External Audit Services

7/27/2019 External Audit Services

1/92

Answer 1 EXTERNAL AUDIT SERVICESValue of an auditCorporate society is sometimes described as an awesome social invention whereby the savingof millions are channelled into the hands of corporations to the mutual benefit of investors anmanagement, thus ensuring that investment capital is managed by those most skilled in thprocess.

However, the process requires that individuals entrust their savings into the hands of strangernotwithstanding concern that their interests may not be adequately safeguarded. The externa

audit plays a vital role in facilitating this process by protecting investors against the risk thamanagement might use investors funds in their own self-interest and not in the investorsinterests. Without the work of auditors, companies would not have access to the capital theneed to engage in profitable projects. The way in which the role of the auditor protectinvestors can be explained in a number of different ways.

Information riskIn order to invest capital investors need reliable information as to the financial position anperformance of the companies in which they are planning to invest. Reliance must necessarilbe placed on management for the provision of such information because of the risks of allowinoutsiders access to confidential information about the business. However, investors would bnaturally suspicious of such information. By allowing independent auditors access to th

companys records, investors may obtain the required assurance as to the reliability of thinformation provided by the company from the auditors assurance as to its truth and fairness.

Society also benefits in that, through such information, securities markets can assess threlative values of shares in each company and an active market in shares becomes possible. Ithis way capital is attracted to those entities whose business is likely to be the most profitablethus ensuring that capital is invested in those activities generating the greatest satisfaction ttheir customers.

Agency theoryUnder the information risk hypothesis it is usually assumed that audits must be required by lawfor companies issuing risk-bearing securities to the public. This is normally recognized by th

presence of a statutorily required audit for most incorporated entities. Agency theory, howevepredicts that it is management who have an incentive to engage an independent auditor sincinvestors are unlikely to be sufficiently reckless as to invest money in companies without sucassurance. The theory derives its name from the depiction of the relationship as one wherebcompany management act as agents for shareholders, the principals, in investing their monein profitable projects. Agency risk is the risk that the agents act in their own self-interest. Aagency contract is one offered by the agent to reassureprincipals that they will act in the principals interests (eg agreeing to provide informatioenabling the principal to monitor their performance). With companies, audited financiastatements constitute the information provided by management to prove that they have actein the shareholders interests.

Insurance hypothesisA further explanation of the role of an audit is that it protects investors by insuring themagainst the risk of loss through relying on false information. This arises through their right trecover such losses from the auditor.

This last hypothesis also exposes some of the limitations in the benefit of an audit to societyThe right to recover losses applies only where the auditor has been negligent. At present therare limitations in the auditors duty to detect fraud and other illegal acts. Arguments that thauditors duty be extended are countered by concern that the cost to the auditor of performinadditional procedures and accepting greater risks does not justify the increased benefit tsociety.

ATC-Adding Value To Your Future 1


2/92

Tutorial note: This answer indicates the type of answer that was acceptable based on the(former)examiners article. Equally acceptable answers could refer to stewardship anaccountability(particularly where the privilege of limited liability is extended to an entity)

professional advice,credibility and independent opinions, potential investors, loans and financeassurance and otherservices, etc.

Answer 3 ISA 200(a) Managements and auditors responsibilities

The management of an entity is responsible for: the preparation and presentation of financial statements which give a true and fair view (oare presented fairly) in accordance with the financial reporting framework and statutorrequirements. This responsibility includes: selecting suitable accounting policies and applying them consistently; making judgements and estimates that are reasonable and prudent; stating whether applicable accounting policies have been followed; preparing the financial statements on a going concern basis. maintaining accounting records and implementing adequate internal controls for safeguardinthe assets and to minimise the risk of fraud or other irregularities.

The auditors are responsible for forming an independent opinion (eg in true and fair terms i

accordance with an identified financial reporting framework) based on their audit and foreporting that opinion to the addressees of the auditors report.

(b) Inherent limitations facing an auditor The inability to examine each transaction and each item making up an account balance withinormal time and cost constraints. This results in the necessity to rely on evidence from sampleand the consequent risk of sample error. The inherent limitations of internal control systems such that any reduction in substantivprocedures based on the assessed level of control risk is dependent on inherent limitations ocontrol not exceeding reasonable levels. Even given reasonable professional scepticism the inability of the auditor to detect fraudulenmisstatements carefully concealed by collusion or deliberate misstatement by senio

management. The fact that audit evidence, mostly relating to past events, is rarely wholly conclusive anthe necessity for reliance on judgement as to the persuasiveness of evidence.

(c) Significant types of judgements made by auditors(i) In gathering evidence Assessing inherent and control risk and determining the appropriate audit strategy to badopted. This includes assessing: the nature and degree of risk of misstatement at both the financial statement level and thlevel of the account balance or class of transactions; the design of internal controls and the effectiveness of the control environment idetermining the nature and extent of possible misstatements. Planning tests of controls and evaluating the results of tests as to whether they confirm thpreliminary assessment of control risk. Given the assessed levels of inherent and control risk, planning substantive procedures as ttheir nature, timing and extent. Planning substantive procedures such that sufficient appropriate evidence is obtained. In turthis requires judgements as to: the materiality of the items concerned the reliability of the evidence obtained relevance of evidence as to each financial statement assertion.



3/92

(ii) In arriving at an opinionIn drawing conclusions and forming an opinion auditors need to consider whether: they have sufficient appropriate evidence to express an opinion on the financial statementtaken as a whole and, if not, whether to report: limitation on scope qualified opinion; or limitation on scope disclaimer of opinion; having sufficient appropriate evidence to form an opinion, the financial statements as a wholshow a true and fair view and, if not, whether to report: disagreement qualified opinion; or

disagreement adverse opinion.

Answer 4 FRAUD AND COMPLIANCE SEMINAR(a) Missing share certificates

The auditors must treat this matter as extremely serious. Not only has a senior executivperpetrated an illegal act, he has also been guilty of deliberately attempting to mislead thauditors. The auditors must report the matter immediately to the audit committee, if there one, or otherwise to the full board of directors (ISA 240). A criminal offence has beecommitted in the theft of the shares and in attempting to mislead the auditors. The auditorwould expect appropriate action to be taken. Any further course of action depends on thaction taken by the directors.

If the directors do not take appropriate action, such as reporting the matter to the police, thauditors must consider the desirability of continued association with the company. Failure ttake action would make the directors a party to the wrongdoing involving, as it does, money fowhich they have a responsibility to the shareholders. In most jurisdictions the auditors do nonormally have any responsibility for reporting the matter to third parties except in thepublic interest or where there is some direct legal duty imposed on auditors. Their duty oconfidentiality prevents their taking further action. However, on resigning, they can take thopportunity to reveal their concerns in any communication accompanying their resignation.

They may also respond appropriately to professional enquiries from auditors nominated treplace them. However, they need to obtain legal advice on the form of such communication tavoid the risk of action for breach of confidence by the company or even defamation by the

finance director.

If the directors do take appropriate action, the auditors must consider their position witrespect to the current audit engagement. The finance director is a key person with respect trepresentations on which the auditors would have relied. Now that the credibility of that officeis in doubt, the necessary level of professional scepticism becomes much greater.

Such an official has the authority to override almost any control and is in a position to conceasuch actions. The control environment must be regarded as being wholly ineffective aninherent risk assessed as high. Extended substantive procedures will now need to bperformed in all areas that could have been manipulated by the chief financial officer.

Providing sufficient appropriate evidence is available then there would be no effect on thauditors report. It is possible, under the circumstances, that the auditors may be unable treassure themselves that further misstatements are not present. In this case they would neeto issue an except for scope limitation qualified auditors report.

(b) Product safetyThe auditors have no duty to search for all instances of non-compliance with all applicable lawand regulations. However, in addition to laws and regulations directly pertaining to financiareporting, the auditors also have a duty (ISA 250) to become familiar with any particular lawand regulations breaches of which might result in the company no longer being a goin



4/92

concern. Moreover, in this case, they have already become aware of the possible breach. Thesuspicions are aroused and they are under a duty to investigate the matter further.

