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Question 1(a)

Audit risk may be defined as the risk that the auditor will deliver an inappropriate or incorrect
audit opinion on the financial statements. The auditor's assessment of risk should be an intrinsic
part of the planning and execution of an audit. The auditor should plan the distribution of audit
effort by identifying the areas involving greatest audit risk, in terms of their materiality, the
existence of adequate internal controls, and previous experience. Detailed testing can then be
concentrated on high risk areas. Audit risk is reduced by appropriate quality control procedures.
These include:

i. The observation of relevant Auditing Standards and Guidelines.

ii. The establishment, maintenance and observance of standards of quality within the audit
firm.

iii. Procedures for ensuring that staff and partners have the ability and knowledge required
to do the job. This implies suitable procedures for recruitment, supervision and training.

iv. Audit files properly reviewed with points of difficulty or error being cleared before the
audit report is signed.

v. Peer review procedures. In addition to routine review of files during the audit, partners
should take part in peer review to ensure that the firm's standards are maintained.

vi. Procedures on deciding whether to accept an engagement. Before accepting an


engagement, the auditor should consider its implications for the firm. Will it threaten the
firm's independence? Does the firm have resources to carry out an adequate audit? Does
the client present a potential risk because of the nature of its business or its financial
position?

Audit risk is made up of three elements:

Inherent risk describes the risk arising from the nature of the client's business or industry and
environment prior to the consideration of the internal control system by the auditor. It will vary
between different account items and different types of industry. Inherent risk is enumerated as
below;

(a) The nature of the business, its products or services, and its market position

(b) The company's present and likely future financial position

(c) The auditor's previous experience of that company

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(d) The existence of circumstances which could put pressure on management to manipulate
results

(e) The susceptibility of the company's assets to fraud.

(f) The existence of related party or unusual transactions.

(g) The possibility that error could have a material effect on the

Control risk is the risk that errors will not be prevented or detected by audit procedures. It
entails;

(a) The quality and effectiveness of management and the degree of supervision exercised by
management.

(b) The existence and quality of internal controls

(c ) The competence of accounting staff

(d) The nature of accounting records kept.

(e) The existence and effectiveness of the internal audit department.

Detection risk is the risk that material error will not be detected by audit procedures.

Audit risks facing Super face Ltd

The various audit risks apparent from the initial planning discussions in respect of the audit of
the annual financial statement for Super Face ltd group for the year ended 30 th September 20X5
includes the following;

(a) Being the newly appointed auditors means that our knowledge of the entity its activities
and the business risks to which it is exposed is highly inadequate. Similarly our knowledge of the
competence and integrity of the management and staff and the pressures to which they are
exposed at personal and entity levels is also insufficient. Therefore during our inherent
assessment we could easily misjudge the competence and integrity of management and staff and
their reaction to pressures thereby reducing the population to be subjected to details testing to too
small a size. Our knowledge of the suitability of design and effectiveness of operation of the

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accounting and internal control system is equally insufficient. We could therefore misjudge the
system and reduce the sample size even further to a much smaller size that it should have been.

(b) The financial statements could be materially misstated by not complying with the
presentation and disclosure requirements of the Company’s Act, Nairobi Stock Exchange,
Capital markets authority or the International financial reporting standards (IFRS).

(c) Lack of segregation of duties i.e. the sole responsibility of the sales manager to sell the
second hand equipment traded in brings about a risk. The key control procedure for the
prevention, detection and correction in a timely basis of errors and irregularities is segregation of
duties for there to be adequate segregation of duties no one individual should be in a position to
initiate, authorize, execute a transaction have custody of the related assets. This function should
be performed by different departments and if they cannot be performed by different departments
different individuals within this department should perform them and if that is not practicable
there should be internal checks i.e. the work of an individual should be complementary to the
work of another individual or should be subject to supervision and review by another individual.
The responsibility for selling second hand equipment is given to one manager means that there is
no segregation of duties if this manager makes a mistake it will not be detected if he perpetrates
an irregularity it will not be detected.

