p7.Summary note.pdf

LEVERAGE ASSOCIATE, LAGOS

2015

ADVANCED AUDIT AND

ASSURANCE PAPER P7 NOTE ON ACCA PAPER P7

COMPILED BY TESLEEM ADELODUN (ACCA)

+2348039399907,[email protected]

F O R M O R E I N F O F O L L O W O U R G R O U P O N F A C E B O O K A T A C C A N A I J A L O A D E D

CONSIDERATION OF LAWS AND REGULATIONS IN AN AUDIT OF FINANCIAL

STATEMENTS ISA 250

Non compliance

Non compliance refers to acts of omission or commission by the entity, either intentional

or unintentional which are contrary to the prevailing laws or regulations.

Companies are subject to many laws and regulations for example:

Company law

Employment law

Income tax law

Labor law

Environmental Protection law etc.

Responsibilities of Management and Auditors

Management

Management is responsible for the prevention, detection and correction of non

compliance with laws and regulations.

The following policies and procedures may be implemented by the management in order

to prevent and detect non compliance with laws and regulations:

1. Maintain a register of significant laws with which the entity has to comply.

2. Engage legal advisors to assist in monitoring legal requirement.

3. Institute and operate appropriate system of internal controls.

4. Develop, publicize and follow a code of conduct.

Auditor

As with fraud, the auditor is not, and cannot be held responsible for preventing non

compliance but they should aim to be aware of those that could materially affect the

Financial Statements. There is unavoidable risk that some material misstatements in the

financial statements go undetected even though the audit is properly planned and

performed.

Audit Procedures to identify non compliance with laws and regulations

1. The auditor should obtain general understanding of the laws and regulations

affecting the entity, which includes procedures such as:

Use the auditor’s existing understanding of the entity’s industry, regulatory and

other external factors.

Enquire of management as to the laws and regulations that may be expected

to have a material effect on the operations of the entity.

Enquire of management concerning the entity’s policies and procedures

regarding compliance with laws and regulations.

Enquire of management the policies or procedures adopted for identifying,

evaluating and accounting for litigation claims.

2. The auditor should obtain sufficient appropriate audit evidence of compliance with

other laws and regulations such as entity’s license to operate (non compliance

may doubt going concern) that may have a fundamental affect on operations of

the entity.

3. The following procedures may indicate the instances of non compliance such as:

Reading minutes

Enquiring from the company’s and external legal advisors.

Performing substantive tests of details of classes of transactions, accounts

balances and disclosures.

4. The auditor should obtain written representation from management and those

charge with governance that they have informed auditor about all known and

suspected non compliance.

Audit procedures when non compliance is identified:

In such a case the auditor shall obtain:

1. An understanding of the nature of the act and the circumstances in which it has

occurred.

2. Further information to evaluate the possible effect on the financial statements.

When evaluating the possible effect on the financial statements the auditor should

consider the following:

Potential financial consequence such as fines and penalties.

Whether potential financial consequence require disclosure

Impact on the auditor’s report.

When non compliance is identified the auditor should:

Reassess the risk.

Reassess the validity of written representation.

Take independent legal advice.

In exceptional cases the auditor may consider whether withdrawal from the engagement

is necessary.

Reporting of identified or suspected non compliance

Communicate to those charges d with governance, unless they themselves are

involved.

If management and those charged with governance are involved consider

reporting to next level of authority like audit committee.

Where no higher authority exists, or if the auditor believes that the communication

may not be acted upon or is unsure as to the person to whom to report, the

auditor shall consider the need to obtain legal advice

Impact of non-compliance on the auditor’s report

When non compliance is material and not adequately disclosed in the financial

statement the auditor shall express qualified opinion or adverse opinion.

When the auditors is precluded by the management and those charged with

governance from obtaining sufficient appropriated audit evidence than the auditor

should express a qualified opinion or disclaim an opinion on the basis of limitation

of scope.

Reporting non-compliance to regulatory authority

If the auditor is precluded by management or those charged with governance from

obtaining sufficient appropriate audit evidence to evaluate whether non-compliance that

may be material to the financial statements has, or is likely to have, occurred, the auditor

shall express a qualified opinion or disclaim an opinion on the financial statements on the

basis of a limitation on the scope.

Withdrawal from the Engagement

The auditor may conclude that withdrawal from the engagement is necessary when the

entity does not take the remedial action that the auditor considers necessary in the

circumstances, even though the noncompliance is not material to the financial

statements. Non-compliance with regulation cast doubt on the integrity of the

management

MONEY LAUNDERING

Money laundering is the process by which criminals attempt to conceal the true origin

and ownership of the proceeds of their criminal activity. In order to be able to spend

money openly, criminals will seek to ensure that there is no direct link between the

proceeds of their crime and the actual illegal activities

Factors indicating money laundering:

Transactions routed through several jurisdiction.

Secrecy over transactions.

Excessive use of wire transfers

High value deposits or withdrawals not characteristics of the type of account

A pattern that after a deposit, the same amount is wired to another financial

institution.

The three stages of the money laundering process

Placement;

Layering.; and

Integration

Anti money laundering procedures

The firm must gather know your client information (KYC) to assist in spotting suspicious

transactions. This includes:

1. Who the client is

2. Who controls it

3. The nature of the client

4. The client’s sources of funds

5. The client’s business and economic purposes.

In the UK, the basic requirements are for accountants to keep records of client’s identity

and to report suspicions of money laundering to the Serious Organized Crime Agency

(SOCA).

Elements of basic money laundering program

1. Appoint Money Laundering Reporting Officer (MLRO).

2. Train the individuals to ensure that they are aware of relevant legislation, know

how to deal with potential money laundering, how to report suspicions to MLRO.

3. Establish internal procedures such as know your client and client acceptance

procedures to prevent money laundering.

4. Verify the identity of new and existing clients and maintain evidence of

identification.

5. Maintain records of identification, and any transactions undertaken for or with the

client.

6. Report suspicions of money laundering to SOCA.

Note:

1. Concealing and tipping off (MLRO or any individual discloses something that

might prejudice any investigation) is itself a criminal offence.

2. The obligation to report money laundering act does not depend on the amount

involved or the seriousness of the offence.

The need for ethical guidance on money laundering

This is needed because there is a clear conflict between the following two situations:

1. The accountants’ professional duty of confidentiality in relation to client’s

business, and

2. The duty to report suspicions of money laundering to the appropriate authorities

as required by law.

Professional accountants are not in breach of their professional duty of confidentiality if

they report in good faith their knowledge or suspicions of money laundering to the

appropriate authority.

Disclosure without reasonable grounds would possibly lead to the accountants being

sued for breach of confidence.

Question

A) Comment on the need for ethical guidance for accountants on money laundering.

(4 marks)

B) The Financial Action Task Force on Money Laundering (FATF) recommends

preventative measures to be taken by independent legal professionals and accountants

(including sole practitioners, partners and employed professionals within professional

firms).

Required:

Describe FOUR measures that assist in preventing professional accountants from

being used for money laundering purposes.

(8 marks)

Ans

A)

1) Accountants (firms and individuals) working in a country that criminalises money

laundering are required to comply with anti-money laundering legislation and failure to

do so can lead to severe penalties. Guidance is needed because:

legal requirements are onerous;

money laundering is widely defined; and

accountants may otherwise be used, unwittingly, to launder criminal funds

2) Further guidance is needed to explain the interaction between accountant’s

responsibilities to report money laundering offences and other reporting responsibilities,

for example:

reporting to regulators;

auditors’ reports on financial statements (ISA 700);

reports to those charged with governance (ISA 260);

reporting misconduct by members of the same body

3) Professional accountants are required to communicate with each other when there is

a change in professional appointment (i.e. “professional etiquette”). Additional ethical

guidance is needed on how to respond to a “clearance” letter where a report of

suspicion has been made (or is being contemplated) in respect of the client in question.

4) Accountants need ethical guidance on matters where there is conflict between legal

responsibilities and professional responsibilities. In particular, professional

accountants are bound by a duty of confidentiality to their clients. Guidance is needed

to explain:

How statutory provisions give protection against criminal action for members in

respect of their confidentiality requirements.

When client confidentiality over-ride provisions are available.

B)

1) Appointing a compliance officer having a suitable level of seniority and experience

The compliance officer being made responsible for:

receiving and assessing money laundering reports from colleagues

making reports to the relevant agency

ensuring that individuals are adequately trained

2) Providing an employee training programme on:

relevant legislation (e.g. the main money laundering offences);

ethical guidance (e.g. ACCA’s Guidance for Accountants); and

the firm’s procedures to forestall and prevent money laundering

3) Performing customer due diligence. Firms should verify the identity of their

customers, when:

establishing business relations;

carrying out occasional transactions (e.g. above a designated threshold);

there is a suspicion of money laundering or terrorist financing; or

there is doubt about the reliability or adequacy of previously obtained

customer identification data

4) Maintaining all client identification records together with a record of all

transactions, in a full audit trail form.

PROFESSIONAL CODES OF ETHICS AND BEHAVIOR

ACCA members are expected to carry out their work with due skill and care while giving proper

regards to technical and professional standards.

Auditors are not only required to be ethical but they must be seen to be ethical. It is on this note

that ACCA publishes rules of professional conduct which all members and students must adhere

to.

The fundamental principles (OPPIC)

Objectivity Members should strive to be objective in all professional

and business judgments.

Professional behavior Members should desist from any act that can bring

disrepute to the accounting profession.

Professional

competence

Members have the responsibility to maintain up-to-date

knowledge that will enable them to competently carry

out their work.

Integrity Members should be straight forward and honest in

their professional dealings.

Confidentiality Auditors should not disclose client’s information to a

third party without due permission from the client.

Threats to the fundamental principles (AFISS). These are situations that make auditor not

to adhere to the fundamental ethical codes.

Advocacy This is a situation where the auditor finds himself in a position he has

to defend the interest of its client before a third party.

Familiarity This threat arise as a result of the auditor becoming unduly

sympathetic towards its client as a result of long association

Intimidation This threat arise when the auditor comes under intimidation by

dominant individual or aggressive atmosphere at the clients

Self interest This arise when personal interest of the auditor conflicts with that of

the client

Self review This threat arise when the auditor have to review or audit the work

that he help to carry out.

