AUDITING 3A - 2014

QUESTION BANK : THE AUDIT PROCESS

SUGGESTED SOLUTIONS

QUESTION AP-1

(a) (i) Information

is material if its omission or misstatement could influence the
economic decisions of users taken on the basis of the financial statements. (2)

(ii) Audit Risk and materiality have an inverse relationship. The higher the audit
risk, the lower materiality needs to be in order to reduce audit risk to an acceptable
level, ie the lower the materiality, the larger the extent of audit coverage obtained
will be and the greater the scope will be, ie the greater the amount of audit evidence
gathered on which to base a conclusion. (3)
(iii) Planning materiality:

Stability of indicators

In comparison to the previous year, all items seem to be fairly stable, except for “net profit”, (1) as a
result of high “other expenses” from the previous year, and “Revenue” – possibly as a result of the
incorrect revenue recognition policies applied by the company. (1)

Actual vs budget

Budgeted figures may be used if it seems likely that actual figures will approximate budgeted figures.
(1) Upon calculation (extrapolation) of actual figures for the year, budgeted figures are found in this
case to be well below the expected actual figures and thus unreliable. Actual figures for the year will
thus be used. (1)

Income Statement vs Balance sheet

As the income statement figures have been found to be unreliable (incorrect revenue policies applied)
(1) emphasis would rather be placed on the balance sheet indicators (1)

Actual
Calc: max 5 Actual (extrapolated) (½)
1/01/2011 - 1/01/2011 -
30/11/2011 31/01/2011 Materiality range

Turnover (0.5%-1%) (½) 350,698 382 580 1 913 – 3 826

Cost of Sales 112,439 122 661
Gross Profit (1%-2%) (½) 238,259 259 919 2 599 – 5 198

Other expenses 101,987 111 259

Net Profit (5%-10%) (½) 136,272 148 660 7 433 – 14 866

Total assets (1%-2%)(½) 786,000 786 000 7 860 – 15 720 (1)

Current assets 657,000 657 000
Fixed assets 129,000 129 000

Total equity (2%-5%) (½) 654,879 629 866 12 597 – 31 493 (1)
Note: Students to receive max marks for calculations if correct basis used, i.e. balance sheet
indicators, and range %.

Due to the fact that there were a number of risks that were identified; such as management integrity is
in question and that this is a first time audit client. It would be considered prudent to be more
conservative with our approach to planning materiality, and thus a lower materiality will be chosen.(3)

Thus materiality is set at R8 000 {as long as student decides on an amount – not range – towards the
lower end of range due to high risk} (1)

OR

Due to the instability of the current year (refer above to “stability of indicators”) income statement the
prior year audited figures can also be used as a basis. (1)

Calc: max 5 Actual – prior year

1/01/2010 - 31/12/2010 Materiality range

Turnover (0.5%-1%) (½P) 232,923 1 165 – 2 329 (½)

Cost of Sales 115,274
Gross Profit (1%-2%) (½P) 117,649 1 176 – 2 353 (½)

Other expenses 132,722

Net Profit (5%-10%) (½P) -15,073 754 – 1 507 (½)

Total assets (1%-2%) (½P) 698,000 6 980 – 13 960 (1)

Current assets 525,000
Fixed assets 173,000

Total equity (2%-5%) (½P) 460,700 9 214 – 23 035 (1)

Available 15 : Max 10

b) Nature, timing and extent of audit procedures:

Based on the information provided, it does not appear that SKSC has a very good system of internal
control. (1) Reliance can therefore not be placed on the company’s system of internal control. (1) The
audit approach will be based on the auditors Risk Assessment Procedures (1)

Nature:
No reliance on internal controls, thus no testing of internal controls.
A Substantive audit approach will be used. (1)

Timing:
As no reliance can be placed on internal controls, early verification procedures cannot be
performed(1) Substantive procedures will thus be performed at or post year end. (1)

Extent:
Due to the high risk profile in the company, and due to the fact of that the company does not have an
adequate system of internal control and management lacks integrity, extended substantive
procedures (1) need to be performed in order to reduce detection risk and ultimately overall audit risk
to an acceptable level. (1)

Available 8 : Maximum 5
c) Risks identified at the overall financial statement level:

Integrity / behaviour of management

Management uses company profits for entertainment purposes (1) – these transactions are
illegal as it results in tax evasion (1)
Previous auditors resigned as a result of a disagreement with management – could indicate
that managements integrity is questionable to cause the previous auditors to resign (1)
Management implements incorrect accounting policies – not willing to adopt IAS 18 (1)
Theft of money and manipulation of the accounting records by management (1)
Management believes that implementing a system of internal control is not cost effective (1)

Nature of business

High level of competition in the market – new competitor started operations in close vicinity to
SKSC (1)

