Monitoring Test MT1A

Advanced Audit and

Assurance
P7AAA-MT1A-Z16-A

Answers & Marking Scheme

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1 JACKSTRAW CO
(a) Audit issues
New audit client
It is necessary to ensure that the balances have
been accurately brought forward from the
previous year.
Business risk
The budgeted reduction in revenue reflects the
declining market which is closely associated
with the property market. Any necessity to
curtail, significantly, the scale of operations
will be contrary to the going concern
assumption.
Actual revenue, that is less than budgeted,
may indicate that inventory is moving more
slowly than anticipated. Inventory could be
overvalued due to:
 newer models becoming available;
 shop soiling/damage (on shelves for
longer);
 changes in fashion (colour and designs).
Management bias
Management may be biased to overstate
profit, e.g:
 to achieve the budget;
 to receive any performance related
incentives (e.g. bonus);
 to obtain finance if cash flow difficulties
arise.
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Effect on audit
The amount of work required on opening
balances is more detailed than for an existing
client.
Ideally, access to the previous auditor’s
working papers should be sought.
Items in the financial statements should be
treated consistently with previous years.
The scope for analytical procedures with
prior years may be limited or not cost
effective.
The budgets may provide a basis for
investigating potential understatement of
sales revenue (e.g. by branch). However, it is
also possible that the budgets are unreliable
and of limited, if any, use.
Inventory turnover (or average stock-holding,
etc) calculations by branch and major product
category should reveal those in which
material error could arise.
Particular attention will be paid to areas of
judgement which could have a significant
impact on reported profit, in particular
inventory allowances.
2
 Branch visits
As the company operates from 15 separate
branches, this will tend to increase inherent
risk.
POS system
Customers’ complaints indicate that the
computerised POS system is not operating
properly.
Sales could be materially overstated.
Either out-of-date prices displayed on the
shelves (the bar-coded products would not
indicate the selling price) or inaccurate prices
on the master file.
EFTPOS
The accounting system and internal controls
have been changed during the year to deal
with the upgraded EFTPOS. It is possible that
the pricing errors identified are related to the
new application.
Physical inventory counts
Inventory is likely to be the most material
current asset. Client’s procedures should
ensure that physical quantities are accurately
recorded at all branches.
Because the RFT system is under test, it is
unlikely to be reliable for full audit evidence
at the year end. However, its use will need to
be evaluated for the following year end.
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Branches selected for year-end visits should
include:
 the largest (i.e. those with the most
material inventory);
 any trading at a loss (as revealed by
analytical procedures on branch returns).
Doubts concerning the reliability of the POS
system and related files may reduce the
reliance sought from tests of controls.
If problems with the accuracy of master files
are revealed, this could be symptomatic of
problems elsewhere in the system which
would have implications for other account
balances.
The client’s year-end procedures should seek
to ensure that accurate cash/sales cutoff is
achieved by recording last till receipts.
For the first time, there will be significant
uncleared lodgements appearing on the bank
reconciliations due to the 3-day delay in
transfer (rather than immediate transfer).
The extent and reliability of continuous
stock-checking procedures should be assessed
by a review of:
 the volume and nature of inventory
operated under the RFT system;
 the nature and size of discrepancies
between book and physical quantities;
 the degree of investigation into these
differences; and
 subsequent amendments to the computer
records.
3
 Physical inventory counts (cont’d)

Obsolete items (unfashionable colours
designs) may have built up during the
recession. Inventory and profit could be
materially overstated if allowances to write
down inventory values are not adequate.
Tutorial note: Marks will not be awarded
twice if this is also identified as a business
risk.
The adequacy of the clients’ physical count
instructions should be assessed at an early
stage. Particular attention should be given to:
 controlling inter-branch transfers around
the year end;
 identifying slow-moving and shop-soiled
items;
 procedures for dealing with irate
(annoyed) customers turning up during
the closure.

The half day allocated to the physical count
may impose time pressure on counters and
checkers. This could result in omissions from
and inaccuracies in, the inventory valuation.
Tutorial note: Credit will also be given for
noticing that the count is on New Year’s Eve.
The commercial desirability of keeping the
stores closure to a minimum must not
threaten our ability to obtain sufficient
evidence to form an opinion on such a
material area.

The adequacy of the time allocated will

depend on:
 the reliability of the computer inventory
quantities as shown by the results of
continuous stock-checking; and
 the number and competence of client
staff involved.