(d) The Company’s Act requires that if a public company has a subsidiary at its year end then it
should produce group accounts for the benefit of the shareholders of the holding company.
However it need not produce group accounts if it is itself a fully owned subsidiary of another
company. In accordance with the provision of IFRS 3 business combinations group accounts are
presented as consolidated financial statement applying the acquisition method of accounting. The
auditor is concerned that the computations could be incorrect conceptually and arithmetically.
The company’s in the group are the legal entities in their own right. They appoint their own
auditors. The auditor of the holding company may not be the auditor of other subsidiary. In
auditing the financial statement of the holding company and the consolidated financial statement,
the auditor of the holding company may have to rely on the work of the other auditor to form his
opinion on the group accounts. He is solely responsible for his opinion on the group accounts.
The auditor of the subsidiary could have carried out a substandard audit and issued an
inappropriate audit opinion and if the subsidiary is material to the operations of the entity the
auditor of the holding company could carry over the qualification into the group audit report,
there is therefore the concern that the auditor of the subsidiary has obtained sufficient and
appropriate audit evidence and expressed an appropriate opinion.

(e) The financial statements could be materially misstated due to manipulation of the figures in
the financial statements as the directors are under pressure from competitors thus areas of
significant subjective judgment such as stock valuation debtors valuation, property plant and
equipment valuation will require closer audit scrutiny.

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(f) Contingent liabilities could be materially misstated as the management many not have
identified all the contingent liabilities existing at the balance sheet date or it may not have
properly assed the likelihood of crystallization of the identified contingent liabilities and give
them the correct accounting presentation and disclosure treatment in accordance with the
provisions of the Company’s Act and IAS37 provisions contingent liabilities and contingent
assets.

(g)Inventories could be materially misstated due to giving them an inappropriate value


particularly any inventories purchased from the foreign supply whose contract with is the subject
of legal action. The net realizable value of the stock items could be significantly lower than the
selling price if the Company has been stopped from dealing in the product by a court order due to
litigation or by customer caution.

(h) The cost of sales could be materially misstated because if the discount proceeds are
recorded as sales then to comply with the matching concept the cost of the related machine has to
be charged to Cost of sales.

(i) The contingent liabilities could be materially misstated in that as long as the rental
agreement is still in force the customers could default and the financial institution could seek
resource from Super face Ltd. This is due to the discounting arrangement arranged with the
financial institution.

(j) If a competitor has used the company there will be contingent liabilities, if one competitor
has sued there is a possibility that other competitors could also sue this could mean more
contingent liabilities. The authoritative documents on the accounting treatment presentation and
disclosure of contingencies are the company’s Act and IAS 37 (provisions contingent liabilities
and contingent assets.) According to IAS 37 the accounting treatment to be given to a contingent
liability or asset depends on the likelihood of that contingency crystallization or materializing
into a genuine obligation of the entity or an inflow of economic benefits. It identifies four
possible likelihood of crystallization or materialization.

1. Remote that is highly unlikely to crystallize or materialize

2. Possible that it can materialize or crystallize.

3. Probable that is very likely to crystallize or materialize and it’s not being practicable to
determine with sufficient reliability the financial effect.

4. Probable and it being possible to determine with sufficient of crystallization IAS 37


requires a different accounting treatment this means that this area of contingencies is
highly subjective and therefore management and the auditors can disagree or arrive at the
wrong assessment with regard to contingent liability the auditor is concerned that
management identify all contingent liabilities and the assess them properly with regard to

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their likelihood of crystallization and then deal with the contingent liability properly in
accordance with the requirements of the Company’s Act and IAS 37.

The contingent liabilities could be materially misstated if claims for breach of contract by
suppliers and customers and claims by employees for unfair dismissal due to the closure of the
facsimile assembly division have not been identified assessed for likelihood of crystallization
and then properly dealt with in the financial statement.