SPECIFIC SITUATIONS THAT THREATEN ADHERENCE TO THE FUNDAMENTAL CODES

Gift and hospitality

This may create self interest and familiarity threat. The IESBA code of ethics states that when a

firm or a member of the assurance team accepts gift and hospitality, unless the value is clearly

insignificant, the threat to independence cannot be reduced to acceptable level by applying

appropriate safeguards, so the firm or team member should decline the gift and hospitality.

Possible safeguards:

Inform the client’s management

Seek legal advice

Inform the auditor’s professional body to seek for advice

Audit firm carrying out actuarial service for clients

Going by IESBA code of ethics, provision of actuarial service and other valuation services may

give rise to self review threat.

If the service involves evaluating matters that are material to the financial statement and the

valuation involves a high degree of subjectivity, the threat to objectivity and independence cannot

be reduced to an acceptable level by applying appropriate safeguards. The service should

therefore not be provided, or the audit firm should withdraw from the engagement if it wants to

carry out the service.


Audit firm should ensure that members doing the valuation work are not part of the audit

team

Auditor should obtain management’s acknowledgement that it is responsible for the result

of the valuation

Audit work done for the client should be reviewed by an independent accountant

Audit firm offering internal audit services to client

Offering of this service may result in self review threats to objectivity. To reduce the threat to an

acceptable level, the firm should ensure that management is ultimately responsible for the control

and management of internal audit.


The client should acknowledge that it is responsible for establishing and monitoring the

system of internal controls

The scope of work to be done should be set by the client’s management

The audit firm should ensure that members responsible for the internal audit service are

not part of the assurance team.

Contingent fee

This is a situation whereby the auditor’s fee depends on the outcome of uncertain future event.

IESBA code of ethics outrightly prohibit contingent fee for audit engagement. It creates self

interest threat to objectivity. No level of safeguards will be adequate in this regards, contingent

fee arrangement should be rejected by audit firm.

Long association with audit client

This may lead to familiarity threat. The auditor may not see anything wrong in what the client is

doing now because it has always get things right in the past. This makes the auditor to lose his

professional skepticism as a result of the close relationship. It may equally lead to self interest

threat because the auditor does not want to lose a source of income.

Safeguard

For listed clients, the IESBA code requires the key audit partner to be rotated after 7 years and

should not be involve in the audit for 2 years.

Recruitment of staff on behalf of audit clients

Provision of this service is not prohibited by the IESBA code. It could however lead to the

following threats:

Self interest threat. This is because the firm will want to protect its fee income from the

recruitment. The firm may compromise quality in order to earn its own fee

Self review threat. Recruitment of staffs is management’s responsibility. Offering of this

service will amount to making management decision. If the staff recruited is responsible

for the financial statement, this will amount to the firm auditing its own work.

Familiarity threat. The interaction made during the process of interview will create

familiarity with the staff. The firm may be less critical of the work of such employee based

on the impression created by the employees during the interview.


Request management to acknowledge that it is responsible for the recruitment of staff

The firm should only make recommendation, the selection should be made by the

management

The fee charged should be disclosed to the audit committee

Temporary staff assignment

This is a situation whereby staffs of audit firm are temporarily assigned to work in a client. This

arrangement will lead to the following threats to objectivity and independence:

Depending on the seniority of staff and the position they are assigned to work, the

assigned staffs may be making management decision. In no way should auditor be

making management decision. It will lead to self review threat because the auditor will be

part of the system he set out to audit.

Self review threat. The seconded staffs will be auditing the work they help to prepare and

may never want to fault their own work. The other staffs of the firm on the audit team may

not want to fault the work prepared by their colleagues.

Familiarity threat. The seconded staffs will be familiar to the members of the audit team

and as a result the team may not be performed the audit with required level of

professional skepticism.


The firm should ensure the seconded staffs do not take on management role or take any

management’s decision.

Seconded staffs should not be included in the audit team to the client

Audit work performed should be reviewed by an independent accountant

Question DEPECHE

You are a manager in Depeche, a firm of Chartered Certified Accountants. You have

specific responsibility for undertaking annual reviews of existing clients and advising

whether an engagement can be properly continued. The following matters arose in

connection with the audit of Duran, a company listed on a stock exchange, for the

year to 31 December 2008:

(1) The audit team included a manager, two supervisors, two qualified seniors

and six trainees. The final audit, which lasted approximately five weeks, was

very time-pressured and the team worked late into the night towards the end

of the audit. Duran’s staffs were very supportive throughout and paid for

evening meals that were brought in so that the audit team could work with

minimum disruption.

(2) Duran’s chief finance officer, Frankie Sharkey, was so impressed with the

commitment of the audit staff that he asked that Depeche pay them all a

bonus through an increase in the audit fee. In April 2009, Depeche paid all

the members of the team below manager status a bonus amounting to a

week’s salary. The bonus was processed through Depeche’s payroll, in the

same way as overtime payments, and recharged to Duran as part of audit

expenses.

(3) One of the points initially drafted for possible inclusion in the report to the

company’s audit committee concerned the illegal dumping of drums,

containing used machine oil, on nearby wasteland. Notes of discussions

between the audit manager and Frankie show that it is the company’s

unwritten policy to disregard the local environmental regulations and risk

incurring the fines, which are only small, as it would be costly to use the

nearest licensed disposal unit. The matter is not referred to in the final report.

Required:

(a)Comment on the ethical and other professional issues raised by each of the above

matters. (10 marks)

(b)Discuss the appropriateness of available safeguards and advise whether or not

Depeche should continue as the auditor to Duran. (5 marks)

(15 marks)

Ans

(1) Hospitality

■ Depeche’s objectivity may be threatened, or appear to be

threatened, by acceptance of goods, services or hospitality from

Duran, unless the value of any benefit is modest.

■ The audit staffs have already accepted the hospitality. Their

objectivity should not have been impaired provided that the meals

were appropriate to the normal courtesies of social life.

■ However, undue hospitality is likely to be regarded as a corrupt

practice, which could be indicative of fraudulent activities having

taken place.

■ As the staff needed to work late to meet the deadlines, an

alternative to Duran buying in the refreshments would have been

for the audit team to make their own arrangement and for Duran to

have been re-charged the expense.

(2) Financial reward

■ The bonus was not accepted in respect of the audit manager’s

involvement. Therefore there is no obvious threat to his

objectivity.

■ The bonus may be perceived to be a reward (or “bribe”) for having

not detected or reported on a matter and acceptance of it may cast

doubt on the audit team’s integrity.

■ The increase in audit fee as a result of the bonus should be

included in the amount disclosed in the note to the financial

statements as auditors’ remuneration.

■ If the audit team had any expectation that a bonus might be

awarded to them it is likely that there will be a perception that their

objectivity could have been impaired.

■ That the bonus was not accepted at the manager level suggests

that this was considered to be a threat to objectivity. This

consideration and the decision to accept the bonus for other

staff should have been documented.

(3) Client/auditor integrity

■ Frankie Sharkey’s apparent disregard for environmental

legislation should have been taken into account when making a

risk assessment of Duran’s control environment. It may cast doubt

on his integrity.

■ The audit of Duran should have been carried out with due regard to:

ISA 250 “Consideration of Laws and Regulations in an Audit

of Financial Statements”; and

ISA 260 “Communications of Audit Matters With Those

Charged With Governance”.

■ if the illegal dumping became apparent during the audit but was not

known at the planning stage, consideration should have been given

to:

the frequency of the illegal act, how long it has been going

on and what measures, if any, had been taken to conceal it

from the auditors;

the potential financial consequences (e.g. fines, penalties,

enforced discontinuation of operations and litigation);

whether the potential consequences require disclosure;

whether risk assessments made at the planning stage need

now to be revised;

the validity of management representation

■ Matters to be communicated to those charged with corporate

governance (i.e. the audit committee) include:

the potential effect on the financial statements of any

significant risks and exposures, such as pending litigation,

that are required to be disclosed in the financial statements

(this could arise from the illegal dumping); and

other matters warranting the attention of those charged with

governance, such as questions regarding management

integrity.

■ It is of potential concern that the matters have not been included in

the final report unless the engagement partner knows, for example,

that the matter has already been brought to the audit committee’s

attention (e.g. in an internal auditor’s report).

Available safeguards

■ The firm’s guidance on receiving hospitality should be reviewed

and amended as necessary. It may be that “on-going” hospitality is

refused, if construable as excessive.

■ Review of the engagement partner’s decision to accept the bonus

on behalf of the staff. For example, whether the firms’ quality

assurance policies and procedures required him to consult with

other partners.

■ Audit staff and the client should be advised that the bonus was a

“one-off” and not to be repeated.

■ Senior staff (the two qualified seniors and two supervisors) should

not be assigned to the audit for the year to 31 December 2009.

■ Involving a second partner to review the conduct of the audit and

advise staff involved of any concerns they have about their

independence from Duran and the integrity of Duran’s

management.

■ If the engagement partner has been involved in the audit for a

number of years (say seven), it may be time to rotate the

assignment.

■ Discuss issues of independence with Duran’s audit committee and

obtain written confirmation that they are aware of the potential

threats posed by public interest, fees, hospitality, etc and that they

are satisfied that the firm’s safeguards are adequate.

Advice whether or not the audit of Duran should continue

The Duran audit should be retained only if a partner of Depeche

unconnected with Duran independently reviews the safeguards available and

considers them to be adequate.

Alternatively: If the safeguards available are not adequate to maintain

independence, Depeche should withdraw from the audit.

Prepared by Tesleem Adelodun (ACCA) [email protected],+2348039399907

Fraud and Error

Fraud involves the use of deception to obtain an unjust or illegal financial advantage and

intentional misrepresentation by management, employees or a third party. Fraud may be

categorized as below:

Fraudulent financial reporting, which involves the following

Falsification or alteration of accounting records

Misrepresentation of transactions

Intentional misapplication of accounting standards

Omitting the effect of transactions

Misappropriation of assets or theft

Detection and prevention of fraud

Management responsibilities

Client’s management and those charged with governance are primarily responsible for the

detection and prevention of fraud. The management of the client is responsible for establishing

strong system of internal controls to be able to detect and prevent fraud.

Auditor’s responsibility

Auditor is not primarily responsible for detecting fraud. Rather ISA 240 requires auditor to be

aware, when planning and performing their audit, that fraud may have taken place. Auditor is

only responsible for detecting fraud to the extent that it is material to the financial statements.

