P7

ACCA REVISION MOCK

Advanced Audit & Assurance (International)

December 2010

Time allowed

Reading and planning: 15 minutes

Writing: 3 hours

This paper is divided into two sections:

Section A – BOTH questions are compulsory and MUST be attempted

Section B – TWO questions ONLY to be attempted

Do NOT open this paper until instructed by the supervisor.

During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor.

This question paper must not be removed from the examination hall.

Kaplan Publishing/Kaplan Financial

Pape

r P7

(IN

T)

ACCA P7 (INT) Audit and Assurance

2 KAPLAN PUBLISHING

© Kaplan Financial Limited, 2010

The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials.

All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

Revision Mock Questions

KAPLAN PUBLISHING 3

SECTION A (Attempt both questions) QUESTION 1

Your firm has recently been appointed auditor of Omega 3 Inc, a newly incorporated company. Omega 3 research, develop and manufacture alternative medicines for commercial production.

You are planning the audit for the year ended 30 September 2010. Draft figures for the year include: turnover – $9.6mn (2009: $5.1mn), profit before tax – $0.5mn (2009: loss of $200k), and total assets – $3.1mn (2009: $1.7mn). In 2009 Omega 3 fell under the local audit threshold, this is therefore their first year of audit.

Most of Omega 3’s revenues (approximately 75% in 2010) are derived from sales of its flagship product “Fishy” a revolutionary soft gel capsule that improves brain and heart function. However they have just begun some product development work for a well known, high street customer, “Hogan & Ballott.”

Work began in July 2010, and is expected to take about nine months to complete. Once the development work is complete Omega 3 will own the patent for the product and sole right to manufacture it. It is hoped that if Hogan and Ballott are satisfied they will trial it immediately in certain stores following completion of product testing. The directors of Omega 3 are confident that this will then lead to a “significant and long term sales contract.” However, you noted during a planning meeting with the Finance Director, Terrence Cod, that development is still in the early phases. He estimates that to date almost $150k of development costs have been incurred on the new product.

In order to facilitate the development, Omega 3 acquired a new laboratory space in May 2010. The laboratory, an adjoining unit to the existing facility, was acquired on a ten year lease at a cost of $30,000 per year. As Omega 3 had to bear the cost of some repair/refurbishment work and because they have to take out buildings insurance Mr Cod has treated the new unit as a capital asset. He has valued it at $300,000 and is depreciating it over a ten year useful life. This way the depreciation charge equals the rental expense, so the accounts reflect the true cost of the laboratory to Omega 3.

During the meeting with Mr Cod you ascertained that in October 2010 the company received some adverse publicity regarding their product “Fishy.” Apparently a number of people reacted badly to the capsules, including symptoms of fever, nausea and rashes. Whilst no-one suffered long term problems one person was hospitalised and considered critical for a number of days. Mr Cod suggested that, whilst the problems were regrettable, this was normal in the pharmaceuticals industry and should not affect the long term success of the product. He also stated that all relevant costs would be covered by Omega 3 and included in the 2011 accounts.

After the meeting with Mr Cod you took a tour of the accounts department and reviewed the information systems. Whilst reviewing a receivables file you noted that there were quite a few credit notes issued in October 2010 ($40k in total). According to the credit controller there have been a number of returns, with customers complaining of broken seals on bottles, exploded soft gel capsules and other quality issues.


4 KAPLAN PUBLISHING

Required:

(a) Discuss the relationship between the concepts of ‘audit risk’ and ‘financial statements risk.’ (4 marks)

(b) Using the information provided in the scenario, identify and explain the principal financial statements risks facing Omega 3 Inc. (12 marks)

(c) Describe the principle audit procedures to be carried out in respect of the following:

(i) The classification of leasing costs; (4 marks)

(ii) The presentation of share capital. (4 marks)

A new internal auditor, Christine Carp, has recently joined Omega 3. She has been asked by management to establish and monitor a variety of operational Key Performance Indicators (KPIs). Ms Carp has no experience in this area, and has asked you for some advice. It has been agreed with Omega 3’s directors that you are to provide guidance to Ms Carp to help her in this part of her role, and that this does not impair the objectivity of the audit.

(d) Recommend EIGHT non-financial KPIs which could be used to monitor Omega 3’s operating performance, and outline the nature of evidence that should be available to provide assurance on the accuracy of the KPIs recommended. Your answer should be in the form of briefing notes to be used at a meeting with Christine Carp. (10 marks)

Note: requirement (d) includes 2 professional marks.

(Total: 34 marks)


KAPLAN PUBLISHING 5

QUESTION 2

You are a manager in a medium-sized firm of accountants, Trousers LLP. You have been assigned to a review engagement based on the prospective financial information of one of your audit clients, Trumpet.

Trumpet are hoping to use the information to support an application for a long-term loan from their bank Dorklays. The funds from the loan will be invested in 2012 into the development and expansion of existing properties with the aim of increasing the range of products offered and the volume of current brands in production.

Statement of Financial Position

Year to 30 June

2010

Quarter to 30 Sept

2010

Year to 30 June

2011

Year to 30 June

2012

(actual) (actual) (forecast) (forecast) $m $m $m $m Non-current assets Property, plant and equipment 58 59 75 105 Accumulated depreciation (42) (44) (54) (62)

–––– –––– –––– ––––Net book value 16 15 21 43

–––– –––– –––– ––––Current assets Inventory 5 6 6 7 Accounts receivable 7 6 8 10 Cash 1 1 0 0

–––– –––– –––– –––– 13 13 14 17

–––– –––– –––– ––––Total assets 29 28 35 60

–––– –––– –––– ––––Equity & Reserves Share capital 1 1 1 1 Retained earnings 6 7 8 11

–––– –––– –––– –––– 7 8 9 12 Non-current liabilities Bank Loans 15 15 15 35

Current liabilities Accounts payable 4 4 5 6 Accrued expenses 3 1 4 3 Overdrafts 0 0 2 4

–––– –––– –––– –––– 7 5 11 13

–––– –––– –––– ––––Total equity and liabilities 29 28 35 60

–––– –––– –––– ––––


6 KAPLAN PUBLISHING

Statement of Comprehensive Income

Year to 30 June 2010

Quarter to 30 Sept

2010

Year to 30 June

2011

Year to 30 June

2012

(actual) (actual) (forecast) (forecast) $m $m $m $m Revenue 39 11 46 60 Cost of goods sold (27) (7) (31) (36)

–––– –––– –––– ––––Gross profit 12 4 15 24

–––– –––– –––– ––––Operating expenses (7) (2) (9) (14)

–––– –––– –––– ––––Operating Profit 5 2 6 10

–––– –––– –––– ––––Finance charges (2) (1) (3) (5)

–––– –––– –––– ––––Profit before tax 3 1 3 5

–––– –––– –––– ––––

Required:

(a) Prepare a report for distribution to the engagement team at the planning meeting that explains and discusses:

(i) The nature and scope of the examination of Trumpet’s forecast statement of financial position and statement of comprehensive income as prepared for the bank. (7 marks)

(ii) The evidence that will be gathered to provide assurance on Trumpet’s prospective financial information. (9 marks)

Note: requirement (a) contains 2 professional marks. (18 marks)

As part of Trumpet’s request for you to provide assurance on their forecasts you have been asked to prepare a report of your findings for presentation to the audit committee.