Financial Position

The company has made losses since incorporation. Small profit made in the current year.
Uncertainty regarding the company’s ability to continue as a going concern (1)
Unusual pressure on management caused by the increased competition and the past history
of losses creates incentive for management to misstate the financial statements. (1)

Control Environment

There seems to be a weak control environment – management might not be committed to

tight internal controls (1)
Mr Zidane’s lack of experience and knowledge of accounting standards may lead to errors in
the financial statements at an overall level. (1)

General

This is the first year that our audit firm is auditing the company. Reliance must therefore be placed on
the opening balances audited by the previous auditors (1). The risk is thus that opening balances may
be misstated. (1)
Available 11 : Maximum 8

d) Risks at the assertion level for significant account balances

Income received in advance

Risk of understatement as accounting policies have not been applied correctly – income from
subscriptions are accounted for revenue at date of receipts, rather than spreading the subscription
fees over the term of the soccer season. (2)

Assertion: Completeness, cut-off (1)

Accounts receivable

Money is being taken by members of management and the accounting records (accounts receivable
balances) are being manipulated to hide the theft of money. Risk that accounts receivable are
incorrectly stated. (1)

Assertions: Completeness, valuation and allocation (1)

Bank and cash

Risk of understatement as management is stealing cash from the corporate teams. (1)

Assertion: Completeness (1)

Revenue – subscription fees

Risk is overstatement as all income received is recorded, and not allocated on a time-proportion basis
over the soccer season. (1) IAS 18 has not been applied correctly.

Assertion: Occurrence, cut-off (1)

Rent paid – soccer fields

Management is not aware of and does not seems to apply the accrual concept of accounting for rent
paid for the soccer fields. Rent is charged in advance, and at the end of the year, a risk exists that
rent charged for the new year, could possibly be accounted for during the current year (i.e. not
accrued)(1)

Assertion: Occurrence, cut-off (1)

Entertainment Expense

Risk of overstatement as personal/private expenditure of the managers is being paid by the company
and processed as a company expense. (1)

Assertion: Occurrence, classification (1)

Provisions or estimates at year end

There is a tight audit deadline. Risk therefore that post balance sheet events may not be fully
investigated and thus not recorded correctly at year end. (1)
Risks relating to these account balances can thus be over or understatement. (1)
Mr Zidane’s lacks of accounting knowledge could lead to incorrect estimates/ understated provisions.
(1)

Assertions: Either existence or completeness, Valuation (1)

Taxation expense

The incorrect accounting treatment of the revenue recording or the rent expense should not affect the
tax expense account, as taxation principles need to be applied to calculate the tax. (1)

There is a risk however, that the expense may be understated as management has processed
personal entertainment expenditure through the records and would most likely have claimed for them
– reducing their tax bill. (1)
Mr Zidane’s tax knowledge is “shaky” could lead to incorrect tax calculations and result in penalties
from SARS. (1)

Assertions: Completeness, Valuation (1)

Available 19 : Maximum 15

Presentation 2
Logic, layout and handwriting
QUESTION AP-2

a) Pre-engagement considerations (1 mark per area, 1 mark per consideration listed in area)

1. New client investigation. In favour of engagement:

i. Client has good reputation
ii. Client is successful
iii. Good business decision (client would pay audit fee)
iv. Client has good audit record
v. Management integrity appears good
vi. Industry is one we would be associated with.
vii. Consider any litigations/ law suits

2. Skills and competence

i. No information provided in question about the skills therefore do not answer
on skills
ii. Competence: need to mention 2 areas:
1. Potential use of CAATS experts and need for audit software to audit
in electronic environment
2. Budget and means to travel internationally

3. Letter of engagement
i. Mention ISA 210 and the need to agree the terms of engagement via a
written letter of engagement signed by both auditor and client

4. Ethical requirements as per SAICA Code of Professional Conduct are adhered to.
There is no threat to the firm’s independence or self interest threats.
i. Consider reason for previous auditors leaving and consider if a vacancy
exists in accordance with s90 of Companies Act.
(Max 6)

b) Audit strategy refers to Scope, Direction and Timing. (To be assessed in context of
demonstrated level of understanding) MAX 10

1. Matters affecting the scope:

i. It is a statutory audit, being a (Pty) Ltd
ii. The number of locations of warehouses would require travel and/or use of
other auditors
iii. Consider the different legislation required due to the fact that there are
different warehouses in different countries.
iv. The accounting system requires specialized knowledge
v. Use of CAATS and related experts.
vi. Information technology will impact greatly on the performance of audit
procedures
vii. Due to foreign exchange transactions and inventory valuation issues, the
application of IFRS may be complex

2. Matters affecting the timing:

i. Timing of conducting of year end stock counts
ii. Timing of gathering audit evidence from debtors (eg circularisations – when
to perform?)
iii. Timing of audit deadline – 6 weeks after year end
iv. Meetings with management
v. Contact previous auditors and hold discussions with them.