The finance director may be right in claiming the matter is of no consequence, but the fact oattempting to conceal the evidence from the proper authorities must arouse suspicions that thmatter is serious. The auditors need to obtain independent expert advice on the implications othe matter. If the company denies access to an independent expert the auditors may considerat the very least, issuing an except for scope limitation qualified auditors report.

If the expert confirms suspicions and the effect is potentially material, at the very least thauditors would require full provision to be made, failing which an except for disagreementqualified auditors report would be necessary (ISA 250).

If the auditors suspicions are confirmed and the effect is material, the auditors would normallreport the matter to the board of directors. In this case, however, the board is implicated in thattempt to cover up the evidence. Again legal advice needs to be sought on whether thactions of the board are illegal. If so, then they may consider it desirable to resign from thaudit. Moreover, consideration must be given to the consequences of the continued supply ounsafe goods. It is likely the auditors have a case for alerting the appropriate authorities in thpublic interest which overrides their duty of confidentiality to the client.

(c) Understatement of royaltiesThis suspected fraud differs in being perpetrated by the company and not by employeeagainst the company. The auditors duty of confidentiality to the company prevents them fromcommunicating their suspicions to the authors. However, the company has a liability under thterms of the royalty agreements which must be provided for until extinguished by the statutof limitations or other limitation on the rights of creditors to sue for amounts due.

The auditors would possibly seek legal advice on whether the companys action was illegasuch as a conspiracy to defraud the authors or false accounting to obtain a pecuniaradvantage. If the directors actions are illegal the auditors would expect the directors to pathe amounts due in full. If the directors refuse, the auditors should consider resigning.

If the action is not illegal, it is certainly unethical, and the audit will be affected in two waysFirstly, if the amounts are material and the company fails to make adequate provisions withithe financial statements, the auditors must issue an except for disagreement qualifieauditors report (ISA 240). Secondly, the auditors will need to revise their assessment oinherent risk at the entity level. They would need to increase the tolerable level of detectiorisk and perform a higher level of substantive procedures than previously would have beeconsidered necessary (ISA 240).

(d) Unclaimed wagesIf there is no immediately apparent explanation, such as an employee on long-term sick leavethe circumstances arouse suspicions that the employee is fictitious possibly a formeemployee whose resignation the supervisor has deliberately withheld from the personne

department. If the amount is wholly immaterial, the auditor has no duty to investigate thmatter further. However, the auditor does have a duty to communicate suspicions promptly tan appropriate level of management and to see that the matter is properly investigated (ISA240). If the auditor is not satisfied that a proper investigation is performed, it is possible thathe level of management to which the suspicions are communicated is also implicated in thfraud. The matter becomes more serious and must be reported to the audit committee or boarof directors.

Answer 6 ADDITIONAL SERVICES(a) Affect on independence, benefits and safeguards(1) Taxation service



5/92

Generally, there should be little effect on the auditors independence in providing taxatioservices to the client. Most audit firms will have staff with specialised skills in taxation, so theyshould provide a good service. Also, there should be a cost saving compared with employinanother firm for this service, as some of the procedures in preparing and auditing financiastatements are helpful in calculating the corporation tax liability (eg non-current asseschedules, analysis of entertainment and some other expenses). Frequently, audit firms wihave different staff responsible for audit work and taxation computations, and this will tend tincrease independence. The auditors independence may be slightly compromised if a disputarises between the company and the tax authorities, or if the auditor has made a

material mistake in the Income Tax computation.

The risks with preparing and negotiating directors tax liability with the tax authorities arslightly greater. A director may not have declared all benefits in kind, or the auditor may nohave given the correct advice on a technical matter, or a dispute may arise with the taauthorities. These problems are likely to create a deterioration in the relationship with thdirector; so the auditor may back down on a contentious issue in the financial statements iorder to maintain good relations with the directors and thus continue as auditor. Ideally, thtaxation computations should be performed by staff independent of the audit staff, and thechecked by the audit staff.

(2) Accounts preparation

Many small companies do not have staff with the skills to prepare the financial statements. Thauditor has these skills, and there is likely to be a time (and cost) saving if the audit firm botprepares and audits the financial statements.

However, if the same staff both prepare the financial statements and audit them, there is greater risk that material errors will not be detected, as one is poor at detecting ones owmistakes. Also, staff may feel the item has been audited when preparing the financiastatements, and this could lead to aspects of the financial statements not being auditesatisfactorily. So, it is desirable (and recommended) that different staff should prepare thfinancial statements from those who audit them. Even in this situation, there is likely to be cost saving, as the staff preparing the financial statements should prepare schedules which whelp in the audit (eg schedules of additions and disposals of non-current assets, and calculatio

of accruals and prepayments).

If the audit firm prepares the financial statements, the letter of engagement for this worshould point out that the client should accept that the accounting records are the responsibilitof the company, and that the financial statements are based on the companys records anexplanations received from employees and the directors.

The ACCAs ethical rules say that the auditor should not prepare the financial statements olisted and other public interest companies, except in emergency situations. In conclusion, thprovision of accounting services is unlikely to have any significantly adverse effect on thauditors independence.

(3) Internal controlsThe auditor may be quite good at advising on internal control systems, as this is an importantaspect of audit work. However, if the auditors recommendations are implemented and thesystem proves to have weaknesses (which may result in serious errors or fraud), the auditormay be reluctant to criticise the system (as he would be criticising himself, so hisindependence would be compromised. For this reason, auditors should not say how internalcontrol systems should be set up in client companies.

However, as a result of audit work, auditors can become aware of weaknesses in internacontrols in accounting systems. They should point out these weaknesses to the client, and anerrors or fraud which have taken place. In addition, they can suggest how the systems can b



6/92

modified to improve controls. The auditor can suggest changes to parts of systems, but theyshould not say how a whole system should be set up (eg a purchases system).

(b) Fees for non-audit work(i) Low audit fees

There is some evidence that audit fees charged to listed companies may be reduced becausof fees the auditor will receive for other services. However, it is very difficult to prove this ihappening. If non-audit work is very profitable, then an audit firm may charge a lower audit fee

This is because the auditor has a greater chance of obtaining non-audit work from the liste

company (ie audit firms tend to have a higher proportion of non-audit consultancy workthan those firms which are not the companys auditor). So, if more high profit work available, the auditor may be prepared to reduce the audit fee to increase the chances oobtaining the non-audit work.

The reason why it is difficult to prove that audit firms are reducing audit fees is that one cannoquantify the audit fee required for a particular audit assignment. A replacement auditor macharge a lower audit fee, but this could be because the audit is carried out more efficiently, othe previous auditor had carried out more work than was necessary.

(iii) Large fees for non-auditThere does seem to be a greater risk that the auditor will compromise his independence if h

obtains fees from both audit and non-audit work, than if he obtains fees exclusively from audwork. If the audit firm is replaced as auditor, the audit fee and most of the fees for nonaudiwork will be lost. As non-audit work is likely to be more profitable than audit work, the pain tthe auditor of losing the audit will be even greater, as he will lose the high profit non-audit worand the relatively low profit audit work.

Risks to the audit firm of being replaced as auditor as a result of modifying the auditors reporThe client may not want the auditors report to contain any form of modification (eg aexplanatory paragraph in an unqualified report indicating going concern problems). So, there a risk that the auditor will be replaced if he modifies his auditors report. Because of thsubstantial loss of fees, the auditor may back down and give an unmodified auditorsreport.

If there is a serious risk that the auditor will be sued for not modifying the auditors report, hwill probably not back down to pressure by the company. The auditor will want to avoinegligence claims, as they involve a lot of staff time in defending them, it adversely affects thauditors reputation, and there will be damages to pay if the auditor loses the case (or settleout of court). Although the auditor should be covered by professional indemnity insurance (PIfor legal costs and the sum paid in damages, he may have to pay an excess (eg the firs$25,000 or $100,000 of the claim), and it is likely that future premiums for PII will increasfollowing a claim.

(iii) Reluctance to modifyStatement (iii) is logical, as a reluctance to modify the auditors report is the outward evidenc

that the auditors independence has been compromised.