(b) Discuss the role and function of an audit committee. (6 marks)

(c) Discuss the possible disadvantages that can arise from the requirement for companies to have an audit committee. (6 marks)

(Total: 30 marks)


KAPLAN PUBLISHING 7

SECTION B

(Attempt 2 from 3 questions)

QUESTION 3

You are a partner at Howie Summerisle, a firm of chartered certified accountants. You have been asked to carry out an investigation by the directors of Wicker. One of the company’s subsidiaries, Woodward, has recently begun making losses. Wicker became concerned about certain reported balances during a review of the most recent quarterly management accounts of Woodward, prepared to 30 September 2010.

Wicker’s management believe that the subsidiary’s purchases of inventories appear unusually high and are concerned that materials consumption is inefficient. They have identified three possible causes:

(1) under-counting or under-valuation of closing inventory;

(2) excessive consumption or wastage of materials;

(3) material being stolen by employees or other individuals.

Woodward only has a few customers and manufactures its products to each customer’s specification. The estimated costs are not compared with actual costs. Although it is possible to analyse purchase invoices for materials between customers’ orders, this analysis has not been done.

A physical inventory count is carried out at the end of each quarter. The next one is due on 31 December 2010, which is also the company’s year-end. Items are entered on inventory sheets and valued manually. The company does not maintain perpetual inventory records.

Required:

(a) Define ‘forensic auditing’ and describe its application to fraud investigations. (4 marks)

(b) Identify and describe the matters that you should consider and the procedures you should carry out to enable your firm to plan an investigation of Woodward’s losses. (8 marks)

(c) Describe the procedures you would plan to perform to quantify the amount of any inventory undervaluation. (6 marks)

(Total: 18 marks)

QUESTION 4

You are an audit manager at Deckard, a firm of chartered certified accountants. Your specific responsibilities include advising the senior audit partner on the acceptance of new assignments and re-engagement with existing clients. The following matters have arisen in connection with three cases brought to your attention:

(a) Your firm has been nominated to act as auditor to Running Blade. The company has been in existence for 3 years, but has never had its financial statements audited, having previously been classified as a small company for exemption to the statutory audit requirement. (6 marks)


8 KAPLAN PUBLISHING

(b) Deckard has been approached by the management of Scott Microchips, a company listed on a recognised stock exchange, to provide a range of assurance services, including statutory audit. Scott Microchips are a major competitor to an existing client of Deckard, Ridley, another company listed on a recognised stock exchange. (6 marks)

(c) For the last five years Rachael has been the audit engagement partner for the firm’s principal client, Rutgers, a company listed on a recognised stock exchange. Rutgers has expanded rapidly in the last 2 years by a policy of acquisition of small competitor organisations. The directors have ambitious plans, which include an aggressive marketing campaign, and the take-over of a number of target competitors. The report for the last audit was signed a few months ago and work is due to commence on the planning of the next year-end audit. (6 marks)

Required:

Comment on the ethical and professional issues raised by each of the above matters and the steps, if any, that Deckard should now take. (Total: 18 marks)

QUESTION 5

Required:

(a) Describe the potential benefits for a company in choosing to have a financial statements audit, even when they fall below national audit threshold limits for small companies. (4 marks)

(b) Discuss the objective of a limited review engagement and contrast the level of assurance provided with that provided in an audit of financial statements. (6 marks)

You are an audit manager with Romero LLP, a firm of chartered certified accountants. A colleague, who you trained with a number of years ago, has recently approached you with some concerns over an engagement to report on the twelve month profit forecast of Dead Beats. Dead Beats has prepared the forecast on the assumption that sales will grow at 1% each month. Your colleague has studied the evidence available and believes that sales are more likely to decrease by 4% over the next year. They have provided you with a copy of the standard wording of an unmodified report on prospective financial information, as follows:

‘We have examined the forecast in accordance with the International Standards of Auditing and Assurance applicable to the examination of prospective financial information. The directors are solely responsible for the forecast including the assumptions set out in Note X on which it is based.

Based on our examination of the evidence supporting the assumptions, nothing has come to our attention, which causes us to believe that these assumptions do not provide a reasonable basis for the forecast. Further, in our opinion the forecast, so far as the accounting policies and calculations are concerned, is properly prepared on the basis of the assumptions, is consistent with the accounting policies normally adopted by the company, and is presented in accordance with relevant accounting standards.’

(c) Explain and justify the nature of the assurance report that should be given for the prospective financial information of Dead Beats. (8 marks)

Note: you do not have to quote the report word for word. However, relevant discussion of the content of the assurance report will score marks, including example wording.

(Total: 18 marks)

ACCA

Paper P7 (INT)

Advanced Audit and Assurance

December 2010

Revision Mock – Answers

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


2 KAPLAN PUBLISHING

© Kaplan Financial Limited, 2010

The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials.

All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

Revision Mock Answers

KAPLAN PUBLISHING 3

ANSWER 1

(a) Financial vs Audit Risk

Audit Risk

According to ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing:

“Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.”

Financial Statement Risk

Financial statement risk is the risk that components of the financial statements could be misstated, through inaccurate or incomplete recording of transactions or disclosure. Financial statement risks therefore represent potential errors or deliberate misstatements in the published accounts of a business.

Financial statement risks are caused by both inherent business risks and control risks (e.g. weak control systems). These are both functions of audit risk.

Relationship

Auditors must plan and perform an engagement to reduce their audit risk to an acceptable level. In so doing they have to assess the risk of misstatement in the financial statements and then design the nature, extent and timing of their procedures accordingly. This is usually referred to as ‘detection risk.’

Given that audit risk must always be low there is an inverse relationship, therefore, between financial statements risk and detection risk. If financial statements risk (i.e. the risk of material error) is high then detection risk must be lowered (i.e. by doing a greater amount of substantive testing) and vice versa.

Therefore an understanding of client specific financial statements risks enables the auditor to effectively plan audit procedures so that they are both sufficient (and efficient) and appropriate.

(b) Financial Statements Risk Facing Omega 3

Tutorial note: no professional marks were allocated to this requirement so presenting the answer in meeting note/report form is unnecessary. However, the use of sub-headings and short paragraphs is still considered good technique to help focus answers and improve marks.

Newly Incorporated Company

There is a financial statements risk that share capital and share premium transactions may not be correctly recorded in the financial statements for the year ended 30 September 2010. These are relatively infrequent transactions and the accountant may have no experience processing the relevant journals. It is important that recently issued shares are correctly identified as ordinary or preference shares, as per IAS 32; that share premiums are correctly allocated; and that called-up and unpaid shares are correctly identified. Given the proximity to the year-end there is a possibility that amounts may be called up but not yet fully paid.

There is also a risk that tax provisions are understated. As a company Omega 3 will fall under relevant company tax law for the first time. It is therefore vital that appropriate year-end corporation tax and deferred tax provisions are made, as per the criteria of IAS 12. At a small company rate of, say, 21% of net profit the tax charge for the year could be estimated at $105k, which is material.


4 KAPLAN PUBLISHING

Opening Balances

This risk is that opening balances carried forward from the year-ended 30 September 2009 may contain material error. This risk is heightened by the fact that the prior year’s accounts were not audited.

This is of particular concern where estimates may have been used, for example; with any provisions or, perhaps more relevantly, the recognition of development costs as intangible assets.

Dependence on a Single Product

The financial statements risk is that the basis of accounting in the financial statements may be inappropriate. If relevant, a break up basis should be adopted.

75% of all turnover comes from one product, “Fishy.” Without the continuing revenues ($7.2mn in 2010) of this product it is unlikely that Omega 3 will be able to fund the remainder of its operations. In particular, it appears unlikely that they would be able to fund the potentially expensive development of new products.

During the meeting with the finance director, Mr Cod, it was noted that: the product had received some adverse publicity; it had lead to the hospitalization of users; and that a material number of returns had been received in one month alone. This could have a damaging impact on the sales of the product.