3. Matters affecting the direction:

i. Volume of transactions – appear to be low based on information about
debtors
 ii. Volume of material balances – low in number based on information about
debtors
iii. Management’s system of internal controls – sound and highly technical
iv. Significant business developments – changes in industry (references to being
highly specialized etc)
v. Consideration of contingent liability from the fire in Tokyo.
vi. Assign more experienced staff to deal with high risk account balances.

c) Audit evidence – special considerations (1 mark for item WITH explanation) MAX 4:

1. Inventory
i. Attendance at stock counts will require international travel and/or use of
experts. Refer ISA 501.

2. Bank and cash

i. Send out bank confirmation to gather evidence re FEC Contracts, bank
balances, commitments, obligations etc

3. Debtors Circularisation
i. Due to revaluation requirements of foreign debtors, obtain external
confirmation of foreign currency balances outstanding at year end and re-
perform calculation of year end valuations

4. Attorneys Confirmation
i. Obtain attorneys confirmation due to litigation by client

d) Assertions are :

1. Occurrence (1) – transactions and events that have been recorded have occurred
and pertain to the entity (1)

2. Completeness (1) – all transactions and events that should have been recorded
have been recorded (1)

3. Accuracy (1) – amounts and other data relating to recorded transactions and events
have been recorded appropriately (1)

4. Cutoff (1) – transactions and events have been recorded in the correct accounting
period (1)

5. Classification (1) – transactions and events have been recorded in the proper
accounts (1)
Max 10
QUESTION AP-3

Part A

a. 1. In order to develop an effective audit strategy and audit plan the auditor is required to:
1.1 make a preliminary judgement of “planning” materiality
1.2 obtain an understanding of the accounting and internal control system
1.3 assess the risk of material misstatement
1.4 identify significant risks
1.5 Identify any significant business risks due to the industry conditions, court
cases/ litigations.

2. None of the above can be achieved unless a thorough understanding of the client’s
business is obtained, and hence an effective audit strategy and plan cannot be
developed.

3. The auditor’s understanding of the client’s business is also the framework within which
the auditor exercises professional judgement. In addition to 1.1. 1.3 and 1.4 the
auditor will need to apply professional judgement to numerous important aspects of
the audit engagement e.g.
3.1 evaluating estimates
3.2 recognising conflicting information
3.3 evaluating management’s responses to audit queries
3.4 considering the appropriateness of accounting policies
3.5 developing expectations for use when performing analytical reviews
3.6 Understanding the trends of the industry and economic situations to compare
performance to.

We can ensure that the audit is effective and efficient being able to plan and budget,
managaing resources and staff or the need for experts. Helps provide a good service to the
client.
Obviously, if the auditor does not have a thorough understanding of the business,
inappropriate judgements on important matters may be made, and responses to risks are
likely to be inappropriate.
Max 5

b. I would:
1. conduct a detailed review of the prior year’s audit work papers.
2. review (and update) the permanent audit file.
3. examine any trade journals/articles which may be relevant to the client.
4. Research on the internet or newspapers for relevant articles on the client/ industry.
5. discuss the audit with my audit manager and any members of the previous audit team
who are available.
6. familiarise myself with any legislation applicable to Signage (Pty) Ltd e,g, Road
Transportation Act, (size of signs, colours etc).
7. contact the holding company auditors to discuss such matters as
6.1 content of, and our obligations and duties in respect of, the audit pack e.g.
how questionnaires are to be completed, nature of additional schedules.
 6.2 Reconciliation of inter company/group balances.
6.3 Group accounting policies which must be adhered to by Signage (Pty) Ltd.
6.4 Deadlines and reporting requirements.

8. meet (as soon as possible) with Mr Rock (financial controller) to discuss e.g.
7.1 risks faced by the company/industry as a whole
7.2 accounting policies
7.3 the extent of the cash flow problems (request budgets/ forecasts)
7.4 the relationship with major customers.
7.5 Related Party transactions??

8. meet with Mr Stone to discuss the role of internal audit and review available internal
audit reports e.g. on systems.

9. contact Signage (Pty) Ltd legal advisors or review correspondence with them, to gain
an understanding of any pertinent legal matters, particularly with regard to the
disputes with the provincial and national roads authorities.

10. visit the Durban manufacturing facility to obtain an understanding of the company’s
operations and processes. (System walkthroughs with production manager) Hold
discussions with employees holding discussions with employees/floor managers to gain a
better understanding of operations/ entity

11. review relevant documents produced by Signage (Pty) Ltd

11.1minutes of meetings, particularly the minutes of the monthly meetings between
Mr Rock and Mr Stone
11.2 policy and procedure manuals
11.3monthly financial reports
11.4general correspondence
11.5company publications e.g. newsletters, brochures.