On discovering fraud by auditor, ISA 240 the auditor’s responsibility relating to fraud in an audit

of financial statements prescribes the following:

Auditor should communicate the discovered fraud to management as soon as

discovered or suspected


If the discovered fraud involves management, the auditor must communicate the matter

to those charged with governance

The auditor should consider if he has statutory duty to report the fraud to a regulatory

and enforcement authorities

The auditor should consider the effect of the fraud on the audit opinion

Error

Error is an unintentional mistake. Auditors have the following duties regarding detection and

reporting of error:

The auditor has the responsibility of discovering material errors

The auditor should assess whether immaterial errors discovered during the audit are

material in aggregate

The records of all errors discovered by the auditor should be communicated to the

management as soon as possible

Auditor should request the discovered errors be corrected by management

The aggregate of uncorrected misstatement that were determined by management not

to be material, both individually and in aggregate to the financial statements should be

communicated to those charged with governance by the auditor

Professional liability (external audit)

Auditors have a duty of care to the body of the shareholders (not to individual shareholder) and

may be found liable to them if the auditor was negligent.

Generally, auditors do not owe a duty of care to third parties and cannot be liable to them. For

auditor to be held liable to a 3rd party, the followings must be established:

There was duty of care at the time of the audit owed by the auditor to the 3rd party

The duty of care was breached by performing negligent audit by the auditor

The 3rd party has suffered a loss as a result of the breach


Ways of reducing auditor’s liabilities:

The audit firm may operate as a limited liability company

The audit firm may use insurance to limit exposure to claims from third party

The firm may operate as a limited liability partnership

Use of liability limitation CAP

Use of disclaimer in the audit report

Performing the audit according to international standards

Auditor’s liability (Non audit assignment)

The auditor will only be liable to the following persons:

Persons with whom proximity can be established

The direct beneficiaries of the information in the report

Persons who can reasonably be foreseen to rely on the report

Ways to reduce auditor’s liabilities:

The report should contain a statement that management is responsible for the

underlying information

The auditor should clearly state in the report that it is only the intended recipient that can

rely on the report

Liability cap may be included in the engagement letter

The assignment should be strictly performed according to the terms of engagement

Use of liability disclaimer paragraph


Ways of reducing auditor’s exposure to litigation

Firm should develop a robust client acceptance procedure. This should ensure that only

client with manageable level of risk is accepted.

Firms should follow quality control procedures as contained in ISQC 1. This will reduce

the risk of performing negligent audit.

Auditors should work to the terms of the engagement.

Signing of limited liability agreement with client. The disadvantage of this is that the

auditor may not be conscious of quality anymore, knowing that arrangement exist to limit

his liability, and leading to poor quality audit. This may reduce the overall value placed

on the auditor’s opinion.

Question T U R N A L S

Turnals is an unlisted manufacturing company with 120 employees, projected sales of $12

million, and estimated profit before tax of $1.5 million. During the current year the

directors’ attention had been brought to a recently discovered fraud perpetrated by Mr

Jones, the purchasing manager: He had set up a fictitious business that had invoiced

Turnals for goods that had never been supplied. The fraud had been going on for over two

years. Mr Jones was immediately suspended from all duties and the police informed. During

their investigation, Mr Jones admitted to the police that he had perpetrated a similar fraud at

his previous employers, who had not informed the police. When Mr Jones had been

employed, no reference had been sought from his previous employers.

Mr Jones had responsibility for obtaining competitive quotes, checking and initially

approving new suppliers. Final approval was authorised by the Managing Director but in

practice this was a formality. Mr Jones also raised most of the purchase requisitions based

on information supplied by the storekeeper and approved any requisitions made by other

members of staff.


The storekeeper’s responsibility was to match each delivery note to a copy of the purchase

requisition before the goods were taken into inventory. The two documents were then

sent to Mr Jones who matched them with the purchase invoice before passing the invoice

to the payables ledger cashier for payment. When the storekeeper was on holiday the

system of internal control specified that a deputy should perform the delivery note

matching procedure. In practice this had always been done by Mr Jones.

The fraud took place during the storekeeper’s holidays (4 weeks each year). It was

discovered when the cashier had to query one of the fraudulent invoices with the

storekeeper because Mr Jones was absent on company business.

Subsequent investigation revealed that approximately $50,000 had been misappropriated by

Mr Jones.

Garner & Co has been the auditor of Turnals for many years. The firm has 12 partners

and 60 audit staff. The internal control over Turnal’s purchase system was recorded and

tested for the first time during last year’s interim audit. In previous years a fully substantive

approach to purchases had been applied and no review of the internal controls over the

purchase system had ever been carried out.

No comments were made to management by the auditors on their findings from the interim

work on the purchase system.

Garner & Co had also acted as management and systems design consultants during the

implementation of Turnals’ purchase system at the beginning of last year. As a result the

directors believe that Garner & Co should be liable for the losses suffered by Turnals as

they employed the audit firm in a dual capacity.

Required:

(a) Describe the regulations and other audit practices that are designed to avoid conflicts of

interest in the provision of non-audit services to an audit client. (5 marks)

(b) Discuss why the following audit procedures may have failed to detect the above fraud:

(i) evaluation of the prescribed system of controls;


(ii) tests of controls on the authorisation of new suppliers;

(iii) analytical procedures.

(10 marks)

(c) Discuss the bases on which Turnals believe they have a claim against their auditors and

the likelihood of its success. (5 marks)

(20 marks)

Ans

(a) Regulations and practices that avoid conflicts of interest

Undue dependence on an audit client

■ It is recommended that the recurring fees from a single client or group of

connected clients should not exceed 15% of the gross practice income

(10% for public companies).

■ The provision of non-audit work will increase the amount of the fees from

this client. However it is debatable whether the consultancy is a “recurring

fee”. If it is not it would be disregarded. In any event it is unlikely that the

15% figure would be exceeded (although the question gives no guidance

on this).

Loss of independence

■ This is a more likely problem area. It could be caused by the auditor

relying on information that has been produced or in some way influenced


by staff of the audit firm. Generally this can occur in areas such as the

preparation of the accounts (accounting services), or acting as a tax

advisor. In this particular situation, the auditor may be more willing to

accept the system of controls as being reliable because it has been

devised, in part at least, by staff of the audit firm.

■ In an attempt to create independence audit practices usually require non-

audit work to be performed by staff that are not involved in the audit. Also

the audit and non- audit work should be supervised by different partners

within the firm. As a further precaution the audit partner and senior audit staff

should be periodically rotated. Staff of the audit firm should never make executive

decisions or become involved in the management of a client no matter what

capacity they are acting in.

■ Ultimately independence and objectivity are a state of mind and cannot be

ensured by sole reliance on the observation of rules and regulations.

(b) Failure to detect the fraud

(i) Evaluation of system of controls

■ In considering a specific transaction cycle (e.g. purchases), the main

controls that prevent fraud and error are authorisation procedures and

segregation of duties. These would ensure no one person, without

collusion, is able to perpetrate a fraud.

■ As part of their work on the control system, the auditor would ascertain

and evaluate the system of internal control at the business level (not

within the scope of the question) and at the transaction level. There is a

potential area of conflict here as the audit firm has had a part in the design

of the accounting systems. Therefore it is possible that the auditor would

be reluctant to criticise any weakness in the prescribed system.

■ In addition, it is a requirement of the auditing standards (ISA 315) that not


only is the business and its environment understood, but also its internal

control. It was only last year that, for the purchase system, this appears to

have been fully carried out. In previous years this understanding had not

been obtained as a substantive approach was used (i.e. control

effectiveness was not tested). ISA 315 makes it very clear that internal

control must be understood regardless of the audit approach.

■ As part of their understanding the business, the auditor should ascertain

and verify if segregation of duties is present and implemented within the

system. The fact that Mr Jones covered for the storekeeper during their

holidays, should have alerted the auditors to a potential breakdown in

segregation of duties and the higher risk of fraud this indicated.

■ In addition, as Mr Jones was responsible for raising purchase

requisitions and initiating the approval of new suppliers, the auditors

should have been placed on guard over the potential for fraud given his

role when the storekeeper went on holiday. This should have triggered

specific testing during the holiday period.

■ As the total of the fraud at Turnals over the two year period was $50,000

individual transactions within this total are likely to have been small and

infrequent as they only occurred during the storekeeper’s holidays. It is

unlikely therefore that a fraudulent requisition would be selected at

random.

(ii) Tests of control on the system for authorising new suppliers

■ The auditor would test on a sample basis that new suppliers are initially

approved by the purchasing manager and then authorised by the

Managing Director. This would be evidenced by the appropriate

signatures appearing on a specific “form”: Whether this check would have

specifically detected the fictitious supplier is doubtful as only a sample of

new suppliers would have been chosen by the auditor.

■ Also, the auditor cannot really ensure that the Managing Director takes the

authorisation process seriously, unless this becomes clear from

discussions with the Managing Director and the auditor’s assessment of

the management’s attitude, awareness and actions as part of their


assessment of the control environment. An indicator of this as a potential

problem area is the fact that no contact was made with the previous

employers of Mr Jones.

■ It is possible for the company and the auditor to employ a detailed check

on suppliers, for example by making enquiries about prospective suppliers

with credit reference agencies, trade directories and other validating

sources. However this approach is more usual for customers and, perhaps

wrongly, is often considered too expensive and unnecessary for suppliers.

■ Supplier statement reconciliation may, again, not have detected this

fraud as the purchase turnover is not material.

(iii) Analytical procedures

■ Analytical procedures may indicate problems or inconsistencies. The

errors created by this fraud would affect the gross profit percentage and

inventory levels.

However the size of the fraud probably does not represent an abnormal

movement in either of these areas and would not arouse the auditor’s

suspicion.

■ To detect the fraud, the auditor would need to carry out specific

procedures on purchases made during the holiday period of the

storekeeper. Any review based on value or volume of purchases in those

periods would not detect the fraud because of its small size. It would be

necessary to have identified the fictitious supplier through the fact that

purchases were only made from that supplier during the holiday periods.

(c) Bases for a negligence claim, and chance of success

Turnals have suffered a loss due to the fraudulent activity of an employee.

There are two possible reasons why the directors of Turnals may believe

they have a claim against Garner & Co:

(i) In the capacity of auditors


■ The auditors have a duty of care to the company. The “Caparo” case

clearly stated that the company can sue the auditors for damages due to

negligence.

