AUDITING QUESTIONS & SOLUTIONS

Question 1
Econet Co is a major communication provider that has extended its operations throughout
Zimbabwe and recently to South Africa where it is trading rapidly.
You are a manager in Nkiwane, a firm of Public Accountants. You have been approached by
Tariro Mhindu, the Chief Finance Officer of Econet, to advice you on a bid that Econet is
proposing to make for the purchase of Telecel. You have ascertained the following from the
briefing note received from Miss Tariro.
Telecel provides training in management, communications and marketing to a wide range of
corporate clients, including multi-nationals. The “TELECEL” name is well regarded in its areas of
expertise. Telecel is currently wholly-owned by Frontiers, an international publisher of
textbooks, whose shares are quoted on International Stock Exchange. Telecel has a National
and an International Businesses. The National Business comprises 11 training centres. The
audited financial statements show revenue of $12,5 million and profit before taxation of $1,3
million for this geographic segment for the year to 31 December 2014. Most of the National
business’s premises are owned or held on long leases. Trainers in the National business are
mainly full-time employees.
The International Business has five training centers in South Africa and Malawi. For these
segments, revenue amounted to $6, 3 million and profit before tax $2, 4 million for the year to
31 December 2014.Most of these International Business’s approaches are on operating leases.
International Trade receivables at December 2014 amounted to $3, 7 million. Although the
International centers employ some trainers full time, the majority of trainers provide their
services as freelance consultants.

Required;
(a) Define “due diligence” and describe the nature and purpose of due diligence review.
(4marks)

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(b) Explain the matters you should consider before accepting an engagement to conduct a due
diligence review of Telecel Co (8 marks)
(c) Illustrate how;
i. Inquiry; and
ii. Analytical procedures
Might appropriately be used in the due diligence review of Telecel Co (8marks)
(d) You are the audit trainee manager and have been given the following scenarios from which
you will be requested to respond to:
(i) The audit senior in charge of the audit of Margot Bank Co has a personal loan from
the bank of $2,000 on which she is currently paying 13% interest.
(ii) The audit partner is responsible for two audit assignments, Harry Co and Jean Co.
Harry Co has recently tendered for a contract with Jean Co for the supply of material
in quantities of goods over a number of years. Jean Co has asked the audit partner to
advice on the matter.
Required
Discuss the above situations in the context of the independence of the auditor, showing clearly
the principles involved (5 marks)

Suggested Solution 1
Due diligence review
Before purchasing a company, it is crucial that the purchaser undertake a comprehensive
survey of the business in order to avoid any operational or financial surprises post-acquisition.
Due diligence can simply be seen as ‘fact finding’, and as a way to minimise the risk of making a
bad investment.

Purpose of due diligence.

Information gathering

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Investigative due diligence is the process by which information is gathered about a target
company, for the purpose of ensuring that the acquirer has full knowledge of the operations,
financial performance and position, legal and tax situation, as well as general commercial
background. Essentially the aim is to uncover any ‘skeletons in the closet’ and therefore to
reveal any potential problem areas before a decision regarding the acquisition is made.
For example, the target company may have taken out debt finance. It is crucial for the acquirer
to understand the terms of any debt covenant attached to such finance, and to know if there is
a history of Target Company defaulting on payment to the provider of that finance. This
information is unlikely to be available unless a detailed due diligence investigation is carried
out.

Verification of specific management representations

Additionally, the vendor may make representations to the potential acquirer which it is
essential to verify. For example, the vendor of the target company may state that the company
has never been the subject of a tax investigation, or that the company fully complies with all
relevant health and safety regulations. Due diligence work should substantiate such claims.

Identification of assets and liabilities

From an accounting perspective it is crucial that all of the assets of the target company are
identified. This is important because internally generated intangibles such as customer
databases, trademarks, and brand names are unlikely to be recognised in the individual
company statement of financial position (balance sheet), but should be identified and valued
for the purpose of calculating goodwill on acquisition. As these assets are, by definition,
without physical substance, only a detailed due diligence investigation will uncover them.
As well as being important for the goodwill calculation, it is crucial to identify these assets as
they represent ‘hidden wealth’ within the target company, and should be taken into account
when negotiating the acquisition price.
Contingent liabilities must also be identified, as the acquirer will need to understand the
likelihood of the liability crystallizing, and the potential financial consequence. Intangible assets

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and contingent liabilities are notoriously difficult to value, and the directors of the predator firm
could choose to have the valuation performed as part of the due diligence exercise, as they
themselves are likely to lack this expertise.

Operational issues
As discussed above, one of the key benefits of due diligence is to discover problems or risks
within the entity. These risks may not necessarily arise in the context of a contingent liability,
but could instead be operational issues such as high staff turnover, or the need to renegotiate
contract terms with suppliers or customers. The directors of the acquiring company will need to
carefully consider whether such matters constitute deal breakers, in which case the investment
would be considered too risky and so would not go ahead. Alternatively, the risks uncovered
could be useful in negotiation to reduce the consideration paid, or the target company could be
asked to provide assurance that these problems will be resolved pre- acquisition.

Acquisition planning
The due diligence investigation will also assess the commercial benefits, and potential
drawbacks, of the acquisition. On the positive side, it will highlight matters such as expected
operational synergies to be created post acquisition, and potential economies of scale to be
exploited. On the downside there will be acquisition expenses to pay, costs in terms of
reorganisation and possible redundancies, as well as the important but hard to quantify issue of
change management. The due diligence provider may be able to offer recommendations as to
the best way to integrate the new company into the group.