Question 1(b)

Some of the audit procedures appropriate to address the audit risks identified above are
explained as follows,

(a) Audit procedure with regards to accounting and internal control systems

The auditor’s procedures will include:

(i) Getting an understanding of the entity as a whole in order to see the accounting system in
proper perspective and thus be able to assess how effective and appropriate the system is.

(ii) By use of enquiry or internal control questionnaires or reading manuals ascertain the
complete system.

(iii) Record the system that he has ascertained either in the form of narrative notes, flow charts,
checks lists or answers to the ICQ.

(iv) If the auditor intends to rely on the internal control then he further has to record the system
of controls in detail.

(v) If the system's record was provided by the client or was obtained through reading manuals,
then the auditor must perform walk through tests to confirm the correctness of the record and
also his own understanding of the system

(vi) The auditor then performs a preliminary assessment of the system, and if he is relying on
controls then he performs a preliminary evaluation of those controls

(vii) If the system of controls and accounting seems adequate and the auditor feels that he can
rely upon the controls he then designs and performs compliance tests. However, if he does not
wish to rely on the controls then he performs substantive tests on the records

(viii) He has to evaluate his evidence and form an opinion on whether proper books of accounts
have been kept and whether the books of accounts form a reliable basis for the preparation of the
financial statements.

Specific control procedures include

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• Reporting, reviewing and approving reconciliations.

• Checking the arithmetical accuracy of the records.

• Controlling applications and environment of computer information systems, for example,


by establishing controls over changes to computer programs

• Access to data files.

• Maintaining and reviewing control accounts and trial balances

• Approving and controlling of documents.

• Comparing internal data with external sources of information.

• Comparing the results of cash, security and inventory counts with accounting records.

• Limiting direct physical access to assets and records.

• Comparing and analyzing the financial results with budgeted amounts.

(b) Audit procedures on fraud

Responsibilities of the Auditor The Auditor has no responsibility for the prevention and
detection of fraud and error although the annual audit may act as a deterrent. As described in ISA
200, ―Objective and General Principles Governing an Audit of Financial Statements, the
objective of an audit of financial statements is to enable the auditor to express an opinion
whether the financial statements are prepared, in all material respects, in accordance with an
identified financial reporting framework. An audit conducted in accordance with ISAs is
designed to provide reasonable assurance that the financial statements taken as a whole are free
from material misstatement, whether caused by fraud or error. The fact that an audit is carried
out may act as a deterrent, but the auditor is not and cannot be held responsible for the
prevention of fraud and error. An audit does not guarantee all material misstatements will be
detected because of such factors as the use of judgment, the use of testing, the inherent
limitations of internal control and the fact that much of the evidence available to the auditor is
persuasive rather than conclusive in nature. For these reasons, the auditor is able to obtain only
reasonable assurance that material misstatements in the financial statements will be detected. In
planning the audit, the auditor should discuss with other members of the audit team the
susceptibility of the entity to material misstatements in the financial statements resulting from
fraud or error. The auditor should make inquiries of management:

(a) To obtain an understanding of:


(i) Management‘s assessment of the risk that the financial statements may be materially
misstated as a result of fraud
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(ii) The accounting and internal control systems management has put in place to address such
risk;
(b) To obtain knowledge of management‘s understanding regarding the accounting and internal
control systems in place to prevent and detect error
(c) To determine whether management is aware of any known fraud that has affected the entity
or suspected fraud that the entity is investigating
(d) To determine whether management has discovered any material errors.

Procedures When Fraud is suspected When the auditor encounters circumstances that may
indicate that there is a material misstatement in the financial statements resulting from fraud or
error, the auditor should perform procedures to determine whether the financial statements are
materially misstated. When the auditor identifies a misstatement, the auditor should consider
whether such a misstatement may be indicative of fraud and if there is such an indication, the
auditor should consider the implications of the misstatement in relation to other aspects of the
audit, particularly the reliability of management representations

When the auditor confirms that, or is unable to conclude whether, the financial statements are
materially misstated as a result of fraud or error, the auditor should consider the implications for
the audit.