■ However there is the argument that the directors have the primary duty

of safeguarding the company’s assets. It was the Managing Director who

was casual about approving new suppliers and this was the main cause

of the fraud.

■ Auditors design their tests to have a reasonable expectation of detecting

a material fraud. This does not appear to be a material fraud.

■ But, the auditors have not followed the requirements of ISA 315. They

have not fully understood the entity’s internal control and may not have

sufficiently assessed the risk of fraud (ISA 240) to enable them to

appropriately plan their audit.

■ In addition, they did not report to management any weaknesses within the

system. It is clear from the scenario that weaknesses did exist (e.g. use of

Mr Jones to cover during holiday periods, the lax approach of the

Managing Director to authorising new suppliers, the failure to obtain

references from previous employers).

(ii) In the capacity of acting as consultants to Turnals

■ This area of negligence is unusual and uncertain. The case of Arenson v Casson, Beckman Rutley and Co, although different in nature to this situation, did establish that auditors acting in a non-audit capacity can be liable for negligence

■ The implication in the question is that the system design has a weakness

and Garner & Co were instrumental in both its design and as auditors, its

testing. Prima facie there is a case to answer.

■ In these circumstances it would be necessary to look at the terms of the

contract for the non-audit services to see if there were any disclaimers of

liability by Garner & Co. Overall it remains the directors who are primarily

responsible for the system of internal controls.


Conclusion

■ The design of the internal control system should have specified that during

the holiday periods of the storekeeper a deputy, other than Mr Jones,

should be appointed and a more rigorous suppliers’ authentication

procedure should have been undertaken.

■ These weaknesses should have been noted by the auditors and

communicated to management.

■ Auditing standards do not appear to have been followed.

■ The probable immateriality of the fraud and the lack of responsibility

shown by the directors, would usually constitute insufficient evidence to

find Garner & Co guilty of negligence as auditors.

■ However, given that they did not fully apply auditing standards in the

planning of their audit and in informing management of the weaknesses

within the system, they could (at least) be held jointly liable with the

directors.

■ As consultants their position is more open to a negligence claim being

successful, but this would largely depend on the terms of engagement

contract as consultants.


Quality control (ISQC 1)

The importance of having good quality control procedures in place is to ensure quality of audit

work is maintained and to ensure the auditor complies with his duty of professional competence

and behavior. Lack of quality audit work will generally bring the audit profession to disrepute and

increase litigation risk against the auditor.

Quality control at firm level

Management of the firm should establish internal culture that promotes quality.

A staff with appropriate level of authority should be appointed as the quality control

manager. This person will ensure quality is maintained within the firm

Firm should ensure it has sufficient staff with required competence and capabilities

Firm should maintain a robust recruitment process

Continuous training of staff

Quality control on individual assignment

The engagement partner should ensure that the team is appropriately qualified and

experienced. staff assignment should be based on competence and capabilities

All assignments should be adequately directed, supervised and reviewed

Acceptance or continuance of client relationship should be carefully evaluated

Engagement partner should ensure that audit evidence is sufficient and appropriate to

support the audit opinion.

All work should be properly planned and documented

Advertising

Advertising is not prohibited for audit firm. However, the content of the advertisement or the

medium used should not bring accounting profession to disrepute. The following principles on

advertising should be followed:


Adverts should not discredit the service offers by other members

The adverts should be truthful and honest

The use of ACCA logo is not allowed to be used in such a manner that portray the firm

as being part of ACCA

If a fee is included in the advertisement, the basis of calculation should also be included

Unsubstantiated claims should be avoided

Audit Fees

Audit fee constitute expense and companies may perceive it to be too high. The auditor must

therefore ensure that they can provide a quality audit for the price charged.

Auditors may use any suitable method to calculate fees, but the basis upon which the fee is

calculated should reflect the level of work done. Contingent fee arrangement is however

specifically prohibited by the IESBA code.

Tendering for new client

When companies want to appoint auditors, they normally invites tender for their audit work. This

will give them the opportunity to obtain a competitive rate. The tender give opportunities to each

audit firm to showcase what they have in their fold to give them competitive hedge against

others.

A typical tender of an audit firm usually have the following contents:

The level of expertise the firm can boast of in the industry

Previous experience in terms of similar companies audited by the firm

Width of coverage in terms of national and international presence

The propose audit fee and the basis of calculation


Lowballing

This is a situation where firms charge less than market rate for an audit. This practice is

common when firms are tendering for new clients.

While Lowballing is not considered ethically wrong, the firm must ensure the following conditions

are strictly upheld:

The auditors must ensure they carry out an audit of required quality as dictated by

international standards of auditing

The auditors must ensure that the low audit fee does not create a situation where their

independence will be compromised.

Ethics of appointment

Ethics of appointment is divided into two phase, procedures to follow before accepting a

nomination and procedures to follow after accepting nomination.

Procedures before accepting nomination:

The firm must ensure that it is completely independent of the client.

The firm should assess the integrity of the directors of the company, where the integrity

of the directors or the company is questionable, the nomination should be rejected

The firm should ensure it has adequate resources in terms of staff strength, expertise

and availability of time to perform the audit

The firm must ensure that there is no any conflict of interest with the potential client

The firm must ensure it is professionally qualified to act for the potential client

Communicate with the incumbent auditor to learn of the reason for the change of auditor

and some other issues the new auditor should be aware of. The firm must seek for

permission from client before making any contact with the incumbent auditor. In the


event that the company refuses to grant this permission, the nomination should be

rejected.

Procedures after accepting nomination:

The firm should ensure that the removal of the outgoing auditor is legally done

The new auditor should request for a copy of the resolution passed at the general

meeting to confirm the validity of his appointment

The auditor should draft letter of engagement to be submitted to the directors of the

company

Question AGNESAL

(a) “Quality control policies and procedures should be implemented at both the level of the

audit firm and on individual audits.” ISA 220 “Quality Control for Audit Work”

Describe the nature and explain the purpose of quality control procedures appropriate to the

individual audit.(7 marks)

(b) You are the manager responsible for the quality of the audits of new clients of Signet , a

firm of Chartered Certified Accountants. You are visiting the audit team at the head office of

Agnesal Co. The audit team comprises Artur Bois (audit supervisor), Carla Davini (audit senior)

and Errol Flyte and Gavin Holst (trainees). The company provides food hygiene services which

include the evaluation of risks of contamination, carrying out bacteriological tests and providing

advice on health regulations and waste disposal.

Agnesal’s principal customers include food processing companies, wholesale fresh food

markets (meat, fish and dairy products)and bottling plants. The draft accounts for the year

ended 30 September 2008 show turnover $19.8 million (2007 $13.8 million) and total assets

$6.1 million (2007 $4.2 million).


You have summarised the findings of your visit and review of the audit working papers relating

to the audit of the financial statements for the year to 30 September 2008 as follows:

(1) Against the analytical procedures section of the audit planning checklist, Carla has

written “not applicable – new client”. The audit planning checklist has not been signed off as

having been reviewed by Artur.

(2) Artur is currently assigned to three other jobs and is working from Signet’s office. He last

visited Agnesal’s office when the final audit commenced two weeks ago. In the meantime, Carla

has completed the audit of tangible non-current assets (including property and service

equipment) which amount to $1.1 million as at 30 September 2008 (2007 $1.1 million).

(3) Errol has just finished sending out the requests for confirmation of accounts receivable

balances as at 30 September 2008 when trade accounts receivable amounted to $3.5 million

(2007 $1.6 million).

(4) Agnesal’s purchase clerk, Jules Java, keeps $2,500 cash to meet sundry expenses. The

audit program shows that counting it is ‘outstanding’. Carla has explained that when Gavin was

sent to count it he reported back, two hours later, that he had not done it because it had not

been convenient for Jules. Gavin had, instead, been explaining to Errol how to extract samples

using value-weighted selection. Although Jules had later announced that he was ready to have

his cash counted, Carla decided to postpone it until later in the audit. This is not documented in

the audit working papers.

(5) Errol has been assigned to the audit of inventory (comprising consumable supplies)

which amounts to $150,000 (2007 $90,000). Signet was not appointed as auditor until after the

year-end physical count. Errol has therefore carried out tests of controls over purchases and

issues to confirm the ‘roll-back’ of a sample of current quantities to quantities as at the year-end

count.

(6) Agnesal has drafted its first ‘Report to Society’ which contains health, safety and

environmental performance data for the year to 30 September 2008. Carla has filed it with the


comment that it is ‘to be dealt with when all other information for inclusion in the company’s

annual report is available’.

Required:

Identify and comment on the implications of these findings for Signet’s quality control policies

and procedures.(18 marks)

Ans

(a) QC procedures

Quality controls are the policies and procedures adopted by a firm to provide

reasonable assurance that all audits done by a firm are being carried out in

accordance with the objective and general principles governing an audit (ISA 220).

Individual audit level

■ Work delegated to assistants should be directed, supervised and

reviewed to ensure the audit is conducted in compliance with ISAs.

■ Assistants should be professionally competent to perform the work

delegated to them with due care.

■ Direction (i.e. informing assistants about their responsibilities and the

nature, timing and extent of audit procedures they are to perform) may be

communicated through:

briefing meetings and on-the-job oral instruction;

the overall audit plan and audit programs;

audit manuals and checklists; and

time budgets.


■ Supervisory responsibilities include monitoring the progress of the audit

to ensure that assistants are competent, understand their tasks and are

carrying them out as directed. Supervisors must also address accounting

and auditing issues arising during the audit (e.g. by modifying the overall

audit plan and audit program).

■ The work of assistants must be reviewed to assess whether:

it is in accordance with the audit program;

it is adequately documented;

significant matters have been resolved;

objectives have been achieved;

conclusions are appropriate (i.e. consistent with results).

■ Documentation which needs to be reviewed on a timely basis includes:

the overall audit plan (including risk assessments);

the audit program (and modifications thereto);

results from tests of control/substantive procedures and conclusions drawn;

financial statements, proposed audit adjustments and the proposed audit opinion.

■ An independent review (i.e. by personnel not otherwise involved in the

audit), to assess the quality of audit work (before the issue of an audit

report) should be undertaken for listed and other public interest or high

risk audit clients.

(b) Implications of findings for QC policies and procedures

Analytical procedures

Applying analytical procedures at the planning stage, to assist in understanding

the business and in identifying areas of potential risk, is an auditing standard and

therefore mandatory. Analytical procedures should have been performed (e.g.

comparing the draft accounts to 30 September 2008 with prior year financial

statements).

