paragraph should be precise
Where management imposes restriction and the auditor is unable to obtain sufficient
evidence, the paragraph should refer to the relevant accounting standard and should
state that a limitation has been imposed by management in respect of the specified
issue. It should state that management did not allow access to evidence and that the
auditor has been unable to determine whether the accounting treatment of the issue is
correct.
The paragraph should not contain unprofessional words e.g. abusive words should be
particularly avoided, it should not contain any form of accusation against management
The opinion paragraph should use the specific form of words sets out in ISA 705 and the
statement that the auditor has been unable to obtain sufficient appropriate audit evidence, and
The auditor should consider whether evidence can be obtained by any alternative
procedures
The auditor should consider the integrity of the management. Any representation made
by the management on the issue should be reconsidered.
Where the restriction will lead to modification of opinion, the circumstances surrounding
this should be communicated with the expected wording to be used
The audit firm should consider withdrawing from the audit engagement to protects its
integrity
This is a paragraph in the auditors report that explain matter that is appropriately presented or
disclosed, but which is so important that special emphasis is needed for users of the financial
statements.
NOTE: emphasis of matter paragraph does not qualify the opinion. Auditor should only include
an EOM if there is sufficient and appropriate audit evidence that the matter is not materially
stated
Early application of a new accounting standard that has pervasive effect on the financial
statements
A major catastrophe that has had a significant effect on the entitys financial position
This explains information that is rightly not present in the financial statements but which is so
important for users understanding of them that it needs to be highlighted in the auditors report.
When auditor is reporting on more than one set of financial statements e.g. using both
The following matters are to be considered by the group auditor if the account of a component is
qualified:
Materiality of the component to the group financial statements. According to ISA 600, a
component is significant to the group where a chosen benchmark is more than 15% of
the same figure for the group. Possible benchmark includes: profit before tax %; total
assets %; and sales %. Materiality must be determined at both the component and
group level
The group auditor should consider whether there is sufficient and appropriate audit
evidence to support the qualified opinion
If the entity is a material component, the group auditor should review the components
If evidence showed that the qualification is inappropriate, the group auditor should
request the component auditor to redraft its auditors report.
If the qualification of the components report is deemed appropriate by the group auditor, the
following steps should be taken:
The group auditor should discuss the issue with the group management
The group auditor should request that the group management ask the components
management to adjust its financial statement. If this is done, the auditor will perform
further audit procedure on the adjustment, if the adjustment is adequate, the component
components audit report will remain qualified, but the groups auditors report will not be
qualified
If there is no adjustment in both the components account and the groups account in
respect of the material misstatement, the groups audit opinion will be qualified except
for because of the material misstatement.
NOTE: should there be any need to qualify the groups opinion in respect of a material
misstatement in the account of a component, the work of the component auditor should
In January 2009, the head office of Theta was damaged by a fire. Many of the companys
accounting records were destroyed before the audit for the year ended 31 March 2009 took
place. The companys financial accountant has prepared financial statements for the year ended
31 March 2009 on the basis of estimates and the information he has been able to salvage. You
Required:
(a) Draft, for inclusion in the auditors report, wording appropriate to Theta. (5 marks)
Note: You are not required to reproduce the auditors report in full.
(c) Explain and distinguish between the following forms of modified report:
Introductory paragraph
We have audited the accompanying financial statements of Theta, which comprise the
Auditors responsibility
The evidence available to us was limited because many of the companys accounting records
were destroyed by fire in January 2009. 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.
Disclaimer of Opinion
Because of the significance of the limitation on the evidence available described in the Basis for
The fire has resulted in limitations in audit work and evidence necessary to form an
The effect of the limitation is so material and pervasive that it is not possible to express
which is discussed in note to the financial statements, for example, going concern.
The paragraph is included after the opinion paragraph
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.
An auditor is unable to express (i.e. 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
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.