Documentation The auditor should document fraud risk factors identified as being present
during the auditor‘s assessment process and document the auditor‘s response to any such factors.
If during the performance of the audit, fraud risk factors are identified that cause the auditor to
believe that additional audit procedures are necessary, the auditor should document the presence
of such risk factors and the auditor‘s response to them.

Communication When the auditor identifies a misstatement resulting from fraud, or a suspected
fraud, or error, the auditor should consider the auditor‘s responsibility to communicate that
information to management, those charged with governance and, in some circumstances, to
regulatory and enforcement authorities.

Existence of errors may indicate that accounting records are unreliable and are therefore not a
satisfactory basis from which to prepare financial statements. The auditor could therefore
conclude that proper books of accounts have not been kept where there are too many material
errors. This is a ground for qualification of an auditor's report. Too many errors may also
indicate that the system of internal control is not reliable, and therefore the auditor wishing to
place any reliance on a system of internal control may not be able to do so. If errors are of
sufficient magnitude, they may be sufficient to affect the true and fair view given by the
accounts.

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Irregularities -can be described as intentional distortions of financial statements for whatever
purpose and also as misappropriation of assets whether or not a company by distortions of
financial statements. The auditor's responsibility towards fraud and other irregularities is exactly
the same as that of errors.
Possible indications of irregularities include:
(i) Missing documents or vouchers, these could have been deliberately destroyed to conceal an
irregularity
(ii) Evidence of altered documents: alterations can take place after the transaction has been
approved
(iii) Unsatisfactory explanation: these are explanations that are vague and are unsupported
(iv) Evidence of disputes
(v) Existence of suspense accounts or unexplained differences on reconciliations; (vi) Evidence
that internal control is not operating as it is intended to; (g) Unduly lavish life styles of
employees and officers
(vii) Figures not agreeing with expectations.

If the auditor suspects that management is involved in irregularities, then he should report to the
main board or to the audit committee.
The auditor should report to management on all actual or potential irregularities and
recommendations for changes.
Auditors can also report irregularities to third parties: the auditor should take legal advice or
advice from his professional body to ensure the accounts give a true and fair view, but only
disclose those matters where he has a clear public duty to disclose for example, if a serious crime
has been committed.

(c) Audit procedure on investment e.g. listed stocks


Since Super face ltd is listed in the Nairobi stock exchange the auditor should carry out the
following audit procedures.

(i) Existence and ownership rights and obligations


-The auditor should examine certificates of title for investments recorded in the investment
records and confirm that they are in the clients name and are free from any charge.
Establishment of title and beneficial ownership of investments is not conclusively possible.
However, evidence is available in the form of:
(a) Share certificates, correspondence with nominee etc
(b) Payments for securities, brokers, or contract notes.
(c) Dividends/interest from securities, dividends warrants.
- Inspect certificates held by third parties e.g. stock brokers to find out whether they are in the
name of the client.

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- If the company has bought new investments the auditor should confirm whether the purchase
was properly authorized by verifying with the contract notes.
-Incase of disposal of investments the auditor should verify the disposal to the sale agreement
confirming proper authorization and confirm whether made is computed correctly.

(ii) Valuation

Valuation of listed securities is easily conformed to appropriated financial publications.


Director’s valuation of unlisted securities is something on which the auditor’s report, and the
basis of the calculations, must therefore be examined. The auditor must also consider whether
any write downs for impairment in value are adequate, which may mean examining copies of
accounts of companies in which investments are held. Income from securities can be verified
with known interest rates for fixed interest securities, and a share information service for listed
shares. Unlisted share income must be verified with copies of the accounts.