12. perform a preliminary analytical review on the most recent financial data available to
gain an insight into the company’s liquidity, solvency and profitability.
MAX 10

Part B: 2 marks per factor – 1 mark for effect (increase/decrease) + 1 mark for reason

1. Increase of sample size due to increase in the auditor’s assessment of misstatement. The
higher the auditor’s assessment of risk of misstatement, the larger the sample size needs to
be. For example, an assessment of material misstatement as high indicates that the auditor
cannot place much reliance on the effective operation of internal controls with respect to the
particular assertion. Therefore, in order to reduce audit risk to an acceptably low level, the
auditor needs a low detection risk and will rely more on substantive tests. The more audit
evidence that is obtained from substantive tests (that is, the lower the detection risk), the
larger the sample size will need to be.
2. Decrease - The use of other substantive procedures directed at the same assertion. The
more the auditor is relying on other substantive procedures (tests of detail or analytical
procedures) to reduce to an acceptable level the detection risk regarding a particular account
balance or class of transactions, the less assurance the auditor will require from sampling
and, therefore, the smaller the sample size can be.

3. Increase - The amount of misstatement the auditor expects to find in the population (expected
misstatement). The greater the amount of misstatement the auditor expects to find in the
population, the larger the sample size needs to be in order to make a reasonable estimate of
the actual amount of misstatement in the population. Factors relevant to the auditor’s
consideration of the expected misstatement amount include the extent to which item values
are determined subjectively, the results of risk assessment procedures, tests of controls, the
results of audit procedures applied in prior periods, and the results of other substantive
procedures.

4. Decrease - Stratification. When there is a wide range (variability) in the monetary size of
items in the population, it may be useful to group items of similar size into separate sub-
populations or strata. This is referred to as stratification. When a population can be
appropriately stratified, the aggregate of the sample sizes from the strata generally will be
less than the sample size that would have been required to attain a given level of sampling
risk, had one sample been drawn from the whole population.

5. Negligible effect/none - The number of sampling units in the population. For large
populations, the actual size of the population has little, if any, effect of sample size. For small
populations, however, audit sampling is often not as efficient as alternative means of
obtaining sufficient appropriate audit evidence.
QUESTION AP-4

a) Factors that will affect the amount of planning of an audit:

 The auditors understanding of an entity and its environment (1)

 Size of the company (1)
 Complexity of the company (1)
 Previous experience of the entity (1)

b) Factors the auditor will consider in obtaining a knowledge of the company:

As part of the planning stage of the audit, I will obtain a knowledge of the business and document
it in the working papers. (1)

 reference to the previous years working paper files (where possible) as well as
permanent audit file (1)

 through discussions with the following: (1)

- the management/directors of the company (½)
- internal auditors (½)
- consultants and advisors to the company (½)
- knowledgeable parties outside the entity (eg. Other auditors of similar companies)
(½)

 through discussions with the previous auditors of the entity (1)

 publications related to the industry (financial newspapers, trade journals etc) (1)

 Legislation and regulations that significantly affect the entity (1)

 Visits to the entity’s premises and facilities (1)

 Documents produced by the entity (eg minutes of meetings, previous years financial
statements, budgets, management reports) (1)

 General economic factors (1)

 The industry of the client (1)

- the demand for sport/team building for corporate teams ( ½ )
- SA is a country that enjoys sport (½)

 The entity (1)

- Management and ownership of the company (½)
- Business operations (½)
- Financial performance (½)
- Reporting requirements (½)
- Laws and regulations (½)
Available 16 ½ ; Maximum 12

c) Importance of obtaining a sufficient level of knowledge of the entity:

Assists the auditor in:

- assessing the audit risks and identifying problems (1)
- planning and performing the audit efficiently and effectively (1)
- evaluating audit evidence (1)
- providing a better service to the client (1)
QUESTION AP-5

a) Pre-engagement activities

Performed a client investigation

Determine our independence as auditors (1)

Determine the nature of the business and the integrity of management (1)
- the previous auditors resigned as a result of a disagreement with management – possible
indication has questionable integrity
Determine whether the previous auditor has been informed of our appointment
Determine whether management has given us permission to communicate with the previous auditors

If client refuses to give us permission, consider not accepting appointment as auditors

If permission granted, write a letter to previous auditors to determine whether or not there are any
professional reasons not to take on the position as auditors.
If no response, try another means to contact previous auditors, if still no response, assume no
professional reasons not to take on position as auditor
Determine whether the client has the financial ability to pay the audit fee.
Determine whether a casual vacancy exists

Determine skills and competence

Determine whether or not, we as auditors have the necessary knowledge, skills and competence to
take on the engagement – we are a small to medium sized audit firm

Determine terms of engagement

Issue an engagement letter that sets out the responsibility of both management as well as that of us
as auditors

Available 12 ; Max 10

b) 5 components of internal control:

1) Control environment – integrity and ethical values

Competence of employees
Management’s philosophy and operating style
Assignment of authority
Staff development (any 1 example)(2)