Pending litigation

Prosecutions by customers in respect of The overcharges are unlikely to be material,

incorrect prices charged may result in: but fines and legal costs could be.
 fines;
Any adverse publicity arising from the over-
 legal costs;
charging and may have an impact on sales.
which, if material, should be accounted for as
contingent liabilities.

Any overcharges not rectified at the year end

will represent an actual liability.

Risk assessment

Inherent risk is high due to:

 new client;
 economic factors affecting industry; and
 possible management bias.

Control risk may be high for revenue and could extend to inventory/receivables or cash.

Tutorial note: Although it is not necessary and sometimes undesirable to adopt a columnar
approach it can aid wider thinking from an auditing perspective.

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(b) Audit effort

Tutorial note: The distinction between effect on audit (in (a)) and “direction of audit effort”
(in (b)) is arguable and fine. Your answer must be carefully planned to make some distinction
otherwise you will not appear to have addressed both of the requirements. Also marks will
not be awarded for repeating in (b) points made in (a).

The audit effort will depend on the assessment of the control environment and the relative
efficiency of tests of controls and substantive procedures on the account balances.

Accounting systems and internal controls

As this is a new client, adequate systems and controls documentation must be obtained. This
should cover EPTPOS and also how the POS was changed to incorporate the new facility.

Evaluating the controls

To assess the effectiveness of general and application controls (and their interrelationship),
attention should be directed to the following controls:

 General controls

Regardless of whether the EFTPOS extension was developed in-house or by

external consultants controls should have operated over the design, testing and
implementation of the modification to ensure that it is technically sound and
reliable.

Staff should have been properly trained in its use and provided with user manuals.

Data file security controls should include:

 library procedures;
 passwords;
 logging of computer usage and master file amendments.

Only if the assessment of general controls proves to be satisfactory can reliance be

placed on the application controls in the system.

 Application controls

Edit checks over input. With universal bar-coding these can include display of the
product name on a screen at the checkout as the light pen is applied. This can be
visually confirmed by the checkout assistant (and customer).

Periodic checking of master files (in addition to the data file security controls
above). Management should request a regular printout of prices for a selection of
goods for independent checking, that prices are those authorised by management.

Credit control checks should be built into the system to confirm credit worthiness
(in excess of a specified minimum) prior to accepting of a customer’s debit card.

To check the accuracy of recording, management should be reviewing

reconciliations of EFTPOS receipts per the till records to subsequent cash receipts
per the bank statements. If this check is not performed, it should be included in our
substantive procedures and the matter noted in our report to management.

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 Tests of controls

The nature of the business and accounting system suggest that good controls should exist. In
areas of the financial statements where account balances are made up of a large number of
relatively low value items, tests of controls with reduced substantive procedures is likely to be
more effective than substantive procedures alone. For example, we would seek to place
reliance on internal controls in order to verify the completeness of recorded revenue and the
accuracy of purchases.

However, much depends on the outcome of investigations into the pricing problems noted by
customers. If these are indicative of a weakness in controls then the scope of substantive
work would be increased. This could include detailed testing of prices on the master file
using statistical sampling techniques.

The depth of testing of inventory depends on the extent and effectiveness of continuous stock-
checking procedures. If adequate controls exist and any discrepancies between book
inventory and physical are minimal, there will be more scope for reliance on internal controls.
Computer assisted audit techniques (CAATs) could be used to identify product lines showing
significant adjustments to the balance on hand resulting from continuous stock-checking
procedures.

Substantive procedures

A substantive approach will be taken to verifying:

 cash/sales cutoff;
 inventory allowances.

CAATs will be used where possible to obtain samples for subsequent verification (e.g.
transactions over a specified amount either side of the year end). Depending on the data
fields on the client’s master file, CAATs could be used to search for product codes where no
sales have been made since a specified date.

Analytical procedures

If the internal control environment does prove to be effective, the extent of substantive
procedures could be limited to analytical procedures. For example, detailed analytical review
of revenue, by superstore and by square foot of floor space, and analysis of other performance
indicators in this industry could be carried out. Payroll, wage-related costs, interest and
depreciation may be verified by tests in total.

Reliance on analytical procedures alone for revenue may not be possible if:

 management bias in preparing budgets/reporting actual is suspected;

 branch performance is significantly varied due to location/local competition, etc.

CAATs may contribute to analytical procedures (e.g. calculating inventory turnover to

identify the potential need for allowances/write-downs).

