GENERAL THEORY QUESTIONS

IMPORTANT NOTE - EXTENDED ANSWERS TO THESE

QUESTIONS ARE NOT REQUIRED IN THE EXAM, SO DO NOT
PANIC. EXTENDED ANSWERS ARE GIVEN HERE JUST FOR
UNDERSTANDING- YOU CAN MAKE YOUR OWN SHORT NOTES
TO ANSWER IN ONE LINE.
(h) In the context of the audit and the Internal Control risk assessment
explain
what is meant by ‘key controls’. Provide one example of a ‘key control’ and
explain why it would be deemed to be ‘key’.

(h) What is the audit purpose of identifying ‘key controls’ in the assessment
of an
entities systems of internal controls.

(b) Explain the concept of ‘segregation of duties’ as an internal control,

giving two
practical examples of its application.

PURPOSE
Internal controls are intended to prevent errors and irregularities, identify problems and ensure that
corrective action is taken
Assessment of Internal controls are established to further strengthen:
● The reliability and integrity of information
● Compliance with policies, plans, procedures, laws and regulations
● The safeguarding of assets

Key controls are those that must operate effectively to reduce the risk to an acceptable level
Example-
Implementing segregation of duties where duties are divided (segregated) among different people, to
reduce the risk of error or inappropriate actions. No one person has control over all aspects of any
financial transaction.

Segregation of duties is a key internal control intended to minimize the occurrence of errors or fraud by
ensuring that no employee has the ability to both perpetrate and conceal errors or fraud in the normal
course of their duties. Generally, the primary incompatible duties that need to be segregated are:
● Authorization or approval
● Custody of assets
● Recording transactions
● Reconciliation/Control Activity
Some examples of incompatible duties are:
● Authorizing a transaction, receiving and maintaining custody of the asset that resulted from the
transaction
● Receiving funds (checks or cash) and approving write-off of receivables
● Reconciling bank statements/accounts and booking entries to general ledger
● Depositing cash and reconciling bank statements
● Approving time cards and having custody of pay checks
(g) Explain the distinction of independence in fact and independence in
appearance and the implications for auditors in the conduct of their duties.

Auditor independence includes independence of mind and independence of appearance. Independence

of mind is the state of mind which permits the expression of a conclusion without being affected by
influences which compromise professional judgement, thereby allowing an individual to act with integrity,
and exercise objectivity and professional scepticism.

Independence in appearance is the avoidance of facts and circumstances which are so significant that a
reasonable and informed third party would be likely to conclude that a firm’s, or an audit team member’s,
integrity, objectivity or professional scepticism has been compromised

EXAMPLES

Independance of Fact: The auditor may not perform any audit for a company which they or their family
holds any interest in, be it through employment, shares, or relation through marriage to someone who
holds employment or shares in that company.
Independance of Appearance: The auditor must maintain a professional distance from employees and
stakeholders of that company. This means you are not allowed to make friends with people relating to that
company or be at risk of taking on the appearance of bias - a big no-no.

(a) In the context of audit planning and the application of an audit risk
model,
explain, using an example, what role, if any, an assessment of ‘business
risk’
might play?

Business risk is an event, circumstance or condition that may result in an organization failing to achieve
its objectives or adversely affect its strategy. For example, a risk that a company might fail to improve
sales, reduce costs or successfully launch a new product under development.

Each example also explains how the business risk may lead to risk of material misstatement of the
financial statements.

Improving Technology
Businesses are exposed to the risk of being left behind in the race for constantly improving technology.
Their methods, techniques and products will become outdated thus resulting in lost sales or inefficient
production. A new method of production may lead to superior quality products resulting in impairment of
inventory already held by a business. The corresponding risk of material misstatement is that inventory is
overstated in balance sheet and cost of sales understated in income statement.
(d) Materiality has both a ‘quantitative’ and a ‘qualitative’ nature. Briefly
explain
what is meant by the ‘qualitative’ nature of materiality and provide an
example
to support your explanation.

(c) In the context of the audit, set out your understanding of the concept of
‘performance materiality’, its purpose and what factors might be pertinent in
its determination.

