P7 Final Assessment - Answers S15-D15

ACCA

Paper P7 (INT-UK)

Advanced Audit and Assurance September and December 2015

Final assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the final assessment questions and submitted them for marking.

PAPER P7 ( INT-UK) : ADVANCED AUDIT AND ASSURANCE

2 KAPLAN PUBLISHING

© Kaplan Financial Limited, 2015

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FINAL ASSESSMENT ANSWERS

KAPLAN PUBLISHING 3

SECTION A

1 FAIRVIEW

Key answer tips

Parts (a) and (b) of this question are typical of the requirements in the first of the case study questions in the real exam.

The focus of part (a) is risk. A business risk is a threat to an ongoing business objective. Audit risk is the risk of giving an inappropriate opinion, i.e. the risk of a material misstatement in the financial statements that the auditor fails to detect. It is important that you clearly explain the commercial implications for business risks but for audit risk you clearly explain the potential impact on the financial statements, or the audit. When explaining business risks take note of the combined effects, don’t just look at each factor in isolation.

In part (b) you must describe audit procedures relevant to the specific named parts of the financial statements. This requires a combination of good knowledge of the financial reporting standards so that you know what to test, and of how to design audit procedures. The procedures must be sufficiently detailed to provide enough information for an auditor to follow the instruction. A core part of this is to explain the purpose/objectivity of the procedure.

Part (c) is more unusual, but a common sense approach will provide a good answer. Note the three overarching reasons why a company would change auditor, i.e. because they want to, because they have to, or because the auditor chooses to end the relationship.

Don’t forget to structure your answer with the use of clear headings and short paragraphs.

(a) Briefing Notes [1 mark]

To: Audit partner

From: Audit manager

Subject: Risk assessment – Wisteria Co

Introduction [½ mark]

These briefing notes evaluate the business risks and audit risks to be considered at the planning stage of Wisteria Co. Training notes for the new recruits explaining the need to perform risk assessment are also included.

(i) Business risk understanding

Definition

A business risk is one resulting from significant events, conditions, circumstances, actions or inactions that could adversely affect an entity's ability to achieve its objectives and execute its strategies. [1 mark]

Link between business risk and the FS

Most business risks will eventually have financial consequences, and therefore an effect on the financial statements. The auditor is required to identify and assess the risks of material misstatement in the financial statements thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement. [1 mark]


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Internal controls

Weak internal systems and controls are often identified as a business risk as they can lead to frauds and errors. Inadequacies in systems and controls could lead to errors or misstatements in any area of the financial statements. [1 mark]

Going concern

Business risks are often linked to going concern issues, because if a business is failing to meet objectives such as cash generation, or revenue maximisation, then it may struggle to continue in operational existence. [1 mark]

The risk of material misstatement in relation to going concern is normally the inadequate disclosure of going concern problems. In the extreme situation where a business is definitely not a going concern, then the risk is that the financial statements have been prepared on the wrong basis, as in this case the ‘break up basis’ should be used. [1 mark]

Generates extensive business understanding

The auditor is required by ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment to obtain an understanding of the entity and its environment in order to identify and assess the risks of material misstatement in the financial statements. This includes obtaining an understanding of the entity’s objectives and strategies, and those related business risks that may result in risks of material misstatement. [1 mark]

In summary, auditors must assess business risk in order to:

− Develop business understanding

− Increase the likelihood of identifying specific risks of material misstatement and

− Evaluate overall audit risk

− Comply with the International Standards on Auditing.

[1 mark]

(ii) Business risks

Poor performance and recent improvement

Wisteria Co has suffered poor performance for a number of years, only recently recovering. [½ mark]

The ability of Wisteria Co to sustain the recent improvement achieved may be difficult, particularly with the plans to downsize the company. [½ mark]

Certainly in the short-term with the sale of land and redundancies that are planned, there are likely to be unforeseen costs and possible losses on the sale of the land that may prevent Wisteria Co from sustaining a profit. [½ mark]

If the company’s profits were to fall further or the downsizing is received badly by the shareholders, the share price may be further affected. [½ mark]

Alleged mis-selling investigation

Wisteria Co is being investigated for mis-selling by a government body. The mis-selling investigation could result in significant financial penalties for Wisteria Co. [½ mark]


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In addition, customer compensation claims could be received if the investigation finds Wisteria Co guilty of mis-selling resulting in further costs. [½ mark]

Whilst the investigation is ongoing, and if the allegations are proven, customer numbers may fall further as a result of damage to Wisteria Co’s reputation. [½ mark]

Wisteria Co is vigorously defending its case, which will result in significant legal and other costs further damaging profits. [½ mark]

Hostile takeover attempts

A number of buyout groups have approached the board of Wisteria Co with an offer to purchase the entire share capital of the company, which have been rejected by the board. [½ mark]

The board of directors may be rejecting a fair takeover offer in order to protect their own interests (job security). [½ mark]

In particular, due to the price-sensitivity of the shares a takeover attempt could be successful. [½ mark]

If a hostile takeover attempt succeeds, this could mean that shareholders do not receive a fair price for their shares. [½ mark]

Government grant

Wisteria Co has been awarded a government grant for installation of energy saving devices in the boilers of 100,000 eligible customers. Wisteria Co is not able to charge customers for the installation of the energy saving devices. [½ mark]

The grant is to cover the costs of installation. It is not clear whether any element of profit can be built in to this for Wisteria Co or if it is a not-for-profit scheme. There is a risk that Wisteria Co will incur costs which the grant cannot be used to cover, reducing Wisteria’s overall profit. [½ mark]

If Wisteria Co does not meet the required 100,000 installation target by the deadline the grant may become repayable in part or in full, significantly reducing profit. [½ mark]

If Wisteria Co installs the device for customers who are not eligible for the grant, they may have to repay the grant in respect of those installations. [½ mark]