Without “Fishy” there are no products to sustain the company. Currently the new product is in its early phases and it is uncertain as to when it will lead to significant revenue streams or if it will reach the market at all. There is therefore significant evidence to suggest that the future of the product “Fishy” and, more importantly, the going concern status of the business are under threat.

Development of New Product

There is a financial statements risk that intangible development assets are overstated and expenses understated. The development costs of $150k represent 30% of profit before tax and 4.8% of total assets and are therefore material to the financial statements.

As per IAS 38 development costs may only be capitalised if they meet certain criteria. One of those is that the product is commercially viable and another is that it will lead to an overall profitable venture. However, neither of these can be established with any certainty given that: the project is in its early phases; no testing has taken place; and it has to go through a trial before a sales contract is to be agreed.

It would appear likely at this stage that all development costs should be expensed. However, given Mr Cod’s confidence that the development will lead to long term sales this may not be the case.

New Laboratory

There is a risk that tangible property assets are overstated and that rental expenses are understated in the financial statements. The property cost of $300k represents 9.7% of total assets and is therefore material to the financial statements.


KAPLAN PUBLISHING 5

Mr. Cod suggests that he has capitalised the leased asset because Omega 3 incurred some repair and insurance costs. Presumably he feels that this indicates a finance lease. However, as per IAS 17, the key to deciding the classification is identifying who bears substantially all of the risks and rewards of ownership. Primary indicators of a finance lease include:

• The lessee (the user) has use of the asset for the substantial majority of its economic life; and

• The present value of the minimum lease payments (PV of MLP) is substantially (i.e. greater than 90%) all of the fair value of the asset at the start of the lease.

The lease is only for ten years. This suggests that Omega 3 do not have use of the asset for the majority of its useful life, which is more likely to be closer to 50 years. The PV of MLP and the fair value are unknown. However, at an estimated discount factor of 8% the PV of MLP works out to be $201k ($30k x cumulative discount factor of 6.710). Whilst the fair value is unknown this does appear to be a somewhat low value for industrial premises.

Given these factors it appears likely that the asset should be removed from the statement of financial position and an operating rental expense of $30k per year be recorded instead.

Even if the capitalization is appropriate the valuation is not. Mr Cod has simply added the gross rentals together and capitalised the building at $300k. This is not in accordance with IAS 17. Finance leased assets are recognized at the lower of fair value and PV of MLP. Using the above calculation as a guide this would result in a capital asset valued at $201k. Hence tangible property assets could be overvalued by $99k, which represents 3.2% of total assets, which is also material to the financial statements.

Adverse Publicity

The effects of the illnesses and the consequent adverse publicity on sales of the product/going concern have been discussed earlier in the answer.

In addition, there is a risk that provisions are understated/contingent liabilities are inadequate in the year-ending 30 September 2010. Mr Cod has suggested that all costs related to the incident would be accounted for in 2011. However, the illnesses and the consequent publicity could represent adjusting events after the reporting period, as per IAS 10. If this is the case then the financial statements for the year-ending 30 September 2010 must be adjusted.

If the patients fell ill or their cases were publicized in October 2010 this indicates that the related sale of goods may well have taken place before the year-end. Even if the illness occurred and the relevant costs are incurred after the year-end the obligation to incur costs for any fines/penalties would have been triggered when the goods were sold.

Therefore Omega 3 should make appropriate provisions for any legal costs or fines in the accounts to the 30 September 2010 in accordance with IAS 37. Whilst the costs are unknown the severity of the one illness indicates that it could be material. If the costs cannot be estimated with certainty then, at the least, the directors must include a contingent liability note in the accounts.


6 KAPLAN PUBLISHING

Credit Notes

There is a risk that profits, receivables and inventory balances may all be overstated in the financial statements for the year-ended 30 September 2010.

During the meeting with Mr Cod certain credit notes, totaling $40k from October 2010 were identified. These represent 8% of profit before tax and 1.3% of total assets and are therefore material to the financial statements.

Given their proximity to the year-end the credit notes most likely refer to goods sold prior to the year-end. In this case sufficient provision must be made against the receivables balance in the year-ending 30 September 2010 in accordance with IAS 37. At the very least this should be $40k. However, given that this was a brief inspection there may be other credit notes to process.

In addition the quality issues identified by customers cast doubt on the valuation of inventory, as per IAS 2. If goods are faulty they should be written down to the lower of cost and net realizable value. If the problem is symptomatic of all inventory, rather than simply a rogue batch, then a more significant write-off may be necessary.

Tutorial Note: the requirement specifically asks for financial statements risks. Discussion of detection risks (i.e. first year of audit) are irrelevant and will not score any marks.

(c) Audit Procedures

(i) Classification of Lease

Tutorial Note: the question specifically refers to the classification of the lease, i.e.: distinguishing between operating and finance leases. Tests referring simply to the valuation of leases will not be awarded marks.

• Enquire of directors why they believe the new laboratory lease qualifies as a finance lease. In particular ask them if they believe the lease term spans the useful life of the asset and if they have estimated the open market value of the property.

• Enquire of the directors if they legally own any similar properties. If so, inspect the useful life of the properties in the 2009 published accounts to identify if they exceed the 10 year life of the new property lease.

• Inspect the new lease agreement and identify the terms of the contract. Agree the 10 year timeframe and the annual rental but also inspect for any other terms, such as: early release clauses; repair/maintenance agreements; and rights to purchase the unit at end of the lease term.

• Inspect local trade press/internet sites to try and identify the current value of similar trade property in the area, e.g. $ per square foot on local industrial estates. Form an independent estimate of the fair value of the property.

• Consult an external expert to estimate the fair value of the property, e.g. chartered surveyor or estate agent.


KAPLAN PUBLISHING 7

• Recalculate the present value of the minimum lease payments quoted in the lease agreement. Compare this to the estimated fair value to assess whether PV of MLP is substantially all of the fair value.

• Inspect the terms of the buildings insurance to identify exactly what Omega 3 is insuring: i.e. does it cover the building or is it simply contents insurance. With reference to this inspect the lease agreement to identify if Omega 3 are required to insure the buildings.

(ii) Presentation of Share Capital

Tutorial Note: the question specifically refers to the presentation of share capital, i.e.: how share capital and related balances are presented in the published financial statements. Responses focussing on the valuation of share capital will receive few, if any, marks.

• Enquire of directors to identify when the share issue took place and how many issues took place in total before the 30 September 2010. All of these must be correctly accounted for in the financial statements.

• Enquire of directors if any fresh issues took place after 30 September 2010. These will require disclosure in the accounts as a note.

• Inspect the board minutes to confirm the number of shares issued during the financial year and for any post year-end issues.

• Inspect copies of the share certificates issued in the year/company register of members to confirm the number and class of shares issued. Compare this to the financial statements to ensure numbers of shares issued and different classes of shares are appropriately disclosed.

• For any preference share capital issued in the year inspect the share certificates to confirm the terms of the shares, i.e.: redemption and dividend rights. Ensure that these are appropriately presented in the accounts in accordance with IAS 32 (as liabilities or equity).

• Inspect the company statement of capital and shareholdings to confirm the nominal value of shares and again ensure this information is accurately presented in the accounts.

• Inspect the cash book to confirm that all amounts declared as fully paid have been received. Reconcile amounts to the bank statement and confirm amounts “fully paid” are accurately presented in the accounts.