2) Risk assessment - Management to ID evaluate and manage risks, estimate likelihood

of occurrence, decide to terminate, transfer, mitigate or accept risks
(any 1 example)(2)

3) Information and communication – System to have clear audit trails, clear

communication to employees (any 1 example)(2)

4) Control activities - Segregation of duties, CIS controls, Physical controls,

operating reviews, Reporting (any 1 example)(2)

5) Monitoring Deviations from actual to expected, rectify weaknesses, confidential

reporting process (any 1 example)(2)
Available 10

c) Inherent risk:
The susceptibility of an account balance or class of transaction to misstatement (1) that could
be material, individually or when aggregated with misstatements in other balances or classes,
assuming that there were no related internal controls.(1)
 Control risk:
Risk that a misstatement will occur in an account balance or class of transaction and that
could be material, (1) individually or when aggregated with misstatements in other balances
or classes, will not be prevented or detected and corrected on a timely basis by the
accounting and internal control system. (1)

Inherent risk and control risk together, has an effect on detection risk (1). If the overall
assessment of inherent risk and control risk combined, is assessed as high, detection risk
must be set as low, in order to reduce overall audit risk to an acceptable level. (1)

If the combined level of inherent and control risk is assessed as low, detection risk may be set
at a higher level.

Available 7

d) Audit strategy:
- Performed after risk assessment and materiality (1)
- Comprises scope, direction and timing (3)
- Refers to audit strategy at a higher level – contains no detailed procedures (1)

Audit plan:

- performed based on the audit strategy (1)

- Puts strategy into detailed procedures and determines(1)
- Nature, timing and extent of procedures (3)

Available 8
Max 5

e) Overall risk assessment at financial statement level should be assessed as HIGH (1), with
the following risk factors having contributed to this assessment:

 Diving is a high risk activity and the potential for liability for negligence on the part of the
company is a high risk item (1)
 Company is listed on the JSE which has more stringent and complex compliance and
disclosure requirements (1)
 The company is reliant on foreign trade and this may pose a going concern risk where
the SA environment may not be deemed to be safe for travel by the foreigners (1)
 Business operates on a largely cash basis which brings inherent risk due to the nature of
cash (1)
 The company has a wide geographical dispersement which may make the control
environment less effective (1)
 The company’s financial system was inadequate and transactions may have been
omitted / misstated / corrupted (1)
 Staff are not familiar with the new system which could lead to errors being made and
remaining undetected (1)
 The IT manager does not appear to have the right level of skill and experience to
manage the IT risks (1)
 The company was found guilty by a court which indicates management is unethical in its
business practices (1)
 The company lost a damages claim and this may give rise to further claims and losses(1)
Available 11
Max 10

QUESTION AP-6
DEVELOPMENT OF THE OVERALL AUDIT PLAN

1. Obtain an understanding of the entity, and its environment

- The homeopathic / pharmaceutical industry is subject to various regulations - gain knowledge
of the legislation / regulations which apply to the industry
- Any valid point with regards to the method of gaining information.

2. Obtain an understanding of the accounting information and internal control systems

- Document the system.
- Study the accounting policies followed.
- Perform a provisional evaluation of controls and determine whether reliance can be placed on
the system.

3. Consider audit risk and the risk of material misstatement

The following inherent risks influence the audit risk and must be considered:
 1st time that our firm is responsible for the audit. (1)
 Audit team and audit partner has no prior experience with the client.
 The company manufactures and sells only 1 product and is thus dependent on the demand in
the market.
 When the product’s patent expires, the company’s going concern might be challenged, unless
the company will be able to compete against its generic rivals.
 The machines used to manufacture the ear drops are designed specifically for the product
and will not be able to manufacture other products to allow the company to diversify its
product range.
 The homeopathic market is small. (1)
 The manufacturing process increases the risk relating to valuation.
 The company’s machine is supplied and serviced by a Hungarian company which increases
the risk in the event that the Hungarian company is no longer willing / able to do so.
 There is a risk relating to the accounting accuracy of the maintenance costs and foreign
currency transactions.
 Seeing that the company is the only one of its type, it will be difficult to find statistical
information for benchmarking purposes. (1)
 Part of the company’s inventory is supplied on a consignment basis. The risk increased
relating to existence, rights and valuation thereof. (1)
 The management director is newly appointed and does not have adequate experience in the
industry.
 The company is currently under financial pressure due to:
o Sales that have decreased during the past year.
o There is pressure on net income as it appears that the company will suffer a net loss.
o Liquidity ratio is decreasing.

4. Determine planning materiality

Stability of indicators:
Figures do not appear stable. The company’s profitability is decreasing.
Forecast or Actual numbers
The question indicated that the forecasted numbers have been reviewed by the auditors and
that we are satisfied therewith. We will use the forecasted numbers.
 Balance Sheet or Income Statement
Users of the financial statements decision making will be influenced by the Income Statement.