Management involvement
Due diligence investigations can be performed internally, by the directors of the acquiring
company. However, this can be time consuming, and the directors may lack sufficient specialist
knowledge to perform the investigation. Therefore one of the purposes of an externally
provided due diligence service is to reduce time spent by the directors on fact finding, leaving

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more time to focus on strategic matters to do with the acquisition and on running the existing
group.

Benefits of using an audit firm for due diligence

There is no reason why an accountancy firm, such as the firm’s auditors, should be engaged to
carry out due diligence. Management could do some or all the work themselves. However
using an external firm to do the work has potential benefits:
 An external investigation will provide an independent, impartial view on the situation,
enhancing the credibility of the investment decision, and the amount paid for the
investment.
 Hiring an external firm to do the work saves management time for the potential buyer. In
addition, the accountants assigned to the due diligence work should have suitable
experience in this type of work. For large takeover, the amount of time and resources
required to carry out proper due diligence can be substantial.
 Using a professional firm to do due diligence may help to reassure shareholders in the
potential buyer (or investors who will be asked to provide loan finance for the takeover)
that the acquisition has been properly evaluated

Scope of a due diligence assignment compared to an audit

When conducting a due diligence assignment, the scope is focused, as discussed above,
primarily on fact finding. This means that although the most recent set of financial statements
will form a crucial source of information, the investigation will draw on a much wider range of
sources of information, including:
– Several years prior financial statements
– Management accounts
– Profit and cash flow forecasts
– Any business plans recently prepared
– Discussions with management, employees and third parties.

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The aim of due diligence, in contrast to an audit, is NOT to provide assurance that financial data
is free from material misstatement, but rather to provide the acquirer with a set of information
that has been reviewed. Consequently no detailed audit procedures will be performed unless
there are specific issues which either cause concern, or have been specifically selected for
further verification. For example, the acquirer may specifically request that the due diligence
exercise provides an estimate of the valuation of acquired intangible assets, as discussed above.
The type of work performed will therefore be quite different, as a due diligence investigation
will primarily use analytical procedures as a means of gathering information. Very few, if any
substantive procedures would be carried out, unless they had been specifically requested by
the client.

Due diligence is much more ‘forward looking’ than an audit. Much of the time during a due
diligence investigation will be spent assessing forecasts and predictions. In comparison audit
procedures only tend to cover future events if they are directly relevant to the year-end
financial statements, for example, contingencies, or going concern problems.
In contrast to an audit, when it is essential to evaluate systems and controls, the due diligence
investigation will not conduct detailed testing of the accounting and internal control systems,
unless specifically requested to do so.

It can be seen that due diligence provides necessary information for the directors of an
acquiring company to decide whether to go ahead with an acquisition, the timing of the
acquisition, the value of consideration to be paid, and to assess the operational impact of the
acquisition. Due diligence should be viewed as a risk management tool, which is crucial when a
significant acquisition is being considered. That a due diligence exercise has taken place will
increase stakeholder confidence in the acquisition decision.

Question 1

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(iii) As another instance of where financial involvement in a client's affairs could be seen to
impair an auditor's objectivity, the code recommends that between an auditor and a client,
there should be no loans or guarantees in respect of loans either way. Any such financial
involvement could be seen to impair the auditor's judgement either because of a client putting
pressure on the auditor or because of the auditor's own fear of suffering some financial loss.
However, the code does allow for one exception in making the above recommendation and
that is where the loan is 'in the normal course of business and on normal commercial terms',
providing it is not to the engagement partner (i.e. allowed for other audit staff members and
practice partners). It is part of a bank's normal business to make personal loans and if the rate
of interest being paid by the audit senior is the normal commercial rate of interest, this
transaction is unlikely to be seen as impairing the auditor's independence.

(iv) The code also considers the problems that can be created when conflicts of interest arise
between different clients and between clients and the auditor's own business interests. It
concludes that every effort should be made to avoid conflicts of interest arising and that it
would be highly unethical for an accountant to act in a situation where he knew that a conflict
of interest existed. The situation described in the question is a good example of the type of
conflict of interest with which the code is concerned. The audit partner should not advise Jean
Co with regard to the contract tender received from Harry Co. The auditor should explain the
professional reasons why he is unable to act on this occasion and suggest that Jean Co seek
advice from another firm of accountants.

QUESTION 2
You are the audit senior assigned to the audit of Ziso Repovo Manufacturing. The audit
manager has asked you to plan the audit of non-current assets for year ending 31
March 2007. He has provisionally assessed materiality at $52,000.
Ziso Repovo Manufacturing maintains a register of non-current assets. The management
accountant reconciles a sample of entries to physical assets and vice versa on a three-monthly
basis. Authorization is required for all capital purchases. Items valued less than $12,000 can be

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authorized by the production manager, items costing more than $12,000 must be authorized by
the Managing Director. The purchasing department will not place an order for capital goods
unless it has been duly signed. The company has invested in a large amount of new plant this
year in connection with an eight year project for a government department.