BenefitsThe provision of other services by audit firms is likely to benefit both the client and the audfirm. This is because the fee charged is likely to be lower, as the audit firm already knows thclient firm and does not have to spend time getting to know the companys business, itemployees and systems. With the close relationship between the audit firm and the companythe companys staff should have a good appreciation of the strengths of the audit firm and beable to use these strengths in non-audit consultancy work. The higher profitability of nonaudwork, and the better chance of obtaining this work, because you are the auditor, means tha



7/92

obtaining a client with a considerable amount of non-audit work is very attractive to the audfirm.

DrawbacksHowever, from the discussion above, it appears that the provision of non-audit work couladversely affect the independence of the audit firm in carrying out the audit. Technically, thaudit firm is appointed by the shareholders, and the auditor reports to the shareholders. It doeseem that the provision of other work creates a conflict of interest in the auditors relationshiwith the shareholders. If the auditor is reluctant to modify his auditors report, the auditor is no

acting in the best interests of the shareholders (and other users who rely on the financiastatements).

ConclusionThe arguments for and against allowing auditors to carry out non-audit services for clients arfinely balanced. However, listed companies have a large number of shareholders and thefinancial statements are relied upon by a large number of organisations. Thus, auditors of listecompanies have enormous responsibilities when reporting on the financial statements. It against the interest of these people that the auditors independence could be compromised bthe provision of non-audit services. So, on balance, it appears that the final statement of thquotation, that auditors of listed companies should be prevented from providing other serviceto client companies should apply.

Answer 8 MANLY(a) Removal from office(i) Removal by management

The financial statements being reported on represent a statement of accountability bmanagement and directors to those on whose behalf they exercise their function, that is thshareholders, in the case of an incorporated business. The ability of management to control thappointment of auditors threatens to undermine the independence of the audit. They caeffectively evade an unsatisfactory auditors report by dismissing the auditor. Even where thright to appoint (and remove) auditors is in the hands of shareholders or membersmanagement are often able to influence the exercise of that function.

There are a number of safeguards available to auditors to minimise the extent of the problem. Not accepting appointment where there is reason to suspect management might seek tdismiss the auditor to evade an unsatisfactory report. Communicating with predecessor auditors to ascertain if such reasons lie behind the proposechange of auditor. Adhering strictly to professional independence rules to ensure an ability to withstanmanagement threats of removal from office in an attempt to dissuade auditors from modifyintheir report. Taking full advantage of whatever statutory protection exists against removal from office sucas a right to communicate with shareholders where a change in appointment is proposed bmanagement. Adhering to professional rules relating to providing advice to non-audit clients, which migh

put undue pressure on their auditor. The other firm in this question appears to be acting ibreach of this rule.

(ii) Audit committeePublic companies have many shareholders few of whom take an active interest in its affairs. they disagreed with the directors proposed change of auditors they would probably sell theshares rather than vote against the resolution. For this reason, companies are encouraged tappoint a number of non-executive directors who are not also involved in the management othe company, and for such directors to constitute themselves as an audit committee. As a sucommittee of the board they are entrusted with matters concerning the audit. A



8/92

nonexecutives they are less likely to be critical of auditors who prevent the company frompresenting over optimistic financial statements. Existence of an audit committee, thereforeprotects auditors against removal from office by management whom they displease.

(b) Provision of other services(i) Rules of Professional Conduct An auditor should not provide accountancy services to listed or public interest company audclients except of a purely mechanical nature such as drafting the statutory financiastatements.

Where accountancy services are provided to other company audit clients, the client shoulaccept full responsibility for the records, the assistance should not extend to managemendecision making and a full audit must also be undertaken.

In the provision of other services, care must be exercised that the service is limited tproviding advice and not the exercise of management functions. This applies particularly iproviding executive recruitment services. The service should be limited to identifying a shortlist and not to making the final selection.

Other services should not include the making of specialist valuations, which are to bincorporated in the audited financial statements.

The provision of non-audit services should not constitute recurring work which brings totafees received from that audit client to more than 15% of the firms gross fee revenues or 10% the client is a listed or public interest company. The reasons for this are evident from the

engagement partners reluctance to qualify the opinion for fear of angering the managemenand losing the audit. Although not over the limit, fees from the provision of non-audit serviceare, nevertheless, high. The engagement partners concern is unprofessional and it would bhoped thatprofessional accountants would be more objective. Nevertheless, it illustrates concerns thawould arise in the minds of users of financial statements if it is seen that the auditors argenerating substantial fee income from providing non-audit services to the companies theaudit.

(ii) Prohibition of non-audit service provisionThe Rules of Professional Conduct state that, in principle, there is no objection to providing nonaudit services to audit clients. However, it is also claimed that the provision of such service

impairs auditor independence. The alleged scenario is as follows:As auditors, the firm is appointed by and is responsible to the members of the company.In providing other services, the firm is appointed by and is responsible to the management.Because of the advantages of dealing with just one firm of accountants, the managemen

tends to prefer to use the audit firm to provide these other services.If the firm loses the audit, they are likely to lose revenues from the provision of other services

This is clearly the case here and the audit partners judgement is strongly influenced by thpotential loss of revenue.

The auditors recognise the ability of the management to influence auditor appointmenWhere auditors receive revenues from providing non-audit services, as in the case of Manly, is alleged that management may exploit this fact in order to put pressure on the auditors.

Other services often attract higher fees than audit services. Firms may seek to secure audi

appointments primarily as a means of obtaining contracts for the provision of more rewardingother services.

For these reasons, it is argued, firms should be forbidden to provide non-audit services taudit clients.

The profession, on the other hand, argues that quarantining audit from the provision ononaudit services denies companies the right to select their professional advisers. It alsimposes costs in that the audit, necessarily, will become more expensive as will the provision ononaudit services as the firm providing the services will not have the benefit of knowledge othe company gained through the audit. As professionals, it is argued, accountants will not allotheir judgement to be influenced by such considerations and the situation illustrated in th



9/92

question is an unlikely one. Moreover, there is bound to be overlap between audit and nonaudservices such as advice on internal control and related matters contained in the managemenletter.

(c) RotationRotation is the term given to limiting the number of years an individual or a firm is associatewith the audit of a particular client.

Professional ethics recommend that audit staff should not spend too many years associate

with the same group of clients. The benefit of understanding of the clients business outweighed by the possible loss of professional scepticism. In this case the audit partner haknown Manlys chief financial officer for too long to be able to entertain ideas that he may nobe trustworthy.

At a further level it is argued that audit firms should only serve a fixed term of office. Thbenefits of securing non-audit work from clients are substantially reduced if the term of officas auditor is limited to say seven years. Similarly, efforts to maintain good relations witmanagement possibly to the extent of condoning questionable financial statements would nlonger serve a useful purpose.

The argument against rotation of audit firms is that it imposes additional costs and risks. It

the first year as auditor that is most costly and also the year the auditor is at greatest risk ofailing to detect misstatement through unfamiliarity with the client. Rotation of audit firms istatutorily required in some countries.

Answer 9 ABEL & CO(a) Shareholding by staff memberWhile partners are not allowed to hold shares in client companies there is no specifprohibition in the ACCAs Rules of Professional Conduct on the holding of shares in audit clientby audit staff providing the staff members concerned are not personally involved in the audit osuch clients. However, some audit firms have adopted a prohibition on the holding of shares iaudit clients by audit staff as an in-house rule.

The argument that independence is not impaired because the holding is insignificant incorrect. If the holding is of such a size as is likely to influence the behaviour of the audit stamember, then it is material. If the staff member was allowed to retain the shares then he oshe should not have been included in the audit team.

If the partner advised the staff member not to sell the shares until after the audit wacompleted, then this would have been unethical and possibly illegal in that it constitutes insidedealing the use of privileged information to secure a personal advantage in the trading oshares.

(b) Management accounting servicesPreparation of accounting records on behalf of a listed or public interest company is normall

prohibited. An exception to this Rule allows such work to be performed in an emergencsituation which does not extend beyond the minimum period necessary and where every carwas taken that management accepted full responsibility for the work of the audit firms stafmember.