Downsizing

Wisteria Co plans to downsize the company by 20%, including cutting jobs in line with the fall in customer numbers. [½ mark]

A 20% reduction in staff numbers is significant and may result in the loss of key staff. This loss in staff may result in a reduction in customer satisfaction or in efficiency and effectiveness of operations. [½ mark]

Revenues may fall and costs increase as a result, and customer numbers may fall further driving a further need to cut staff numbers, creating a vicious circle. [½ mark]

Motivation of staff may be affected by the high level of staff cuts and turnover of staff may increase. This may further damage efficiency and effectiveness of operations. [½ mark]


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Financing

The fluctuating profits and plans to downsize may make debt finance difficult to obtain. [½ mark]

Wisteria Co may be able to sustain the planned growth with money obtained from the sale of the land and savings from staff-cuts and other efficiency savings in the short-term. [½ mark]

Long-term growth may be very difficult to achieve without further outside finance as there is a limit to which the company can achieve savings and sell assets whilst still maintaining operations. [½ mark]

Land

Wisteria Co are selling plots of land acquired for development to grow the business in the future. Selling the land will prevent the achievement of this growth. [½ mark]

Wisteria Co may be selling the land in order to obtain cash necessary to run the business which is not a sustainable cash flow. [½ mark]

The losses incurred on the sale of the land to date suggest that the remaining plots will also have to be sold at a loss, further reducing profit. [½ mark]

(iii) Audit risks

New audit client

Fairview & Co has recently been appointed as auditor of Wisteria Co. [½ mark]

A lack of cumulative audit knowledge and experience increases detection risk. [½ mark]

The auditor may fail to detect material misstatements that exist in the financial statements. [½ mark]

In addition, there is a risk that the opening balances are materially misstated as they have not been audited by Fairview & Co. [½ mark]

Provision for mis-selling

Wisteria Co is under investigation for breaching regulations, and could face potentially material financial penalties if found guilty. [½ mark]

If it is considered that the company faces a probable cash outflow, then a provision and associated expense should be recognised. If the outflow is considered possible, then a note to the financial statements should describe the contingent liability and show an estimate of the potential financial effect in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. [1 mark]

Therefore the audit risk is both understated liabilities and overstated profit, if the cash outflow is considered probable but no provision is made. Alternatively, the risk is incomplete disclosure if the outflow is considered possible and no note is provided. [1 mark]


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Management bias

A number of buyout groups have approached Wisteria Co offering to purchase the shares of the company. [½ mark]

These hostile takeover attempts and the CEO’s own financial interest in the share price create an incentive for the financial statements to be manipulated in order to prevent a hostile takeover or secure a more favourable price for the shares. [1 mark]

There is a risk of overstatement of income/assets or understatement of expenses/liabilities. [½ mark]

Government grant

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires that grants should be recognised as income over the periods necessary to match them with the related costs that they are intended to compensate. This means that the income should be deferred, and recognised as income to match the costs of each installation of an energy saving device. [1 mark]

The risk is that the income has been immediately recognised in full, overstating profit for the year. [½ mark]

Secondly, there are two conditions attached to the grant. If Wisteria Co fails to meet the installation target, or if the grant is used to cover the costs of installing the device for ineligible customers, the grant may have to be repaid partly or in full. If this is the case, a provision should be recognised for the potential repayment (or a note should disclose a contingent liability in the case of a possible repayment). [1 mark]

There is a risk of understatement of provisions if the conditions of the grant have been breached. [½ mark]

Provision for redundancies

Although Wisteria Co plans to make further redundancies, there does not currently appear to be any fixed plans in relation to future job cuts. [½ mark]

IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that a provision should not be made unless there is a constructive obligation at the statement of financial position date, i.e. redundancy notifications issued to employees. [1 mark]

However, if the plans are communicated after 31 May 2015, it should be disclosed as a non-adjusting event (IAS 10 Events after the reporting period). [½ mark]

There is a risk of overstated provisions and inadequate disclosure in respect of the redundancies. [½ mark]

Land: Impairment

There are indicators that the land could be impaired at the year end as some land was sold at a loss during the year. [½ mark]

In accordance with IAS 36 Impairment of assets, an impairment review must be carried out if there are indicators of impairment to an asset. [½ mark]


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It is likely that land will be overstated in the statement of financial position, and expenses understated, unless an impairment review is conducted and any resulting loss fully recognised. [1 mark]

In addition, the losses made on the disposal of land during the year should be separately disclosed in the statement of profit or loss or a note to the financial statements per IAS 1 Presentation of Financial Statements. [1 mark]

There is a risk of inadequate disclosure if this is not done. [½ mark]

Land: Held for sale

If the land that Wisteria Co has yet to sell meets the criteria of IFRS 5 Disposal of Non-current assets (management intends to sell the land, the land is available for sale and Wisteria Co is actively marketing the sale of the land) it must be presented separately on the face of the statement of financial position. The details of the asset and facts and circumstances of sale should be adequately disclosed in the notes to the financial statements. [1 mark]

The land should be held at fair value less costs to sell and depreciation stopped. [½ mark]

There is a risk of inappropriate classification and disclosure of the land held for sale, and overstatement of depreciation. [½ mark]

Conclusion [½ mark]

The business risks and audit risks must be addressed when designing audit procedures to be included in the audit plan and when deciding on the audit team members to be assigned to the audit.

(b) (i) Audit procedures on the condition attached to the grant received by Wisteria Co [1 mark per procedure]:

• Obtain the grant document and review the terms, to verify the 100,000 installation targets, deadline for installation and criteria for eligible customers.

• Review the terms to establish the financial repercussions of breaching the condition, e.g. would the grant be repayable in full or in part, and when would repayment be made.

• Obtain documentation from management showing the application criteria that have been used for installations, to ensure that only eligible customers have received the free device.

• Enquire how eligible customers are identified, and the plans in place to ensure 100,000 installations are achieved.