Audit staff may have insufficient knowledge of the highly specialised service

industry in which this new client operates to assess risks. In particular, Agnesal may

be exposed to risks resulting in unrecorded liabilities (both actual and contingent) if

claims are made against the company in respect of outbreaks of contamination


(e.g. CJD, BSE, foot and mouth, listeria, etc).

The audit has been inadequately planned and audit work has commenced before

the audit plan has been reviewed by the audit supervisor. The audit may not be

carried out effectively and efficiently.

Supervisor’s assignments

The senior has performed work on tangible non-current assets which is a less

material (18% of total assets) audit area than trade receivables (57% of total assets)

which has been assigned to an audit trainee. Tangible non-current assets also

appear to be a lower risk audit areas than trade receivables because the carrying

amount of tangible non-current assets is comparable with the prior year ($1.1m

at both year ends), whereas trade receivables have more than doubled (from

$1.6m to $3.5m). This corroborates the implications of (1).

The audit is being inadequately supervised as work has been delegated

inappropriately. It appears that the firm does not have sufficient audit staff with

relevant competencies to meet its supervisory needs.

Direct confirmation

It is usual for direct confirmation of accounts receivable to be obtained where

accounts receivable are material and it is reasonable to expect customers to

respond. However, it is already more than 2 months after the end of the reporting

period and, although trade receivables are clearly material (57% of total assets),

an alternative approach may be more efficient (and cost effective). For example,

monitoring of after-date cash will provide evidence about the collectability of

accounts receivable (as well as corroborate their existence).

This may be a further consequence of the audit having been inadequately planned.

Alternatively, monitoring of the audit may be inadequate. For example, if the audit

trainee did not understand the alternative approach but mechanically followed

circularisation procedures.

Depending on the reporting deadline, there may still be time to perform a

circularisation. However, consideration should be given to circularising the most


recent month end balances (i.e. November) rather than the year end balances

(which customers may be unable or reluctant to confirm retrospectively).

Cash count

Although $2,500 is very immaterial, the client’s management may well expect the

auditor to count it, albeit routinely, to confirm that it has not been misappropriated.

Monitoring of the trainee may have been inadequate. For example, Gavin may

not have understood the need to count the cash immediately the request was made

of the client . However, the behaviour of Gavin also needs to be investigated in that

he failed to report back to the audit senior on a timely basis and allowed himself to

be unsupervised.

The trainees do not appear to have been given appropriate direction. Gavin

may not be sufficiently competent to be explaining sample selection methods to

another trainee.

Although it is not practical to document every matter, details should have been

recorded to support Carla’s decision to change the timing of a planned

procedure. (Carla’s decision appears justified as it is inappropriate to perform a

cash count when the client is “ready” for it). Also, if some irregularity is discovered

by the client at a later date (e.g. if Jules is found to be ‘borrowing’ the cash),

documentation must support why this was not detected sooner by the auditor.

Inventory

Inventory is almost as immaterial as the cash in (4) from an auditing perspective,

being less than 2.5% of total assets (2007 2.1%). Although it therefore seems

appropriate that a trainee should be auditing it, the audit approach appears highly

inefficient. Such in-depth testing (of controls and details) on an immaterial area

provides further evidence that the audit has been inadequately planned.

Again, it may be due to a lack of monitoring of a mechanical approach being

adopted by a trainee.

This also demonstrates a lack of knowledge and understanding about Agnesal’s

business – the company has no stock-in-trade, only consumables used in the supply

of services.


Report to Society

The audit senior appears to have assumed that this is “other information” to be

included in a document containing audited financial statements “To be dealt with”

presumably means “to be read” with a view to identifying significant misstatements

or inconsistencies. However, Agnesal may be intending to publish it as an

entirely separate report and require an assurance service (other than audit) such as

an independent verification statement on performance standards.

As the preceding analysis casts doubts on Signet’s ability to deliver a quality audit

to Agnesal, it seems highly unlikely that Signet has the resources and expertise

necessary to provide such assurance services.

Question VALDA

As manager responsible for prospective new audit clients you have received a telephone

call from an acquaintance of a client. The caller, Richard Stone, has asked for your assistance

concerning Valda Co, a supplier of electrical alarm equipment. Business has boomed over

the last two years due to reported increasing crime rates. Turnover has nearly doubled and

the company is very profitable.

Mr Stone asks you for an estimate of the cost of a “cheap and cheerful” review of the

company’s accounting systems and internal controls and of a new computer installation. The

new computer is to be supplied next month, by R S Office Equipment, subject to board

approval. He suggests that you could spend a few days looking at the systems’ flowcharts

and documentation. He wants you to tell him anything else that could be significant to the

board’s decision to adopt his proposals.

Although you are keen to gain the business, you inform him that you will write after giving the

matter further consideration.

Required:

(a) Identify and comment on the issues raised as they affect your decision to gain the

business. (10 marks)

(b) State what procedures you would adopt to clarify and agree the basis on which your

firm would undertake this work. (5 marks)


(15 marks)

Ans

(a) Issues raised

Identity of caller

Mr Stone may be a major shareholder in Valda or otherwise control the voting. He

may be an officer (e.g. the managing or finance director). His interest(s) in the

companies concerned should be ascertained to establish:

■ his authority to commission the proposed review;

■ his interest in the outcome of the decision to purchase; and

■ whether this is a related party transaction. Richard Stone could own RS Office

Equipment.

Valda’s auditors

The company’s auditors might expect to be approached to undertake this

assignment. If approached, they may have declined due to lack of resources or

even expertise. If not approached, the reasons must be established. The auditors

should be notified of the special work requested as a matter of professional

courtesy. A new computer installation will concern the auditors and they would

expect to be involved.

Future business

There may be an opportunity to gain the audit of Valda or additional non-recurring

work. In particular, the company’s rapid expansion may result in the current auditors

being outgrown.

Timescale

As for all professional work, it should be carried out with a proper regard for the


technical and professional standards expected. It is unlikely that the level of care

and skill expected can be met within a restricted timescale. “A few days” is

unlikely to be feasible for the work proposed and conclusions cannot be drawn

until the fieldwork is completed. If the purchase cannot be deferred beyond next

month it may not be possible to accept the work.

Access to information

Restricted access to information and explanations, which limits the scope of the

proposed review, may prevent conclusions being drawn. It may be necessary to

discuss sensitive issues including proposed business expansion, technical

obsolescence of products, product development, etc. Also, the current auditors’

permission should be sought to review their management letter.

Reporting

Presumably the findings of the review will be reported, possibly to Mr Stone rather

than the board. Any opinions must be commensurate with the scope of the review

performed. In particular, the report will not recommend the board’s decision.

Nature of review

The company’s flowcharts and documents may not be up to date. The

“reviews” could require some element of verification (e.g. using walk-through

checks). Alternatively, it may be assumed that the flowcharts and documents are

reliable and accurate. In this case, management’s responsibility for the information

provided must be made absolutely clear in any report.

Decision to purchase

The decision to purchase, or not, will be taken by the board. Matters significant

to the board’s decision, which may not be included in Mr Stone’s proposals, could

be:

■ cost and availability of software support;


■ alternative methods of financing the acquisition;

■ capacity to meet future needs if growth continues at current rate;

■ Mr Stone’s commission or other interest, if any; and

■ the potential impact on the conduct and cost of the annual audit.

Fees

The assignment cannot be accepted if fees are contingent on the outcome. Fees will

be based on time spent and the level of skill of staff involved.

Resources available

The assignment will require at least one member of staff with relevant systems and

computer knowledge and experience. Some knowledge of the industry will be useful.

Such a person may not be available, at such short notice, without disturbing the

services provided to existing clients. For this reason alone, the assignment could be

declined.

(b) Procedures

Telephone Valda and enquire as to the status of Mr Stone.

If appropriate, telephone the existing client (with whom Mr Stone

is acquainted) and ascertain their relationship. Decline

nomination if a conflict of interest could arise.

Undertake company searches of Valda and RS Office Equipment to

establish:

current auditors;

Mr Stone’s interests as director/shareholder.

Call or write to Mr Stone:

declining work if there are obvious barriers at this stage; or


arranging a meeting at Valda’s premises.

Meet at Valda’s premises to discuss the unresolved issues concerning

acceptance of the assignment.

Advise Mr Stone of the need to notify and liaise with Valda’s auditors.

Obtain the systems flowcharts/documentation and consider whether the

level of detail provided is consistent with the review required.

Agree a provisional timetable to accommodate the needs of Mr Stone, the

review work, board decision and supplier’s delivery/installation.

Agree the basis on which fees will be charged and the account rendered paid.

Write to the existing auditors:

advising them of the assignment being undertaken;

requesting a copy of the latest management letter, if relevant

Draft an appropriate letter of engagement.


AUDIT OF FINANCIAL STATEMENTS

Audit planning

Proper planning is required in audit to avoid performing negligent audit. Overall audit plan

includes consideration of the following:

Knowledge of client’s business

Understanding of accounting policies of client and reporting framework

Assessment of risk and materiality

Consideration of nature, timing and extent of procedures to perform in gathering

evidences.

Co-ordination, direction, supervision and review

Knowledge of the business

The followings are the aspect of the client’s business which the auditor must understand:

Understand nature of the industry and its regulatory framework

Nature of the entity. This includes knowledge of the corporate structure, organization

structure, management’s objectives and philosophy, capital structure and the

composition of the board of directors

Nature of business. This includes knowledge of products, market, suppliers and

operation

Financial reporting framework

Business risk. This is the risk that the company may not achieve its objectives. Business

risk is a good indicator of going concern problem

Internal control. Assessment of the internal control will determine the audit strategy to be

adopted


Performance measurement. The auditor need to understand key performance ratios

used to assess the performance of the entity. Management may deliberately manipulate

the financial statements to obtain a better assessment

Procedures to gain business understanding

Discuss with regulatory agencies to gain knowledge of the industry regulations

Discuss with internal audit personnel and review the internal control manual to obtain

knowledge of the internal control system in operation

Observe internal control activities to assess the effectiveness of the internal control

system

Perform analytical procedure on the entries in the financial statements to assess risk of

material misstatement

Discuss with management to gain knowledge of the corporate structure

Read industry related publications to gain knowledge about the industry

Inspect documentations to obtain knowledge of ownership structure

Audit approach

Risk-based approach

In this approach, the auditors assess the risks associated with the client’s business,

transactions and systems and direct their testing to risky areas. The extent of detailed testing

depends on the outcomes of risk assessment.