The management accountant has provided you with the following schedule of non-current
assets:
accountant has provided you with the following schedule of non-current assets.
Land and Plant and Motor
buildings equipment Computers vehicles Total
$ $ $ $ $
Cost
At 31 March 20X6 500,000* 75,034 30,207 54,723 659,964
Additions 250,729 1,154 251,883
At 31 March 20X7 500,000 325,763 31,361 54,723 911,847
Accumulated depreciation
At 31 March 20X6 128,000 45,354 21,893 25,937 221,184
Charge for the year 8,000 28,340 2,367 13,081 51,788
At 31 March 20X7 136,000 73,694 24,260 39,018 272,972
Carrying amount
At 31 March 20X7 364,000 252,069 7,101 15,705 638,875
At 31 March 20X6 372,000 29,680 8,314 28,786 438,780

*Of which, $100,000 relates to land and the rest are leased property.
Required
(a) Without undertaking any calculations, assess the audit risk of the tangible non-current
assets audit (10 marks)
(b) State the audit procedures you would undertake on non-current assets in respect of the
following assertions:
(i) Existence (3 marks)
(ii) Valuation (excluding depreciation) (4 marks)
(iii) Completeness (3 marks)
(c) What evidence does the audit manager expect to find in your audit working papers?(5
marks)

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Suggested Solution 2
(a) Risk in the tangible non-current asset audit
Control risk
The controls over non-current assets at Ziso Repovo Manufacturing appear to be strong. The
company maintains and reconciles a non-current asset register and there are authorisation
procedures in operation. These controls should be tested, and if they prove effective, control
risk could be assessed low.

Inherent risk
The tangible non-current assets are material on the basis of the proposed materiality level.
There has been a substantial movement on the plant and equipment account this year, but this
appears to be supported by the information given by the management accountant. There
appear to be no disposals in the year, which may indicate that they have been omitted, or that
obsolete items are included in the register. It is also unclear whether land is being depreciated.
It would be inappropriate if it was being depreciated. Overall, the inherent risk seems to be
medium.

Detection risk
Given that inherent risk has been assessed as moderate and control risk has been assessed as
low, detection risk will be assessed as higher. However, there is usually good evidence in
relation to the existence and valuation of non-current assets and these are the key assertions
which the auditors are interested in. There will also be scope to carry out good analytical
procedures, such as proofing-total of depreciation.

Conclusion
The audit of non-current assets appears to be medium to low risk.

(b) Audit procedures

(i) Existence

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In many cases it is self-evident that land and buildings exist. However, it is important for the
auditors to verify all components of land and buildings contained within the statement of
financial position, if they are on a site different to the one which the auditors are primarily
attending, for example. Land and buildings should also be verified to title deeds to ensure that
they not only exist, but that they are owned by the client.
The other classes of asset should be inspected. A sample of assets from the register should be
agreed to the physical asset. There may be scope to rely on the work that the management
accountant has undertaken here. The auditor should check a reconciliation which the
accountant has performed. The auditors should make use of any identification marks on assets
recorded in the register, for example, security tags or bar codes which are kept on assets to
distinguish them. The auditor should inspect the condition of the assets and ensure that they
are in use.
The motor vehicles should be reconciled in terms of number of vehicles existing at the opening
and closing positions. Again, to ensure that they not only exist, but are owned by the company,
the auditors should check the registration documents to ensure that the company is the
registered owner.
For all the above assets, the external auditor should also review the insurance provision for the
assets. This gives third party evidence of the existence of assets as the insurer would not insure
an asset which did not exist.

(ii) Valuation (excluding depreciation)

Land and buildings appear to be stated at historic cost as the schedule does not contain the
words 'at valuation'. The auditors should confirm that this is the case with the management
accountant. The cost can then be agreed to brought forward figures as there have been no
additions in the year. These figures will have been audited in the previous year. If the assets are
held at valuation, the auditors must ensure that the requirements of IAS 16 in relation to
revaluations are being complied with.
Similarly, as there have been no movements in the year, motor vehicles can be agreed to the
opening position.

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To audit the valuation of plant and computers, the auditors should agree the opening position.
They should then obtain a schedule of additions to non-current assets, which can be agreed to
purchase invoices to verify valuation.
Lastly, the auditors should investigate whether the cost figures include any fully-written down
assets. This is implied by the fact that the depreciation charge on plant excluding additions is
low. If so, the auditor should find out whether these assets are still in use, and if not, consider
whether they should be excluded from the cost and accumulated depreciation figures
contained within the notes to the accounts. Excluding them would have a net effect on the
reported figure of $0.

(iii) Completeness
The schedule of non-current assets prepared should be reconciled to:
 The opening position (that is, the previous statement of financial position)
 The closing position (what is disclosed in the financial statements)
 The underlying records (the nominal ledger)

If the non-current asset register contains details of the cost and accumulated depreciation of
each asset, the register should also be reconciled to the schedule. Explanations should be
sought for any differences.
The additions of the schedule should also be checked to ensure that the opening and closing
positions reconcile within the schedule.
The auditors should also carry out a test on some of the individual additions, tracing the
transaction through the system, from purchase orders to delivery notes and invoices and
through the ledgers to the financial statements to ensure that additions have been included
completely.

(c) Depreciation
(i) Appropriateness
The appropriateness of the rates should be considered and discussed with management.

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Relevant factors to consider are matters such as:
 The replacement policy for the asset
 The pattern of usage in the business
 The purpose of the asset being owned

In this instance, the auditors should establish the rationale behind the depreciation rates
applied, particularly in the case of plant. In the case of the plant purchased this year, the
depreciation rate applied is 10%. However, the assets have been purchased in relation to an 8
year project, so 12.5% might be a more appropriate rate.