(d)Audit procedures are regards stocks

Auditor’s duties as regards stocks can be summarized as follows:

(a) Ascertaining the accounting policies adopted by the entity for valuing stocks

(b) As the guiding standard on stocks is IAS 2 inventories, the auditor has to consider the
suitability of the policies selected by the organization. You must note that under IAS 2

i. The lower of cost and net realizable value is obligatory. FIFO or weighted average cost is
used to allocate costs.

ii. The cost should where appropriate include a proportion of production overheads whether
or not they vary on a time basis. The proportion included must be based upon the normal
level of act

iii. Where identical items are purchased or made at different times and therefore have differing
costs the method of arriving at cost should be FIFO, weighted average
(c) The auditor should test check the stock sheets or the continuous stock records with relevant
documents such as invoices and costing records to determine if cost has been correctly arrived at.
(d) The auditor must examine and test the treatment of overheads.
(e) The auditor must test the treatment and examine the available evidence for items valued at net
realizable value.
(f) The auditor must check the arithmetical accuracy of the calculations made.
(g) The auditor must check and confirm the consistency with which the amounts have been
computed.

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(h) The auditor must consider the adequacy of the description used in the accounts and the
disclosure of the accounting policies adopted.

The auditor’s procedures are covered under three stages, before, during and after.

(a) Before
(i) Study of the clients stock taking instructions and recommendations for changes or
improvements if the auditor considers them inadequate.
(ii) Familiarization with the location of the stocks and the opportunity to plan for the work to be
undertaken.
(iii) Familiarization with the nature and volume of stocks and especially with high value items.
(iv) Review of previous year’s working papers and discussions with the managers of any
significant changes from the previous year.
(v) Consideration of the location of stocks and likely points of difficulty e.g. cutoff.
(vi) Consideration of any involvement of the internal audit department and the extent of reliance
to be placed upon their work.
(vii) Arranging to obtain from third parties confirmation of stocks held by them.
(viii) Establishing whether expert advice may be needed.

(b) During

The main task during stock taking is to ascertain whether the client's employees are carrying out
their instructions properly. It is usually advisable for the auditor to test the efficiency of the
counting by counting selected items. In this case the auditor should select items for counting
from the records and from the factory flow. The auditor should make notes for follow up
purposes of items counted in his presence, details of defective, damaged, obsolete or slow
moving items, Incidence of stock taking instructions not being followed e.t.c. Details of items for
cut off purposes. He must enquire into, observe and discuss with the store keeping staff the
procedures for identifying damaged, obsolete and slow moving stocks. He should enquire and
test the cut off arrangements. Form a mental impression of the quantity of stock held for
comparison with the accounts. Record fully the work done and his impression of the stock take
exercise. He must form a conclusion as to whether the stock take can be relied upon. He should
take photocopies of the rough stock sheets. He should take details of the sequence of the stock
sheets. He should pay special attention to high value items.

(c) After
It is mainly a follow up exercise and it involves:
(i) Checking the cut off with the details of last numbers of stock movement forms and goods
inward and goods outward notes during the year and after the year end.

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(ii) Ensuring that the final stock sheets have been properly prepared from the count records. He
must particularly check that all the forms issued were returned.
(iii) He should check the final stock sheets for pricing, extensions, casting, summarization and
the necessary improvement.
(iv) Follow up any notes made and the attendance.
(v) Inform the management of any problems in the stock taking exercise so that they can act
accordingly.
Because of the inherent uncertainty in estimating the outcome of legal actions, this is an
especially difficult area for the auditor. Some actions are possible that assist in verifying the
existence but not necessarily the amount of liabilities that will arise out of legal action. These
include:

(e) Audit procedure on Pending Litigation

(i) Review of the client system for recording claims and disputes and the procedures for
bringing this to the attention of the board.

(ii) Review of the arrangements for instructing solicitors.

(iii) Examination of the minutes of the board for references to and indications of possible
claims.

(iii) Inspection of bills rendered by the solicitors.

(iv) Review of correspondence with solicitors and obtaining a list of all matters referred to
solicitors with an estimate of the possible ultimate liability.