Audit risk

Audit risk is the risk that the auditor may give an inappropriate opinion.

Components of audit risk

Audit risk= inherent risk x control risk x detection risk


Inherent risk- is the susceptibility of an account balance to misstatement. It is a risk which

remains until the causative agent is removed.

Control risk- is the risk that the system of control put in place by the management will fail to

detect material misstatement.

Detection risk- is the risk that the procedures performed by the auditor will fail to detect material

misstatements

If both control risk and inherent risks are low, the overall audit risk will be low. The auditor will

perform less substantive testing

If both control risk and inherent risks are high, the auditor needs to reduce the overall audit risk

by keeping the detection risk as low as possible as this is the only component of the audit risk

the auditor can control. To do this, the auditor will need to test more details

Advantage of risk-based strategy

This approach ensures that the greatest audit effort is directed at the riskiest areas, so that the

chance of detecting misstatement is enhanced and less time is devoted to less risky areas.

Disadvantage of risk-based strategy

It lays too much emphasis on test of details. This may make the auditor overlook other

important issues like frauds and going concern problem.

Its time consuming

Business risk or Top down Approach to Audit

This approach starts by considering the business and its objectives and works down to the

financial statements, instead of working up from the financial statements. The auditor will


establish what the business risks are and then relate these to how they could cause material

misstatement in the financial statements.

The auditor gains an understanding of management’s business strategy, business processes,

key performance indicators and associated risks and controls; he then compares his

assessment of these factors with the position reflected in the financial statement.

This approach save auditor’s time and add more value to the client

Components of business risks

Environmental risks

Increase in competition

Adverse weather condition

Financial risks

Cost of maintenance

Cost of any inputs

Increase lease obligations

Customer dissatisfaction lead to reputational damage and loss of revenue

Foreign exchange risk may reduce company income

Tax complications may lead to paying more tax e.g. wrong tax computation may to

paying fines

Compliance risks

Right or license to operate

Health and safety

Operational risks

Age of plants

Safety


Risk management

The following are the ways of dealing with risks:

Accept risk

Reduce risk. E.g.

Improved internal control

Staff training

Hedging

Avoid unacceptable risk

Transfer risk, e.g. using insurance

Difference between Audit strategy and Audit plan

Audit strategy sets the overall scope, timing and direction of the audit. The suitability of an audit

strategy depends on the risk characteristics of the audit. In other words, the strategy to be

adopted for a particular audit depends on the result of risk assessment carried out by the

auditor.

Audit plan details the specific procedures that need to be carried out in order to implement the

strategy and complete the audit. It details the step-by-procedures needed to gather evidences

for the completion of the audit.

Relationship between business risk and financial statement risk

Financial statement risks include both inherent and control risk. Financial statement risk is

generally the risk that the assertions in the financial statement may not be correct.

Business risk on the other hand is the risk that the business may not achieve its objectives. For

example, any factors capable of eroding the profit of an organization constitute business risk.

Any factors that threaten the going concern of an organization equally constitute business risk.


The presence of business risks makes the financial statement susceptible to manipulation. This

is because business risk put management under pressure. Management would likely want to

hide the effect of the business risk from the shareholders. This would make management to

manipulate the financial statements.

Specific examples of business and financial statement risks

Highly geared company

A highly geared company is faced with financial risk. This is because of the huge financial

commitment involved. Interest payments reduce the company’s profit, and as such, it constitutes

a business risk. This may equally lead to going concern problem because some of the assets of

the company may have been used as collateral to secure the loan. Inability to meet interest

obligation or loan repayment will lead to the seizure of such assets. This cause operational

problem and could eventually lead to the company going out of business. The financial

statement risk here is possible understatement of liabilities or non disclosure of going concern

problem.

A business that requires a license to operate

The business risk here is non-renewal of the license as a result of not meeting the attached

conditions. If the license is not renewed, the business will become inoperative. The associated

financial statement risk is non-disclosure of going concern problem in the financial statements.

A company Listed on multi exchange

A company listed on multiple stock exchanges is inherently risky to audit because the reporting

requirement on each exchange differs

Company that operate in multiple location

Presence in multiple locations increases control risk in that the entity system of control may not

cover all location. It equally increases detection risk in that the auditors need to attend and

obtain information from various locations.


Risks particular to a retail business

Transactions tend to be high volume, low value transactions

Transactions are often carried out in cash

Trade receivables are likely to be immaterial and therefore low risk

It is difficult to establish completeness of income

The risk of theft is very high

Industry specific risk

Some companies operate in industries that make use of complex assets that are difficult to

value. This constitutes inherent risk

Hints on answering questions on business and financial statement risk

When you are provided with extracts of financial statements and ask to highlight business and

financial statement risks, perform analytical procedures for the followings:

Movement in revenue

Movement in finance cost

Movement in profit margin

The percentage increment or decrement of the following pair of items should ideally be fairly the

same. Compare the percentage changes in the items and explain any variance with possible

misstatement.

Percentage change in sales revenue versus percentage change in cost of sale

Percentage change in sales revenue versus percentage change in material expenses

Percentage change in sales revenue versus percentage change in trade receivables

Percentage change in trade payables versus percentage change in material expenses


If the company operate overseas branch, the following risks should be identified

Foreign exchange risk

Tax complication as a result of the company not understanding the foreign tax system.

When customers are dissatisfied for whatever reasons, the following risks are possible

Reputational damage which may lead to brand impairment

Drops in revenue which may lead to going concern problem

The following areas of financial statements are highly susceptible to manipulation:

Inventory. Valuation may be wrong, in which case IAS 2 is not followed

Contingent liabilities/provisions. Contingent liabilities may not be disclosed where

required. Provision may be understated or not made at all. Theses translate to not

complying with the provision of IAS 37

Intangible assets. Intangible assets may be overstated or wrongly classified as against

the provision of IAS 38. Impairment review may not be carried out in compliance with the

requirement of IAS 36. Of particular importance in this regard is the treatment of website

costs. It is only the expenditure in the development phase that may be capitalized.

Expenditure incurred before and after the development phase is to be expensed in the

period.

Leased assets. Assets may be wrongly classified and the lease obligation may be

wrongly calculated as against the treatment laid out in IAS 17.


SUBSTANTIVE PROCEDURES

These are tests carried out to obtain audit evidence to detect material misstatement in the

financial statements.

Types of substantive procedures are:

Analytical procedures

Test of details

Substantive tests carried out to obtain evidence on financial statement assertions are described

below:

Audit objective Typical audit test completeness (a) Review of post balance sheet items

(b) Cut off (c) Analytical review (d) Confirmations (e) Reconciliations to control account (f) Sequence checks (g) Review of reciprocal populations

Right and obligations (a) Checking invoices for proof that item belongs to the company

(b) Confirmations with third parties Valuation (a) Checking to invoices

(b) Recalculation (c) Confirming accounting policy consistent

and reasonable (d) Review of post balance sheet payments

and invoices Existence (a) Physical verification

(b) Third party confirmations (c) Cut off testing

Occurrence (a) Inspection of supporting documentation (b) Confirmation from directors that

transactions relate to business (c) Inspection of items purchased

Measurement (a) Re-calculation of correct amounts (b) Third party confirmations (c) Expert valuation (d) Analytical review

Disclosure Check compliance with law and accounting standards


Analytical procedures consist of the analysis of significant ratios and trends including the

resulting investigations of fluctuations and relationships that are inconsistent with other relevant

information or which deviate from predictable amounts.

Auditor must apply analytical procedures at the planning and review stage of the audit. In

addition it may be used as substantive procedures to obtain audit evidence

According to international standard of auditing, analytical procedures include:

The consideration of comparisons with:

Similar information for prior periods

Anticipated results of the entity, from budgets or forecasts

Predictions prepared by the auditors

Industry information

Those between elements of financial information that are expected to conform to a

predicted pattern based on the entity’s experience, such as the relationship of gross

profit to sales

Those between financial information and relevant non-financial information, such as the

relationship of payroll costs to number of employees

Analytical procedures at the planning stage of audit

Auditors must apply analytical procedures at the planning stage to assist in understanding the

business and in identifying areas of potential risk.

The followings are the possible sources of information about the client:

Interim financial information

Budgets

Management accounts

Non-financial information


Bank and cash records

Sales tax returns

Board minutes

Discussions or correspondence with the client at the year end

Industry information

Limitation of analytical procedures at planning stage

Figures used are likely to be in draft form: - subsequent adjustment to these figures will

invalidate analytical procedures performed.

Information will not cover the entire accounting period e.g. seasonal variation may distort

information making analytical procedures misleading.

Information may not be prepared on the same basis as the previous year.

Information may not be available before the year-end accounts are produced.

Reasons for performing analytical procedures during risk assessment

To develop business understanding at the planning stage of the audit e.g. profit margin

may be compared with industry trend

To identify key audit risk so as to allow the auditor direct work to key risky areas and

reduce chance of unnecessary work

Analytical procedures on Statement of Comprehensive Income

Review trends in the following

Revenue

Gross profit

Net profit

Compare actual revenue and profits for like 3 years with projected revenue and profit.

Compare actual and budgeted figured on the following expenses

Staff cost

Training cost

Property cost


Calculate and make comparison of the following ratios

Return on capital employed

Earnings per share

Gross and Net profit margin

Analytical procedures on Statement of financial position

Calculate and make companions of following ratios:

Account receivable collection period

Account payable collection period

Current (liquidity) ration

Analytical procedures as substantive procedures

ISA 520 Analytical procedures states that auditors must decide whether using available

analytical procedures as substantive procedures will be effective and efficient in reducing

detection risk for specific financial statement assertions.

The followings are the factors which the auditor should consider when using analytical

procedures as substantive procedures:

Availability of information

Reliability of the information

Relevance of the available information

Source of the information. Information from independent sources are generally more

reliable than internal sources

Comparability of the information available

Use of Analytical Procedures as a Substantive Tests during Fieldwork to provide sufficient

Appropriate Audit Evidence

Proof in total test can be used to assess the reasonableness of items in the statement of

comprehensive income such as depreciation, wages and salary change.