• Recalculate amounts received above the nominal value of shares to verify that appropriate share premium accounts are presented in the financial statements


8 KAPLAN PUBLISHING

(d) KPI’s

Briefing notes

Guidance on the establishment of non-financial operational Key Performance Indicators (KPIs) within Omega 3

For discussion with Christine Carp, internal auditor of Omega 3

Introduction

Many companies use KPIs as a means of establishing performance targets and measuring actual results against the performance target set. Operational KPIs involve performance relating to internally controlled operations, such as: procurement, human resources, production, quality control and distribution.

The following recommendations provide examples of the types of non-financial operational KPI that could be applied to a business such as Omega 3 and the evidence that internal audit should be able to gather to identify if targets are being met.

Tutorial note: KPI’s must be SMART (specific, measurable, achievable, relevant and timely). If not then they are a useless benchmarking tool. Suggestions that don’t adhere to this will not receive any marks. For example: staff turnover – this has no criteria against which to measure the target; reduce complaints by 10% - when should this target be achieved by; reduce the number of deaths – is this relevant to a producer of herbal remedies?

Human Resource KPI’s

1 To reduce production/warehousing staff turnover by 5% in the next 12 months.

Typical evidence would include payroll records, such as personnel files and exit interview records.

2 To reduce staff absenteeism across the whole company by 10% in the next 12 months.

Evidence would include payroll records, in particular amounts paid under statutory sick pay and medical notes/self-certifications to support sick leave.

3 To increase the time spent on staff training and development by a total of 1 day per member of staff in the next 12 month period.

To verify time spent in training internal audit would need to review timesheets of hourly paid employees. In addition training portfolios/meeting attendance lists could be reviewed for all training initiatives implemented during the year.

Procurement KPI’s

4 To reduce the average time delay between identifying and fulfilling inventory requirements by one day over the next 12 months.

Internal audit could inspect the dates on original purchase requisitions/requests and the dates on consequential goods received notes.

Production KPI’s

5 To reduce production line ‘downtime’ by 5%/or X hours in the next 12 months.

Evidence available should include production schedules and manufacturing output reports.


KAPLAN PUBLISHING 9

6 To reduce the amount of production faults by 5% in the next 12 months.

Inventory write-offs will provide evidence as to the volume of faulty/damaged goods produced during the year.

7 To increase productive hours by 5%/ X hours in the next 12 months.

Evidence available should include production schedules and manufacturing output reports.

Quality Control KPI’s

8 To reduce the volume of returned goods by 10% in the next 12 month period.

Evidence available would include quality control inspection reports, credit notes raised by the accounts department and inventory write-off records.

9 To reduce customer complaints by 5% in the next 12 month period.

Evidence would include copies of written complaints and conversation minutes of telephone complaints.

Distribution KPI’s

10 To reduce the time delay between receiving and fulfilling orders by an average X days in the next 12 months.

The most likely source of evidence would be original sales orders and signed proofs of delivery.

11 To reduce the number of total deliveries by X miles in the next 12 months (and hence improve efficiency of delivery schedules)

Evidence would include driver mileage charts/servicing records of vehicles.

Conclusion

The specific KPIs set by Omega 3 should reflect the priorities of the company. There is an extremely wide range of measures that could be used – the important thing is to make each measure quantifiable and to ensure that evidence will be readily available to support the stated KPI. In the absence of this, the KPIs may lack credibility, will be useless as performance analysis tools and may possibly prove to be de-motivating to staff if they feel they will be harshly measured against targets they have little control over.

Tutorial note: The answer states more than the required number of KPIs to illustrate the wide variety of points that could have been made in answering the question. As indicated in the conclusion, there are many alternative KPIs which could have been suggested. Credit will be awarded for any suitable KPI and associated evidence.


10 KAPLAN PUBLISHING

MARKING SCHEME Marks

(a) (i) Audit vs. Financial Statement Risk

Generally 1 mark per discussion point. Maximum of 2 to be awarded if candidate fails to discuss relationship between two areas of risk.

• Definitions:

− Audit risk (1 mark);

− Financial Statement Risk (1 mark);

• ISA 200 (½ mark);

• Relationship between components of audit risk;

• Risk and audit planning;

• Impact on procedures. 4 marks

(b) Financial Statements Risks

Generally ½ mark per identification of risk and a further 1 mark for supporting explanation (which must be applied to the scenario).

½ mark awarded for correct calculation and identification of materiality (max of 2 for question)

½ mark awarded for correct reference to financial reporting standards (only give credit for a standard once, max of 2 for question)

Ideas

• New company:

− Incorrect recording of share capital transactions (IAS 32);

− Underprovision of tax balances (IAS 12)

• Errors in opening balances (max 1);

• Overdependence of single product/incorrect basis of accounting;

• Overstatement of development assets (IAS 38);

• Overstatement of property/laboratory asset (IAS 17);

− Incorrect lease classification;

− Incorrect asset valuation.

• Understatement of fine/legal provisions (IAS 37/IAS 10);

• Overstatement of receivables/understatement of credit note provisions (IAS 37). 12 marks

(c) (i) Classification of Lease Costs

Generally 1 mark per explained audit procedure. Vague lists, e.g. inspect contract, do not provide sufficient explanation and should not score.

Ideas

• Enquire of directors re. classification;

• Compare to similar, owned properties;

• Inspect lease agreement;

• Inspect local property reports;

• Consult surveyor/estate agent;

• Recalculate PV of MLP;

• Inspect insurance documents. 4 marks


KAPLAN PUBLISHING 11

(ii) Presentation of Share Capital

Generally 1 mark per explained audit procedure. Vague lists, e.g. inspect board minutes, do not provide sufficient explanation and should not score.

Ideas

• Enquire of directors when issues took place;

• Inspect share certificates;

• Inspect board minutes;

• Inspect preference share terms;

• Inspect statement of capital;

• Inspect cash book;

• Recalculate related balances. 4 marks

(d) KPIs

Generally ½ mark per KPI identified (must be SMART!) and ½ mark per piece of evidence suggested (giving a max of 1 mark per suggested KPI with accompanying evidence). Max of 8 marks!

2 professional marks are available to be awarded as follows:

− ½ mark for format of briefing notes;

− ½ mark for introduction;

− Up to 1 mark for clarity and relevance of explanation, including a brief conclusion/summary. 10 marks

Total 34 marks

ANSWER 2

(a)

Planning Memorandum

To: Engagement Team

From: Managers name

Date: 4 October 2010

Subject: Review engagement of Trumpet’s two year forecast

Introduction

Included below is a discussion of the nature and scope of the review of Trumpet’s forecasts and a summary of the evidence that will need to be gathered in order to facilitate a negative assurance report.

(i) The Nature and Scope of the Review of Trumpet’s Forecast Financial Statements

Distribution of Report

This PFI has been prepared to show an external third party user – Dorklays bank – the financial consequences of Trumpet’s plans. The purpose of which is to aid the bank’s decision whether to provide loan finance to Trumpet.

If Trumpet is successful in their loan application the forecasts will then provide Dorklays with a management tool against which to assess the progress of Trumpet and the security of their investment.



The forecast – and more specifically, our assurance report – is not for distribution to any other party. This would breach the terms of our engagement letter. If Trumpet wish to distribute the report to any other party they must firstly seek written approval from the engagement partner.

Form of Assurance Provided

The report on the forecasts will provide limited assurance as to whether the assumptions provide a reasonable basis for the PFI. A negative statement of opinion will be provided as to whether:

• The assumptions made are consistent with our understanding of the business;

• The PFI has been properly prepared on the basis of those assumptions; and

• The forecasts are presented in accordance with a relevant financial reporting framework.