It is more reasonable, however, to argue that the assignment of a staff member to the positioof management accountant is likely to breach the rules on independence. It amounts to a stamember of the firm being engaged in making management decisions on behalf of the client

The firm will thus be reporting on a statement of financial performance in which one of its owemployees had played an active part. A user of the financial statements might conclude tha



10/92

the audit firm might have an incentive to conspire with management in concealing pooperformance attributable, in part, to the actions of its own staff member.

Tutorial note:An alternative answer could suggest that the work of the senior in winding upthe priors year audit be reviewed by a manager/partner unconnected with the client to confirmthat the standard of audit work was not in any way impaired by the knowledge that he was totake up a new position. It could also be considered whether the audit senior could participate inthe audit of the current year financial statements (for which he has contributed to thmanagement accounting system). It might be suggested that if the management and financia

accounting systems are very independent (as is sometimes the case) then he would not bauditing his own work. However, the personal relationships which have built up over a 3 month

period while he has effectively been an employee of the client alone might be sufficiengrounds for his removal from the audit team.

(c) Advice on controlsThis raises a controversial area in auditor independence. While the reporting of controweaknesses discovered during the audit is a required procedure, advising on the developmenof new systems to overcome those weaknesses is seen by some critics as a possible threat toindependence. There is both a general and a specific issue. The general issue is that audit firmgenerate revenues from clients for both audit and non-audit work. However, contracts for nonaudit work are given by management. In performing the audit, the auditors may be reluctant t

disagree with management for fear of losing non-audit contracts. The specific issue is thaknown as self-review. Since the firm designed the new internal control system, there is presumption, when evaluating control effectiveness at the next audit, that there willbe no weaknesses in the system.

Rules of Professional Conduct do not prevent auditors from providing non-audit services withithe overall fee limit of 15% from any one client. However, they do stress that, in advising thclient, the audit firm must not make executive decisions. The implementation of advice is thresponsibility of management over which the auditor has no control. At the next audit thauditor must check that the system has been properly put into operation and that it is beinoperated effectively.

(d) Advice to non-audit clientsAlthough Abel and Co are not threatening their own independence their action is in breach oprofessional rules on second opinions. By offering advice they are prejudicing thindependence of the auditors of the company they are advising. This practice is sometimereferred to as opinion shopping and is carried out by companies in order to exert pressure otheir existing auditors. This casts doubt about the integrity of this clients management whichas implications for the inherent risk assessment of such a client.

When invited to provide such advice, professional rules require Abel and Co to communicatdirectly with the companys auditors to ensure that their advice is based on all available factrelevant to the judgement. Abel and Co are under an ethical responsibility to decline to bnominated as auditors and to write to the company retracting the advice previously given i

the light of further information.

Answer 10 MELTON MANUFACTURING(a) Investigations and practical and ethical matters to be considered

Eligibility the firm should be recognised to provide audit services (eg a firm of ChartereCertified Accountants) and the reporting partner should hold a recognized qualification (eg be member of the Association of Chartered CertifiedAccountants and hold a practising certificate). The firm should have adequate professionaindemnity insurance (PII) cover.

The reason for the change in auditor whether it is just that the directors believe they do noreceive a cost effective service from the existing auditor. There may be problems with the leve



11/92

of the audit fee or the existing auditor may want to modify his auditors report (which thdirectors are trying to prevent).

Previous years audited accounts. If the auditors report is modified, it indicates that the audhas a higher than normal risk. From these accounts it may be possible to assess:

whether the company appears to be having going concern problems (eg by calculatinappropriate ratios, eg debt/equity ratio);

if there could be weaknesses in the system of internal control (because the company is smaor has a dominant proprietor). With a manufacturing company there are likely to be morproblems with the valuation of inventory, but there would be less risks over sales an

purchases as they are likely to be on credit. There could be problems with obsolete plant anequipment.

The size of the audit client and the fee compared with other clients. The Guide to ProfessionaEthics says that an auditors independence may be compromised if the fee from a single clienexceeds 15% of the total practice income (10% for listed and other public interest companies).

This does not appear to be a public company, but for a public company the auditor should nonormally both prepare and audit the financial statements. For other companies, if the auditoboth prepares and audits the financial statements, it is desirable that these are carried out bdifferent staff.

Independence issues in particular, shares should not be held in the client company. (Anyshareholdings should be disposed before being appointed as auditor.) Close family anbusiness relationship with any directors of the company would also impair objectivity.

Fees should be sufficient to provide an acceptable return. An inadequate fee could result iinsufficient audit work being carried out and thus increase the audit risk.

Prior experience of the manufacturing industry and auditing companies in this industryWithout such experience the auditor may not have the skills necessary to audit inventoryimpairment of plant and equipment, etc. Thus, the invitation to accept the audit appointmenwould need to be declined.

Whether staff with special skills (eg of computer-aided manufacturing design) or externaspecialists may be required to carry out certain aspects of the audit.

Whether Melton Manufacturing will give permission to communicate in writing with thretiring auditor. If the prospective client refuses, the nomination should be refused.

With permission, the retiring auditor will be contacted and asked if there are any professionareasons why the appointment should not be accepted.

If the company has not paid the retiring auditors fees, the appointment can be acceptedHowever, if it suggests that Melton is a bad payer it can obviously be declined.

(b) Letter of engagement(i) Importance

The main reason why it is important that an auditor should send a letter of engagement to thclient is that it explains the duties of the auditor: and the contract, which exists between thauditor and the client. If no letter of engagement is sent, disputes and misunderstandings maarise about the auditors duties.

The letter of engagement explains that the auditors duties are governed by the relevanlegislation and cannot be limited by the company. Also, the auditor reports to the shareholder(and not the directors) whether the financial statements show a true and fair view.

Further, it explains the directors responsibilities, particularly that they are responsible fopreparing the financial statements (although the auditor can prepare the financial statementfor the directors, if requested) and for ensuring there are proper systems of internal control tprevent or detect errors, irregularities and fraud.

The auditors are only responsible for giving an opinion on the financial statements. They arnot responsible for detecting small errors and fraud, but their audit procedures should have reasonable expectation of detecting material errors and fraud.

Finally, the engagement letter explains that the fee is based on the time spent by partnerand staff in carrying out the audit.



12/92

It is important that the auditor obtains the directors agreement of the letter of engagemenand that a revised letter is sent when there are significant changes to the terms of the existinletter.(ii) Main contents

The letter is written on the auditors headed paper and is addressed to the directors of MeltoManufacturing.

It states the directors responsibilities for keeping proper accounting records and for preparinfinancial statements which show a true and fair view. The directors must make available to thauditor all the records he may reasonably require, and provide answers to the auditor

questions.

The auditor has a duty to report on whether the financial statements show a true and fair viewand comply with any relevant legislation.

Normally, the auditor would report if the financial statements do not comply in any materiarespect with accounting standards (IASs).

The audit is conducted in accordance with Auditing Standards (ISAs).Oral or written representations may be asked from the directors concerning various matters i

the financial statements.The directors are responsible for preventing and detecting irregularities and fraud. The aud

procedures would be designed so there is a reasonable expectation of detecting materiamisstatements in the financial statements: However, the audit should not be relied upon fo

detecting all irregularities and fraud that may exist.As auditor, we may provide additional services. For example:Preparing financial statements;Lodging returns with the Registrar of Companies;Investigating irregularities and fraud;Providing taxation services.Fees are based on the time spent by partners and staff and on the levels of skill and

responsibility involved. The letter ends by saying that it remains effective until it is replacedand it asks the directors to agree the terms of the letter in writing.

Answer 11 BONDI(a) Arguments against acceptance of nomination

Rapid growth is often accompanied by inadequate accounting systems and weak internacontrols. Of itself this is not sufficient reason to decline an audit but it increases inherent risk.

Rapid growth through aggressive take-overs implies a management philosophy that is willinto accept risks and this is likely to apply to controls as well. Again this increases inherent risk.