For depreciation and amortization, the expected change for the year can be calculated

by applying the depreciation policy for each class of asset to the opening balance and

factoring in the acquisitions and disposal in the year.

For wages and salaries, the average numbers of employees can be taken and multiplied

by the average salary for the year to get an estimate of the salary charge for the year-

any pay rise should be factored into the calculation.

Comparisons of current year figures to prior year figures can be made for immaterial

items to form an assessment about the reasonableness of the figure. Comparison can

also be made with budget figures for the year.

Accounting ratios can be used as analytical procedures to provide audit evidence. The

ratios can be calculated for prior periods and for comparable companies.

Extent to which reliance can be placed on analytical procedure as audit evidence

Materiality of the item involved. Analytical procedure would be used for those items that

are not material to the financial statements. It is not suitable to use analytical procedure

on items that are material.

The accuracy with which the expected results of analytical procedures can be predicted

Analytical procedure can be use to proof in total for specific items in the accounts e.g.

depreciation, staff costs

Analytical procedures are more suited to large volume transactions. The auditor need to

test if the controls are effective to determine the extent of reliability


MATERIALITY IN PLANNING AND PERFORMING AN AUDIT – ISA 320

An item is material if its omission or misstatement could influence the economic

decision of user of the financial statements.

An item might be material due to:

1. Nature

2. Value

3. Impact.

There is an inverse relationship between the risk and the materiality. The higher the risk

the lower the materiality level and vice versa. When materiality level is set at lower level

then the auditor will have to verify more transactions.

Materiality is set at two levels:

1. Overall financial statements level. (Overall materiality)

2. For each account balance appearing in the financial statement (Performance

materiality).

Performance materiality is set at much lower level than the overall materiality so that

small misstatements in aggregate should not cross the overall materiality level.

Following are the bench marks for the materiality:

Profit before tax 5%

Profit after tax 5%-10%

Revenue 0.5%-1%

Total assets 1%-2%


The following factors may affect the identification of an appropriate benchmark:

1. Elements of financial statements (assets, liabilities, equity, revenue, expenses)

2. Whether there are items on which users tend to focus.

3. Relative volatility of benchmarks.

Gathering evidences

Students will be required to suggest audit procedures for specific matters raised in an

examination scenario. To be able to do this, students need strong knowledge of

accounting standards. Students must first identify the accounting issues in the questions

before prescribing procedures.

Using the Work of an auditor’s expert ISA 620

Professionals audit staff are highly trained and educated, but their experience and

training is limited to accountancy and auditing matters. In certain situations it will

therefore be necessary to employ someone else with different expert knowledge to gain

sufficient and appropriate audit evidence.

Examples of situation where expert’s opinion is required:

1. Valuation of certain types of assets for example land and building, plant and

machinery.

2. Determination of quantities or physical conditions of assets.

3. Determination of amounts using specialized techniques for example pensions

accounting.

4. The measurements of work completed and work in progress on contracts.


5. Legal opinion.

Competence and objectivity of the auditor’s expert

This involves considering:

1. The expert’s professional certification or licensing by or membership of an

appropriate professional body.

2. The expert’s experience and reputation in the relevant field.

The risk that the expert’s objectivity is impaired increases when the expert is:

1. Employed by the entity.

2. Related in some other manner to the entity, for example by being financially

dependent upon or having an investment in the entity.

The scope of work of the auditor’s expert

The auditor shall agree in writing when appropriate on the nature, scope and objectives

of that expert’s work. Such agreement/instruction should cover the following factors:

1. The objective and scope of the expert’s work.

2. A general outline as to the specific matters the expert’s report to cover.

3. The intended use of the expert’s work.

4. The extent of the expert’s access to appropriate records and files.

5. Clarification of the expert’s relationship with the entity.

6. Confidentiality of the entity’s information.


Assessing the work of the auditor’s expert

This requires the consideration of:

1. The source data used.

2. The assumptions and methods used.

3. When the expert carried out the work.

4. The reasons for any change in assumptions and methods.

5. The results of the expert’s work in the light of the auditor’s overall knowledge of

the business and the results of other audit procedures.

Reference to an auditor’s expert in the audit report

The auditor shall not refer the work in an auditor’s report unless required by law or

regulation. The reason is that such a reference may be misunderstood and interpreted

as a qualification of the audit opinion or division of responsibility neither of which are

appropriate.

Question RAVENSHEAD CONSTRUCTION

You are carrying out the audit of Ravenshead Construction Inc. The company’s business

includes large civil engineering contracts – the construction of buildings and roads. It also owns

investment properties which are let to third parties – these comprise offices and industrial

buildings.

During the year ended 30 April 2009 the company received a substantial claim for damages

from Netherfield Manufacturing Inc for faults in a building it had constructed – this claim includes

the cost of repair and damages, as the customer alleges that the building cannot be used


because of the faults, so alternative accommodation has had to be found. The company has

obtained advice on the likely outcome of this claim from a local solicitor.

In the year-end accounts the investment properties have been revalued by an independent

valuer and the construction contract has been valued by an employee of the company who is a

qualified valuer.

Required:

Describe the matters you would consider and the other evidence you would obtain to enable

you to assess the reliability of the work of specialists in the following cases:

(a) Legal advice obtained from the local solicitor on the outcome of the claim by Netherfield

Manufacturing; (6 marks)

(b) Valuation of the investment properties by the independent valuer; (7 marks)

(c) Valuation of the construction contract by the internal valuer. (7 marks)

(20 marks)

Ans

(a) Solicitors advice

Enquire into the background of the local solicitor and establish that he/she has no

connection with the company or with the officers of the company.

The auditor should investigate the experience of the solicitor – ideally he should be a

specialist at this type of litigation.

The reputation of the solicitor should also be considered and his/her track record in the

past in advising the company should also be taken into account.


The information supplied for the solicitor and the correspondence with the solicitor

should be inspected; any opinions given by the solicitor should be from him in writing

and should not be merely the transcripts of conversation. The opinion of any learned

counsel briefed by solicitor is also relevant in this area. Lastly the materiality of the

amount of the claim should be considered and the solicitor’s opinion should be read

carefully. The solicitor may only give a very pessimistic estimate of the likely outcome of

the case. This should be considered in the light of any precedence and will obviously be

relevant in examining the accounting treatment of the item in the financial statements.

(b) Independent valuer of investment properties

The independence of the valuer should be considered. He/she should have no

connection with the company or with any officer or director of the company. The

requirements of IAS 40 in this regard should be noted.

The qualification of the valuer should be noted. Membership of the/a national institute for

surveyors is a recognised qualification for this purpose.

The terms of reference given to the independent valuer should be noted. There may be

important reservations with regard to how the valuation is conducted. This may obviously

affect the quality of the valuer’s opinion.

The basis used for valuation must be reasonable and generally acceptable. Investment

properties are valued on the basis of the future income that they generate. The

calculations for the valuation should be examined and verified by the auditor. This will

involve communicating with the experts and establishing sight of his working papers.

The auditor should also consider the valuation of other investment properties in a similar

area with those contained within the portfolio of his client.


(c) Internal valuation of construction contract

The value of the construction contract and the degree of monetary precision which would

be acceptable for its valuation.

The basis of valuation should comply with IAS 11 and should be consistent with previous

years.

The accounting records for the contract should be reliable and should be capable of

substantiation.

The past record of the valuer should be considered; there should be other construction

contracts which have been completed in the past and the valuation basis should have

been capable of validation with the benefit of hindsight.

The auditor should also examine the estimate of cost of completion and estimated

contract revenue. The estimates of cost completion should allow for remedial costs and

for cost escalation in the price of materials. Any fixed price contract is likely to be

exceedingly risky. The auditor should check the calculation of attributable profit and

establish that all adjusting events after the reporting period have been taken into

accounts in the valuation of the contract. Where a loss is foreseen provision should be

made in full as per IAS 11.


Presentation

This standard requires management to make assessment of an entity’s ability to

continue as a going concern. Should there be any indication of material uncertainties

regarding the ability of the entity to continue as a going concern IAS 1 requires

adequate disclosures.

Audit issue or risk regarding going concern problem

Management may use inappropriate basis of preparing the financial statements

Assets and liabilities may be misclassified as noncurrent when they should be classified

as current in a situation where the entity will be liquidating its assets.

There may be inadequate disclosure in the account regarding the going concern

uncertainty

ISA 570 summarizes the main responsibilities of both management and auditor regarding going

concern. The going concern assumption is a fundamental principle. Readers of the financial

statements would assume the entity is viable unless it is clearly stated otherwise

Responsibilities of management

Management should assess the entity’s ability to continue as a going concern

Management should use the correct basis of presentation e.g. where the entity is no

more a going concern, alternative basis of presentation should be adopted E.g. break-up

basis.

Adequate disclosure should be made in the notes to the account regarding any

uncertainty in the going concern of the entity.

Responsibilities of Auditor

The auditor should obtain sufficient, appropriate evidence about the appropriateness of

management’s use of the going concern assumption in preparing the financial

statement.


Based on the evidence collected, the auditor should conclude whether there is a material

uncertainty about the entity’s ability to continue as a going concern.

Auditor should determine the implication on the auditor’s report. If there is material

uncertainty on the entity’s ability to continue as a going concern and this has been duly

disclosed by the management, there will be no need to qualify the auditor’s opinion,

otherwise qualified opinion will need to be issued.

The auditor shall remain alert throughout the audit for audit evidence of events or

condition that may cast significant doubt on the entity’s ability to continue as a going

concern

NOTE: The auditor shall cover the same period as management in the evaluation of

management’s assessment of going concern

The following range of indicators may be used by both the auditor and the management in

making assessment of going concern:

Financial indicators: Analytically compare key financial ratios. Any adverse movement could

indicate going concern problem e.g. drop in profit margin, decrease in interest cover,

decrease in current ratio.

Operating indicators: The following factors could indicate going concern problem

Inability to obtain finance to fund operation or invest in new projects

Emergence of a successful competitor

Inability to renew operating license

Loss making, this is because losses deplete owners’ capital and reserves

High gearing. Interest payment commitment reduces earnings and causes liquidity

problem. It may equally create operational problem if there is charge on the entity’s

assets.

Reliance on overdraft facilities. This is an unsuitable source of long term funding. It

is not sustainable on long term and it usually carries high interest rate.

Unusual increase in inventory level or insufficient inventory level.


Selling of non-current assets in order to raise capital for the business. This will

create further operational problem.