Nature of Evidence Gathered

The engagement is an examination to obtain evidence concerning:

• The reasonableness of the assumptions made given current market growth rates and other general economic factors;

• The consistency of the forecasts with historic performance and trading since the end of the last financial year (30 June 2010);

• Proper preparation of the forecasts on the basis of stated assumptions; and

• Consistent presentation with historical financial statements, using appropriate accounting principles.

As it is a review engagement the evidence gathered will be mainly in the form of enquiry, analytical procedures and written representation of management.

The Timescale of the Projections

The period of time covered by the forecast is two years. Whilst the assumptions for the year ended 30 June 2011 are likely to be based upon a number of current factors, such as forward order books and existing contracts, the 2012 estimates are likely to be much more speculative.

This is of particular concern given Trumpet’s wish to expand into new and untried product ranges. It will therefore be more difficult to make an unbiased assessment of likely future sales in these areas.

By the time that the review is conducted a significant portion of the forecast period for the year to 30 June 2011 will have been realised. Therefore, historic evidence should be available for – at least – the three months to 30 September 2010 to analytically review against the first three months of the forecast.

Experience of Management

Prior experience of Trumpet’s management team in preparing forecasts will be important in our assessment of the nature of the assumptions used, for example; in making accounting estimates (e.g. for provisions, impairment losses, etc).



Therefore it will be important to spend time making enquiries of management about how they arrived at their forecast figures and what the basis of any of their assumptions are. It will also be important to assess how well they have forecast similar matters in the past, for example; by comparing provision assessments with actual costs incurred in following periods.

The Basis of the Forecasts

During the review it will be important to ascertain the nature of any assumptions made, i.e.: which of the following estimation techniques have the directors used:

• Historical financial modeling: this is where historical financial information is projected into the future and adjusted for the effects of the planned loan and capital expenditure;

• Best guess: this is where the directors use their cumulative knowledge of the market to make educated estimates about sales and cost levels.

Other Issues

The planned nature and scope of the examination will have to take into account both time and fee budgets. This will be affected by:

• The locations that we will need to visit to access data and management;

• How much our prior knowledge as auditors contributes to our understanding of the assumptions made;

• Any time constraints for our final report made on us by the client and, ultimately, the bank. Much will depend on when they are meeting to decide upon whether to grant the loan or not.

(ii) Evidence to be Gathered During Review

To Provide Assurance On Consistency With Historical Policies

Firstly the figures quoted in the report for the year ended 30 June 2010 should be agreed to the audited financial statements. If these are not yet finalised they should be agreed to the general ledger/trial balance. The quarter ended 30 September 2010 can also be reviewed in comparison to the quarter ended general ledger/trial balance.

The accounting policies adopted during the year ended 30 June 2010 should be reviewed in comparison to prior years to ensure that the directors have consistently applied them. If any policy changes or changes in basis of estimation have taken place the effect should be quantified.

The policies adopted in this period should then be compared to the quarter ended 30 September 2010 and the forecasts ended 30 June 2011 and 2012. This is to ensure that the projections are in line with prior accounting practices and have not been adapted to flatter the figures.



To Provide Assurance On Consistency With Historical Performance

The forecast performance should be analytically reviewed in comparison to historical performance. This will help identify any unexpected trends that do not reflect prior achievements. Any such fluctuations will need to be discussed with directors. For example; in the two year period to 30 June 2012 the directors are forecasting that gross margins will improve from 31% to 40% and that operating margins will improve from 13% to 17%. These are significant improvements and will require explanation.

Assessing the Accuracy of the Forecasts for the Year Ended 30 June 2011

In order to assess managements’ ability to effectively forecast we can analytically review the budgeted figures for the quarter ended 30 September 2010 to the actual results achieved. This will help gain an understanding about how capable management are of building forecasts and estimating future trends.

The actual performance to 30 September 2010 can also be used to help identify how effectively management estimated provisions and contingencies at the year ended 30 June 2010. This will also help to build a picture regarding how competent management are at forecasting.

Assessing the Forecast Assumptions

Management have built some significant changes into their forecasts over the two years to 30 June 2012 and it will be vital to assess the assumptions that underpin these. For example:

• Property, plant & equipment:

− This has been forecast to increase by $47m. Enquiries should be made to understand how this cost is broken down and supporting evidence sought to confirm the estimates, such as: tender documents for construction of new property; quotes for new plant; invoices for any purchases subsequent to 30 June 2010.

− Useful economic lives of new properties and plant should be discussed with management and assessed in comparison to long term forecasts.

• Whilst reviewing the above it will be important to enquire as to how the directors are funding the growth. $20m appears to be funded by external long term loans and $4m from short term overdraft facilities but it is unclear where the remainder will come from. If further debt is being sought this and any related finance costs should be built into the forecasts. Likewise if further share capital will be raised.

• Terms of funding:

− Whilst significant increases in finance costs have been forecast, the rate applied to external debt must be considered in comparison to currently available lending rates.

− We must also review any existing overdraft agreements with the bank to ensure that Trumpet have the facility to increase their short term borrowings to $4m. It is likely that such a significant amount of overdraft will carry high interest charges so the assumed rate must be confirmed to the overdraft agreement.



− All covenants (for long and short term debt) must be reviewed and any forecast breaches in this discussed with directors. For example: gearing is set to increase to 75%. This could exceed thresholds set by the bank and this could trigger a repayment option for the bank. Obviously this would have catastrophic effects on the business as the cash would not be available to repay the loan.

• Sales: growth rates of existing products lines can be reviewed in comparison to historical performance and any forecast growth discussed with directors. For assessing the growth of new product lines, however, we will need to review market research and forecasts for individual products. It will be important to review forecast marketing spend as any growth in sales will need to be fuelled by heavy advertising and promotions.

Other Procedures

The mathematical accuracy of the forecasts should be checked.

A forecast cash flow statement for the same periods should be sought. There is evidence to suggest that the cash flows will not be able to sustain the business, despite the forecast profits. The most obvious indicator is the reduction in cash balances. In addition it can be noted that the quick ratio is set to fall from 1.1 in 2010 to 0.8 in 2012 and that the interest cover will from 2.5 to 2. It is possible that the strategy proposed by Trumpet is simply not sustainable and that the increase in external debt would lead to going concern problems.

(b) Role and Function of an Audit Committee

Having established an audit committee the company must determine its role and function. The objectives will depend upon the nature of the company and the regulatory regime under which it operates. Therefore the business segment and the country will be important factors to consider in establishing the role and function of the audit committee but general considerations include:

• The appointment of the external auditor, the setting of audit fees to be paid, and reviews of such fees, and any matters of external auditor dismissal or resignation.

• Review the nature and extent of non-audit services provided by the external auditor.

• Discussions with the external auditor before the audit commences regarding the nature and scope of the audit.

• If more than one audit firm is used, to co-ordinate the activities of the various parties involved.

• Review the interim and annual financial statements before submission to the board.

• Review compliance with regulatory requirements. This includes that accounting policies are in line with any legal regulations, corporate governance requirements, stock exchange reporting requirements and professional accounting standards.

• Discuss problems and reservations arising from the external audit. This can be very useful to the external auditor wanting to avoid a breach of confidentiality on a matter the auditor would like to discuss.



• Review the external auditor's management letter and management response. The audit committee should be in a position to ensure that the points made by the external auditor are followed up.

• Review the company's internal control systems and their effectiveness.

• Review any internal audit programme, ensuring that there is close co-ordination and co-operation between the internal audit function and the external auditors.

• Consider, and report on, the major findings of internal investigations and management's response. As such the committee also provides a channel for ‘whistleblowing.’