Calculation of ranges:
Indicator Range Forecast Lower range Top range
Turnover ½ - 1% 40 000 200 400
Gross Profit 1-2% 4 000 40 80
Net Profit 5-10% (56) - -
Equity 2-5% 400 000 8 000 20 000
Assets 1-2% Not indicated
Percentages (5 x ½)
Calculations (5 x ½)

Conclusion
Decreasing profits can lead to management manipulating results.
A good accounting and internal control environment reduces CR.
Audit risk assessed as medium
Because the net income is not stable, we will use either gross profit or revenue as indicator.

Materiality is set at R200 000 representing the lower range for Turnover. (1)
(Marks awarded for an acceptable level of materiality within the prescribed ranges and for motivation
given).

5. Audit approach (nature, scope, timing)

- As it is a new client, additional procedures must be performed on opening balances.
- Careful consideration should be given to the timing of the inventory counts and debtors’
circularisation.
- The possible use of specialists must be considered.
- There is a time limitation and we must complete our audit before the deadline.

6. Co-ordination, supervision and review and other considerations

- Careful consideration should be given to staff needs.
Maximum 35
Of which presentation: 2
QUESTION AP-7

Part (a)

1. Budgeted indicators are used, as the company appears likely to achieve its budget. (1)

2. All figures reported appear stable. (1)

3. The nature of the company indicates that users of the financial statements may rely on both
the statement of financial position and income statement indicators.

Amount per Materiality Materiality

% Budget Lower limit Upper limit
Turnover 1/2% - 1% 10 000 000 50 000 100 000
Gross Profit 1% - 2% 6 000 000 60 000 120 000
Net income 5% - 10% 2 500 000 125 000 250 000
Total assets 1% - 2% 4 100 000 41 000 82 000
(3)

4. Materiality is set at R80 000 representing the lower to middle range for profit and Revenue
while within the range for assets. (1)

5. Materiality should be set at a conservative level as risk is slightly higher due to this being a
first-time audit and to mitigate the problems associated with under-auditing (in the event of
final materiality revealing a lower level). (1)

Max (6)
Part (b)

NATURE:
 As we have arrived at a favourable preliminary assessment of the risk of material
misstatement, we will probably follow a system-based combination audit approach involving
test of controls. (1)
o This would be necessary in view of the extent of computerisation, the likely
dependence on systems of control for recording sales as well as the tight audit
deadline. (2)
o This would be possible as the company has sound controls, competent management
and accurate management accounts displayed by the reliable budgeted figures. (1)
 If a combination audit approach is adopted, we would need to perform detailed evaluations of
key internal controls.
o This would include both computerised and manual controls. (1)
o If computerised application controls are to be tested, a review of the general control
environment must be performed. This may require the use of system based CAATs.
(2)
 The combination system-approach would enable us to reduce the extent of substantive
testing.
o Detailed testing would be reduced and be more reliable in order to perform analytical
review procedures. (1)
o The use of analytical procedures is strengthened by the accurate management
accounts and the probably similarities between various fast food outlets in the
industry. (1)
o The use of data CAATs may enable us to further reduce test of detail (TOD). (1)
TIMING:
 Due to the tight audit deadline and strong controls, we are likely to perform most verification
procedures in advance of the year-end, i.e. interim audit procedures, and then perform roll-
forward procedures. (2)
 The services of a CAATs specialist may be required. We would also need to consider access
to the computer environment and scheduling of audit staff, including the expert (specialist). (1)

EXTENT:
 Materiality of R80 000 will determine the sample sizes. (1)
 Due to the medium risk profile of the company, and due to the fact that the company has an
adequate system of internal control, substantive procedures will not have to be as extensive
as the audit approach includes test of controls. (1)
 Sufficient procedures must be performed to reduce the overall audit risk to an acceptable
level. (1)

QUESTION AP-8

1) Steps in the audit sampling process:

1. Objective√: to establish the objectives of the audit procedure, ie they type of audit evidence
that we are seeking to gather and over which assertion or item√
2. Determine the procedure√: to establish the actual audit procedure that must be performed in
order to gain the evidence required√
3. Confirm the completeness and appropriateness of the population√: in order to ensure that the
population is the same as that on which an opinion must be expressed and that the data
being used is complete an up to date in this regard, and will provide the most appropriate
audit evidence to address the audit objective√
4. Define the units of the population√: to ensure that the sampling is applied to and the
identification of items is done on the correct units that make up the population, so that a true
result can be obtained on which a conclusion on the sample may be extended to the
population√
5. Determine the sample size√: with reference to the influencing factors, being confidence level,
tolerable misstatement, expected misstatement and the population size√
6. Select the sample√: to ensure that a sample of the correct size is selected in the method most
likely to produce a sample that is representative of the population, using one of the following
methods: random, systematic, haphazard or block√
7. Perform the audit procedures√: carrying out the intended procedure on the sampling units
selected in the sample size√
8. Analyse the nature and cause of deviations and misstatements√: to determine whether they
are anomalous or recurring and their effect on the evaluation√
9. Project the sample results over the population√: to extrapolate the error rate in a sample over
the population to identify the potential misstatement in a population√
10. Evaluate√: to compare the projected error against the tolerable misstatement√
Marks 20 ; Max 15
2) Error 1 is an anomalous error and will not be projected. √
An anomaly is a misstatement or deviation that is demonstrably not representative of
misstatements or deviations in the population , i.e. one in which the circumstances giving rise
to the error are not deemed to carry a risk of recurrence in the remaining balance of the
population. √√
Errors 2 and 3 are deemed to be recurring errors and must be extrapolated across the
population to estimate the error in the population. √
 Recurring errors are deemed to be representative of errors or misstatements in the
population, and the weaknesses in the internal control system which resulted in the error are
of such a nature that they would have recurred throughout the population. √√
Marks: 5

QUESTION AP-9

Working paper heading: Risk assessment and materiality (1)

Client: Pills (Pty) Ltd (1) File reference: P2/2 (1)
Year end: 31 May 2012 (1) Prepared by: A Student (1)
Date: 08-Jun-12 (1) Reviewed by: A Moderator (1)
Max 5 (working paper format)

a) Inherent risk assessment at financial statement level is assessed as high (1) due to the following
reasons:
1. Poor control environment as no standard approach followed by all companies in group – each
company’s management encouraged to use their “entrepreneurial spirit” (1)
2. Management compensation based on entrepreneurial spirit applied (1)
3. And performance of the company (1)
4. Poor financial results to date (1)
5. Possible liquidity problems (1)
6. Possible payment of bribes (1)
7. Possible non-compliance with laws and regulations relevant to pharmaceutical companies (1)
i.e. alleged price fixing and fast-tracking of registration
8. Possible supply problems related to imported raw materials may cause going concern
problems. (1)
9. Foreign transactions may result in misstatements due to inappropriate application of foreign
exchange rates. (1)
10. Possible pressure by management of holding company on management of subsidiary to
manipulate financial statements OR manipulation by management of subsidiary to meet
expectations of holding company. (1)
11. New audit client therefore risk related to opening balances & lack of knowledge regarding
client history. (1)
12. The new computerised system: (2)
 We have no background on this system and may have difficulty in obtaining it.
 We were not involved in the conversion which increases the risk of not detecting
incorrectly converted accounts.
 The staff of Popping Pills (Pty) Ltd may still be unfamiliar with data capture and
preparation procedures for the accounting system. This adds to the risk of errors
and/or misstatement being undetected by internal controls and could affect numerous
assertions.
Max 12 (risk assessment)
b) Materiality (max 8):

Indicator Revenue, or
Net income before tax (1)
Reason Company is profit driven;
Investors will rely on these figures;
Holding company interested in these results. (1)
Financial statements used Actual 2011 (1)
Reason Budget not used due to recent events in company and do not
represent actual achievable results (1). Recent events in
company and system conversion might have an effect on
company’s actual current 2012 results. (1)
2010 results outdated
Calculation (3) Actual 2012: Revenue ½% - 1% 260k * 12/9 = 347k 1 735 - 3 470
Net income 5% - 10% 21 000 * 12/9 = 28k 1 400 - 2800
Actual 2011: Revenue ½% - 1% 370 000 1850 - 3700
Net income 5% - 10% 32 000 1 600 - 3 200
% Conservative percentage due to high risk audit client;
Lower % due to possible manipulation in light of information
provided. (1)
Conclusion Planning Materiality set at R1 400 (1)
A mark was awarded if the student concluded on a materiality
amount based on their own calculations.
QUESTION AP-10

PART A

a) 1. Servicing the client (ISA 220 and ISQC 1) (1)

1.1 the firm would have had to decide whether the firm had, or had access to, the
necessary technical competence (1) to service this client.
* the previous auditors felt compelled to resign the audit despite having
acted for many years as they did not have these attributes.
1.2 as this is a large company the firm must be satisfied that it has the necessary
resources and time to perform the audit, e.g. staff members available to deal
with the 31 July year end, a particularly busy period for our firm. (1)

2. Ethical requirements – Independence (ISA 220 and ISQC 1) (1)

2.1 A potential problem here is the fact that senior partner is providing other
services in the form of tax consulting to the family. (1) The nature of the
relationship between your senior partner and the Zee family members must
be considered. If the relationship is such that other parties, such as the
investment bank, might question the ability of our firm to provide a truly
independent audit opinion, then the engagement should not have been
accepted. (1)
2.2 On the other hand the business is essentially a "family" business and if
independence is not impaired, it would make sense for the family to
consolidate their professional relationship with our firm.(1)