(ii) Audit procedures

Depreciation on buildings can be verified by agreeing the purchase date of the buildings to last
year's file or historic invoices/purchase documents and the valuation applied to the building
portion.
For the other classes of asset, depreciation should be agreed for individual assets, as it is not
possible to agree them in total. The auditors should obtain a breakdown of the charges for the
year. They should be able to recalculate the depreciation from details in the noncurrent asset
register and compare the results.

QUESTION 3
You are the audit manager of Builders World Merchants, a listed company which distributes
building and construction material in the five provinces of Zimbabwe. You are finalizing the
audit for year 31 December 2014 .From the working papers you obtained the following
exceptional matters;
(i) Included in trade receivables, which total $980 00 is a debt amounting to $150,000 from
customer who went burst on 20 January 2015.You have ascertained from the liquidator
that your client is unlikely to receive a distribution. The statement of comprehensive
income for the year shows a pre-tax profit of $100 000 and the directors is not prepared
for this debt.

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(ii) The financial statements of Builders World Merchants do not contain a statement of
cash flows
(iii) Builders World Merchants operates a warehousing and distribution service, and owns
120 properties. During the year ended 31 December 2014, management changed its
estimate of the useful life of all properties, extending the life on average by 10 years.
The financial statements contain a retrospective adjustment, which increases opening
non-current assets and equity by a material amount. Information in respect of the
change in estimate has not been disclosed in the notes to the financial statements.
(iv) The financial statements do not disclose the fact that a director’s wife was using a
company vehicle worth $10 000 which was to be depreciated over ten years.
Required.
For each of the above scenarios
(i) Identify the implications on your audit opinion? (18 marks)
(ii) Draft the relevant paragraph (s) of your report. (7 marks)

Suggested solution 3
(a) This represents a material misstatement. The debt represents 8% of the total receivables
balance and 45% of the profit for the year. The auditor’s opinion would be qualified. The
basis of qualified opinion paragraph would refer to the fact that the customer is in
liquidation and there is little prospect of payment. It would also state that net assets and
profits are overstated by $45,000. The qualified opinion paragraph would state that "except
for" the absence of this allowance the financial statements present fairly, in all material
respects (or give a true and fair view).

(b) As the client is listed, its financial statements should include a statement of cash flows. The
auditor’s opinion should therefore be qualified as the financial statements are materially
misstated. This disagreement is not pervasive to the financial statements, it is limited to the
statement of cash flows, so this would be a qualified opinion. The basis of qualified opinion
paragraph will refer to the fact that the financial statements do not contain a statement of

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 cash flows and include the figures required, and the qualified opinion paragraph will state
that the financial statements give a true and fair view and have been properly prepared in
accordance with an applicable financial reporting framework except for the omission of a
statement of cash flows.

(c) The auditors need to determine whether the legal claim is a material matter and even
whether it is pervasive to the financial statements as a whole. For example, if the customer
involved is a major customer, it could be that an adverse outcome could affect the going
concern basis of the company. It appears that the disclosure in the financial statements is
adequate and there appears to be no basis on which to make a provision in the financial
statements. However, the auditor’s report will be affected by the fact that there is an
uncertainty affecting the business. The auditor will have to decide whether the inherent
uncertainty is fundamental to users’ understanding. If so, the auditor’s report should
include an emphasis of matter paragraph beneath the opinion paragraph with details of this
matter. It should also state that the auditor’s opinion on the financial statements is not
modified in relation to this matter.

Question 4
You are the audit manager for Patison, a limited liability company which sells books, CDs, DVDs
and similar items via two divisions which are the mail order and online ordering on the Internet.
Patison is a new audit client. You are commencing the planning of the audit for the year ended
31 May 2015. An initial meeting with the directors has provided the information below.
The company’s sales revenue is in excess of $85 million with net profits of $4 million. All profits
are currently earned in the mail order division, although the Internet division is expected to
return a small net profit next year. Sales revenue is growing at the rate of
20% p.a. Net profit has remained almost the same for the last four years. In the next year, the
directors plan to expand the range of goods sold through the Internet division to include toys,
garden furniture and fashion clothes. The directors believe that when one product has been
sold on the Internet, then any other product can be as well.

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The accounting system to record sales by the mail order division is relatively old. It relies on
extensive manual input to transfer orders received in the post onto Patison’s computer
systems. Recently errors have been known to occur, in the input of orders, and in the invoicing
of goods following dispatch. The directors maintain that the accounting system produces
materially correct figures and they cannot waste time in identifying relatively minor errors. The
company accountant, who is not qualified and was appointed because he is a personal friend of
the directors, agrees with this view,
The directors estimate that their expansion plans will require a bank loan of approximately $30
million, partly to finance the enhanced web site but also to provide working capital to increase
inventory levels. A meeting with the bank has been scheduled for three months after the year
end. The directors expect an unmodified auditor’s report to be signed prior to this time.
Required:
(a) Identify and describe the matters that give rise to audit risks associated with Patison.(8)
(b) Explain the enquiries you will make, and the audit procedures you will perform to assist you
in making a decision regarding the going concern status of Patison in reaching your audit
opinion on the financial statements. (10)
(c) Explain the difference between negative and positive assurance in the context of the
external audit and review engagements. State some of the limitations of the external audit.
(7)

Suggested Solution 4
(a) Matters giving rise audit risk in Patison
Overtrading
The turnover of Patison is growing quite rapidly, although this growth is not matched in net
profits. The company has been expanding into the Internet, and plans to introduce other
product lines for sale in this division. There is the risk that the business will exhaust any cash
reserves as it continues to expand but does not generate sufficient additional cash to pay for
that expansion. In this situation suppliers may go unpaid and at the extreme the business will

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be forced into liquidation. Therefore the financial statements may not adequately disclose
doubts about going concern.

