The Institute of Chartered Accountants in England and Wales 2010. ICAEW\183\D10 141763

PROFESSIONAL STAGE APPLICATION EXAMINATION

TUESDAY 14 DECEMBER 2010

(2 hours)

AUDIT AND ASSURANCE This paper is made up of SIX short-form questions (20 marks) and THREE written test questions (80 marks). 1. Ensure your candidate details are on the front of your answer booklet. 2. Answer each question in black pen only. Short-form Questions (1 6) 3. Answer the short-form questions in note form only. Complete sentences are not required. 4. Answers to short-form questions must begin on a new page and should be submitted in

numerical order. Written Test Questions (7 9) 5. Answers to written test questions must begin on a new page. Ensure that each question is

clearly numbered. Use both sides of the paper in your answer booklet. 6. The examiner will take account of the way in which material is presented in the written test

questions.

IMPORTANT Question papers contain confidential information and must NOT be removed from the examination hall. DO NOT TURN OVER UNTIL YOU ARE

INSTRUCTED TO BEGIN WORK

Place your label here. If you do not have a label you MUST enter your candidate number in this box

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BLANK PAGE

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1. Libra LLP (Libra) has tendered for the external audit of Sagittarius plc. Libra has proposed a fee which is less than the market rate in the hope that the firm will subsequently be awarded the more lucrative tax and advisory work. Identify and explain the ethical issues posed by Libras proposal. (4 marks)

2. As a result of the banking crisis, the issue of external auditors providing non-audit services to their audit clients is being reviewed by regulators in the UK and around the world. Set out the benefits to clients from having non-audit services provided by their external auditors.

(4 marks)

3. Your firm has received notice from Pisces plc (Pisces), a listed company, that it will not be re-

appointed as external auditor when its term of office expires as the audit committee of Pisces has recommended the appointment of another firm.

Set out the rights and responsibilities of your firm, including those under the Companies Act 2006,

relating to the change in appointment. (4 marks)

4. An audit firm undertakes an engagement quality control review for all external audits of financial

statements of listed entities and for those other audit engagements for which the firm has determined an engagement quality control review is required. Set out the tasks to be undertaken in an engagement quality control review in respect of an audit of financial statements. (3 marks)

5. During your planning meeting for the external audit of Leo Ltd (Leo), the finance director informed you that the managing director, who owns all of the shares in Leo, is planning to sell his shares in the business. He has been negotiating with a prospective purchaser who has agreed in principle to purchase the shares. The purchase consideration will be calculated as a multiple of the current years profit before tax. Explain how this matter will affect the overall audit strategy. (3 marks)

6. You are planning the audit of Scorpio plc (Scorpio) for the year ending 31 December 2010. Scorpios principal activity is the manufacture of a range of electrical appliances. In todays newspapers, there are headlines about Scorpio recalling one of its most popular products due to electrical faults which, in a number of cases, have caused fires. Explain why this matter should be considered when planning the audit of Scorpio for the year ending 31 December 2010. (2 marks)