• Review the results and adequacy of any monitoring that has taken place before the year end (for example, any instances of ineligible customers receiving free installation of the energy saving device, and achievement of interim installation targets).

• Discuss the progress of the scheme with an appropriate employee, e.g. sales manager/director to identify any issues with meeting the target.


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(ii) Audit procedures on the land held for sale by Wisteria Co [1 mark per procedure]:

• Inspect board minutes for evidence of management’s plan to sell the land.

• Enquire of management whether the land is currently in use, and whether it is available for sale if in use.

• Obtain written confirmation from Wisteria Co’s solicitors to confirm the likelihood of sale within next 12 months.

• Inspect evidence of active marketing of land, e.g. real estate agents particulars, advertising etc.

• Recalculate fair value of land less costs to sell and verify any impairment loss recognised in financial statements.

• Inspect purchase agreements for sale of land completed to date, and compare to fair value included for land held for sale for reasonableness.

• Inspect the financial statements to ensure the land is disclosed appropriately and separately on face of statement of financial position as assets held for sale. A description of the facts and circumstances of disposal, expected timing and details of impairment losses should be adequately detailed.

(c) INT syllabus

Choosing to change auditor [1 mark per reason]

• There may be a change in the relationship between the auditor and client that means either the auditor or the client may choose to end the relationship.

• The auditor and client may have disagreed about an accounting policy.

• Dissatisfaction with auditor’s work (e.g. the client may feel that the audit was too disruptive).

• Dissatisfaction with the value added by the auditor (e.g. recommendations on improvements to internal controls).

• The client may wish to reduce costs. Different audit firms charge different fees and the client may feel that the existing auditor’s fees are too high.

• The client may wish to reduce the overall fees paid by obtaining audit and accounting services from one firm, rather than a number of firms.

• The client may wish to obtain the services of a larger audit firm who can offer a wider range of services.

• The client may wish to obtain the services of a more specialist firm who can offer industry and market specific advice.

Compelled to change auditor [1 mark per reason]

• The audit firm may have ceased trading.

• There may be a statutory requirement to rotate audit firms on a periodic basis in the jurisdiction in which the client is based.

• The parent company of a newly acquired subsidiary may impose a group auditor.

• The client may have a policy of regular rotation of audit firms.


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Audit firm not seeking reappointment [1 mark per reason]

• There may be ethical, in particular independence issues which mean the auditor is not able to seek reappointment.

• The audit firm may have doubts regarding the integrity of the company’s management.

• The audit firm may decide to resign based on strategy, e.g. a decision to concentrate in other markets/industries.

(c) UK syllabus

Fraudulent trading

Fraudulent trading is where a company carries on a business with the intention of defrauding creditors or for any other fraudulent purposes. [1 mark]

This would include a situation where the director(s) of a company continue to trade whilst insolvent, and enter into debts knowing that the company will not be in a position to repay those debts. [1 mark]

The Insolvency Act 1986 governs situations where, in the course of a winding up, it appears that the business has been carried on with the intent to defraud creditors, or for any other fraudulent purpose. [1 mark]

A director who is found guilty of fraudulent trading can be made personally liable for the debts of the company, be disqualified as a director for between two and 15 years and can be imprisoned for up to ten years. [1 mark]

Fraudulent trading needs to be proven beyond reasonable doubt (i.e. it is almost certain that the director(s) are guilty of fraudulent trading). [1 mark]

Wrongful trading

Wrongful trading is when the director(s) of a company have continued to trade when they ‘knew, or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation’. [1 mark]

A director can defend an action of wrongful trading if they can prove that they have taken sufficient steps to minimise the potential loss to creditors. [1 mark]

Wrongful trading is an action that can be taken only by a company's liquidator, once it has gone into insolvent liquidation (either voluntary or compulsory liquidation). [1 mark]

Unlike fraudulent trading, wrongful trading needs no finding of intent to defraud. [1 mark]

A director who is found guilty of wrongful trading can be made personally liable for the debts of the company, and be disqualified as a director for between two and 15 years. [1 mark]

In addition, because wrongful trading is a civil offence (fraudulent trading is a criminal offence), it only needs to be proven ‘on the balance of probabilities’ (i.e. it is more likely than not that the director(s) are guilty of wrongful trading). [1 mark]


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ACCA marking scheme Marks (a) (i) Business risk understanding 1 mark per point of discussion • Definition • Link between business risk and FS • Internal control systems • Going concern (up to 2 marks) • Generates extensive business understanding

Maximum 5 (ii) Evaluation of business risks

½ mark for identification (to a max of 2) up to 1½ further for evaluation

• Poor performance • Alleged mis-selling • Hostile takeover attempts • Government grant • Downsizing • Financing • Land

Maximum 8 (iii) Evaluation of audit risks

½ mark for identification (to a max of 2) up to 1½ further for evaluation

• New audit client • Provision for mis-selling • Management bias • Government grant (up to 3 marks) • Provision for redundancies • Land impairment (up to 3 marks) • Land held for sale

Maximum 8 Professional marks 4

(b) (i) Principal audit procedures for grant condition 1 mark per procedure • Confirm terms of grant from grant document • Verify financial penalties if condition breached • Review compliance with eligibility requirements • Review results of monitoring performed • Discuss progress

Maximum 3 (ii) Principal audit procedures for land held for sale

1 mark per procedure • Inspect board minutes • Determine status of land • Written confirmation from solicitor • Evidence of marketing • Confirm fair value • Purchase agreement • Disclosures

Maximum 3 (c) INT syllabus: Reasons for changing auditor

Up to 1 mark per adequately discussed reason. Max of 3 within each category

• Chosen to change • Compelled to change • Auditor resigns/retires

Maximum 4



UK syllabus: Fraudulent and wrongful trading Up to 1 mark point Fraudulent trading • Intention of defrauding creditors • Continuing to trade while insolvent • Insolvency Act 1986 • Penalty for fraudulent trading • Prove beyond reasonable doubt Wrongful trading • Director knew or ought to have known the company was insolvent • Defence if minimising losses to creditors • Action taken by liquidator • No intention required • Penalty for fraudulent trading • Civil offence not criminal – more likely than not

Maximum 4

Total ––––

35 ––––

2 FALLON

Key answer tips

Part (a) focuses on identifying quality control issues arising in several audit engagements. This requires knowledge of the Code of ethics, ISAs and ISQC 1.