Internet trading
The decision to expand the Internet business may cause other problems for Patison. Selling of
books and CDs appear to be related as they are both forms of entertainment and the customer
knows what the product is like. Selling toys may fall into a similar category, but garden furniture
and clothes are different. Garden furniture is bulky and will certainly cost more to deliver while
clothes are sold more on taste and a high level of returns can be expected. Specific risks with
this decision therefore relate to:
 the overall ability of management to run the business given their apparent lack of
knowledge of Internet trading
 the need to setup and manage systems for the sales of many new products
 the need to allow for a much larger volume of returns
 the possibility of inventory obsolescence if Patison overstocks on clothes which go ‘out
of fashion’

Control environment
The whole environment in which the control systems should be operating appears weak. There
are errors in the systems, the extent of which are not known, and the directors and the
accountant do not appear to be inclined to attempt to remedy the situation. The skills of the
accountant may also be questioned because he appears to have been appointed not on merit,
but from some personal relationship with the directors. Other errors may also have occurred
which have not been detected. The risk is that the financial statements may have material
errors in them.

Bank loan
The directors require additional finance to expand the business. To provide this finance it is
likely that the bank will require sight of the audited financial statements; the directors of

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Patison expect the audit to be completed prior to meeting the bank. The auditor may need to
write to the bank to disclaim reliance on the audit report for the purposes of making a bank
loan. There is a risk to the audit firm of being sued if the bank relies on the report and sustains
financial loss. There is also a risk to Patison that the loan is not obtained and the company goes
into liquidation. The financial statements may need to be prepared on a breakup basis.

First year of audit

The audit is also risky for the audit firm because it is the first year of an audit and the client has
expectations about the type of auditor’s report to be produced. The accounting systems also
appear to be unreliable, again increasing the risk of material error. The audit firm must ensure
that sufficient time and resources are allocated to the audit to ensure that the audit opinion
can be supported. Pressure from the directors to complete the audit quickly will have to be
resisted.

(b) Going concern work

 Review the financial position of the company in detail. Budgets and cash flow forecasts
showing income and expenditure for at least the next 12 months must be reviewed. The
accuracy of these forecasts can be determined in part by checking how accurate past
forecasts were. If the directors have not produced this information, then the auditor will
ask them to produce it.
 If not already done so, obtain a standard audit bank confirmation letter. Check the letter
for overdraft and loan facilities to ensure that they have not been exceeded. Also check
review dates (although it appears this will be three months after the end of the year)
and confirm with directors what accounting information will be expected at these dates.
 Review correspondence with the bank for signs of strain with the bank. A poor
relationship implies that further loans may not be granted and alternative finance will
be required. However, it is unlikely that any details of the relationship with their client
will be provided by the bank.

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  Make enquiries with the directors regarding the availability of other finance which will
be necessary for the planned expansion. Obtain supporting evidence for this finance,
such as letters confirming amounts available and interest rates payable.
 As close as possible to the date of the auditor’s report, review the most recent
management accounts to help determine the extent of any additional finance required.
 Obtain a letter of representation from the directors confirming their responsibility for
preparing cash flow forecasts and for the overall going concern status of Patison.
 Use all the evidence obtained to take a view on the going concern status of Patison and
review the adequacy of disclosure (if any) in the accounting policy note to the financial
statements.

(c) Difference between negative and positive assurance

A negative assurance report means that nothing has come to the attention of the audit, which
indicates the financial information being reported on has errors in it. However, the extent of
the work carried out is normally less, which means that less reliance can be placed on this
report.

The advantages of providing negative assurance include:

 the user of the financial information receives some comfort that the information is
correct, even though that assurance is less than positive assurance
 the report adds some credibility to the financial information because it has been
reviewed by a professional accountant
 for the preparer, the report will be more cost effective than obtaining a full positive
assurance report.

Assurance engagements are engagements in which a professional accountant expresses a

conclusion which provides the intended user with a level of assurance about a particular subject
matter. External audits and review engagements are examples of assurance engagements.

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An external audit provides only reasonable assurance because of the inherent limitations of the
audit such as the fact that not all the transactions in the accounts can be tested and that
judgement is required in the audit of provisions, for example.
Review engagements only provide negative assurance – this means that nothing has come to
the attention of the auditor which indicates that the accounts have not been prepared
according to the applicable framework.

Limitations of the external audit:

– Not all items in the financial statements are tested.
– Judgement is required.
– There are limitations in the accounting and control systems.
– The audit report is issued a while after the balance sheet date.