(c) Differentiate between ‘quantitative’ materiality and ‘qualitative’ materiality

and
provide two examples of the latter that clearly displays why they may be
material to the user of the financial statements.

An item or group of items may be material due to their amount (quantitative materiality), nature or the
context in which the deviation occurs (qualitative materiality).

Quantitative materiality
Quantitative materiality is determined by setting a numerical value, The numerical value is achieved by
taking a percentage of an appropriate base, which both reflect, in the auditor's judgement, the measures
that users of the information are most likely to consider important.
​ When establishing the overall audit strategy, the auditor shall determine materiality for the
financial statements or the audited population as a whole (overall materiality).
​ Performance materiality is established while performing audit procedures on certain account
balances and/or transactions and is deliberately settled lower than the overall materiality so that
overall misstatements are kept under the overall materiality level.
​ the overall materiality amount cannot be used to plan audit procedures, because the procedures
will detect only individual misstatements that are material, and auditors want to plan their
procedures to identify misstatements which, individually or in aggregate, exceed the materiality
amount. Therefore, performance materiality is calculated, usually by applying a percentage
between 50% and 75% to the overall materiality amount. (depending on professional judgement
of auditor)
Qualitative materiality
misstatements or non-compliance, while not quantitatively material, may - because of their nature or
because of the context in which they arise - be qualitatively material and thus have an impact on the audit
conclusion reached.
​ material by nature: this is related to inherent characteristics and concerns issues where there
may be specific disclosure requirements or high political or public interest. It includes any
suspicion of serious mismanagement, fraud, illegality or irregularity or intentional misstatement or
misrepresentation of results or information;
 ​ material by context: this concerns items that are material by their circumstance, so that they
change the impression given to users. It includes instances where a minor error may have a
significant effect, e.g. misclassification of expenditure as income, so that an actual deficit is
reported as a surplus in financial statements.

b) Identify three threats that might present to the independence of the

auditor
giving a clear example in each case to explain the threat.

Five Threats to Auditor Independence

The following are the five things that can potentially compromise the independence of auditors:
1. Self-Interest Threat
A self-interest threat exists if the auditor holds a direct or indirect financial interest in the company or
depends on the client for a major fee that is outstanding.
Example
The audit team is preparing to conduct its 2020 audit for ABC Company. However, the audit team has not
received its audit fees from ABC Company for its 2019 audit.
Issue
The audit team might be tempted to issue a favorable report so that the company is able to secure a loan to
settle the fees outstanding for their 2019 audit.
2. Self-Review Threat
A self-review threat exists if the auditor is auditing his own work or work that is done by others in the same
firm.
Example
The auditor prepares the financial statements for ABC Company while also serving as the auditor for ABC
Company.
Issue
By having the auditor review his or her own work, the auditor cannot be expected to form an unbiased
opinion on the financial statements.
3. Advocacy Threat
An advocacy threat exists if the auditor is involved in promoting the client, to the point where their
objectivity is potentially compromised.
Example
The auditor is assisting in selling ABC Company while also serving as the auditor for the company.
Issue
The auditor may issue a favorable report to increase the sale price of ABC Company.
4. Familiarity Threat
A familiarity threat exists if the auditor is too personally close to or familiar with employees, officers, or
directors of the client company.
Example
ABC Company has been audited by the same auditor for over 10 years and the auditor regularly plays golf
with the CEO and CFO of ABC Company.
Issue
The auditor may have become too familiar with the client and, thus, lack objectivity in their work.
5. Intimidation Threat
An intimidation threat exists if the auditor is intimidated by management or its directors to the point that
they are deterred from acting objectively.
Example
ABC Company is unhappy with the conclusion of the audit report and threatens to switch auditors next year.
ABC Company is the biggest client of the auditor.
Issue
The auditor’s independence may be compromised, as ABC Company is their biggest client and they, quite
naturally, do not want to lose such a client. Therefore, the auditor may issue a report that appeases ABC
Company.

(g) Briefly set out your understanding of the role and purpose of audit
‘Engagement Letters’.

A letter of engagement is a mandatory requirement which sets out the legal relationship
between a professional firm and its client.
Role and purpose as follows -

● scope of work
● responsibility for your work
● your client’s responsibilities
● limitation of liability
● fees
● instructions.