Part (b) asks for the consequences of not complying with professional standards, i.e. why does it matter? Remember that there isn’t just an impact to the audit firm if they get it wrong. The profession as a whole is affected, as well the client themselves.

Part (c) requires knowledge of ISQC 1 which deals with quality control for all types of engagements, not just audits. There are 6 building blocks of ISQC 1 so use these as headings and write something under each one. By creating structure like this it will make it easier to generate sufficient points for the mark allocation.

(a) Quality control and other professional issues

(i) Written representations are required to comply with ISA 580 Written Representations. Even if there are no specific matters to be included, the directors must sign to acknowledge their responsibilities in relation to the preparation of the financial statements and provision of information for the audit. [1 mark]

(ii) The audit of estimates involves judgement which requires experience. An audit junior should not be auditing this balance as they do not have sufficient experience, especially as they are new to the firm. [1 mark]

Even though the evidence is from an expert, the auditor should consider whether the expert is competent, capable and independent. [1 mark]

Greater scepticism should be applied here as this is a management’s expert rather than an auditor’s expert. In particular we would need to ensure the surveyor is independent and objective as the client may have requested the report to show a specific figure. [1 mark]



This involves consideration of whether the expert is an employee of Roots Ltd, whether there is any familiarity between the surveyor and client and any indication of self interest or intimidation. [1 mark]

In addition, the auditor should consider whether the assumptions used by the expert are reasonable and also whether the evidence provided appears reasonable and consistent with other evidence obtained. [1 mark]

(iii) Sample sizes are chosen in accordance with the audit risk assessment that is carried out at the planning stage. These sample sizes would have been chosen to ensure sufficient evidence was obtained in accordance with ISA 500 Audit Evidence. [1 mark]

By scaling down the sample sizes there is a risk that the evidence is no longer sufficient and material misstatements could go undetected. [1 mark]

A more appropriate way of dealing with the time pressure to ensure that the quality of the audit is not hindered would be to bring additional staff in to help complete the work within the deadline. [1 mark]

Alternatively, the audit manager should have spoken to the client to see if an extension to the deadline could be agreed, especially if the difficulties encountered during the audit were caused by the client rather than the audit firm. [1 mark]

(b) Consequences of not complying with professional standards

• Failure to comply with regulations could result in claims for negligence from clients and other users. This can lead to compensation being awarded to the injured party which can be a significant cost for the company. [1 mark]

• Whilst professional indemnity insurance is likely to cover this cost, subsequent insurance premiums are likely to increase as a claim has been made. [1 mark]

• The profession itself might investigate the firm as failure to comply with professional standards can result in damage to the reputation of the profession as a whole. The profession would need to be seen to be taking such matters seriously to ensure that public confidence is maintained. [1 mark]

• The ACCA may impose fines or may withdraw the firm’s authorisation to perform audits to penalise firms acting in such a manner and to act as a deterrent. [1 mark]

• The firm’s reputation may be damaged as a result of any bad publicity which can lead to a loss of clients and therefore income. In the worst case scenario the firm could be forced to close. [1 mark]

(c) ISQC 1

(i) Leadership

There should be a senior partner in the audit firm assigned responsibility for quality control. They will be responsible for ensuring the firm develops and implements robust quality control procedures to try and avoid the risk of issuing an incorrect opinion or doing poor quality work generally. [1 mark]

This is effectively the tone at the top in the audit firm, essentially working on the principle that the partners should create a culture of quality and lead by example. If the partners are seen to be taking quality seriously, the employees are more likely to follow their example. [1 mark]



(ii) Ethics

Compliance with the Code of Ethics is part of good quality control. If the audit firm is not competent they are more likely to issue an incorrect opinion. [1 mark]

If the firm is not independent they are more likely to allow bias to affect their professional judgement which could mean that an incorrect opinion is issued. [1 mark]

A lack of integrity could imply that the auditor does not care whether they do their work properly and may lie about the work they have done (or not done) and claim to have performed the audit work when they actually haven’t. [1 mark]

(iii) Acceptance and continuance

Audit firms should perform procedures prior to acceptance to ensure that they only take on clients of acceptable risk as high risk clients may be more likely to mislead the auditor or manipulate the financial statements. [1 mark]

This involves consideration of the ethical matters mentioned above as well as consideration of the integrity of management, adequacy of resources and any other risks that may affect the engagement. [1 mark]

(iv) Human Resources

The human resources aspect of quality control relates to the employees of the audit firm. This involves recruitment and selection, induction, training, coaching, performance appraisal, career development and disciplinary proceedings. [1 mark]

Employees should be chosen that have not just the right qualifications and skills but also the right personal attributes such as integrity. [1 mark]

The firm should make sure that people are treated fairly within the organisation and are given the necessary training and support to be able to do their jobs effectively and to the desired standard. [1 mark]

(v) Engagement performance

Engagement performance concentrates on the individual engagement and the quality control procedures that should occur. This covers consistency, supervision, review, consultation and engagement quality control review. [1 mark]

Each engagement should be performed consistently in terms of compliance with professional standards. Employees should be briefed on each and every client to understand the individual issues and risks that need to be taken into account when performing the audit. [1 mark]

The audit should be adequately supervised to ensure it is on track and that staff have enough time to perform the work in accordance with the audit plan. Supervision also involves identifying and resolving issues on a timely basis which may require the need to consult with an expert where the auditor feels they do not have sufficient expertise. [1 mark]