Distinctions
There are three issues which distinguish the form of modified reports
EITHER the matter does not affect the auditors opinion as in case (i)) or it does affect the
opinion as in cases (ii), (iii) and (iv)
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 case (iv));
EITHER the matter is so material and pervasive as in cases (iii) & (iv)
OR not so material and pervasive as in case (ii)) resulting in an except for opinion
Independence
Whether deadlines can be met
Whether the auditor has the competency level required by the assignment
Staff availability
Integrity of clients
Content of report
Level of assurance. This will usually take the form of negative assurance as the work will
be less detailed compared to statutory audit. This type of work only rely on analytical
procedure and enquiry in gathering evidences
Deadlines
Limitation of liability. Liability to third party should be discussed
Distribution of report. The use of the report will normally be restricted to the intended
users
Types of evidence to be sought for
Engagement letter
Fess to be charged
Agreed-Upon Procedures
negative assurance. Instead, the auditor issues a report that details the specific
procedures performed and the results of such procedures. Users of the report assess
for themselves the procedures and findings reported by the auditor and draw their own
Due diligence review refers to the work commissioned by a client involving enquires into
agreed aspects of the accounts, systems, and activities of the target company in
This assignment mainly requires the auditor to make enquiries and perform analytical
Unlike audit engagement, a financial due diligence review would not only look at the
historical financial performance of a business but also consider the forecast financial
performance for the company under the current business plan and consider the
reasons for the trends observed in operation results of the company over a relevant
time period and report on this in terms of relevancy for the proposed transaction.
Whether there are ethical reasons why the work should not be undertaken
Deadlines
Fess
Whether there any terms in the contract of employees which entitled them to
ownership
change of ownership
the future and possible actions by an entity. It is highly subjective in nature and its
Forecast
basis of assumptions as to future events which management expects to take place and
the actions management expects to take as of the date the information is prepared (best
estimate assumptions).
Projection
(a) hypothetical assumptions about future events and management actions which are
not necessarily expected to take place, such as when some entities are in a start up
phase or are considering a major change in the nature of operations, or
capital investment; or
expectations.
A document for the information of lenders which may include, for example,
which it is based. The auditor may be asked to examine and report on the prospective
financial information to enhance its credibility whether it is intended for use by third
information
assumptions
Assess inherent and control risk as well as limit his or her detection risk.
Consider the sufficiency of external sources and internal sources of information
supporting the underlying assumptions.
Assess the consistency of the assumptions and the sources from which they are
predicated.
Assess the consistency of the assumptions themselves.
Assess the reliability and consistency of the historical financial information used.
Evaluate the preparation and presentation of the prospective financial statements
to ensure conformity with relevant standards
The nature of the assumptions, that is, whether they are best estimate or
hypothetical assumptions
Whether the information will be for general or limited distribution. General use
means that the statements will be used by persons not negotiating directly with
the responsible party. Limited use refers to situations where the statements are
to be used by the responsible party alone or by the responsible party and those
Make enquiry of the preparer of the forecast and verify that they are competent
Obtain direct confirmation from major trading partners of the client that they will
Discuss sources of cash inflow in the forecast and evaluate the validity of the
reasons obtained
Obtain and review the financial statement of loan provider to assess whether it
has sufficient fund available
Should there be any claimed subsidy, inspect the application made for the
In addition to the above, inspect correspondence with the subsidy awarding body
Agree the opening cash position to cash book and bank statement
Review the forecast and assess if the assumptions used reflects business reality.
Obtain written representation from management confirming that the assumptions
Assess the sufficiency of the loan requested to cover the intended expenditure.
Forensic Accounting
examination into companys financial affairs. Forensic accounting refers to the whole
witness if the fraud comes to trial. Forensic Accounting provides an accounting analysis
that is suitable to the court which will form the basis for discussion, debate and
Forensic Audit
Forensic auditing refers to the specific procedures carried out in order to produce
evidence. Audit techniques are used to identify and to gather evidence to prove
Forensic Investigation
Identifying the type of fraud that has been operating, how long it has been
operating for, and how the fraud has been concealed.
Identifying the fraudster(s) involved.
Quantifying the financial loss suffered by the client.
Gathering evidence to be used in court proceedings.
Providing advice to prevent the reoccurrence of the fraud.
Unless robust safeguards are put in place, the firm should not provide audit and forensic
Advocacy threats. The audit firm may be promoting interest of the client in court as they
are concerned about losing their audit fees
Self review. The self review threat arises because the investigation is likely to
IFACs Code of Ethics for Professional Accountants applies to all ACCA members
involved in professional assignments, including forensic investigations. There are
specific considerations in the application of each of the principles in providing such a
service.
Integrity
The forensic investigator is likely to deal frequently with individuals who lack integrity,
are dishonest, and attempt to conceal the true facts from the investigator. It is
imperative that the investigator recognises this, and acts with impeccable integrity
throughout the whole investigation.