(c) Disadvantages of Having an Audit Committee

There are many disadvantages, perceived or real, and these will have more relevance in some countries than in others. Possible disadvantages which may be considered important enough to prevent the establishment of audit committees include:

• The committee will consider, and report on, the major findings of internal investigations and management's response. This could lead to a culture of fear within management structures.

• If the role and function of the audit committee is not appreciated and approved by all board directors its establishment could lead to a ‘two-tier’ board, where some directors appear to be 'more equal' than others.

• The functioning of the audit committee may encroach on management responsibilities. Without clear terms of reference this can cause conflict and less than optimum use of the audit committee by some members of the management team. It also means that non-executive directors become over-burdened with detailed roles.

• Audit committees in many countries are powerless because they cannot enforce their recommendations or report directly to shareholders.

• Audit committees incur costs and time. This can only be justified on a cost/benefit basis, but measuring the benefits can be a problem.

• The existence of such a committee may encourage excessive prudence and risk aversion, which can hamper initiative and flair, both of which can be vital to survival in certain business segments and environments.

• The audit committee may not be effective because they meet only infrequently, have little real understanding of what is happening in an organisation, and may lack an objective approach. (For example, it can be argued that Enron’s Audit Committee had little or no effect in saving the company from financial catastrophe).




(a) (i) Nature/Scope

Generally ½ mark each issue identified and up to 1 mark for thorough discussion/explanation, to a maximum of 7.

Ideas

• Distribution;

• Form of assurance;

• Nature of evidence;

• Timescale;

• Experience of management;

• Basis of forecasting.

(ii) Evidence Gathered

Generally ½ mark for each procedure identified and up to 1 mark for thorough explanation, to a maximum of 9.

Ideas

• Consistency of policy;

• Consistency of performance;

• Accuracy of quarter ended 30 September 2010;

• Assumptions:

− Property, plant & equipment;

− Source of funding;

− Terms of funding;

− Sales growth;

• Others.

Professional marks: ½ for format, ½ for introduction and up to 1 mark for presentation of report and clarity of explanation 18 marks

(b) Role/function of an audit committee

Generally 1 mark per explained procedure to a maximum of 6.

Ideas

• Appoint & set fees;

• Review services;

• Discuss nature/scope;

• Co-ordinate multiple auditors;

• Review accounts;

• Review compliance;

• Discuss audit issues;

• Review management letter;

• Review internal controls;

• Review internal audit;

• Whistleblowing. 6 marks

(c) Disadvantages of an audit committee

Generally 1 mark per explained point to a maximum of 6.

• Culture of fear;

• Two tier board;

• Encroach management roles;

• Lack of power;

• Cost & time;

• Risk aversion;

• Lack of understanding. 6 marks

Total 30 marks



ANSWER 3

(a) ‘Forensic auditing’

Definition

The process of gathering, analysing and reporting on data, in a pre-defined context, for the purpose of finding facts and/or evidence in the context of financial/legal disputes and/or irregularities and giving preventative advice in this area.

Tutorial note: Credit will be awarded for any definition that covers the key components: An ‘audit’ is an examination (e.g. of financial statements) and ‘forensic’ means used in connection with courts of law. Forensic auditing may be defined as ‘applying auditing skills to situations that have legal consequences’.

Application to fraud investigation

As a fraud is an example of an irregularity, a fraud investigation is just one of many applications of forensic auditing, where evidence about a suspected fraud is gathered that could be presented in a court of law. The pre-defined objective of a fraud audit is:

• to prove or disprove the suspicions of the client; and, if proven,

• to identify the persons involved;

• to provide evidence for appropriate action, possibly criminal proceedings.

As well as being ‘reactive’, forensic auditing can be ‘proactive’ by being preventative. That is, the techniques of forensic auditing can be used to identify risks of fraud with a view to managing those risks to an acceptable level.

(b) Matters/Procedures Prior to Planning the Engagement

Tutorial note: The phrases ‘matters … and … procedures’ are used to encourage candidates to think more widely than just ‘considerations’ or just ‘actions.’ A possible structure for this answer could be under two separate headings: ‘matters’ and ‘procedures’. Candidates should note that a tabular/columnar answer is NOT appropriate as any attempt to match matters and procedures is likely to result in repetition of the same point.

Scope of Assignment

• Discuss the assignment with Wicker’s management to determine the purpose, nature and scope of the investigation. In particular, discuss whether any irregularity (theft/fraud) is suspected and, if so, whether evidence gathered will be used:

− in criminal proceedings;

− in support of an insurance claim.

• Investigation will involve consideration of:

− possible understatement of inventory value at 30 September 2010;

− high material consumption for the quarter ended 30 September 2010.



• The type of assurance (most likely to be limited or negative but not restricted to this as it will be an ‘agreed upon procedures’ engagement) is likely to have a bearing on:

− any caveats in the report;

− the level of risk/potential liability for any errors in conclusions given in the final report;

− the level of necessary detailed testing required (even if an audit is not requested).

• The investigation may have been commissioned to give credence to the year-end’s accounts. The investigation may therefore be of the nature of a limited audit.

Terms of Engagement

• Obtain clarification of terms of reference (TOR) in writing from Wicker’s management.

• The TOR should give the investigating team full access to any aspect of Woodward’s operations relevant to their investigation and key staff for enquiries.

• An engagement letter must be drafted and Wicker’s management must agree to its terms in writing before any investigative work can begin. The letter of engagement should include:

− details of work to be carried out;

− likely timescale;

− basis of determining fee;

− the reliance that can be placed on the final report and results of the investigation;

− the extent of responsibilities agreed;

− any indemnity agreed;

− the information to be supplied as a basis for the investigation; and

− any areas specifically excluded.

Engagement Restrictions/Intended Audience

• Wicker’s management will presumably want the investigation completed before the next inventory count (at 31 December 2010) to know if the findings have any implications for the conduct of the count and the determination of year-end inventory.

• The depth of the investigation will depend on matters such as:

− the extent of reliance expected to be placed on the investigation report;

− whether the report is for Wicker’s internal use only or is it likely to be circulated to bankers and/or shareholders.



• Assess the appropriateness of an exclusion clause; for example: ‘CONFIDENTIAL – this report has been prepared for the private use of Wicker only and on condition that it must not be disclosed to any other person without the written consent of the preparing accountant’.

Planning Considerations

• Determine the level of experience of staff required for the investigation and the number of staff of each grade.

• The availability of suitable staff may affect the proposed start of the investigation. Alternatively, the timing of other assignments may have to be rescheduled to allow this investigation to be started immediately.

• Produce a budget of expected hours, grades of staff and costs. Agree the anticipated investigative fee with Wicker’s management.

(c) Procedures to quantify the amount of any undervaluation

Tutorial note: Any tests directed at quantifying an overstatement and/or instead of understatement will not be awarded credit.

Physical count

• Inspect the warehouse/factory areas to identify high value inventory items and confirm their inclusion on the inventory sheets at 30 September 2010 (or otherwise vouch to a delivery note raised after that date).

• Recast all additions and recalculate all extensions on the inventory sheets to confirm that there have been no omissions, transposition errors or other computational discrepancies that would account for an undervaluation.

Cutoff

• Ascertain the last delivery notes and despatch notes recorded prior to counting and trace to purchase/sales invoices to confirm that an accurate cutoff has been applied in determining the results for the quarter to 30 September 2010 and the inventory balance at that date.

• Trace any large value purchases in September to the 30 September inventory sheets. If not on the inventory sheets enquire of management whether they are included in production (or sold). Verify by tracing to production records, goods despatch notes, etc.