Review of work ensures that the work has been completed to the required standard and that sufficient appropriate evidence has been obtained. Ultimately the review should ensure that the objectives of the audit have been achieved. [1 mark]



(vi) Monitoring

Monitoring is the process of ensuring that professional standards have been complied with. [1 mark]

This is undertaken by the firm through the use of cold reviews. The professional regulatory bodies in individual countries may also perform annual checks on a sample of audits from a range of audit firms to enable independent monitoring of firms. [1 mark]

A cold review should make sure the firm’s own quality control policies and procedures have been appropriately designed and implemented and then followed by the employees of the firm. [1 mark]

Where deficiencies are identified, the firm should take corrective action and communicate to the employees what changes have been made to the policies and procedures or what changes are needed to be made in the performance of the work by the employees. [1 mark]

ACCA marking scheme Marks (a) Quality control and professional issues Up to 1 mark per properly explained point • Written representation required by ISA 580 • Estimates, judgemental, requires experience • Need to consider whether expert can be relied on • Independence, capability, competence • Greater scepticism as mgmt. expert • Consider threats such as self-interest, familiarity, intimidation • Reasonableness of assumptions used and source data • Sample sizes affect SAE • Reducing sample sizes increases risk of wrong opinion • Should have used more staff • Extension to deadline

Maximum 9 (b) Consequences

1 mark per explained point • Negligence claims and compensation from users • Increase in PII premiums • Investigation by professional body • Penalties imposed by ACCA • Damage to reputation/loss of clients

Maximum 3 (c) ISQC 1

1 mark per point. Max of 2 marks if only the names of the headings of ISQC 1 given

• Leadership: responsible for QC policies • Leadership: create culture of quality • Ethics: competence • Ethics: independence • Ethics: integrity • Acceptance: only accept clients of acceptable risk • Acceptance: acceptance considerations • Human resources: recruitment, selection, training, etc. • Human resources: qualifications and personal attributes • Human resources: firms should provide appropriate support • Engagement performance: consistency, supervision, review • Engagement performance: consistency explanation • Engagement performance: supervision explanation • Engagement performance: review explanation • Monitoring: ensures professional standards complies with • Monitoring: firms and profession • Monitoring: cold review purpose • Monitoring: corrective action

Maximum 13

Total ––––

25 ––––



SECTION B

3 GRENDEL

Key answer tips

Part (a) is a typical completion question. The requirement asks for matters to consider and evidence expected to be on file. The MARE approach is useful for structuring this type of answer. As the marking guide shows, there are often significantly more points that can be made than are actually needed to score full marks. Good exam technique requires you to make enough points for the mark allocation and to know when to stop. Providing a fully comprehensive answer as detailed as the one below is a waste of time.

Part (b) requires knowledge of ISA 450 Evaluation of misstatements identified during the audit.

(a) Home delivery service

Matters

$1.6m represents 2.2% of reported revenue (prior year 2.6%) and is therefore material. [1 mark]

NB: it is clearly not of such significance that it should raise any doubts whatsoever regarding the going concern assumption.

Accounting treatment

The home delivery service does not classify as a discontinued operation, as described in IFRS 5 Non-current Assets Held for Sale and Discontinued Operations, for the following reasons:

• 2.2% of revenue does not represent a major line of business or geographical area of operations.

• The closure is not part of a coordinated plan to dispose of a major line of business or geographical area of business.

• The service is not a subsidiary acquired exclusively with a view to resale.

[1 mark]

For this reason there should not be any separate disclosures of discontinued operations in the financial statements, either in the statement of profits and losses, or in the notes. [1 mark]

The delivery vehicles should only be classified as held for sale if their carrying amount will be recovered principally through a sale transaction rather than through continuing use. [1 mark]

For this to be the case the following criteria must be met, according to IFRS 5:

• Management must have committed to a plan to sell the vehicles.

• The vehicles must be available for immediate sale in their present condition.

• Their sale must be highly probable.



• The vehicles are being marketed at a reasonable price compared to its fair value.

• It is unlikely that significant changes will be made to the plan.

[1 mark]

However, even if the classification as held for sale is appropriate, the measurement basis is not. Non-current assets classified as held for sale should be carried at the lower of carrying amount and fair value less costs to sell. The vehicles should no longer be depreciated. [1 mark]

The vehicles are currently being valued at a fair value of $1m, whereas the carrying value is $0.5m. The vehicles have been overstated by $0.5m. [1 mark]

This error represents 6.8% of profits and 2.7% of total assets, which is material to the financial statements. [1 mark]

According to IAS 37 the directors must make adequate provisions for all probable costs incurred as a result of the closure. The main issues likely to require provisions are redundancy costs, legal costs incurred contesting any contractual obligations (maybe with customers or suppliers) and the likely compensation that will have to be paid out. [1 mark]

Risk of material misstatement

There is a risk that assets are overstated and depreciation is overstated and a risk of understatement of provisions. [1 mark]

Audit evidence [1 mark per piece of evidence]

• A copy of the board minute documenting management’s decision to cease home deliveries as well as any press releases and internal memoranda to staff.

• An analysis of revenue (e.g. extracted from management accounts) showing the amount attributed to home delivery sales to confirm that the service is not a major component.

• Copies of the contracts of employment for individuals made redundant to confirm the terms of their redundancy payments.

• A recalculation of the redundancy provision to confirm the reasonableness/ completeness of the redundancy provision (e.g. number of employees × sum of years employed × payment per year of service).

• Copies of any legal correspondence indicating the likelihood of contractual disputes following the cessation of services and any probable costs that might be incurred.

• A schedule of depreciated cost of delivery vehicles extracted from the non-current asset register to confirm that the vehicles are no longer being depreciated.

• Notes of enquiries made with management asking how they assessed the fair values of the vehicles held for resale.