Failure to take action against employee fraud brought to their notice by the auditors is morserious. This fosters a visible culture of unethical behaviour that is likely to permeate thcompany and to be shared by all employees. This will result in a weak control environment.

Introduction of a new computer system must be undertaken very carefully. Inaddition, an unnecessarily complicated system is one of the warning signs of fraud.

Such a computer system may be difficult to audit.

Aggression against audit staff is a well known device for concealment of top managemenfraud. There are many documented examples of audit failure through fear of the audit staff tquery management explanations.

The impending public listing means that the company is under pressure to show an improvinperformance but also means that the work of the auditor will come under increasing scrutiny

There are always significant risks in accepting an audit under such terms.

Arguments for accepting nominationATC-Adding Value To Your Future 12


13/92

As a larger firm your firm is likely to have the capability of influencing the directors of Bondand persuading them of the benefits of a more ethical style of business. This will benefit thcompanys shareholders. If your firm rejects the audit they are likely to appoint a less reputablfirm. This will not be in the shareholders interest and may discredit the profession.

(b) Matters relevant to obtaining knowledge for development of the audit planEmployee frauds

More information is needed about the alleged employee frauds. In particular thespecific control weaknesses that were exploited and whether any changes have since

been made to the accounting and internal control systems.

The current positions held by the guilty employees and whether they have access toassets and accounting records. Also, whether they are adequately supervisedespecially if a lack of segregation of duties is apparent.

Computer systemParticular attention should be given to the control environment relating to computer system

and to the evaluation of general (IT) and application controls.

The audit team should include sufficient computer audit specialists.

Tests of controls could include the use of test data or other computer assisted audtechniques.

Contracts with manufacturersExamine the terms of contracts and the strategies adopted by the company for securing

maximum benefit from them.

An industry specialist may provide evidence regarding the problems encountered bmanufacturers and dealers in confirming compliance with these contracts.

As the incentive schemes may have accounting implications (eg 0% finance) the commerciasubstance as well as the legal form of the transactions with the manufactures must b

understood and the impact on the financial statementsassessed.

(c) MisstatementAs this appears to be a fraud against the government through falsification of accountin

records, the evidence that the falsification of the records is deliberate and not an accidentaconsequence of a poorly designed computer system, must be documented.

The matter must be discussed with management. Management must be asked to: correct the fictitious records; make full provision for all taxes including any penalties for which they are potentially liableand

make a full disclosure to the taxation authorities.

If management refuse, the audit opinion should be qualified if the amount of taxes noprovided for, if material. (However, the auditors report should not, for example, accuse thdirectors of impropriety.)

The auditors duty of confidentiality prevents the auditor from raising the matter with thtaxation authorities. Therefore, it may be most appropriate to resign from the audit management refuse to put a stop to the malpractice. Any written statement of circumstancesrequired on ceasing to hold office could allude to the matter but would need to be carefull



14/92

worded, probably with legal advice, to avoid accusing the directors of fraud and exposing thfirm to a charge of defamation.

Answer 12 PLANNING DOCUMENTATION(a) Overall audit plan vAudit program

These documents are prepared during the planning process. The general strategy to the audassignment is first set out in the overall audit plan. The detailed approach for the nature, timinand extent of the audit procedures is set out in the audit program. The overall audit placonsiders those factors which underlie the conduct of the audit as a whole such as the natur

and location of the business, whether systems are computerised, risk and materiality, and usof the work of others (eg internal audit and experts).

The plan typically contains significant information such as:Terms of engagement scope of the audit and any other services to be provided;

Key figures, ratios and indicators and the basis on which materiality is determined at thfinancial statements level;

Client assistance including preparation of working papers, branch visits, etc;

Audit approach extent to which reliance is likely to be placed on tests of control, analyticaprocedures and tests of detail;

Timetable, including attendance at physical inventory counting, direct confirmation dates anreporting deadlines.

Staffing requirements with time budget and estimate of audit fee. The audit program is morspecific and concerns the principal audit areas. Fore example, tangible assets, inventoryrevenue cycle (ie sales, receivables and cash receipts), etc. A program typically contains:

Audit objectives eg To ensure inventory is materially correctly stated;

Audit procedures eg attendance at physical inventory count;

Timing of tests of control (usually interim audit procedures) and substantive procedure

(usually at the final audit).

The audit program has to be much more detailed than the overall audit plan in order to servas a set of instructions.

(b) Standardized audit programsTutorial note: The Q refers only to the use of standardized AUDIT PROGRAMS and noworking papers in general. Thus references to the use of standard letters and documentationother than programs are not relevant to answering the question set.

AdvantagesTheir use can lead to more efficient planning in identifying the audit objectives and adoptin

an approach based on these objectives. Greater assurance as to the completeness of the audapproach is obtained than if it were started from scratch. Planning can be undertaken by lessenior staff.

Standardised programmes facilitate delegation to junior staff and help to instruct in basiaudit techniques. They help to ensure that all assignments are planned and conducted to consistent quality.

A standardised approach makes the review of audit working papers easier. Programmes mainclude sections to be completed, thereby reducing the need for separate supporting workinpapers.



15/92

DisadvantagesStandardisation may lead to an overly mechanical approach. This may stifle initiative becaus

an alternative, more efficient approach may not be considered.

No account is taken of the particular circumstances of the individual enterprise. This decreasin the use of professional judgement for a particular assignment might result in over-auditinlow risk or immaterial areas.

There is a risk that sufficient, relevant and reliable audit evidence may not be obtained. Foexample, where alternatives to tests not applicable to a particular client, are not considered.

ConclusionStandard audit programmes may be useful on certain assignments to improve audit efficienc

but they cannot replace the need for professional judgement.

(c) Information in working papers relating to attendance at physical inventory countViewcos physical count arrangements and instructions should be obtained before attendinthe count:

to assess the adequacy of the clients planned procedures; andto ascertain whether clients staff are carrying out their instructions properly.

Pre-selected (eg high value) items chosen to ensure that an adequate proportion of the finainventory value is tested (to conclude satisfactorily on the population).

Results of test counts (ie serial/component references and quantities) provide evidence as tthe completeness and accuracy (or otherwise) of the count records (ie rough count sheets

Test counts also enable the auditor to assess whether the clients count procedures ancontrols are working properly.

The sequence of rough count sheets issued and used will detect any additional items beinincluded subsequent to attending the count.

Inventories identified as damaged, obsolete or slow-moving must be detailed to assess theadequacy of allowances/provisions for items with net realisable value less than cost.

Items owned by third parties must be recorded to ensure exclusion from the final inventorvaluation sheets.

Last goods movement document references for 31 December 2003 (ie goods received notestores requisition, despatch note/sales invoice) are needed to check the accuracy of the yeaend cutoff.

Movements, if any, during physical inventory counting to ensure items are not omitted odouble-counted in error.

Other pointsA floor plan (sketch) of central warehouse should ensure complete coverage (by managemen

and auditor) of the physical inventory count. Details (eg serial numbers) of finished goods held by third parties are required to confirm the

validity of their inclusion in the final inventory value. The degree of assembly of incomplete TVs and VRs must be noted to assess appropriateness

of stage of completion used in valuing WIP. Instances where the clients procedures have not been satisfactorily carried out (eg damage

items not set aside) will be required for the report to management with recommendations foimprovements (eg in standing instructions for physical counts).