Analytical procedures

• Compare large volume/high value items on inventory sheets at 30 June with those at 30 September to identify any that might have been omitted (or substantially decreased). Enquire of management if any items so identified have been completely used in production (but not replaced), scrapped or excluded from the count (e.g. if obsolete). Any items excluded should be counted and quantified.

• Compare inventory categories for 30 September against previous quarters and obtain explanations for significant fluctuations. In general, increases in inventory might be expected to support increased trading activity. Alternatively, decreases in inventory may reflect difficulties in obtaining supplies or maintaining inventory levels if demand has increased.



Scrap materials

• Make enquiries of Woodward’s key warehouse and production staff regarding the company’s scrap/wastage policy and any records that are kept. Enquire as to how such items are identified and whether they are ‘quarantined.’

• Review production records on a month-on-month basis and discuss with the factory manager whether any production problems have increased wastage in the quarter to 30 September 2010.

Pricing test

• Raw materials – select a sample of high value items from the 30 June 2010 inventory valuation and confirm that any unit price reductions as shown by the 30 September 2010 valuation are appropriate (e.g. vouch lower unit price to recent purchase invoices or write down to net realisable value).

• WIP and finished goods – agree a sample of unit prices to costing records (e.g. batch costings). Recalculate unit prices on a sample basis and vouch make-up to invoices/payroll records, etc.


(a) Forensic Audit

Generally 1 mark for each issue that is thoroughly discussed.

Ideas

Definition

• Audit (examination);

• Forensic (legal);

Application to fraud investigation

• Irregular nature of fraud;

• Objectives;

• Reactive vs. proactive; 4 marks

(b) Matters and procedures

Generally 1 mark for each issue that is thoroughly discussed.

Ideas

Scope

• Use of evidence;

• Understatement of inventory/high material consumption;

• Assurance offered;

• Period end accounts;

Terms

• Written clarification;

• Access to staff/info;

• Engagement letter;

Restrictions/audience

• Deadlines;

• Distribution;

• Exclusions;

Planning

• Experience of staff;

• Availability of staff;

• Budget. 8 marks



(c) Inventory tests

Generally 1 mark per thoroughly explained test.

Ideas

• Physical count;

• Cut-off;

• Analytical procedures;

• Scrap materials;

• Pricing tests. 6 marks

Total for Question 18 marks

ANSWER 4

(a) Running Blade

Ethical Issues

Deckard must assess whether they can satisfy the objectives of the client with the necessary competence and due care. They should consider whether they have the knowledge, skills and experience to complete the engagement. They must also consider whether they have the resources available to perform these services given other client commitments.

They should also consider whether any impediments exist to the objectivity and independence of the firm. For example; they must consider whether any senior staff members have personal relationships with or financial investments in Running Blade. They should also assess whether accepting Running Blade conflicts with existing clients, who may be direct competitors. This may preclude Deckard from accepting the appointment.

Professional Issues

NB: Deckard has no duty to communicate with previous auditors as this is Running Blade’s first year of audit. As this is therefore irrelevant no marks should be awarded for discussion of this issue.

Deckard should confirm with Running Blade’s management that no previous auditors have at any point been appointed to the company.

Deckard should consider whether accepting this client is in line with their own strategic objectives. It does not necessarily follow that all audit work should be accepted purely because it will provide fee income. Deckard must consider whether the client operates within an industry that Deckard wishes to enter or already has experience in.

Deckard will be required by law to perform Client Due Diligence for money laundering purposes. To this end they should seek the necessary certificates of registration of the company, including the register of members and the registered address.

If Deckard accepts nomination they must ensure that appropriate resolutions are passed, officially appointing Deckard as auditor, before they begin any work on the assignment. Prior to commencing work they must also receive a signed copy of the engagement letter from the client.

Given that this is a new client consideration must be given to ISA 510 Initial Audit Engagements – Opening Balances when planning the initial audit of Running Blade.



(b) Scott Microchips

Ethical Issues

Deckard should clarify with the management of Scott Microchips the nature and extent of the assurance services required in addition to statutory audit. There could be a potential threat to objectivity and independence arising from a self-review threat. This could occur if the results from non-audit services are reflected in the amounts included or disclosed in the financial statements.

Deckard may also suffer from a threat to their objectivity if the firm undertakes work that involves making judgments and/or taking decisions on behalf of management. Deckard must seek clarification of what services are required and ensure that Scott Microchips understands that Deckard may only provide advice and a range of possible solutions to clients.

Given that Scott Microchips has requested a “range of assurance services” and that it is a listed client (and therefore presumably large) it is reasonable to question how significant the fee related to these services will be. As a listed client fee income should not exceed 10% of total income for Deckard, as this would create an intimidation threat. If the fee for the services exceeded this limit Deckard would have to consider declining certain services.

Professional Issues

There is likely to be a conflict of interest as Deckard is currently the auditor of Ridley, a major competitor of Scott Microchips. Accepting the engagement may upset the existing client as this increases the risk that sensitive, confidential information may be leaked to the competition via the audit team (note: could also be considered under ethical threats). Deckard may therefore feel that accepting Scott Microchips as a client is not in the overall interest of the firm.

Again, Deckard should consider the desirability of Scott Microchips as a client of the firm. This will include assessing whether they have the necessary skills and resources to adequately plan, supervise and review all the relevant services. This will be particularly important given the self-review threat. Deckard will need to ensure that separate teams are available to be used on the various assignments to manage this risk.

Permission should be sought from the management of Scott Microchips to communicate with the previous auditor to obtain professional clearance before accepting the engagement. If permission is refused then Deckard should not accept the engagement.

Finally, a separate partner and team from the one currently engaged with Ridley should be allocated to the audit of Scott Microchips. This will help manage any confidentiality risk increased by the acceptance of the engagement.

(c) Rutgers

Ethical Issues

As the firm’s principal client there is an implied threat to objectivity arising from the level of fee income received from Rutgers. Any change in the services provided to Rutgers or changes in other areas of the business, such as the loss of other key clients, could result in the fees from Rutgers contributing more than 10% of Deckard’s total fee income. This would result in an increased risk of intimidation due to dependency on the client.



It suggests in the question that Rutgers has expanded rapidly in the last two years and that they are continuing to seek new growth. It must be assumed that as the size of the group increases so does the scale of the audit and the fee charged.

As Rachael has been the engagement partner for five years there is an implied familiarity threat between her and the directors of Rutgers.

Professional Issues

An independence review should be conducted prior to the commencement of the current audit. It would be prudent if the review were conducted by the ethics partner, given the engagement partners familiarity with the staff of Rutgers. If the fees from Rutgers have exceeded the 10% barrier then Deckard must seek to cut back the services they offer.

Deckard should make provision to rotate the engagement partner and any other key staff that have been involved in the audit for the last five years. As this causes some disruption to the client relationship Deckard must handle the transfer sensitively, communicating with their client (perhaps with the audit committee) by explaining the need to protect against familiarity threat.

This would also cause significant disruption to the planning and performance of the audit because at least one senior member of the team will not be involved. The loss of such a senior member will undoubtedly mean that the team, on the whole, has less experience of the client and the unique audit risks it poses Deckard. Therefore sufficient time must be allocated to ensure that thorough planning can be conducted.

It would also be prudent to plan to utilise as many of the same staff as in the prior year to reduce the impact of the loss of the partner. This will ensure some continuity and will counteract the loss of the partner’s knowledge and experience.


(a) Running Blade

Generally 1 mark each issue thoroughly discussed.