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 Attendance at physical inventory count

Year-end visits will be planned, in association with the internal auditors to cover the material
and high risk branches. CAATs may be used to select high-value and slow-moving lines for
physical inspection.

Attendance at the physical inventory count visit should also include:

 inspection of non-current assets (e.g. premises, directors’ cars, delivery vans,

forklifts and electronic cash registers);

 observation of the till “cashing up” procedure when trading ceases;

 counting cash on the premises (may be outstanding lodgement at the year end);

 agreeing the number of employees (for analytical procedures) etc.

Discussions with management

The following matters should be discussed with management at the earliest opportunity and
an ongoing basis as developments become apparent:

 the cause of the overpricing errors;

 contingency plans for physical counting if half day closure is insufficient for a
branch;

 current/planned level of operation, going concern, cash flow and mitigating factors.

Legal advice

It is probable that we will seek to confirm the prosecution in respect of overcharging with the
company’s legal advisors.

2 FALLAPARTS CO

(1) Trade receivable balance - $320,000

(i) Impact on audit conclusion

Year-end trade receivable balances, net current assets and profit before tax per the draft
financial statements may be overstated by as much as $320,000 in respect of a doubtful debt.

The current balance ($400,000) is twice last year-end’s balance and may indicate:

 deterioration in Fallaparts debt collection of amounts due from Aceparts; and/or

 expansion by Aceparts which should be supported by a commensurate increase in
Fallaparts’ sales to Aceparts.

The current balance is 25% more than the current year-end balance. Such a large increase in
so short a period of time could indicate that Aceparts is taking advantage of its credit
arrangement with Fallaparts and is about to go into liquidation. Alternatively, Fallaparts may
be “realising” old inventory in post year-end sales which may be subsequently be returned
(see item 3).

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 The floating charge may not provide sufficient grounds for the absence of allowance against
amounts due from Aceparts, even if it satisfies legal requirements (has been properly
registered, etc). For example, the charge will rank after properly constituted reservation of
title clauses which Aceparts’ other customers may have attached to their goods, or the bank
may have a first floating charge. The charge will be insufficient to secure repayment if
Aceparts’ inventories are sold because, unlike a reservation of title clause, it cannot be traced
to subsequent receivables/cash.

Further work is required to confirm the assertion that no allowance is required. This should
include:

 a month by month analytical review of Aceparts’ average collection period (days);

and

 a review, up to the date of signing the audit report, of further sales to/returns from
Aceparts and cash receipts.

If the weight of evidence supports the view that some allowance is necessary, but the directors
refuse to adjust the financial statements, an “except for” opinion will be required. In the event
of such a qualification, it may also be necessary for the financial statements to disclose
trading after the end of the reporting period to indicate the total potential loss to Fallaparts.

(ii) Materiality

The current year-end balance outstanding is likely to be material to total trade accounts
receivables as the 2015 outstanding balance was 15.4% of total trade accounts receivable at
30 June 2015 and the current balance ($320,000 + $80,000) is twice that amount. The
maximum potential adjustment to profit before tax per the draft financial statements is a
reduction of $320,000 and would be considered material if more than 5% of profit. If the post
year-end increase (currently $80,000) is also considered material it should be disclosed by
way of note.

Tutorial note: Notice the need to infer (a higher level skill) that the current balance will be
material based on the prior year’s figures (in the absence of relevant current year total
balances).

(2) Inventory discrepancies

(i) Impact on audit conclusion

Inventory, net assets and profit are potentially overstated in the draft financial statements by
the difference between physical and book quantities.

Tutorial note: Overstatement is more likely than understatement in the light of (3).

Further work is required to confirm the client’s assertion that discrepancies are compensating
unders and overs. This should include matching of the larger unders and overs which have
been individually identified.

It is also necessary to establish whether it is the book or physical quantities which are in error
(e.g. by performing test counts of the more significant items involved and rolling them back
to year-end quantities). The unexplained inventory increase, in (3), suggests that book
quantities may be overstated. The impact on the audit report should therefore be considered
alongside the findings from (3).

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 Additional work is also required to confirm the reasons for the mistakes occurring in order
that suitable recommendations can be made in the management letter. For example, returned
damaged parts may be recorded in book quantities though not returned to physical inventory.

(ii) Materiality

If the difference between physical and book quantities is material in the context of the book
value (currently included in the financial statements) and/or profit before tax per the draft
financial statements a potential adjustment should be considered. In the first instance,
adjustment could be made for all agreed differences identified. If the remainder is not material
no further adjustment may be necessary.