(v) Written assurance in the form of a representation letter from an appropriate director that he
is not aware of any other matters referred to the lawyers other than those disclosed. If the
auditor is in doubt he should obtain a direct confirmation from the Company's lawyers. The
request must be sent by the client not by the auditor.

(iv) Examine legal expense account

(vi) Review the client‘s system of recording claims including the procedure for bringing them to
the attention of management.

When litigation or claims have been identified or where the auditor believes they may exist, the
auditor should seek direct communication with the entity‘s lawyers. The letter should be
prepared by management and sent by the auditor. It should specify the litigation and
management‘s assessment of the outcome, and request that the lawyer confirm directly to the
auditor the reasonableness of the statement and to provide the auditor with further information if
the list is incomplete. If the lawyer is likely to respond to a more general enquiry, then that
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would be better - lawyers are generally unwilling to do this unless there is nothing to report. In
complex situations the auditor may need to meet the lawyer, with the client‘s permission and
preferably with the client in attendance. Where permission to communicate with lawyers is
refused, a qualified audit opinion will normally follow.

(f) Audit procedures on Contingent Liabilities IAS 37

A contingent liability is a possible obligation that arises from past events and whose existence
will be confirmed by the occurrence of one or more future events which are not in control of the
organization.

IAS 37 requires that (in accordance with the definition of a liability) a provision should be made
where the matter gives rise to a constructive or legal obligation and where there is a probability
that there will be an outflow of economic benefits which can be reliably measured. In addition
IAS 37 gives examples of how specific situations should be dealt in terms of recognition,
measurement and disclosure depending on the circumstances

The specific procedures are as follows:


(i)The auditor should obtain details of all provisions and contingent liabilities that have been
disclosed and seek supporting documentation in the form of legal opinions, correspondence with
customers, environmental and technical reports.
(ii) Determine for each material provision which has a present obligation as a result of post
events by reviewing correspondences relating to the item and also holding discussions with
directors to find out whether they have created a valid expectation with the other party that t
would discharge the obligation.
(iii) Determine for each material provision and contingency whether it’s probable that the
transfer of economic will be required to settle the obligation.
(vi) Recalculate the provisions that have been made.
(v) Compare any amounts provided for with any payments made after year end with payments
made for similar items.
(vi) In an event that is not possible to eliminate the amount of the provision, check whether the
contingent liability has been reflected in the accounts.
(vii) Physically inspect any sites in respect of which clean up restoration provisions have been
made
(viii) Consider the need for expert technical assistance
(xi) Assess the need for further similar provisions

(g) Discontinued Operations


A discontinued operation is a component of an entity that either has been disposed of or is held
for sale. It may be a subsidiary, or a major line of business or geographical area. Management of

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Super face ltd is committed a formal plan to discontinue the facsimile assembly division. Some
of the audit procedure that should be undertaken is as below;

Audit procedure

The accounting and auditing issues are mainly concerned with identifying the point in time at
which the initial disclosure even occurs, and also ensuring that lonely appropriate costs are
included in any provision for restructuring that is established. Appropriate formats must be used
for the information to be disclosed. The key auditing matters arising are that the auditors should
confirm whether they agree with the company‘s view as to the need for disclosure of proposed or
actual discontinuance, and that they agree that the company‘s disclosures are appropriate.
Typical procedures would include:

(i) Determine the client‘s policies and procedures in respect of discontinuing operations
(ii) Review board minutes and other relevant management documentation
(iii) Make enquiries of management into significant disposals of assets and investments
(iv) Examine after date information
(v) Verify the makeup of discontinuing operations by reference to supporting documentation.

References:

1. Company external audit risk and the complexity of the company Abbott.el al (2004)

2. Srivastava R.P. and Shafer G.R (1992) Belief function formula for audit risk

3. International auditing by David O’ Regan

4. Modern auditing by Wilham C Baynton

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