Objectivity
As in an audit engagement, the investigators objectivity must be beyond question. The
report that is the outcome of the forensic investigation must be perceived as
independent, as it forms part of the legal evidence presented at court. The investigator
Confidentiality
Normally accountants should not disclose information without the explicit consent of
their client. However, during legal proceedings arising from a fraud investigation, the
court will require the investigator to reveal information discovered during the
investigation. There is an overriding requirement for the investigator to disclose all of the
information deemed necessary by the court.
Outside of the court, the investigator must ensure faultless confidentiality, especially
because much of the information they have access to will be highly sensitive.
Professional behaviour
Fraud investigations can become a matter of public interest, and much media attention
is often focused on the work of the forensic investigator. A highly professional attitude
must be displayed at all times, in order to avoid damage to the reputation of the firm,
and of the profession. Any lapse in professional behaviour could also undermine the
integrity of the forensic evidence, and of the credibility of the investigator, especially
when acting in the capacity of expert witness.
Question FLASHMARK
Flashmark is an audit client of your firm and manufactures household furniture. It has a year end
of 30 June.
On 13 November 2008, a fire destroyed the companys factory complex, which included the
area used for storing raw materials. The fire was caused by an electrical fault. The factory has
now been rebuilt and the company recommenced trading in May 2009.
The finance director of Flashmark produces monthly management accounts; in these, inventory
and cost of sales are estimated, based on sales figures less assumed margins. At 30
September and 31 March, the company conducts full physical inventory counts for its own
purposes in addition to its year-end count. The results of these counts are compared with the
management accounts for September and March and adjustments are made to reflect the
physical quantities and their appropriate values.
The finance director has contacted your firm to provide a certificate in support of his claim for
losses of profits and loss of inventories arising as a result of the fire.
Required:
(a) Identify and comment on the issues raised as they affect the extent and scope of this
assignment. (8 marks)
(b) State the information you would seek and the procedures you would perform in order to
reach an opinion on the companys claim for losses of profits and loss of inventory.
(7 marks)
Ans
The financial information on which a certificate is required is for a period (not yet expired) in
respect of which the annual audit has yet to be undertaken. The losses of profits will essentially
be forecasts of the finance directors best expectation of the most likely results of 6 months
trading after the fire.
Assumptions
The finance director will have had to make assumptions which reflect his judgment as to the
conditions prevailing during the period of non-trading activity. Some assumptions will be highly
subjective, for example, concerning the level of winter sales in a year in which the housing
market (to which household furniture sales will be related) has been in recession.
Scope
The investigation will encompass the raw material inventory valuation, loss of profits calculation
and statement of assumptions.
Managements responsibilities
Managements responsibility for the assumptions and other matters of judgement and opinion
Report required
Although the finance director has requested a certificate, it will not be appropriate for his
claims to be guaranteed in any way. The form and content of the report(s) required must be
Timescale
As for all professional work, the assignment should be carried out with a proper regard for the
technical and professional standards expected. It is unlikely that the level of skill and care
necessary for forming opinions in these areas can be exercised within a restricted timescale.
Access to information
There should be unrestricted access to all information and explanations necessary to form an
opinion on the companys claims. It may be necessary to discuss sensitive issues, for example,
relating to the cause of the fire and any police investigation.
Some relevant information is probably included in the prior year audit working paper file as the
fire is likely to have occurred before the auditors report was signed (or even before the field
work was completed). Some verification work may have already been undertaken, for example,
for disclosure of the financial effect of this non-adjusting event after the reporting period.
It may be expeditious to perform certain audit work while undertaking this assignment (e.g. to
avoid having to repeat or extend tests at a later date). In particular, the insurance claim is likely
to constitute a receivable balance at 30 June 2009.
Engagement letter
All relevant matters concerning responsibilities, scope of work and reporting requirements,
should be set out in a letter of engagement which the finance director should acknowledge in
Insurance cover, terms and conditions including sums insured and deductibles.
Specifically:
whether raw material inventory is insured for replacement cost or a written down
value;
how gross profit is defined (e.g. the amount by which turnover and closing
inventory exceed opening inventory and specified operational expenses)
Latest amounts declared for consequential loss cover (e.g. based on last years audited
financial statements).
Results of 30 September 2008 (and earlier) inventory counts. The quality as well as the
quantity of slow-moving items should have been noted (at least for last year- end).
Monthly profits for the 6 months of disruption, the previous 6 months and the
Procedures
Inspect the insurance policy and obtain details of any claims already submitted, for
example, in respect of damage to buildings (which could include cleaning costs which
Compare managements assumptions and policies with those normally adopted for the
preparation of management accounts and annual financial statements. Confirm the
suitability of any significant departures (e.g. if insurance cover is for replacement value
of inventory).
policy.