NOVEMBER 2015
Question 1
Simbisainhungo Co, a leisure company whose head office is in Harare has twenty six centres in
all the Zimbabwean districts. Facilities at each centre are standard design which incorporates a
swimming pool, air-conditioned gym and physical fitness studio with a supervised childcare.
Each centre is managed on a day –to-day basis, by centre manager, in accordance with
company policies. The centre manager is also responsible for preparing and submitting monthly
returns to head office.
Each centre is required to have a license from local authority to operate. Licenses are granted
for periods between two to five years and are renewable to the satisfaction reports from the
local authority inspectors. The average annual cost of a license is $2 000.
Members pay a joining fee of $300 plus $90 per month for “peak” membership or $60 per
month for “off-peak”, payable quarterly in advance. All fees are stated to be non-refundable.
The centre in Magwegwe in Bulawayo closed from July to September 2015 after a chemical spill
in the swimming pool caused serious accident. Although the centre was re-opened,

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Simbisainhungo has recommended to all centre managers that swimming pool facilities be
suspended until further notice.
In response to complaints to the local authorities on childcare facilities, Simbisainhungo has
issued centre managers with revised guidelines for minimum levels of supervision. Centre
managers are finding it difficult to meet the new guidelines and have suggested that childcare
facilities should be withdrawn.
Staff lateness is recurring problem and a major cause of customer dissatisfaction particularly for
the early comers whose sessions start at 07.00. New employees are generally attracted to the
industry in the short term for its cash benefits, including free use of the facilities –but leave
when they require increased financial rewards. Training staff to be qualified lifeguards is costly
and time consuming and retention rates are poor. Turnover of centre managers is also high,
due to the constraints imposed on them by company policy.
Six of the centres are expected to have run at a loss for the year to 31 December 2015 due to
falling membership. Simbisainhungo has invested heavily in hydrotherapy pool at one of these
centres, with the aim of attracting retired members with more leisure time. The building
contractor has already billed twice as much and taken three times as long as budgeted for the
work. The pool is now expected to open in February 2016.

Cash flow difficulties in the current year have put back the planned replacement of gym
equipment for most centres. Insurance premiums for liability to employees and public have
increased by nearly 45% .Simbisainhungo has met the additional expense by reducing its
insurance cover on its plant and equipment from replacement cost basis to a net realizable
value basis.
Required
(a) Identify and explain the business risks which should be assessed by the management of
Simbisainhungo (13 marks)
(b) Explain how each of the business risks identified in (a) may be linked to financial statement
risk. (12 marks)

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Suggested Solution 1

Question 2
The date is 3 December 2014. The audit of Domingo Co is nearly complete and the financial
statements and the audit report are due to be signed next week. However, the following
additional information on two material events has just been presented to the auditor. The
company's year-end was 30 September 2014.

Event 1 – Occurred on 10 October 2014

The springs in a new type of mattress have been found to be defective making the mattress
unsafe for use. There have been no sales of this mattress; it was due to be marketed in the next
few weeks. The company's insurers estimate that inventory to the value of $750,000 has been
affected. The insurers also estimate that the mattresses are now only worth $225,000. No claim
can be made against the supplier of springs as this company is in liquidation with no prospect of
any amounts being paid to third parties. The insurers will not pay Domingo for the fall in value
of the inventory as the company was underinsured. This entire inventory was in the finished
goods store at the end of the year and no movements of inventory have been recorded post
year-end.

Event 2 – Occurred 5 November 2014

Production at the Shamva factory was halted for one day when a truck carrying dye used in
colouring the fabric on mattresses reversed into a metal pylon, puncturing the vehicle allowing
dye to spread across the factory premises and into a local river. The Environmental
Management Agency is currently considering whether the release of dye was in breach of
environmental legislation. The company's insurers have not yet commented on the event.
Required

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(a) For each of the two events above:
(i) Explain whether the events are adjusting or non-adjusting according to IAS 10 Events
After the Reporting Period. (6 marks)
(ii) Explain the auditors' responsibility and the audit procedures and actions that should be
carried out according to ISA 560 Subsequent Events. (12 marks)
(b) Assume that the date is now 20 December 2014, the financial statements and the audit
report having just been signed, and the annual general meeting is to take place on 10
January 2015. EMA has issued a report stating that Domingo Co is in breach of
environmental legislation and a fine of $900,000 will now be levied on the company. The
amount is material to the financial statements.
Required
Explain the additional audit work the auditor should carry out in respect of this fine. (7)

Suggested Solution 2
(a) Subsequent events
(i) Event 1 – Defective chemicals
Domingo Co quality control procedures have identified that inventory with a cost of $0·85
million is defective; the scrap value of this inventory is $0·1 million. This information was
obtained after the year end but provides further evidence of the net realisable value of
inventory at the year-end and hence is an adjusting event.
IAS 2 Inventories requires that inventory is valued at the lower of cost and net realisable value.
The inventory of $0·85 million must be written down to its net realisable value of $0·1 million.
The write down of $0·75 million (0·85 – 0·1) is material as it represents 13·4% (0·75/5·6) of
profit before tax and 1·4% (0·75/55) of revenue. Hence, the directors should amend the
financial statements by writing down the inventory to $0·1 million.
The following audit procedures should be applied to form a conclusion on the adjustment:

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  Review the board minutes/quality control reports to assess whether this event was the
only case of defective inventory as there could potentially be other inventory which
requires writing down.
 Discuss the matter with the directors, checking whether the company has sufficient
inventory to continue trading in the short term.
 Obtain a written representation confirming that the company’s going concern status is
not impacted.
 Obtain a schedule showing the defective inventory and agree to supporting production
documentation that it was produced prior to 30 April, as otherwise it would not require
a write down at the year-end.
 Discuss with management how they have assessed the scrap value of $0·1 million and
agree this amount to any supporting documentation to confirm the value.

