Paper F8 (INT & UK) Audit and Assurance
Revision Mock Examination December 2010 Answer Guide
Health Warning! How to pass Attempt the examination under exam conditions BEFORE looking at these suggested answers. Then constructively compare your answer, identifying the points you made well and identifying those not so well made. Simply read or audit the answers congratulating yourself that you would have answered the questions as per the suggested answers.
How to fail
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Tutorial help and key points
This question is typical of the 30 mark case study you can expect to see in Q1 of the F8 paper. 30 marks may seem rather daunting at first! Our best advice is – deal with each individual requirement as though it were a separate question and this will help you to manage your time more effectively. Part (a) asks you to identify FIVE weaknesses in a client’s payroll system then to say what the consequences of those weaknesses are and to suggest controls to mitigate the weaknesses. You should be identifying the more obvious weaknesses such as the lack of authorisation of timesheets, the fact that there is little segregation of duties, no checking of the payroll and no authorisation needed to make changes to the system Parts (b) is more theoretical and asks you to think about why control systems are never 100% perfect at preventing and detecting fraud. Remember that controls are operated by humans, so there is always a chance that they will make mistakes or worse, deliberately override the controls to commit fraud. Part (c) may seem tricky at first. The way to approach this question is to remember which types of analytical procedures the auditor can use: ● ● ● ● This year to last year Actual to budget Client to industry Auditor calc to client calc
Then apply these ideas to the payroll costs. Part (d) is a popular type of question asking you how audit software can be used to audit payroll costs. It helps to think about the type of substantive procedures that would normally be carried out on payroll and then choose the ones that can be done with the help of a computer, rather than manually. Part (e) Those of you who have thoroughly revised the class notes should have no problem listing the disadvantages and advantages of using audit software. Marking scheme (a) Each weakness Each consequence Each control (b) (c) (d) (e) Each reason Each procedure Each procedure Each advantage or disadvantage 1 mark/max 5 1 mark/max 5 1 mark/max 5 1 mark/max 5 1 mark/max 3 1 mark/max 3 1 mark/max 4 Total maximum marks = 30
(a) Weakness Timesheets are not reviewed or authorised by a supervisor or manager before submission to the payroll department The timesheets are not numbered in a sequence Consequence Employees may be claiming for hours that they did not actually work and as a result, the company’s cashflow will be adversely affected Recommended Control All timesheets should be reviewed and signed by the relevant site supervisor and manager before submission to payroll
Timesheets may go missing en-route to payroll leading to employees not being paid Lynn may accidentally enter the details on a timesheet twice so an employee is paid for extra hours
All timesheets for the week should be sequentially numbered and Lynn should check the sequence for missing numbers Each time sheet should be stamped and filed away once the details have been entered onto the system. An exception report should be printed off the PC detailing employees who have worked over the average number of hours in the week and this should be investigated The payroll list should be scrtuinised by a manager before sending to the MD to check. A spot check should be carried out on some of the calculations and a sample of hours worked should be agreed back to time sheets
Lynn does not formally stamp or file away the time sheets once the hours have been entered onto the system
The MD signs the payroll but does not scrutinise it or carry out spot checks
There may be obvious errors in the payroll that will not be picked up
The payroll details are kept on a disc in Lynn’s drawer
This is not a very safe location and could lead to the disc being stolen, tampered with or damaged
The disc should be kept in a safe in a director’ s office
Supervisors do not need authorisation in order to ask Lynn to add new joiners onto or take leavers off the payroll Lynn does not repeat the details back to the supervisors
The supervisors could give fictitious employee details for Lynn to add to the system or, Lynn could add the fictitious employees herself Lynn may take the details down incorrectly leading to the wrong people being paid/wrong amounts being paid
Authorisation should be obtained in writing from a director before an employee is added or removed from the system Before adding an employee, Lynn must check that there is a contract/offer letter and a form of ID for that employee New joiner details/leaver details must be provided to Lynn on a written form which is sent to the MD for authorisation before a change can be made to the system The MD should obtain a monthly print off of changes to standing data and review it for reasonableness
Overall there is a lack of segregation of duties in the payroll department
If Lynn has control over too many parts of the process, she will be able to keep fraud hidden
Duties should be shared out between a number of employees.
Why an internal control system cannot give complete assurance ● ● ● ● ● There is potential for human error/misunderstanding Senior staff members may use their authority to override controls People may collude to override controls Internal controls may become inadequate overtime – especially if the business changes rapidly/significantly Non-routine transactions will usually not have established internal controls.
Analytical procedures – employment costs ● ● ● Recalculate total employer tax liability as ‘total salaries x tax rate’ and compare to the client’s calculation to ensure it is reasonable Divide total payroll costs by average number of employees and compare to prior year Compare current year payroll costs with budget to assess the overall reasonableness of salary costs.