Ideas

• Competence/due care;

• Self interest assessment;

• Confirm no previous auditor;

• Strategic objectives of Deckard;

• Client due diligence;

• Resolutions/engagement letter;

• ISA 510. 6 marks

(b) Scott Microchips


Ideas

• Self review;

• Management decisions;

• Fee level/intimidation;

• Conflict of interest/confidentiality;

• Desirability/resources;

• Permission to communicate with current auditor;

• Separate teams. 6 marks



(c) Rutgers


Ideas

• Fee level/intimidation;

• Familiarity;

• Fee review;

• Partner rotation;

• Discussion with audit committee;

• Audit team disruption. 6 marks


ANSWER 5

(a) Benefits

There are several benefits to choosing a voluntary financial statement audit.

Decision Making

An annual audit will help detect any material mistakes made in preparing the year-end financial statements. This is important as directors use the year-end accounts to review trading progress and will need reliable figures to assess performance. An audit will give directors comfort that the financial statements are a sound basis for making business decisions.

Budgeting

Accurate figures also enable more effective budgeting and forecasting, which are crucial to achieving growth and stability, which are likely to be important for small – in particular new – businesses.

Management accounts

The auditors are likely to use any management accounts produced as part of normal audit procedures. To this end they are able to advise clients of improvements that could be made to the management accounts, for example: increased levels of detail, and more frequent reporting. Better quality management accounts aid the day-to-day running of businesses and enables speedier responses to any problems arising during the year, which is critical to the success of a small business that perhaps lacks effective internal reporting systems.

Management letter

As a by-product of the audit, a management letter (report to those charged with governance) is produced. This identifies weaknesses and offers recommendations on areas such as systems and controls, which will improve the smooth running of client businesses. This is vital to small businesses where, in a significant number of cases, internal controls are unsophisticated.

Growth

If small companies seek growth it is likely that they will require funding in order to expand. It is likely that potential investors or lenders would request audited figures for review, before making finance decisions. It will therefore be simpler – and potentially cheaper – to raise finance with audited financial statements already available.



Deterrent

Many small businesses deal in cash sales and hold inventory. The external audit can act as both a deterrent and a detective control, thus reducing the risk of fraud and resultant detrimental impact on the financial statements.

Enhance credibility

Accurate financial statements will be the best basis for tax assessment and tax planning. An audit opinion will enhance the credibility of the figures.

Audit Limit

If the small business grows rapidly, then it is likely that at some point in the future, the audit exemption limit will be exceeded and thus an audit will become mandatory.

Choosing to have an audit during the early life of the business will reduce potential errors carried down to subsequent periods and thus avoid modifications due to opening balances when the audit threshold is exceeded.

(b) Review engagement

The objective of a review engagement is to enable the auditor to obtain moderate assurance as to whether the financial statements have been prepared in accordance with an identified financial reporting framework.

In order to obtain this assurance, it is necessary to gather evidence using analytical

procedures and enquiries with management. Detailed substantive procedures will not be performed unless the auditor has reason to believe that the information may be materially misstated.

The auditor should approach the engagement with a high degree of professional scepticism, looking for circumstances that may cause the financial statements to be misstated. For example, in smaller companies, the financial reporting systems may not be sophisticated and may lead the auditor to believe that there is a high inherent risk that the figures are misstated.

As a result of procedures performed, the auditor’s objective is to provide a clear written expression of negative assurance on the financial statements. In a review engagement the auditor would state that ‘we are not aware of any material modifications that should be made to the financial statements….’

Negative assurance means that the auditor has performed limited procedures and has concluded that the financial statements appear plausible. The user of the financial statements gains some comfort that the figures have been subject to review, but only a moderate level of assurance is provided.

Users may need to carry out additional procedures of their own if they want to rely on the financial statements. For example, if small companies were to use the financial statements as a means to raise further bank finance, the bank would presumably perform, or require the company to perform, additional procedures to provide a higher level of assurance as to the validity of the figures contained in the financial statements.

Audit

In comparison, in an audit a reasonable level of assurance is provided. The auditors

provide an opinion of positive, but not absolute assurance. The user is assured that the figures are free from material misstatement and that the auditor has based the opinion on detailed procedures.



(c) PFI Report

Responsibilities

It is the accountant’s responsibility to report on three issues:

1 Whether the assumptions provide a reasonable basis for the forecast;

2 Whether the forecasts are prepared on the basis of those assumptions;

3 Whether an appropriate financial reporting framework has been adopted/ applied in the forecast data.

Limited/Negative Assurance

As this is a limited assurance review engagement the accountant will only offer a negative opinion, i.e. that nothing has come to light during the review that identified any material departures from the objectives of the engagement.

Sales discrepancy

The issue here is that Dead Beats has prepared the forecast using a set of assumptions that, in the opinion of the accountant, are not all reasonable. The forecast has been prepared assuming a 1% increase in sales per month, which equates to in excess of 12% over the year. Whereas the auditor thinks there will be a decrease of 4% for the same period. There is obviously doubt over the suitability of the assumptions as a basis for the forecast.

The question then arises as to whether this is of material significance to the user. Since the profit forecast is shown per month, then it may not be appropriate to consider any disagreement in relation to the profit for the year. Instead we should consider whether the effect of this disagreement 'could influence the economic decisions made by the users' of the forecast. In this case, preparing a forecast with a monthly activity increase of 1% when the reality may be a decrease of 0.3% could influence a decision made.

Action taken

Given the likelihood that the forecast could mislead users we would have to request that the directors of Dead Beats review their assumptions and, if necessary re-draft their forecast for the twelve month period. If they failed to review the forecast or to provide evidence to support their original assumption then we would have to produce a report that shows no basis of evidence can be obtained to support one of the assumptions.

This is not the same as no basis of evidence can be obtained to support the entire forecast or whether a relevant accounting framework has been applied.

Example wording

An example of the wording would be:

'We have examined the forecast in accordance with relevant standards of auditing and assurance applicable to the examination of prospective financial information. The directors are solely responsible for the forecast including the assumptions set out in Note X on which it is based.

The profit forecast has been prepared using the assumption that sales will increase by 1% each month over the next year. We have not found any evidence to support this assumption, and therefore do not believe this assumption provides a reasonable basis for the forecast.



Except for the effect of the matter of the reasonableness of the assumption regarding sales, based on our examination of the evidence supporting the assumptions, nothing has come to our attention which causes us to believe that these assumptions do not provide a reasonable basis for the forecast. Further, in our opinion the forecast, so far as the accounting policies and calculations are concerned, is properly prepared on the basis of the assumptions, is consistent with the accounting policies normally adopted by the company, and is presented in accordance with relevant financial reporting standards.'


(a) Benefits of choosing to have financial statement audit

Generally 1 mark per comment

Ideas

• Improves reliability of figures;

• Improve quality of management accounts;

• Detective and preventative control;

• Increased assurance for external users;

• Reduces accumulation of errors carried down;

• Advice provided in letter to management;

• May need audit in future years: 4 marks

(b) Objective of review engagement and assurance provided

Definition/objective – 2 marks maximum

2 marks for each comment on level of assurance NB NEEDS TO BE CONTRASTED WITH AUDIT

Ideas

• Limited procedures;

• Negative assurance;

• Only moderate level of assurance. 6 marks

(c) Dead Beats

Generally 1 to 1½ marks for each thorough discussed point relating to the nature/wording of the report.

Ideas

• Nature of PFI reporting;

• Negative opinion/limited assurance;

• Unsuitable sales assumption;

• Material significance to users;

• Request directors review/amend;

• Material - no basis of evidence obtained for sales – no effect on entire basis of preparation;

• Wording:

− Evidence does not support sales assumption;

− Except for......;

• Nothing come to attention. 8 marks


P7

Documents

Transcript of P7