16/92

Answer 13 BESTWOOD TRADING(a) Audit working papers(i) Contents

The permanent audit file contains information which is relevant to many years audits. Itscontents can include:

the letter of engagement;the memorandum and articles of the company;a history of the company, a description of its business and details of directors and

senior staff;copies of previous years financial statements with ratio analysis and comment on

the figures;AUDIT AND INTERNAL REVIEW (INTERNATIONAL)

Accountancy Tuition Centre (International Holdings) Ltd 2004 1027details of the companys accounting systems, flowcharts of those systems and

completed Internal Control Evaluation Questionnaires (ICEs) or Internal ControlQuestionnaires (ICQs);

copies of significant documents, including minutes of significant board meetings.The current audit fire contains documents which are relevant to the current years audit. Thisinformation includes:

evidence of planning of the audit including the audit planning memorandum;

copies of board minutes, significant management reports, management accounts, thetrial balance and draft financial statements. There should be a reconciliation of anydifference in profit between the draft financial statements and the managementaccounts;

consideration of audit risk for each area of the audit. This could include notes onhigh risk areas of the audit and decisions on sample sizes;

copies of flowcharts and completed ICQs or ICEs if they are not included in thepermanent audit file;Tutorial note: It may be preferable to include flowcharts and ICEs or ICQs in thecurrent audit file when there are changes to the systems in the year.

the results of evaluation of controls supporting the assessed level of control risk;records of the audit work done, problems encountered and conclusions reached (see

below);by whom the schedules have been prepared and reviewed (as evidenced by their

initials) and when (ie date);a section for the managers and partners attention which lists significant problems

encountered in the audit. This will include a summary of unadjusted errors. Thissection will direct the partner to these important areas, and to decide whether thefinancial statements need amending or a qualified auditors report should be given.(ii) Referencing systemRecording audit work in working papers is usually divided into sections which have areference letter or number. For instance, the letter R could be used for Sales andReceivables work. Thus, for any audit carried out by the firm, any member of staff wantingto look at audit work on Sales or Receivables can go to the section with the letter R. Within

each section, there will be a sub-division whereby verification of receivables will be in pagesRl to 099 and audit work on the sales system will be on pages R100 to R199 (ie tests onbalance sheet items will be on pages 1-99 and tests on accounting systems will be on pages100-199 these numbers will be preceded by a letter which signifies the area of the audit,with R being for sales and receivables). The front page of the R section of the audit filewill show the value of receivables in the balance sheet, and references on the make-up ofreceivables will be to the pages where details of verification of these items is included in theworking papers. For instance, the total value of receivables will be broken down into:

verifying the gross value of trade receivables (eg on page R2 of the audit file);checking the bad and doubtful debt provision (eg on page R5);audit of sundry receivables and prepayments (eg on page R10).



17/92

AUDIT AND INTERNAL REVIEW (INTERNATIONAL) Accountancy Tuition Centre (International Holdings) Ltd 2004 1028

By using this standardized procedure for referencing audit files, all members of the firmsaudit staff, including managers and partners can review each section of the audit in asystematic manner. This should enable them to come to an appropriate conclusion on theaudit work done and the form of auditors report which should be attached to the financialstatements. If no standardized procedure is used. the partner would find it time-consuming tofind a particular matter in the audit file. By standardizing audit files, the audit work should becarried out in a more systematic manner which should ensure a high quality audit is carried

out.Particularly important sections in audit files include:

conclusions reached in each area of the audit and notes of any significant problemsdetected;

matters for consideration by the partner and the summary of unadjusted errors(which should include significant uncertainties).(iii) Types of checklists

Internal control evaluation questionnaires (ICE) and internal control questionnaires(ICQ) for evaluating controls in accounting systems.

Physical inventory count checklists which are used to record work done and toensure all aspects are covered.

Companies Act and International Financial Reporting Standards checklists to ensure

the financial statements comply with relevant statutory and professionalrequirements.

Audit completion checklists to help the auditor ensure all material audit work hasbeen performed and matters considered.Checklists are important, as they are a means of ensuring that all aspects of the audit work arecarried out. A standard ICE on the sales system would be better than one prepared for eachaudit, as the standard ICE will be tried and tested so there will be a lower risk of a matterbeing omitted than if the checklist was prepared by the auditor at each audit.Types of specimen letters

The engagement letter which the auditor should send to the client (and get agreed bythe client) before the audit is accepted. The contents of this letter should bereviewed and a new one issued and agreed when there are significant changes in the

auditors responsibilities.Management letters which are letters sent by the auditor to the company recording

weaknesses found in the audit.Management representation letter which is a letter drafted by the auditor, but on the

companys letter heading and signed by the directors. It is used to enable thedirectors to confirm to the auditor certain matters where the auditor cannot obtainadequate evidence from other sources.

Bank letter, where the bank states the balances on the companys bank accounts andother matters.AUDIT AND INTERNAL REVIEW (INTERNATIONAL)

Accountancy Tuition Centre (International Holdings) Ltd 2004 1029Direct confirmation letters from customers. The circularisation letter asks

customers of the company to confirm (or otherwise) the balance on the sales ledger.(b) Reasons why auditors have working papers

As a record of work performed on the audit, and to ensure a consistent, logical andreasoned approach to audit work by following an audit plan and recording workperformed as the audit progresses.

To assist the manager in reviewing the audit work, and the partner in coming to anaudit opinion. The audit working papers will provide evidence to the partner ofwork done. From the working papers it may become apparent that insufficient workhas been carried out in certain areas and more work is required.

To provide evidence of work done if there is a threat of or action taken against theauditor for negligence. The audit working papers should provide evidence that



18/92

appropriate audit procedures have been carried out and conclusions reached, In thecase of a material doubtful debt, should show the evidence the auditor has obtainedand the matters he has considered in deciding whether the companys estimate ofthe bad debt provision is reasonable.Generally, all audit work should be recorded in the audit working papers. Work performed onsome immaterial items may not be included. However, as is noted in part (c) below, it isdesirable that all audit work is recorded, as an item which may appear to be immaterial maysubsequently become material. For instance, an item which is checked in a test of controlsmay not in itself be material, but an error detected in a test will probably be material in terms

of the conclusion reached on the population (using statistics). To a certain extent, auditworking papers are a summary of work done. So a check performed in a test of control maybe signified by an audit tick against the item, and the tick will be explained at the bottom ofthe schedule. If some audit work is thought to be unimportant (and thus there is thepossibility of it not being recorded) the auditor should consider whether it is necessary tocarry out that work.It is important to record audit work as, if legal action is taken against the audit firm, it may benecessary for the firm to demonstrate that items have been checked and support theconclusions reached.(c) Late banking of cash receiptsIf the late banking of receipts of $7,000 was a fraud at 31 October 2002, this is 4.4% of profitbefore tax, so it is unlikely to be material. When the fraud was found in May 2003, it

amounted to 11.25% of profit before tax which is probably material. If the auditor did notreport the late banking to the company which he found at 31 October 2002, then he could beheld (partially) responsible for the loss between 31 October 2002 and when it was found inMay 2003. The loss during this period is $11,000, or 6.9% of profit before tax, which may bematerial.AUDIT AND INTERNAL REVIEW (INTERNATIONAL)

Accountancy Tuition Centre (International Holdings) Ltd 2004 1030(i) Reported in the management letterIt appears the auditor is not negligent. The only matters which might be unsatisfactory in theauditors work are:

it appears he has not determined whether a fraud was being carried out at 31October 2002; and

the company should have been informed immediately at the time the discrepancywas found, rather than leaving it to the management letter.However, both of these criticisms of the auditor appear to be relatively minor. It may not bepossible at todays date to determine whether there was fraud at 31 October 2002, as the$7,000 of late banking could have been held by the cashier (although this seems unlikely). Inconclusion, the auditor is probably not liable for negligence in this situation. The companyhas been warned of the risk of a fraud but appears to have taken no action until May 2003.(ii) Not mentioned in the management letterIn this situation, the auditor may have some liability for negligence. The late banking ofdeposits should have been reported to the company both verbally and in the auditorsmanagement letter. Also, the auditor should have been put upon enquiry by the delay andinvestigated the matter further as at 31 October 2002 (or at the date he checked the bank

reconciliation). Thus, the auditor has some liability for negligence for not reporting thematter to the companys management and not carrying out further procedures.

The auditor could argue the possible fraud at 31 October 2002 was immaterial as it is 4.4% ofprofit before tax, but by taking no action on the matter it has increased to 11.25% of profitbefore tax, which is material. The auditor should not be held wholly responsible for the extraloss of $11,000 (between 31 October 2002 and May 2003) as it is probable that thecompanys control procedures were inadequate. As the cashier was recording cash receivedand preparing the bank reconciliation as well as having custody of the cash received therewas an inadequate division of duties, so another person in the company should either haveprepared the bank reconciliation or checked it. It is apparent that either this check was notbeing performed or it was not performed competently. As the auditor was aware of the late



19/92

banking of $7,000 of cash receipts and he should have been aware of the weakness in controlover the cashier, the auditor should have reported these problems to the company, eventhough the fraud was immaterial at the time of the audit.