Even if further audit work shows that value of the year-end inventories are not materially
misstated in the financial statements it may be necessary to report, by exception, that proper
accounting records have not been kept. This would be the case if physical recounts rolled
back to the year-end show that mistakes in the description and categorisation of inventory
items occurred in the year-end physical counts (rather than in transactions wrongly recorded
against book quantities).

(3) Inventory increase

(i) Impact on audit conclusion

Further work is required to substantiate the managing director’s assertion that bulk buying
opportunities contributed to the overall inventory increase. This should involve, for example,
the client identifying relevant invoices against which the “attractiveness” of the prices can be
considered.

A possible reason for a net increase is a comparative decrease in the level of inventory
allowances required. Old inventory items may have been excluded from the “old inventory
listing” due to:

 movements of non-obsolete inventory items incorrectly allocated to obsolete

product lines;

 arranging transactions of obsolete inventory items (e.g. with Aceparts).

Additional work is required to ensure that adequate allowance is made for old, slow-moving
inventory items, etc. In particular, all significant items on last year’s “old inventory listing”
should be traced to this year’s listing. The net realisable value of omitted items (e.g. in
respect of which a bona fide sale has been made) must then be substantiated and/or additional
allowances made.

If the additional work above fails to account for the substantial rise further substantive work
could include:

 extensive net realisable value review of significant year-end product lines;

 analytical review of monthly inventory turnover for the year;
 detailed testing of goods returns.

If further tests fail to resolve the matter and the client is not prepared to undertake an
extensive line-by-line review an “except for” qualification may be required.

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(ii) Materiality

A substantial increase is likely to be regarded as material (if not on its own then when
considered in combination with (2)). Even if inventory is not materially overstated in the
current year it may be material to next year’s results (e.g. if profits are tending to decrease).

Tutorial note: Again be aware of the higher level skill of recognising the cumulative impact
when considering materiality and the impact on the audit/auditor’s report.

Overall

The three problems all indicate potential overstatement of current assets, total net assets and
profit before tax. Even if these items, in isolation, are not considered material, their combined
effect may be. The most likely form of audit qualification would be “except for” on the
grounds that the realisable values of certain inventories and trade receivables as asserted by
management cannot be substantiated.

3 NON-AUDIT SERVICES

Need for other services

In today’s highly commercial environment many audit firms are looking to provide the best quality
service to their clients which includes expertise in other fields apart from auditing. Typical examples
include accountancy, taxation, management consultancy and company secretarial.

The benefits to the client of these non-audit services are that:

 the auditor’s knowledge of the business enables him to provide these extra services at a lower
cost than would otherwise be available; and

 providing such services will enable the auditor to perform his work more effectively by
enhancing his knowledge of the client’s business.

Also, some services may be required to be provided by the auditor (e.g. regulatory returns under
Financial Services legislation).

Impact on integrity

However, as the quote suggests, providing these additional services may (depending on their scale and
scope) compromise the auditor’s integrity. Deriving very substantial consultancy fees from auditing
clients creates the perception, if not the reality, that the audit opinion may be clouded by conflict of
interest.

This concern is illustrated by the fact that a number of European countries have, for many years, had
legislation specifically preventing the provision of non-audit services by the company’s auditor.

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Recent developments

The issue of non-audit services has been central to proposals for the strengthening of auditor
independence ever since the Enron and WorldCom “scandals”.

Many argue that legislation is unnecessary, that SMEs (in particular) need to benefit from the provision
of other services, and that the ACCA (or IFAC’s) Ethical Code will ensure that there is no loss of
independence or objectivity where such non-audit services are provided. However, a distinction has to
be made between those entities that are considered to be public interest entities and those that are not.

The US Securities and Exchange Commission (SEC) identified nine non-audit services which it deemed
to be inconsistent with an auditor’s independence. These were incorporated into the Sarbanes-Oxley
Act (2002) for entities listed on the New York stock exchange.

The European Commission has for many years considered making the requirement to prohibit provision
of other services mandatory in all EU member states. In December 2013 they, the European Parliament
and Council of Ministers reached political agreement on draft legislation to reform the audit market in
the EU. The legislation was voted through the Parliament in April 2014 and it came into force in mid-
2014 with most provisions to be enacted in mid-2016. The legislation introduces new restrictions on the
non-audit services that auditors can provide to their EU public interest entity audit clients. The
restrictions take the form of a cap on the amount of non-audit fees that can be billed (expected to be
70% of the average audit fees over the previous three years) and a list of twenty one prohibited services
that the auditor can’t provide.