Event 2 – Explosion
An explosion has occurred in one of the offsite storage locations and property, plant and
equipment and inventory valued at $0·9 million have been damaged and now have no scrap
value. The directors do not believe they are likely to be able to claim insurance for the damaged
assets. This event occurred after the year end and the explosion would not have been in
existence at 30 April, and hence this event indicates a non-adjusting event.
The damaged assets of $0·9 million are material as they represent 16·1% (0·9/5·6) of profit
before tax and 1·6% (0·9/55) of revenue. As a material non-adjusting event, the assets should
not be written down to zero; however, the directors should consider including a disclosure note
detailing the explosion and the value of assets impacted.
The following audit procedures should be applied to form a conclusion on any amendment:
 Obtain a schedule showing the damaged property, plant and equipment and agree the
net book value to the non-current assets register to confirm what the value of damaged
assets was.
 Obtain the latest inventory records for this storage location to ascertain the likely level
of inventory at the time of the explosion.

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  Discuss with the directors whether they will disclose the effect of the explosion in the
financial statements.
 Discuss with the directors why they do not believe that they are able to claim on their
insurance; if a claim was to be made, then only uninsured losses would require
disclosure, and this may be an immaterial amount.

(b) Audit report

The explosion is a non-adjusting post year-end event and the level of damaged assets are
material. Hence a disclosure note should be included in the 2013 financial statements and the
write down of assets would be included in the 2014 financial statements.
If the directors refuse to make the subsequent event disclosures, then the financial statements
are materially misstated and as the lack of disclosure is material but not pervasive, the audit
report will be modified and a qualified opinion will be necessary.
A basis for qualified opinion paragraph would need to be included before the opinion
paragraph. This would explain the misstatement in relation to the lack of subsequent events
disclosure and the effect on the financial statements. The opinion paragraph would be qualified
‘except for’.

Question 3
Muliswa is a company that provides call center services for a variety of organizations. It
operates in a medium sized city and your firm is the largest audit firm in the city. Muliswa is
owned and run by two entrepreneurs with experience in this sector and has been in existence
for five years. It is expanding rapidly in terms of its client base, the number of staff it employs
and its profits. It is now 15 June 2015 and you have been approached to perform the audit for
the year ending 30 June 2015. Your firm has not audited this company before. Muliswa has had
three different firms of auditors since its incorporation.

Muliswa’s directors have indicated to you informally that the reason they wish to change
auditors is because of a disagreement about certain disclosures in the financial statements in

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the previous year. The directors consider that the disagreement is a trivial matter and have
indicated that the company accountant will be able to provide you with the details once the
audit has commenced. Your firm has explained that before accepting the appointment, there
are various matters to be considered within the firm and other procedures to be undertaken,
some of which will require the co-operation of the directors. Your firm has other clients that
operate call centers. The directors have asked your firm to commence the audit immediately
because audited accounts are needed by the bank by 30 July 2015.
Your firm is very busy at this time of year.
Requirement:
(a) Describe the matters to consider within your firm and the other procedures that must be
undertaken before accepting the appointment as auditor to Muliswa. (15 marks)
(b) Explain why it would be inappropriate to commence the audit before consideration of the
matters and the procedures referred to in (a) above have been completed. (5 marks)
(c) Explain the purpose of an engagement letter (5 marks)

Suggested Solution 3
(a) Internal matters and other procedures before appointment
The firm needs to consider a variety of commercial issues and ethical matters (under ACCA’s
Rules of Professional Conduct).
Internal matters
Before accepting appointment the firm should ensure that:
The firm should:
1. it has the necessary staff with appropriate competencies to complete the audit (this
seems likely given that the firm has other clients in this sector);
2. the staff are available at what is a busy time of year for the firm (it may be possible that
all of the staff with the necessary competencies are otherwise occupied)
3. the firm is independent of Muliswa. It is unlikely that there will be any issues
concerning shareholdings in the client (because it is owned and run by two

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 entrepreneurs), however, there may be staff or partners who are related to the client
or are otherwise connected with it
4. there are no conflicts of interest that cannot be properly managed. Conflicts of interest
may exist because the firm has other clients in this sector.
Other procedures
5. seek the directors’ permission to communicate with the company accountant about the
nature of the ‘disagreement’ and the directors should authorise the accountant to co-
operate with the firm.
6. seek the directors’ permission to communicate with the incumbent auditors. If
permission is refused, the appointment should not be accepted
7. ask the client to write to the incumbent auditors notifying them of the change and
giving them permission to communicate with the firm (if Muliswa refuses to give
permission to the incumbent auditors the appointment should not be accepted)
8. communicate with the incumbent auditors (preferably in writing) requesting all the
information which ought to be made available to enable the firm to decide whether or
not to accept the appointment (if there are no such matters, the incumbent auditors
should inform the firm of this)
9. seek appropriate transfer information (such as a copy of the last set of accounts and a
detailed trial balance reconciled to the accounts)
10. indicate a likely fee (or the basis on which fees are calculated) to Muliswa, ensure that
this is acceptable and that the client is able to pay (by some form of credit check)
11. ensure that the incumbent auditor has properly resigned, been dismissed or has not
sought reappointment in accordance with legal requirements