Thus, in this situation, the auditor has some liability for the fraud continuing but this ismitigated by the fact that there was a clear weakness in the division of duties with the cashierand the company should have established an effective system of internal check over thecashiers work. This was either not being performed or not being performed competently.

Thus, the company must accept some liability for the fraud developing. If the case came tocourt, reference will probably be made to the audit working papers as one factor in

determining the extent of the auditors liability for negligence.

Answer 15 PHONES ANYWHERE(a) Risks associated with the audit

There appear to be considerable risks associated with undertaking the audit. In particular;Phones Anywhere appears to have a very high inherent risk.

The low coverage of the country will be a disincentive to new subscribers. Initially,subscribers will only be those who operate in the town with a population of1,000,000. The service will not be available when the subscribers are outside thattown. There will be serious doubts about going concern if the company does nothave the financial resources for future developments (to towns with a population of250,000 in the next year and its planned developments to the year 2006).

The companys plans for extending the network do not appear to be realistic, asmany mobile phones are used on motorways and trunk roads. Motorways will notbe covered until the year 2006, and coverage of other roads is not mentioned. Theseplans are likely to be a serious disincentive to new subscribers joining the system,when competitors cover most of the country. The risk of business failure appears tobe high.

The central computer is pivotal to the organization, as it relays the calls andcalculates the bills for subscribers. Will this computer and its software be reliable?

The consequences of a breakdown of the computer will be very serious. Ideally,there should be more than one computer running the system, and the system shouldbe able to continue if one of the computers fails.

What is the capacity of the main computer? With the planned expansion, it is

probable that it will run out of capacity in the near future. Is it possible to expandthe capacity of the computer? Has the cost of upgrading the computer beenincluded in future forecasts? Will the current software be able to process a largeincrease in subscribers, or will it have to be re-written (at substantial cost)?

Is it reasonable to amortise the cost of the relay stations and main computer over sixyears? Six years may be realistic for the buildings part of capital expenditure, butit may be too long for electronic components including the main computer andtransmitters.

Is the discount paid to retailers for the purchase of the phones recoverable? It iscapitalised and amortised over four years. Do subscribers remain connected to asingle operator for as long as four years (if many change in less than four years, thisamortisation period is too long), and are subscribers likely to change their phones

within four years (to update to a more advanced model)?Paying the executive directors a bonus based on the number of subscribers of the

system could encourage them to obtain as many subscribers as possible (by offeringdiscounted prices) rather than charging a realistic price which will ensure the longterm future of the company. However, the executive directors should be concernedwith the long-term future of the company, as this will ensure they continue to bepaid (rather than have to find a new job when the company fails).AUDIT AND INTERNAL REVIEW (INTERNATIONAL)

Accountancy Tuition Centre (International Holdings) Ltd 2004 1035In view of the planned high borrowings, and future trading losses, there is a very

serious risk the company may not be a going concern. This increases the risk of theATC-Adding Value To Your Future 19


20/92

audit firm being sued for negligence. Also, Phones Anywhere will put severepressure on the audit firm to give an unmodified auditors report. This pressure willincrease because the audit firm is small and Phones Anywhere is a relatively largeand rapidly growing company.

As an alternative to the company not being a going concern, there is the risk thatother investors may purchase more shares in the company (to provide additionalequity finance) or purchase the company outright from the existing directors (or theadministrator/liquidator). If this occurs, recent financial statements will be subjectto close scrutiny. The standard of audit work will have to be high, and the problems

mentioned above (eg complex computer systems and depreciation rates which maybe inaccurate) could lead to undetected material errors in the financial statements.

Thus, there is a high risk that legal action for negligence could be taken against theaudit firm following a take-over or purchase of shares.

Flotation of the company on the Stock Exchange is a further risk. Immediatelyprior to the flotation, audit work carried out will be subject to close scrutiny. Theincrease in audit risk must be reduced by an increase in audit work (to reducedetection risk) increasing the cost of the audit and reducing its profitability. Also,when the company becomes quoted on the Stock Exchange, it is probable the auditfirm will be replaced as being too small. The majority of companies quoted onrecognised Stock Exchange are audited by one of the big 5 firms.

This is a high technology industry. The technology or customer requirements may

change, which could make parts of the equipment obsolete. Alternatively, it couldbe expensive to modify the equipment or software to meet the demands ofsubscribers. Is the company currently providing a similar range of facilities to othermobile phone companies. If its service is not as comprehensive as other mobilephone companies, it may not be successful in breaking into the market.

This appears to be a very competitive industry. Are the competitors profitable, orare they making losses to keep prices low to prevent other companies entering themarket? Establishing Phones Anywhere as a major company in the market willprobably require large expenditure on advertising and offering new subscribers aservice at a lower price than competitors. Both of these factors will tend to makePhones Anywhere unprofitable (as note (j) in the question suggests).

The reputation of the three major shareholders and the executive directors should be

assessed. If they have been directors of companies which have failed, or beeninvolved in financial or other wrongdoings, this will increase the inherent risk. Thereputation of the financial director and the quality of the accounting records shouldalso be considered.AUDIT AND INTERNAL REVIEW (INTERNATIONAL)

Accountancy Tuition Centre (International Holdings) Ltd 2004 1036(b) Professional and ethical matters

The size of the audit fee. The Association of Chartered Certified Accountants(ACCA) rules of professional conduct say the fees for audit and other recurringwork paid by one client should not normally exceed I5% of the gross practiceincome (and 10% for listed and other public interest companies). If the plannedaudit fee is over 15% of the current practice income, the audit should not be

accepted. However, the rate of expansion of Phones Anywhere will probably bemuch greater than the increase in practice income, so the 15% rule may become aproblem in the next few years. When Phones Anywhere becomes a listed companyin the year 2006, the audit fee from Phones Anywhere must be less than 10% of thefees of the practice. It seems probable that this limit of 10% will be exceeded. Inpractice, it is undesirable for the audit fee to approach 15% of the practice income,as reliance on such a large audit fee could be seen to affect the firms independence.

The audit firm may be able to audit Phones Anywhere at its current size. However,when the system covers all towns with a population of over 250,000, on occasionsaudit work will probably have to cover all areas of the country, and it is mostunlikely that the audit firm will have sufficient staff to perform this work.



21/92

Whether the firm is technically competent to perform the audit, and whether the sizeof the firm being audited is too large for the experience of the practice. Mobiletelephone companies are very complex and have specialised accounting procedures;both in terms of the accounting system and the ways matters are treated in thefinancial statements (eg the advance payment of $200 given towards the purchase ofphones purchased by new subscribers). The firm will probably not have experiencein auditing the computerised accounting system which controls calls and generatesbills for subscribers. This requires specialised computer auditing techniques. Thefirm may also be unfamiliar with many of the accounting treatments for non-current

assets and may not be able to determine whether the lives given to non-currentassets are reasonable. This lack of experience will probably mean that the audit willbe too high a risk for the audit firm (ie the firms relative inexperience will meanthat a satisfactory audit cannot be carried out, so there will be a high risk of materialmisstatements in the financial statements, which increases the risk of litigationbeing brought against the firm).

The audit firm must have adequate professional indemnity insurance (PII) cover.This is unlikely in view of the size of Phones Anywhere, so there will be anincreased cost of obtaining more PII cover. The insurance company may refuse toincrease the PII cover if it perceives this to be a high risk audit which is exacerbatedby the small size of the firm.Other matters

The audit partners must have no family or personal relationships with the directorsof Phones Anywhere. These relationships also apply to any staff involved in theaudit. Ideally, none of the firms staff should have relationships with the directorsof Phones Anywhere.

No one in the audit firm should own shares or any investments in PhonesAnywhere.