3. Integrity of Hipvibes (Pty) Ltd’s management (ISA 220 and ISQC 1) (1)
As the firm already has a professional relationship with the management of the firm,
we should be satisfied with the integrity of the directors. (1)

4. Establishing a professional relationship - Sound business decision (1)

4.1 The firm would also have considered whether there were any negative
aspects to taking on Hipvibes (Pty) Ltd. (1)

4.2 An important point here is the potential high audit risk (1) arising out of the
nature of the business. The potential for material misstatement in inventory
and revenue and debtors, key account headings in both the balance sheet
and income statement is high. The firm must be confident that it is not laying
itself open to unnecessary risk of litigation, etc. (1)

Also marks may be awarded for listing as per the 3 stages

Client acceptance issues or similar (1)
Capacity skills competence requirements or similar (1)
Establishing the terms of the engagement or similar (1)
Available marks: 16
Maximum: 10
PART B

b) 1. Account Balance : Property - low risk (1)

Justification
1.1 None of the assertions relating to the property will present any difficulties. (1)
* existence - simple physical inspection. (1)
* completeness - one property only and no incentive to include
fictitious properties (1)
* rights - no encumbrances (1)
* valuation - cost is easily established and as the property is
situated in a sought after area (the market value is unlikely
to be below cost). (1)

2. Account balance – Foreign Debtors – high risk (1)

 Justification
2.1 Debtors represent a material amount of current assets and material
misstatement could therefore occur in the account balance.(1)

2.2 Foreign debtors increase audit risk in the risk that not all debtors included in
the balance actually exist. (1)

2.3 As debtors are foreign the risk of material misstatement relating to the
valuation (1) assertion is increased.
* determining the recoverability (1) of the debts may be more difficult.
* incorrect conversion rates and transaction dates may be used when
converting foreign currency invoices to rand values, resulting in
incorrectly valued debtors (debtors are valued in foreign currencies).
(1)
2.4 Local debtors – high risk (1)
* valuation – because debtors are only invoiced if they are completely happy,
the amount of the debt cannot be established until a month after the sale (1),
and because credit terms are so generous (60 days), debts may not be
collected easily (pple take advantage) (1)
* completeness – because debtors are only invoiced a month after the items
have been fitted, debtors owing at year end and not yet invoiced may not be
recognized as debtors (1)
*rights – because debtors have no contractual obligation to pay for the goods
in the first month, there may be doubt as to whether the debtors may be
sufficiently owned by the company (1)

3. Account Balance - Inventory - High risk (1)

Justification
3.1 Inventory in its various forms represents a high value of current assets and of
total assets. (1)
3.2 In a company like this inventory is fundamental to fair presentation as
numerous figures in the financial statements would be affected by material
misstatement in the account heading, e.g. profit, taxation, current assets, etc.
(1)
3.3 As the items are so state-of-the-art and desirable in nature and are imported
(1), the inherent risk relating to the existence and valuation assertions is
significant. (1)
* when attempting to test pricing of the raw materials to invoices we
will be unable to determine whether the invoice presented to us
refers to the item of inventory we are attempting to price (foreign
currency) (1)
* although finished goods and work in progress can be identified to a
job card, we would still be unable to determine whether the costs
allocated to the job are correct (1)
* when attending the inventory count we will probably not know what
we are looking at. (1)
* we will have difficulty in establishing what to include in inventory
where items have been fitted into customers’ vehicles but have not
yet been invoiced therefore completeness carries a high
misstatement risk (1)

3.4 The risk associated with the valuation assertion is increased by the following
factors:
3.4.1 determining cost is complicated by the fact that:
* items are imported, involving currency translation, (correct
conversion dates and rates? forward cover?). (1)
* import duties, freight charges must be correctly calculated
and included in the cost calculation. (1)
 3.4.2 determining whether the net realisable (1) value of each unique item
will be very difficult and risk is increased as:
* there is no standard price list to compare the item to (each
piece is unique). (1)
* MP3 players run a very high risk of technical obsolescence
(1)
* there is a small risk from the fact that stock items may not be
supplied in future or that supply will take too long due to the
current economic circumstances in Japan and its adverse
affect on supply globally. (2)
3.4.3 the previous valuator has retired
* there may not be consistency between the assumptions and
methods (1)

4. Account Balance - Current Liabilities – medium (1)

4.1 The completeness assertion (1) is normally the one most at risk with current liabilities.
However, as Hipvibes (Pty) Ltd has a very limited number of long standing suppliers,
there is little risk that the account heading could be understated materially, and
should be easily picked up by comparison to prior year creditors on the list. (1)

4.2 Risk relating to the valuation assertion may be slightly increased by the fact that there
are foreign creditors. (1)
* use of the correct transaction date and conversion rate in establishing the
amount owed. (1)
* forward exchange contract complications. (1)

Available marks: 40
Maximum: 40