(b) Starting the audit

It is inappropriate to start the audit before the procedures referred to above have been
completed because:
1. without the staff with appropriate competencies the firm will be in breach of the Rules
(and may be found negligent if things were to go wrong)

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 2. without complying with the requirements relating to independence and conflicts of
interest, the firm will not only be in breach of the Rules, but will lack objectivity and may
find that the client (or other party) objects to the appointment to another client in the
same sector
3. without performing appropriate procedures the firm will be unable to form an opinion
on the integrity of the client – it may find itself associated with an entity engaging in
doubtful or even illegal activities (taking account of the disagreement over disclosures)
4. without agreeing a fee it is almost inevitable that misunderstandings or disagreements
will arise
5. without communicating with the accountant and the incumbent auditor, it is quite
possible that disagreements over disclosures will arise, similar to those that have arisen
in the past
6. without ensuring that the incumbent auditor is no longer in place, it will be
inappropriate for the firm to seek appointment.

(c) Engagement letter

The engagement letter is of benefit to both the client and auditor and helps prevent
misunderstandings. It:
1. confirms the auditor’s acceptance of appointment and constitutes a contract between
the auditor and the client
2. summarises the respective responsibilities of directors and auditors
3. contains details on:
(a) the responsibilities of the directors (for accounting records, the financial statements
and the accounting policies on which they are based)
(b) the responsibilities of auditors and the scope of the audit (their duty to conduct an
audit in accordance with auditing standards, to review accounting policies and
disclosures, to perform tests and to form an opinion on the financial statements)
(c) the form of report to be issued
(d) other services to be provided

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 (e) the basis of calculation of fees
(f) applicable legislation.

Question 4
(a) What is the difference between positive and negative assurance? (5 marks)
(b) State and explain the five elements of an assurance engagement.
(c) Described below are situations which have arisen in three audits. The year-end in each case
is 31 March 2015. (5 marks)

Controversy
On 21 March 2015, the ZIMRA commenced a major inquiry into all aspects of the tax affairs of
the company. Until the inquiry is completed it is not possible to estimate, with any reasonable
degree of certainty, any ultimate liability which may fall upon the company. Consequently, no
liability in respect of this matter has been included in the financial statements. The directors
have included a note to the accounts explaining the situation.

Vakwenyana
Included in the balance sheet at 31 March 2015 are non-current assets at cost of $3.5 million
which have been constructed by the company during the year. The costs include own labour
capitalized of $180,000. The labour costs are based on the directors’ estimates of time spent by
employees on the construction work, which are unsupported by time records. There are no
satisfactory audit procedures to confirm that labour costs have been appropriately capitalized.
The pre-tax profit of Vakwenyana for the year ended 31 March 2015 is $550,000.

Vamayaya
In January 2015, the company received a government cash grant of $6.6 million in respect of
assistance with the acquisition of tangible non-current assets which have estimated useful
economic lives of between five and ten years. The $6.6 million has been credited directly to the
income statement for the year ended 31 March 2015. The directors insist on continuing with

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this treatment despite having been informed that this is not in accordance with the relevant
accounting standard, which requires such grants to be credited to income statement over the
useful economic lives of the assets to which the grant relates.
The pre-tax profit of Vamayaya for the year ended 31 March 2015 is $950,000.
Required:
In respect of each of the situations outlined above, reach a conclusion on whether or not you
would qualify your audit report. Give reasons for your conclusion, and describe the effect on
your audit report. (15 marks)

Suggested Solution 4
(a) Elements of an assurance engagement
In accordance with ISAE 3000 Assurance Engagements other than Audits or Reviews of
Historical Financial Information, an assurance engagement will involve three separate parties:
– The intended user who is the person who requires the assurance report.
– The responsible party, which is the organisation responsible for preparing the subject matter
to be reviewed.
– The practitioner (i.e. an accountant) who is the professional who will review the subject
matter and provide the assurance.
A second element is a suitable subject matter. The subject matter is the data that the
responsible party has prepared and which requires verification.
Suitable criteria are required in an assurance engagement. The subject matter is compared to
the criteria in order for it to be assessed and an opinion provided.
Sufficient appropriate evidence has to be obtained by the practitioner in order to give the
required level of assurance.
An assurance report is the opinion that is given by the practitioner to the intended user and the
responsible party.

Question 3 misplaced

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(d) This represents a potential material limitation on scope because the 'missing' inventory
represents 12% of the total. The auditor would expect all inventory counting sheets to be
available. The auditor’s opinion would be modified. The auditor’s report would include a
basis of qualified opinion paragraph before the opinion paragraph which would refer to the
fact that the inventory counting sheets for this depot were lost. The qualified opinion
paragraph would state that "except for" adjustments that may have been necessary in
relation to this inventory, the financial statements present fairly, in all material respects (or
give a true and fair view). The auditor’s report would also state that in relation to inventory
quantities:
 All information and explanations considered necessary were not obtained; and
 The auditor was unable to determine whether proper accounting records were kept.

ABOUT THE COMPILER OF SUGGESTED SOLUTIONS

Tawanda. T. Herbert is the Co-Founder and Managing Partner of Herbert and Co. Chartered
Accountants. Among other qualifications, he is a holder of the following qualifications:

ACCA, CIMA, CIS, M.Com in Applied Accounting and B.Sc. in Applied Accounting. He is also a
PHD in Accounting candidate.

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