• The formation of an independent estimate of the fair value of the vehicles by comparison with second hand market prices. Second hand price guides could be used.



• If any vehicles have been sold after the year end the net proceeds should be inspected in the cash book and bank statements. These proceeds should be checked in comparison to the fair value estimates.

• Notes taken during physical inspection of the condition of unsold vehicles that might indicate the need for impairment.

• Copies of the relevant element of the statement of financial position confirming that assets held for sale have been separately identified and copies of the notes showing the assets held for sale in the reconciliations of non-current assets.

Soft Furnishings

Matters

Soft furnishing revenue represents 11.2% of reported revenue (PY: 15.4%) and is therefore a major segment of the business. [1 mark]

Accounting treatment

However, according to IFRS 5 operations should only be treated as discontinued if they were either:

• Formally discontinued before the year end or

• Are being held for sale at the year-end.

[1 mark]

Given that the announcement came two months after the year end, the first criterion has not been met. Neither is the business being held for sale, it has ceased activity, so the second criterion has not been met. The soft furnishings should not be classified as discontinued operations in the financial statements being audited. They would be considered as discontinued in the following accounting year. [1 mark]

A separate issue is that the discontinuance is an event after the reporting period and provides evidence that certain adjustments may be required in the financial statements. [1 mark]

Possible adjustments include:

• Provisions for credit notes due to poor quality goods sold before the year-end.

• Allowance (or possible write-off) for all unsold inventory, or at least items of poor quality.

• Plant and equipment used exclusively in the production of the soft furnishings range should be tested for impairment.

• Provisions or contingent liabilities may be required for any legal claims.

[1 mark]

Risk of material misstatement

There is a risk that the presentation of the financial statements is materially misstated due to discontinued operations being shown separately which do not meet the criteria of IFRS 5. [1 mark]

In addition, assets such as inventory and non current assets may be overstated if they are now impaired. Provisions may be understated if credit notes and legal claims are probable. [1 mark]



Evidence [1 mark per piece of evidence]

• A copy of Grendel’s announcement (external ‘press release’ and any internal memorandum) to discontinue the product line.

• Copies of credit notes raised after the year-end for faulty products sold before the year end and a reconciliation of these amounts to any year-end provisions.

• Copies of cash book entries for refunds paid to customers after the year-end, once again traced back to any year-end provisions.

• Notes from the year-end inventory count discussing how poor quality/returned items are held separately (or at least identified) so they may be separately valued at the year-end.

• Notes of enquiries with management discussing how they have valued inventory, in particular how they have identified the required impairment to remaining inventories. This should include discussion of whether management have found any alternative sales channels for their remaining soft furnishings. If they have, the expected NRV should have been discussed.

• Copies of any post year-end sales invoices for obsolete inventory items with a reconciliation back to original cost (cost vs. NRV).

• Copies of legal correspondence from customers requesting reimbursement for poor quality items.

(b) Evaluation of uncorrected misstatements [1 mark per point]

• Aggregate the uncorrected misstatements to assess whether they are material when added together.

• Ask management to correct all of the misstatements and if they refuse, consider reasons why.

• If management refuse to correct the misstatements, discuss the issue with those charged with governance and ask them to correct the misstatements.

• Obtain written representation from management that they believe the effect of the uncorrected misstatements to be immaterial.

• Assess the materiality of any uncorrected misstatements.

• Consider implications for the audit report if the misstatements remain uncorrected. If the auditor considers them to be material in aggregate the audit report and opinion should be modified.



ACCA marking scheme Marks

(a) Matters and evidence 1 mark per explained point Home delivery service • Materiality calculation • IFRS 5 criteria • No separate disclosure • May need to show assets held for sale if criteria met • Criteria for assets held for sale • Value at lower of CV and FV less costs to sell • Calculation of misstatement • Materiality assessment of misstatement • Potential provisions • Risk of material misstatement Evidence • Board minutes • Analysis of revenue • Contracts of employment • Redundancy calculation • Legal correspondence • Schedule of assets • Notes of enquiries • 2nd hand price guides • Notes of inspection of assets • FS disclosures

Maximum 8 Soft furnishings • Materiality calculation • IFRS 5 criteria • Criteria not met • Event after the reporting period • Potential provisions for claims and asset impairment • Risk of material misstatement: discontinued operations • Risk of material misstatement: impairment of assets Evidence • Announcement • Credit notes • Cash book • Inventory count • Notes of enquiries re inventory • Post year end sales invoices • Legal correspondence

Maximum 8 (b) Evaluation of misstatements

Up to 1 mark per explained point • Assess materiality in aggregate • Ask management to correct all misstatements • If refuse, speak to TCWG • Obtain written representation • Assess materiality of uncorrected misstatements • Consider implication for the audit report

Maximum 4

Total ––––

20 ––––



4 BARTOLOME

Key answer tips

This question is typical of many of the ethical and professional issues questions that appear in the P7 exam.

Don’t forget to consider both ethical and professional issues. Remember that the auditor will always consider the significance of a matter as part of evaluating the issue.

When discussing relevant actions, the focus for ethical issues will be safeguards. Include any specific rules within the Codes of Ethics.

Finally, note the number of marks that are available for each scenario described, and adjust the number of points you write accordingly.

(a) Moreno Co

Leon’s independence is in doubt as he is threatened by self-interest. Leon’s objectivity in relation to the audit may be influenced by a desire to please and impress Moreno as a prospective employer. [1 mark]

Leon should be removed from the audit assignment immediately regardless of whether or not he is finally appointed by Moreno and a new senior assigned. [1 mark]

Leon should be given a warning for failing to adhere to the Code of Ethics which requires disclosure to the firm of any possible involvement with an audit client. [1 mark]

The working papers for all audit work relating to Moreno performed under the supervision of Leon should be reviewed as soon as possible to ensure his objectivity has not been impaired and his work has been affected. [1 mark]

Communication should be made via human resources about the need to disclose such job applications to audit clients. The ethical importance of this situation must be stressed. [1 mark]

(b) Chatam Co

An unmodified report means that:

• There have been no material misstatement identified by the auditor; and

• The auditors’ report does not include an emphasis of matter paragraph (e.g. regarding going concern).