QUESTION 6 COMPLETES THE SHORT FORM QUESTIONS

WRITTEN TEST QUESTIONS (7 9) FOLLOW

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7. Your firm is the external auditor of Lagg Ltd (Lagg) for the year ended 30 November 2010. The principal activity of Lagg is the installation of thermal and acoustic insulation systems for a wide range of industries. The manager responsible for the audit of Lagg has received a phone call from Laggs finance director who requested that the audit is completed by 31 January 2011. The company is seeking to increase its overdraft facility and the companys bank requires the audited financial statements to be available prior to agreeing the new facility. The finance director has also requested that a member of your firm assists with the preparation of the financial statements so that the 31 January deadline can be met. The finance director has performed an assessment of the companys ability to continue as a going concern, including profit and cash flow forecasts which indicate that the company can continue to trade profitably and meet its debts as they fall due in the year ending 30 November 2011. The forecasts assume that the companys overdraft facility will be increased. During the year ended 30 November 2010, the company experienced a decline in demand for its services, mainly due to a fall in demand from the construction sector and competition from other companies which are undercutting Laggs prices. The company has managed to pay its trade suppliers and stay within the current overdraft facility by delaying payments to HMRC. The finance director has recently agreed a deferred payments plan with HMRC to pay off the arrears of payroll taxes over the next four months. All contracts entered into by Lagg are fixed-price and require the customer to pay the full contract price within seven days of the invoice date. The invoice is raised once the work has been completed and signed off by the customer. It is company policy to recognise revenue when a customer has signed off the work as having been completed satisfactorily. However, one customer who signed off the work as having been completed and was invoiced in September 2010 has not yet paid. The amount due represents 12% of Laggs year-end receivables balance. Laggs inventory of raw materials consists of consumable materials held in its stores department and unused insulating materials at customers premises. The value of these items is not material to Lagg's financial statements. The insulating materials required for each contract are only ordered once a contract has been agreed and are delivered directly to the customers premises. All direct costs (labour and materials) relating to each contract are recorded in the companys job costing system which is integrated with the purchases and payroll applications. The job costing records are used by the finance director to estimate the value of work in progress for the monthly management accounts and the year-end financial statements. For the work in progress valuation, a percentage is added to the direct costs to cover overheads. The finance director determines the percentage by taking the overheads figure in the management accounts as a percentage of direct costs in the management accounts. Many of the contracts entered into by the company require the removal of existing insulation material. Some of this material is classed as hazardous waste (harmful to health and the environment). The company is legally obliged to dispose of this waste in a safe manner. The company is currently being investigated by the regulatory authority for alleged illegal disposal of hazardous waste. Laggs freehold premises were valued by an external valuer in October 2010. The premises are currently included in the accounting records at cost less accumulated depreciation. The directors wish to recognise the revalued amount in the financial statements for the year ended 30 November 2010. The audit manager has asked you to consider the following key areas of audit risk:

(1) Going concern (2) Trade receivables (3) Work in progress (4) Property, plant and equipment.

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Requirements (a) Explain why an auditor should consider whether a company is a going concern. Your answer

should consider the implications for both the financial statements and the audit report. (7 marks)

(b) Justify why the items listed in (1) to (4) above have been identified as key areas of audit risk

and, for each item, describe the procedures that should be included in the audit plan in order to address those risks. (20 marks)

NOTE: You should present your answer in a two-columnar format using the headings

(i) Justification; and (ii) Procedures to address the risk. (c) Explain the matters that should be considered, including any actions to be taken, by you and

your firm, if during the course of the audit you discovered that the directors of Lagg had authorised the illegal disposal of hazardous waste in order to save costs. (6 marks)

(d) Identify and explain the principal threats to objectivity which arise from a member of your firms

staff assisting with the preparation of the financial statements as requested by the finance director of Lagg. State how your firm should mitigate these threats. (7 marks)

(40 marks)

PLEASE TURN OVER

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8. Your firm has been engaged by the management of Bambi Ltd (Bambi) to undertake a review of and provide an assurance report on the interim financial information of Bambi for the six months ended 30 November 2010. The terms of the engagement are restricted to making enquiries of management and applying analytical procedures to the financial information. The business was started in 1998 and has grown steadily with no outside investors. Management wishes to increase the rate of expansion and has identified a potential investor who has asked for assurance on the interim financial information. Historically, the principal activity of Bambi has been the retailing of high quality and stylish childrens clothing. However, in July 2010, the company launched a new range of up-market accessories which includes childrens chairs, prams, cots and bedding. The company holds a limited amount of inventory of the most expensive accessories, but guarantees delivery of any item ordered within six weeks of the order date. The clothing is sourced from suppliers in the UK and more recently Portugal. The accessories are sourced from suppliers in Germany. Sales are made through the companys eight retail outlets, by mail order and over the internet. Seven of the retail outlets are in the UK and one, which was opened in April 2010, is in Paris, France. Revenue has grown steadily at between 4% and 6% per annum over the five years ended 31 May 2010. To assist management with its objective to increase the rate of expansion, the company entered into a contract, in October 2010, to lease a purpose-built warehouse facility and, in November 2010, it upgraded its IT infrastructure. The following is an extract from Bambis financial information. Income statement