Agree the make-up of costs deducted from lost sales and ensure they are
valid/allowable under the terms of the insurance policy.
Purpose of report and for whom it is prepared (e.g. to the directors of Flashmark).
The financial information investigated, i.e. the valuation of lost inventory and loss of
profits.
The date of the event (13 November) and the nature of the disruption, i.e. fire followed
by periods of closure and rebuilding.
Scope of investigation undertaken, for example, in accordance with the terms of the
letter of engagement and ISA 920 Engagements to Perform Agreed-Upon Procedures
Regarding Financial Information.
Principal assumptions and judgements relating to the valuations concerning, for
example:
A new client of your practice, Peter Lawrence, has recently been made redundant. He is
considering setting up a residential home for old people as he is aware of an increasing need for
this service with the ageing population. He has seen a large house, which he plans to convert
into an old peoples home; each resident will have a bedroom, there will be a communal sitting-
room and all meals will be provided in a dining-room. No long-term nursing care will be
provided. The large house is in a poor state of repair, and will require considerable structural
alterations, and repairs to make it suitable for an old peoples home, and in particular new
furniture and fittings, decoration of the whole house, and specialised equipment.
Mr Lawrence and his wife propose to work full-time in the business, which he expects to be
available for residents six months after the purchase of the house. Mr Lawrence has already
obtained some estimates of the conversion costs, and information on the income and expected
running costs of the home.
Mr Lawrence has received about $30,000 from his redundancy, and expects to receive about
$30,000 from the sale of his house (after repaying his mortgage). The owners of the house he
proposes to buy are asking $50,000 for it, and Mr Lawrence expects to spend $50,000 on
conversion (i.e. building work, furnishing, decorations and equipment).
Mr Lawrence has prepared a draft capital expenditure forecast, a profit forecast and a cashflow
forecast which he has asked you to check before he submits them to the bank, in order to obtain
finance for the old peoples home.
Required:
(a) Identify and comment on the issues you would consider before undertaking such work.
(5 marks)
(b) Describe the factors you should consider in verifying each of the three forecasts.
(15 marks)
Before accepting such an engagement the accountant must ensure that he has sufficient
foresees no limitations imposed on his work by management then he can accept the
engagement.
An engagement letter should be issued to confirm the nature, responsibilities and scope
of the work. The letter should emphasise that management are responsible for the
forecasts.
In planning his work the accountant needs to obtain a good understanding of the
The capital expenditure forecast will be split into monthly periods. The accountant would carry
out the following checks to establish that the forecast is reasonable.
Peter Lawrence. Consider estimates of solicitors fees, survey fees and stamp duty on
the purchase. The latter cost is unavoidable and maybe a significant part of the cost of
purchase.
Building and repairs Review of the estimate and comparison to any architects
The forecast should also include specialised plumbing for kitchens, bedrooms and
bathrooms which would be required for the type of clientele in the home.
The accountant would enquire whether Mr Lawrence intends to purchase any of these
items on Hire Purchase; alternatively whether any of the items are to be leased which
would have a bearing on the cashflow forecast.
The profit forecast will include income and expenditure. The accountant will consider the
following:
Income The majority of income will arise from room lettings. It will be unlikely that Mr
Lawrence will have 100% occupancy when the home becomes operational. Therefore it
will be necessary to establish that realistic estimates of income have been obtained.
There should obviously be no income in the period when the home is being renovated.
The reasonableness of the rate per room should be checked with any Health Authority
what the Health Authority regard as desirable. The rates of pay for the staff should be
verified by reference to local newspapers, staff agencies and any other homes of a
similar type.
Rent and water rates can be verified by reference to local authority data or from
surveyors correspondence.
Telephone there will be an initial charge for installing the telephone and a reasonable
estimate of expenditure should be made.
Insurance this will include public liability insurance, employers liability insurance and
fire insurance. Correspondence with Mr Lawrences underwriter should reveal estimates
for these.
Interest the interest charge should be based upon Mr Lawrences capital requirements
Verifying the capital expenditure line in the outgoings part of the forecast with the capital
expenditure forecast.
Verifying the pattern of cash inflows with the profit and loss account income section.
Verifying the payment of overheads, telephone, electricity and gas, with the profit and
loss account and establishing that the total paid in the year is broadly equivalent to the
Checking that the computations on the cashflow forecast are consistent with the profit
forecast.