Ethical codes

All members of the ACCA are required to adhere to the ACCA’s Code of Ethics and Conduct (e.g. as a
condition of continued membership). One of the Fundamental Principles of the Rulebook addresses the
objectivity issue by requiring all members not to compromise their professional or business judgement
because of bias, conflict of interest or the undue influence of others. Guidance relevant to the provision
of other services includes the following:

 Recurring fees (including non-audit) paid by one client should not exceed 15% of the gross
recurring fees of the practice for two consecutive years;

 Care must be taken not to perform executive functions or to make executive decisions;

 A practice should not participate in the preparation of accounting records of a public interest
audit client. The “emergency” provision was removed in an update to the Code in 2015. For
a private company, if this service is provided care must be taken to ensure that the client
accepts full responsibility for such records and that objectivity in carrying out the audit is not
impaired;

 A firm should not audit a client’s financial statements which include the product of a
specialist valuation carried out by it (or an associated practice).

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Ways to minimise perceived difficulties

However, in the current economic climate, the auditing profession (especially where it aspires to be
self-regulated) is not seen to be sufficiently monitored and regulated to provide investors with the
confidence which global capital markets need. As independence is clearly open to question when
auditors also perform a significant consultancy role (especially where the audit contract may have
served as a loss-leader to acquire the more lucrative business) there is a strong case for more disclosure.
For example, in addition to their current role and monitoring of the external auditors, the audit
committees could be required to:

 assess the extent of non-audit work and notify shareholders of any potential conflicts of
auditor interest (already part of the UK requirements);

 publish details of audit and non-audit contracts, giving a detailed justification of the
arrangements to shareholders.

To reinforce the general principle that auditors should not be permitted to audit work done by
themselves (such as specialist valuations) there should be legislation to strictly define such services and
enforce this prohibition (e.g. as established in the EU and US). Specifically (for example) external
auditors should not:

 undertake internal audit services for public interest clients (already banned in the US and
included in the EU restrictions):
 provide sophisticated tax planning advice (as distinct from computation and compliance
work) particularly where remunerated on a fee-for-results basis (banned in the US and subject
to strict audit committee verification and authorisation in the EU).

Other measures could include:

 the setting up of a single, independent, regulator to make audit appointments; and

 audit committees of non-executive directors to select auditors (to be put to the shareholders)
and agree their remuneration (always required in the UK and more recently throughout the
rest of the EU).

Conclusion

Substantial non-audit services are a threat to the integrity of the auditing profession as a whole and
measures beyond those which can be achieved under self-regulation should be implemented if investor
confidence is to be restored and then maintained.

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 Marking Scheme

Marks

1 JACKSTRAW

(a) For each comment on an issue raised and its effect on

the audit – 1 mark to a max 3 for any one issue

Ideas

 New audit client, op balances and consistency

 Aspects of business risk including fashions and going
concern
 Other aspects of inherent risk – management bias
 – branches
 POS system weakness
 EFTPOS and cash cutoff
 Physical inventory count
 Conclusion on inherent and control risk
___
15
For each point contributing to a description of the audit
effort – 1 mark

Ideas

 Ascertaining and recording the system

 Identifying and evaluating controls
 Tests of controls including continuous stock-checking
 Substantive procedures including CAATs
 Analytical procedures
 Attendance at physical count
 Discussions with management
 Legal advice

10
___
25
___

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 Marks Marks

2 FALLAPARTS

(i) For each comment contributing to a discussion of

impact on audit conclusion 1 mark

Maximum for any one (of 3) matters 5

Ideas

 aspects of fin stats affected

 what problem means/indicates
 further work required
 possible conclusion = audit opinion

For overall summary 1

___
available 16

(ii) For each comment contributing to an assessment of

materiality 1 mark
Maximum for any one (of 3) matters 2
___
available 6
___
max 15
___
3 NON-AUDIT SERVICES

For each relevant issue briefly discussed 1 mark max 10

Introduction
 need for other services
 benefits to clients
Impact on integrity
Recent developments
 company collapses
 EU/SEC restrictions
 legal prohibitions vs self-regulation
Ethical code
 fees
 accounting records
 specialist valuations
Proposals to minimise perceptions
 increased disclosure
 audit committee/corporate governance
 ban on defined other services

For a conclusion clearly derived from the discussion 1

___
max 10
___

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