Six months ended 30 November 2010 2009 000 000 Revenue 6,716 6,064 Cost of sales (3,761) (3,517) Gross profit 2,955 2,547 Operating expenses (1,947) (1,394) Profit from operations 1,008 1,153

Statement of financial position As at 30 November

2010 2009 000 000 Current assets

Inventories 1,780 1,388 Current liabilities

Trade payables 701 771 Your preliminary analytical procedures have identified the following as matters of significance to discuss with management:

Six months ended 30 November 2010 2009 000 000 Increase in revenue 10.8% 6% Gross profit margin 44% 42% Operating margin 15% 19% Inventory days 86 days 72 days Trade payables days 34 days 40 days

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Requirements (a) Prepare briefing notes on the matters which you wish to discuss with the management of

Bambi in respect of the information provided in the scenario. Your notes should include reference to the results of your preliminary analytical procedures. (12 marks) You are not required to calculate any additional ratios.

(b) Identify the financial information, in addition to the interim financial information, that would be

useful when undertaking analytical procedures in respect of Bambis performance for the six months ended 30 November 2010. (4 marks)

(c) Comment on the level of assurance provided by the report on the financial information of Bambi

and explain how and why it differs from the level of assurance provided by an audit report on annual financial statements. (4 marks)

(20 marks)

PLEASE TURN OVER

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9(a) You are responsible for the external audit of the financial statements of Conco Ltd (Conco), a company operating in the construction sector. During the audit of the financial statements for the year ended 30 September 2010, you have identified the following significant internal control deficiencies. (i) The companys policy requiring contract managers to compare the costs incurred on each

contract with the budgeted costs on a weekly basis was not adhered to in 50% of the contracts examined by the auditors. All contracts entered into by Conco are fixed-price.

(ii) The company maintains a non-current asset register which records details of Concos plant and

machinery, fixtures and fittings, motor vehicles and computer equipment. The details in the register are reconciled with the nominal ledger on a monthly basis but no other internal control procedures involving the asset register are required to be undertaken.

Requirement Prepare extracts suitable for inclusion in your firms report to the management of Conco. For both internal control deficiencies identified above, you should outline the possible consequence(s) of the deficiency and provide recommendations to remedy each of the deficiencies. (10 marks)

9(b) Described below are situations which have arisen at two unrelated external audit clients of your firm. The year end in each case is 30 September 2010. Pembroke Ltd (Pembroke) The management of Pembroke has refused to provide written representations that:

it has fulfilled its responsibility for the preparation of the financial statements in accordance with the applicable financial reporting framework;

it has provided the auditor with all relevant information and access as agreed in the terms of engagement; and

all transactions have been recorded and are reflected in the financial statements. Snowdonia Ltd (Snowdonia) On 12 October 2010, Snowdonia received an invoice for equipment costing 2.4 million which has an estimated useful life of five years. The equipment was installed and brought into use on 1 September 2010. The invoice was dated 8 October 2010 and had been posted to the ledger accounts as an October 2010 transaction. It has not been included in the financial statements for the year ended 30 September 2010. The directors of Snowdonia have refused to amend the financial statements in respect of this matter. The draft financial statements for the year ended 30 September 2010 show profit before tax of 750,000 and total assets of 16.5 million. Requirement In each of the two situations outlined above, state whether you would modify the audit opinion. Give reasons for your conclusions and describe the modification(s), if any, to each audit report.

(10 marks)

(20 marks)