Ways in which audit software can assist in the audit of payroll costs ● ● ● ● Cast the payroll list to ensure that the totals agree with the amount in the control account Assist with analytical procedures such as recalculation of employee tax figures and average wage per employee Stratification of balances so that material balances can be identified and items chosen for testing Produce an exception report detailing any employee working more than a specifies number of hours or earning more than a specified amount so that this can be investigated
Benefits and disadvantages of using audit software on the audit of Fitta Ltd Benefits ● Once suitable audit software has been designed for the client, it can speed up the audit and ultimately reduce costs If the auditor uses live client files to perform the tests on, they can be sure that data has not been tampered with Disadvantages ● There can be significant set up costs when developing audit software for the first time Use of audit software limits audit tests to test on data in electronic form – for inventories, a number of physical tests will still need to be carried out such as test counts If the client provides copy files the auditor needs to be sure that they have not been tampered with
The development of suitable audit software requires a thorough understanding of the client’s system which will enhance the auditors knowledge of the client for future years
Tutorial help and key points
The 10-mark knowledge Q on the F8 paper is often a good place to start. There is very little application needed here – you will either know the answer or not! If you know the answer, use this opportunity to gain some quick, easy marks. If not, do not spend ages trying to remember it! Leave yourself some time at the end of the paper to come back and try and jot down as many points as possible. Marking scheme (a) (b) For each relevant point Definition of detection risk Each factor (c) For each factor 1 mark/max 2 1 mark/max 1 1 mark/max 3 1 mark/max 4 Total maximum marks = 10
Engagement letter ● ● ● Sets out the respective responsibilities of the directors and the auditors. Minimises the possibilities of misunderstandings between the client and auditor. Legally binding contract once signed that sets out the scope of the work and creates a legal basis for payment.
Detection risk If detection risk is high, it means that there is a high risk that the auditor’s procedures will fail to spot a material misstatement Detection risk will be higher where: ● ● ● ● Client is new. Auditor chooses unrepresentative samples. Auditor is inexperienced or untrained. Client has placed pressure on auditor to meet a tight deadline.
Reliance on external experts ● ● ● ● ● ● Is the expert independent? Qualifications and experience. The scope of their assignment. Was their work documented? adequately planning, supervised, reviewed and
Did they have the necessary resources? Were their assumptions and methods reasonable?
Tutorial help and key points
Explaining ethical issues and safeguards is a very popular requirement at F8. Part (a) asks you consider why the concept of independence is crucial to external auditing. Pick up an easy mark by explaining the term ‘independence’ and then go on to explain why it is important that the external auditors are independent, ie to protect the shareholders who are relying upon their opinion. Part (b). In this part of the question, you need to explain the threats that arise specifically from the provision of other services (here, internal audit and consultancy services to the client). These will be the self-review threat (as we may be giving advice on systems that we then come to audit at a later date), the management threat and the self-interest threat (as the increased fee income from the services may result in the auditor becoming too dependent on the client). Remember to explain the threats fully in order to gain the marks available Part (c). If you have revised your class notes carefully you should easily be able to explain the activities carried out by the internal audit department within a company. Marking scheme (a) (b) For each relevant point For each threat explained For each safeguard (c) For each activity 1 mark/max 5 1 mark/max 6 1 mark/max 6 1 mark/max 3 Total maximum marks = 20
Independence Auditors should be free from influence/be unbiased/have an objective state of mind. They should also be seen to be independent. Users need financial statements that portray as closely as possible the true financial position of the company. However, management may desire to show the results of its stewardship in the most favourable light. Auditors are therefore required to be independent to protect shareholders If users do not perceive auditors to be independent there will be: ● ● A lack of credibility in the financial information A loss of confidence in the profession.
Threats to independence and how they many be resolved Threat The provision of internal audit services presents a self-review threat as those carrying out the audit may: ● ● Place too much reliance on the work of colleagues Be reluctant to inform management of any shortcomings in their colleagues’ work.
It also represents a management threat which may be unacceptably high. By taking on the role of internal auditors, the external auditors may have to take decisions or make judgements that are the responsibility of management. Safeguards ● Ensure that audit firm does not make management decisions regarding: o o ● the scope and nature of the internal audit services to be provided; the design of internal controls or the implementation of changes to internal controls.
The audit should be reviewed by an independent partner not involved in the audit engagement.
Threat Acting for a long period of time poses familiarity, self interest and selfreview threats as the auditor may be too sympathetic to their client/too trusting/have reduced professional scepticism. Safeguards ● ● As Stanley plc is a listed company the engagement partner should be changed every five years. Key audit partners and senior staff should be rotated regularly (every seven years).
Threat The provision of additional services (ongoing consultancy work) presents a self-interest/fee dependency threat as fear of losing the fee may tempt the auditor to ignore any problems found. There is also depending upon the actual work, a self-review threat. Such work should not be taken on if a ‘reasonable and informed third party’ would perceive that the work is incompatible with an independent audit. Safeguards Ensure that fees from Stanley plc are less than 10% of total fee income. Use a separate team for the additional services. Do not take on management role. Ensure an independent partner review is carried out on the audit files. 10
Activities of internal auditors ● ● ● Review of the economy and efficiency of operations. Special investigations. Review of compliance with laws and regulations.