[1 mark]

By implication, the auditor must have obtained sufficient appropriate evidence that notwithstanding the losses:

• The going concern basis is appropriate to Ayora’s financial statements and any related matters (e.g. parental support) are adequately disclosed.

• Goodwill in Chatam’s consolidated financial statements is not materially impaired.

[1 mark]



Management’s written representation that the goodwill is not impaired must have been necessary otherwise it should not have been asked for. This means that Bartolome does not have sufficient other, more reliable audit evidence. [1 mark]

This seems dubious as management should have carried out an impairment test to ensure that goodwill is not impaired. This test should have been reviewed by Bartolome to ensure it was appropriately done. [1 mark]

If there is evidence that goodwill is impaired, management’s refusal to write it down might be considered fraudulent financial reporting and could result in material misstatement of the financial statements. [1 mark]

The matter may cast doubt on the quality of audit evidence obtained in other areas. All other matters on which management representations have been obtained should be reviewed by independent partner. [1 mark]

It is possible that some pressure has been exerted by Charles Barrington to encourage the audit partner not to modify the opinion as he is retiring next year and his share options would presumably be worth less if goodwill was written down. [1 mark]

Bartolome may be unduly influenced by a combination of factors such as familiarity and previous experience, and failing to exercise the necessary degree of professional scepticism. There may also be a self-interest threat to accept the representation as sufficient in order to retain the client. [1 mark]

A change in senior audit staff and audit manager may be overdue. The unmodified auditors’ reports should be subject to a cold review and any quality control issues raised with the team who conducted the audit. [1 mark]

(c) Pinzon Co

A self interest threat has arisen as Bartolome and Pinzon are in opposition concerning the fee note for the audit. [1 mark]

If Pinzon’s allegations are true this may cast serious doubt on the integrity of Bartolome. Pinzon should be advised to take its claims first to ACCA’s Disciplinary Committee. [1 mark]

If Bartolome has indeed been reimbursed for full air fares when substantial discounts had been obtained this could be due to Bartolome incorrectly believing this to be an acceptable industry practice; or a billing error/oversight. [1 mark]

In either case Bartolome should issue a credit note, although this may be insufficient to make amends and salvage the auditor-client relationship. [1 mark]

Bartolome may have legitimately claimed for full airfares if this was agreed in its contract (i.e. the terms of engagement) with Pinzon. [1 mark]

Unless the threat of legal action is amicably resolved very quickly which is perhaps unlikely, Pinzon and Bartolome are in conflict. Bartolome cannot therefore be seen to be independent and so should tender its resignation as auditor. [1 mark]

(d) Matisse Co

Secondments of staff are not prohibited by the Code of Ethics provided the ethical threats are managed appropriately. The main threats will arise when the audit senior returns to work for the audit firm. [1 mark]

If the audit senior was involved in any activity which impacted the financial statements being audited then a self review threat would arise. The audit senior could be auditing aspects he had been responsible for during the secondment and may not identify the errors in his own work, or might not want to admit to them if they are identified. [1 mark]



In addition, there may be a familiarity threat as the audit senior will have been working closely with the finance staff and may become too trusting of their work to audit it with sufficient professional scepticism. [1 mark]

The audit senior should not be assigned to the audit team after the secondment to safeguard against the self review threat. [1 mark]

It should be agreed before the secondment commences that the audit senior should not be responsible for any management decisions for Matisse. Any judgements or decisions should be taken by Matisee. [1 mark]

ACCA marking scheme

Marks (a) Moreno Co Up to 1 mark per explained point • Self-interest threat • Remove Leon from audit • Warning • Review working papers • Communicate policy to staff

Maximum 4 (b) Chatam Co

1 mark per explained point • Implication of unmodified report • Implication re SAE • Written representation used in absence of better evidence • Fraudulent FR – risk of material misstatement • Quality of other representations • Intimidation • Familiarity threat • Rotation

Maximum 7 (c) Pinzon Co 1 mark per explained point • Self-interest threat • Doubt over integrity • Possible error or oversight • Issue credit note • Contractual agreement • Resign if not resolved

Maximum 5 (d) Matisse Co Up to 1 marks per explained point • Secondments ok if managed appropriately • Self-review threat • Familiarity • Cannot be assigned to the team • Should not perform management role

Maximum 4

Total ––––

20 ––––



5 MOUSE

Key answer tips

Completion and audit reporting will feature in every P7 exam.

Part (a) examines definitions of 3 of the modifications to the audit report. It is important to understand the difference between the different modifications so that if a question asks for the appropriate modification to the report, like in part (b), you are able to suggest the correct one.

Part (b) is typical of the completion and audit reporting questions in the P7 exam, requiring you comment on the required modifications to the audit report. This requires discussion of the accounting treatment that is wrong or the issues suggesting a lack of sufficient appropriate evidence Remember that the opinion is only one section of the audit report. Other implications could include the need for a basis of opinion paragraph, an emphasis of matter paragraph or an other matter paragraph. Your answer should explain why each of these would be included and where it should be positioned within the report.