No one in the audit firm should be a beneficiary or trustee of a trust which holdsshares in Phones Anywhere. The ACCAs rules of professional conduct do allowemployees of the audit firm to be a beneficiary of shares in an audit client, but thatemployee must not be employed on the audit of that client. For trustees, the trustshould hold less than 10% of the shares of the company, and the value of the shares

should be less than 10% of the total assets of the trust.Employees and partners of the audit firm must not vote on the appointment, removal

or remuneration of a firm which is an audit client.The audit firm should not make a loan to or accept a loan from an audit client

(exceptions to this rule apply where the audit client is a bank or other financialinstitution which does not appear to apply in this case).

The audit fee has been considered earlier in this section. However, the audit fee should besufficient for the firm to perform the audit to a satisfactory standard. Thus, it would not beacceptable to offer a very low fee (often called lowballing) in order to obtain the audit, asthis would impose pressure on the time allowed to carry out the audit. This could lead toinadequate audit work being carried out which would increase the risk that materialmisstatements in the financial statements may not be detected.

Other matters covered by the ACCAs rules of Professional ConductWhen the audit firm is asked to accept the audit appointment, the clients

permission to communicate with the existing auditor must be sought. If thispermission is refused, the firm should decline to accept appointment as auditor.

The audit firm should write to the existing auditor requesting all the informationwhich ought to be made available to decide whether or not to accept the auditappointment.

The audit firm should consider the reply from the existing auditor. If the existingauditor makes adverse comments, further consideration should be given whether ornot to accept the audit appointment.

If the existing auditor does not reply to the letter, a further letter should be sentATC-Adding Value To Your Future 21


22/92

giving notice (eg seven days) that if no reply is received in that time, it isunderstood that there are no professional or other reasons preventing the firm fromaccepting the audit appointment.

Before finally accepting the audit, a letter of engagement should be prepared and thedirectors of Phones Anywhere asked to sign it.

(c) ConclusionFrom the discussion above, the firm should not offer itself nor accept the appointment as

auditor of Phones Anywhere. The main reasons for this decision are:Phones Anywhere appears to be too large a company for the firm to audit, and it is

likely to grow faster than the audit firm. The audit fee will probably exceed theACCAs limit of 15% of the practice income, and if this is not exceeded now, it islikely to be exceeded in the next few years.

Phones Anywhere is a specialised company with complex computer systems. It ispossible the firm will not have the skills to perform this work.AUDIT AND INTERNAL REVIEW (INTERNATIONAL)

Accountancy Tuition Centre (International Holdings) Ltd 2004 1038The accounting conventions for Phones Anywhere may be unfamiliar to a small

firm, particularly the treatment of the $200 given to new subscribers to purchase thephones and the lives of the non-current assets. If the firm doe not have the skills to

consider whether these treatments are satisfactory this could lead materialmisstatements in the financial statements being undetected.

Phones Anywhere appears to be undercapitalised. Currently, leverage is 20% butthis will increase substantially with expansion of the network and losses in earlyyears of trading. Thus, there is a serious risk that Phones Anywhere will fail or betaken over, which could result in the firm being sued for negligence.

The large size of Phones Anywhere and the small size of the audit firm couldcompromise the firms independence. Third parties (including shareholders) willperceive that the firm is not independent (on the relative size criteria), and PhonesAnywhere could bring severe pressure on the firm which would be hard to resist (iethey will ask for an unmodified auditors report to be given when either a qualifiedopinion should be given or an emphasis of matter paragraph included).

The potential listing of the company on the Stock Exchange increases the audit risk,as there will be greater scrutiny of the financial statements prior to listing, whichcould highlight problems in the financial statements.

Finally, because of the large size of Phones Anywhere and the large audit fee,Phones Anywhere may attempt to squeeze the audit fee. Accepting a reducedaudit fee (rather than losing altogether such a large audit fee) could result in areduction in the time to perform the audit and thus increase the risk of not detectingmaterial misstatements in the financial statements.

Answer 16 BRIDGFORD PRODUCTS(a) Importance of planningISA 300 Planning requires that The auditor should plan the audit work so that the audit will

be performed in an effective manner. It goes on to say that planning means developing ageneral strategy and a detailed approach for the expected nature, timing and extent of theaudit.As this is a continuing audit, the general strategy will probably be similar to last years audit.However it will be modified by problems experienced in last years audit and significantevents which have taken place in the company since last years audit. The timing of the auditwork is important, as time will be wasted if it is planned to carry out audit work when theappropriate information is not available from the company.

The timing of the audit work will influence the make-up of the audit staff during the audit (iethe balance between junior and experienced audit staff). It will be necessary to agree atimetable with the company of when information will be available and this will determine



23/92

when the audit work is carried out. Also, the following dates will be important:the inventory countwhen the full financial statements are available for auditwhen the financial statements are agreed and signed by the directors and the auditorthe date of the annual general meeting when the financial statements are approved

by the shareholders.

The extent of the audit work in each area will have to be considered. This will be based on a

number of factors, including the materiality of the item and the audit risk based on experiencein previous years audits.A budget will be prepared which suggests the time which should be spent on each aspect ofthe audit and the completion dates of each part of the audit.During the audit, progress will be compared with the audit plan. Any adverse (andfavourable) variances against the plan will be investigated, and the plan amended if it isconsidered appropriate.Planning an audit is important. One would not build a house without a plan, so one shouldnot carry out an audit without a plan. The requirement to plan an audit ensures senior auditstaff have considered the work which is required to complete the audit, and the timing of thatwork so that it fits in with the dates information is available from the company and theplanned completion date when the financial statements are approved by the directors and the

auditor. By having a plan, the auditor should take a more considered approach to the auditwhich will improve the quality of the audit, and thus both minimise the time spent on theaudit and the overall audit risk. When the audit is carried out, the progress can be monitoredagainst the plan, and action taken when the audit starts to take more time than expected, bothin terms of staff time and in reaching deadlines.(b) Matters to be considered and further action(i) Sales and profits

The companys sales for 10 months are $130 million, which given an annualised sales of$156 million, is a 41.8% increase over the previous years. The annualised profit before tax is$4.8 million, compared with $8 million last year, which is a fall of 40%. It appears thecompany is increasing sales at the expense of profits. If profits are falling, the actual profitfor the 10 months to 30 November 2003 may be even less than the $4 million shown by the

monthly accounts. The fall in profit indicates problems which may not be fully reflected inthe monthly accounts(ii) New computerised inventory systemAudit work will have to be carried out on the new computerised inventory control system.Computer audit specialists within the audit firm will probably have to be used. It may beappropriate to carry out this work before the year end, so that any problems with the systemcan be highlighted and either overcome or allowed for at the year end.

The company says it will not be carrying out an inventory count at the year end, so as auditorI will have to place considerable reliance on the accuracy of the inventory quantities reportedby the inventory control system. I will have to determine from the company how frequentlythey count the inventory, the proportion of the inventory counted at each inventory count, andthe checks they make to the inventory quantities on the computerised system. If there are a

large number of differences between the physical inventory quantities and those on thecomputer, inventory counts should be carried out more frequently and on a larger proportionof the inventory than if differences are infrequent. This information will have to bedetermined before the year end, as, if differences are frequent, it may be necessary to carryout a full inventory count at the year end. Otherwise, there is a high risk the auditors reportwill have to be modified.

(iii) Product reliabilityReliability problems with the companys products could result in the following:

Certain inventory being unsaleable, and thus worth less than cost (or even beingworth only scrap value);



24/92

Legal claims against the company;Customers not paying for the products.

Tutorial note: These last two points are mentioned in the question.Further details will have to be obtained about legal claims against the company and customersrefusing to pay their outstanding balances. Information can be obtained for this by inspectingcorrespondence with customers and discussing the matter with the companys staff, includingthe company secretary, sales director and the credit controller.

The audit risks with these problems include:The difficulty in estimating the costs (ie the costs of defending legal claims and

damages which may have to be paid, and the cost of the bad debts).The risk that there may be more claims and bad debts, which relate to the yea

External Audit Services

Documents

Transcript of External Audit Services