Tutorial help and key points
Part (a) is a typical ‘audit risk’ style question where you are asked to explain the audit risks from the information in the scenario. It helps to think of two things: i) What is the factor that concerns you?
ii) How can that lead to an error in the financial statements? You must be very careful to explain the risk properly, ie focus on the errors that could arise in the FS. No credit is given in these questions for explaining the risks to the business – they must be audit risks. Part (b). Once you have identified the possible risks to the audit, you must then say what the auditors will do to address them. The answers to questions such as this lend themselves very nicely to a column format. Marking scheme (a) (b) For each risk explained For each procedure 1 mark/max 10 1 mark/max 10 Total maximum marks = 20
Audit risks Import/export trade foreign currencies may involve
Audit work Check appropriate exchange rates have been used
Misstated amounts in respect of translation of purchases, payables, receivables, revenue or inventory if wrong FX rates are used. Garden furniture is sold with a 10 year warranty Warranty provision is judgemental and/or difficult to calculate and may be misstated Online ordering May give rise to income recognition problems/incomplete recording of data Re-perform calculation Assess reliability of provision calculation in the past Compare post year end warranty costs to the provision Check cut off procedures
Investment in the website Inappropriate accounting treatment of development costs Lack of familiarity with payroll processing due to previous outsourcing Failure to account for payroll costs and liabilities in particular, tax liabilities
Review costs incurred on website to ensure appropriate capitalisation
Evaluate and test controls over payroll system Perform detailed analytical procedures on payroll costs Confirm that tax liabilities are paid on time Inspect advisors correspondence with legal
Cancellation of contract with service provider Failure to disclose provision/contingent liability for damages Pending sale of business Overstatement of assets and understatement of liabilities to impress new buyer (especially receivables and inventories)
Inspect terms of contract for potential penalties to be paid on cancellation Receivables circularisation Review after date receipts from receivables Evaluate controls over inventory Attend inventory count
Limited period to complete audit Audit may be rushed so not enough attention paid to risk areas or failure to spot material misstatements Limited time for identification of events after the reporting period.
Independent partner review of files Remind current owner of importance of the audit and stand firm in face of pressure to rush.
Tutorial help and key points
Question 5 on the paper often covers issues such as audit reports, going concern or subsequent events. Part (a). It will help to break down your answer as per the requirement. • • • Explain the term = define materiality and explain that items in the FS can be material by size or by nature Discuss its role in the audit = auditors only care about errors that are material Explain why it it’s a difficult area for the auditors = remember that it is subjective and judgemental and will change for every client.
Part (b) describes three separate audit clients, each with an issue with their FS. You are then asked how the auditors will need to modify the audit report in each case. For each scenario describe: ● ● ● The type of problem (disagreement or insufficient audit evidence) Its materiality The resulting modification
Marking scheme (a) (b) For each relevant point For each relevant point 1 mark/max 8 1 mark/max 12 Total maximum marks = 20
Materiality A matter is material if its omission or misstatement would reasonably influence the decisions of the users of the financial statements. Materiality is determined either by the size of an item or its nature. To determine whether or not something is material by its size, yardsticks are used such as % of pretax profit or a % of revenue. Items that are material by their nature include transactions such as directors’ emoluments. Role in the audit Materiality influences: ● ● The nature, timing and extent of the audit work. Whether or not an error is corrected before the financial statements are published.
Whether the audit report is modified.
Why it is a difficult area for the auditor The users of financial statements are diverse and so will all have a different opinion as to what is material or not. Materiality does not have a mathematical definition and requires the use of professional judgement and should be determined by a responsible person.
Audit report modifications Vista plc ● ● The repairs and maintenance costs should have been expensed and not capitalised. Since $8.5m exceeds pre-tax profits, if the error were to be adjusted the profit would turn into a loss so the matter is clearly material, most probably pervasive considering its significance. Modify the audit opinion with an adverse opinion due to the material misstatement. The report would state that the financial statements do not give a true and fair view with the reason and amount stated before the opinion paragraph.
Rayton Ltd ● ● ● ● ● ● There is a difference between cost and NRV of $60,000. Cost = $240,000. NRV = $320,000-$140,000 = $180,000. At 2.5% of pre-tax profits it is unlikely to be considered material. Audit opinion will not be modified. All audit differences however should be noted on a schedule of differences.
Viva Ltd ● ● ● ● The payment to Mary Benton represents a related party transaction and must be disclosed regardless of its size. It is material by nature. The audit opinion will be modified with an ‘except for’ due to a material misstatement. The reason and amount involved would be stated in a paragraph before the opinion paragraph.