(a) Independent auditor’s report terms

(i) Qualified opinion

A qualified opinion is expressed when the auditor concludes that an unqualified opinion cannot be expressed but that the effect of any material misstatement, or inability to obtain sufficient appropriate evidence is not so material and pervasive as to require an adverse opinion or a disclaimer of opinion. The key words of a qualified opinion are ‘Except for…’. [1 mark]

(ii) Disclaimer of opinion

A disclaimer of opinion is expressed when the possible effect of an inability to gather sufficient appropriate evidence is so material and pervasive that the auditor does not express an opinion on the financial statements. [1 mark]

(iii) Emphasis of matter paragraph

An auditor’s report may be modified by adding an emphasis of matter paragraph to highlight a matter of significant uncertainty affecting the financial statements that is included in a note to the financial statements that more extensively discusses the matter. An emphasis of matter paragraph does not affect the auditor’s opinion. [1 mark]

(iii) is clearly distinguishable from (i) and (ii) because (i) and (ii) affect the opinion paragraph, whereas (iii) does not. [1 mark]

(i) and (ii) are distinguishable by the degree of their impact on the financial statements. In (i) the effects are isolated to one area of the financial statements. In (ii) the matter is pervasive, that is, affecting the financial statements as a whole, making them unreliable. [1 mark]

(ii) can only arise in respect of insufficient evidence that has a pervasive effect. (i) is not pervasive and may be issued in the event of a material misstatement or where there is sufficient evidence. [1 mark]



(b) Implications for auditor’s report

Selective revaluation of premises

The revaluations of $1m and $2.7m represent 6.5% and 17.5% of total assets, respectively (and 24% in total) and are clearly material to the statement of financial position. [1 mark]

As the effects of the revaluation on line items in the financial statements are clearly identified (e.g. revalued amount, depreciation, surplus in statement of changes in equity) the matter is not pervasive. [1 mark]

The valuations of the nine properties after the year end provide additional evidence of conditions existing at the year end and are therefore adjusting events per IAS 10 Events after the reporting period. [1 mark]

IAS 16 Property, Plant and Equipment does not permit selective revaluation of assets thus the whole class of premises would need to have been revalued for the year to 31 March 2015. [1 mark]

The revaluation exercise is incomplete. Unless the remaining three properties are revalued before the auditor’s report on the financial statements is signed off:

(1) the $3.7m revaluation made so far must be reversed to show all premises at depreciated cost as in previous years;

or

(2) the auditor’s report would be qualified ‘except for’ due to a material misstatement relating to the application of IAS 16.

[1 mark]

Assuming the revaluation is written back, before giving an unmodified opinion, the auditor should consider why the three properties were not revalued at the same time as the other nine that were revalued shortly after year end. In particular if there are any indicators of impairment (e.g. physical dilapidation) there should be sufficient evidence on the working paper file to show that the carrying amount of these properties is not materially greater than their recoverable amount (i.e. the higher of value in use and fair value less costs to sell). [1 mark]

If there is insufficient evidence to confirm that the three properties are not impaired (e.g. if the auditor was prevented from inspecting the properties) the auditor’s report would be qualified ‘except for’ on grounds of insufficient audit evidence. [1 mark]

If there is evidence of material impairment but management fail to write down the carrying amount to recoverable amount the auditor’s report would be qualified ‘except for’ due to a material misstatement regarding non-compliance with IAS 36 Impairment of assets. [1 mark]

A basis for qualified opinion would be required above the opinion paragraph to explain the reason for the qualified opinion and would also quantify the issue, e.g. state the value of the properties for which evidence was not available or state the extent of the material misstatement. [1 mark]

10-year guarantee

$9.1m on golf sales amount to 43.1% of revenue and are therefore material. [1 mark]

The draft note disclosure could indicate that Mouse’s management believes that Mouse has a legal obligation in respect of the guarantee that is not remote and likely to be material (otherwise no disclosure would have been required). [1 mark]



A best estimate of the obligation amounting to 5% profit before tax (or more) is likely to be considered material, i.e. $45,000 (or more). Therefore, if it is probable that 0·5% of sales made under guarantee will be returned for refund, this would require a warranty provision that would be material. [1 mark]

There is a present obligation as a result of a past obligating event for sales made during the year to 31 March 2015. It is probable that some outflow will be needed to settle the class of such obligations. [1 mark]

The note in the financial statements is disclosing this matter as a contingent liability. This term encompasses liabilities that do not meet the recognition criteria of IAS 37 Provisions, Contingent Liabilities and Contingent Assets, e.g. the estimate can be reliably measured. However, it is extremely rare that no reliable estimate can be made. [1 mark]

Management must make a best estimate of the cost of refunds/repairs under guarantee taking into account, for example:

• The proportion of sales during the year that have been returned under guarantee at the reporting date (and in the post reporting date period).

• The average age of golf equipment showing a defect.

• The expected cost of a replacement item (as a refund of replacement is more likely than a repair, say).

[1 mark]

If management do not make a provision for the best estimate of the obligation the audit opinion should be qualified ‘except for’ due to a material misstatement arising from non-compliance with IAS 37. [1 mark]

The disclosure made in the note to the financial statements, however detailed, is not a substitute for making the provision. [1 mark]

A basis for qualified opinion would be required above the opinion paragraph to explain the reason for the qualified opinion and would also quantify the issue. [1 mark]



ACCA marking scheme Marks

(a) Audit report terms Up to 1 mark per explained point • Qualified • Disclaimer • Emphasis of matter • Qualified and disclaimer – modified opinions • Disclaimer – pervasive, qualified – only material

• Disclaimer = pervasive lack of SAE, qualified = either lack of SAE or material misstatement

Maximum 5 (b) Audit report implications

1 mark per explained point Selective revaluation of properties • Materiality calculation • Not pervasive – isolated • Adjusting event • Non-compliance with IAS 16 • Revaluation should be reversed • Consider reasons for not revaluing all properties • Qualified if prevented from inspecting properties • Qualified except for material misstatement if impaired • Basis for qualified opinion above the opinion, explains reason 10 year guarantee • Materiality calculation • Disclosure note indicates significant • Best estimate can be determined • Present obligation and probable outflow • Not a contingent liability • Methods of estimating provision • Qualified except for material misstatement • Disclosure not a substitute for provision • Basis for qualified opinion above the opinion, explains reason

Maximum 15

Total ––––

20 ––––

P7 Final Assessment - Answers S15-D15

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