Over-trading. This may come in the form of too rapid expansion. It may lead to poor

working capital management if the entity do not get enough cash to settle its current

liabilities e.g. inability to pay salaries or suppliers.

Loss of key customer and key staff

Impairment of assets

Debts going bad

Note: any of the above points constitute matters to be consider regarding going concern

problem when asked by the examiner

Audit procedures on going concern

If the auditor becomes aware of factor of uncertainty casting significant doubt on the entity’s

ability to continue as a going concern, the auditor must carry out further procedure to obtain

sufficient evidence. The following specific procedures may be helpful:

The auditor should evaluate management’s future plan to sustain the entity’s going

concern. E.g. management’s plan for the expansion of its business or invest in new

projects.

The auditor should consider the availability and sufficiency of finance available to fund

any future business expansion or new projects.

The auditor should obtain direct confirmation from the entity’s bank on its readiness to

provide the needed finance for the entity.

The auditor should assess the viability of management’s plan e.g. by assessing the

market research report.

The auditor should evaluate management’s cash flow forecast to determine if the

underlying assumptions are reasonable

Auditor should obtain written representations from management regarding its plan for

future and the feasibility of the plan.


Note: these are general procedure; students should make sure that the procedures they

prescribe are tailored to the fact of the scenario given in an examination

Implication of going concern on audit opinion

The followings are the implications of going concern issues on the auditor’s report:

Where the auditor consider that there is significant level of concern about the ability of

the entity to continue but do not disagree with management’s use of the going concern

assumption in preparing the financial statements, an unqualified opinion will be issued

provided it is adequately disclosed in the notes to the account. The auditor’s report

would include an emphasis of matter paragraph to draw readers’ attention to the note.

If the use of the going concern is appropriate but there is material uncertainty on the

going concern, if required disclosures are inadequate the auditor would issue a qualified

or adverse opinion depending on the pervasiveness of the uncertainty to financial

statements.

If the auditor disagrees with the basis of preparation, an adverse opinion will be issued

because it is pervasive to the financial statements.

Where the accounts have been prepared on an alternative basis, e.g. break up basis,

and the disclosure to this effect is considered not adequate, the auditor’s report would

need to be modified on the ground of inadequate disclosure

If there is clear indication that the entity will be liquidating its assets and there is no

adequate disclosure, regardless of the basis of preparation of the financial statements,

an adverse audit opinion should be expressed. The use of the “except for” qualification

or disclaimer of opinion would be grossly inappropriate in this situation.


Client with going concern problem applying for a loan: - Audit implication

If the client is unable to obtain the loan, the financial statement must contain disclosures

regarding the material uncertainty over going concern. The auditor’s report should

contain an emphasis of matter paragraph discussing the uncertainty and referring to the

note.

If the financial statements do not contain the disclosures, the auditor’s opinion would

need to be either qualified or adverse

Audit Procedures in respect of an entity with going concern problem applying for bank loan

to fund a project

Obtain & review the forecasts and projections and assess if the assumptions used

reflect business reality.

Obtain written representation confirming from management that the assumptions

used in the forecasts and projections are considered achievable.

Obtain & review the terms of the loan to see if the client can make the repayments

required.

Consider the sufficiency of the loan requested to cover the costs of the intended

project.

Review the repayment history with the client’s bankers to form an opinion as to

whether the client has any history of defaulting on payments.

Obtain confirmation from the banker of their intention to provide the finance.

Discuss with management, to ascertain if any alternative providers of financial is

considered.

Obtain a written representation from management stating management’s opinion as

to whether necessary finance is likely to be obtained.


Inventories

Requires that inventory should be valued at the lower of cost and net realizable value.

The method used in allocating costs to inventory need to be selected with a view to providing

the fairest possible approximation to the expenditure actually incurred in bringing the inventory

to its present location.

Notes:

It is permitted to value inventory at market price at year end only if the rate of turnover

and fluctuations in the market price is very high, but this is a departure from IAS 2 and

as such needs to be adequately explain and justified in the financial statement.

LIFO is not acceptable method of valuing inventory under IAS 2.

Base inventory valuation is not acceptable.

Selling price less gross profit margin is an acceptable method of approximating to cost of

inventory

Inventory valuation- matters to consider for audit

Cut-off. Inventory will be undervalued or overvalued if cut-off has not been appropriately

applied.

Counting. Inventory will be undervalued if not all inventory items have been included in

count.

Inventory will be undervalued or overvalued if the valuation methods are incorrect

Audit Procedures to carryout

Obtain inventory counting instructions in place and review to make an assessment of

their adequacy.

Perform analytical procedures, any unexpected result should be discussed with

appropriate staff

Discuss scrap and wastage policy with the concerned staffs.

Examine details of scrap and discuss reasonability of figures with appropriate staff


Agree cost to purchase invoice to confirm valuation

Check sales invoices immediately after the year end and compare to the cost of

inventory to confirm the net realizable value is not lower.

Test cut-off is correct by tracing the last goods delivery notes and dispatch notes to the

invoices.

Recast additions on inventory sheets to verify accuracy.

Discontinued Operation

A division will be a discontinued operation if it is an independent business division which can be

distinguished operationally and for financial reporting purposes. It must constitute a separate

line of business

Disposal group: the assets of a discontinued operation are a disposal group per IFRS 5.

IFRS 5 Requires that a disposal group is recognized as held for sale where the assets are

available for sale in their present condition, the sale is highly probable and the sale should be

expected to take place within 12 months.

According to IFRS 5:

The assets in disposal group should be measured at the lower of their carrying amount

and the fair value less cost to sale.

The assets should not be depreciated.

The assets should be presented separately in the statement of financial position.

Audit procedures regarding disposal group:

Review board minutes for evidence that the sale is certain

Assess any announcement made regarding the sale

Confirm that results of the discontinued operation are presented separately in the

statement of profit or loss as per the requirement of IFRS 5

Confirm that the disposal group is presented as assets held for sale in the statement of

financial position.


Obtain evidence of the estimated fair value, possibly by engaging an auditor’s expert.

Inspect any correspondence with potential buyers to confirm management is actively

looking for buyers

Disclosure Requirement on the closure of a Business Segment

In order to be separately disclosed:

The discontinued operations should be a component that is separately identifiable from

the rest of the business.

The disposal should be as a result of a single coordinated effort to dispose a major line

of business.

If products are different from the products of the continued operations, then it is arguable that a

component has been closed as part of a single coordinated plan to dispose of a separate major

line of business. In this case, there should be separate disclosure in the financial statements.

If the discontinued operations are not separately identifiable either by products or geographical

location, there is no need to make separate disclosure.

Accounting policies, change in accounting estimates and error

Prior period (retrospective) adjustment is required where:

There is a change of accounting policy in the current year

An error is discovered in the prior period

IAS 8 states that a company should only change its accounting policy towards an item if

required to do so by an accounting standard or if the change in policy would give a more reliable

and relevant reflection of the substance of the transaction

In a case where there is prior year overvaluation of inventory, comparative figures should be

restated in the financial statements and adjustments should be made to the opening balances of


reserves for the effect. The effect should equally be adequately disclosed in the notes to the

account e.g. the prior year profit might have been wrongly calculated because of the wrong

valuation of the inventory, this will have a cumulative effect on the retained earnings.

There should be no specific reference to the corresponding figure in the auditor’s report merely

because they have been restated (ISA 710). However, if the corresponding amounts have not

been properly restated or appropriate disclosures have not been made, the report should the

modified with respect to the corresponding figures.

Audit procedures

Compare prior year accounting policies with the current policies to determine if there is

any change in accounting policies.

If there is any change in policy, auditor should ensure effect of the change is applied

retrospectively to comply with the requirement of IAS 8

The auditor should recalculate any restated figure in statement of changes in equity due

to prior period error.

The auditor should ensure adequate disclosure is made in the notes to the account

regarding any change in accounting policies and error.

Financial instrument

An entity should recognise a financial asset or liability in the statement of financial position when

it becomes a party to the contractual provisions of the financial instrument.

Financial asset:

Financial assets should be initially measured at fair value

A financial asset must be measured at amortised cost if both of the following conditions are met:

The asset is held within a business model whose objective is to hold assets in order to

collect contractual cash flows; and


The contractual terms of the financial asset give rise on specified dates to cash flows

that are solely payments of principal and interest on the principal amount outstanding.

Any asset which is not measured at amortised cost must be measured at fair value

Financial liabilities

Financial liabilities are measured at amortised cost unless held for trading

Matters to consider for audit

Materiality of the assets should be first determined

Classification may not be correct.

Assets shown at fair value may be subjective

Disclosure may not be made

Amount recognized in the statement of profit or loss as a result of movement in fair value

may not be in accordance with IFRS 9

Audit Evidence

Agreement of the fair value to year end market price

Recalculation of total gain or loss recognized as a result of movement in the fair value.

Review of disclosure in the notes.

Agree purchase price to documentation

Events after reporting period (subsequent events)

A subsequent event is any event occurring after the date of the financial of the financial

statement being audited.

Material non-adjusting events must be disclosed in the note- explaining the event and its

financial implication.


Auditor’s concern

The auditor needs to consider whether the events have been properly accounted for in

accordance with the requirements of IAS 10 Events after the reporting date

According to ISA 560, subsequent events divide into three periods:

Events occurring between date of the financial statement and the date of auditor’s report

In this period:

The auditor has an active duty to perform procedures to identify any subsequent events.

The auditor should perform procedures to identify events that might require adjustment

or disclosure in the year-end financial statements.

The auditor should consider the impact on the audit reports and whether modification is

necessary to the audit report

Events occurring after the date of auditor’s report but before the financial statements are issued.

In this period:

The auditor has a passive duty

The auditor does not have a duty to search for evidence of events after reporting period.

If the auditor becomes aware of information which might have led him to give a different

audit opinion he should disclose the matter to the directors. In addition the following

actions should be taken by the auditor:

The auditor should request that management amend the account to allow for the

subsequent event

The auditor should review any amendment made by management

The auditor should re-issue the audit report.

In the event that management fails to make adjustment to the account regarding the

subsequent event, the auditor should take the following steps:

The auditor should take necessary step to prevent reliance on the report

The auditor should speak about the event at the general meeting of members


The auditor should seek for a legal advice

The auditor should consider resigning from the engagement.

Events discovered after the financial statements are issued

Auditors have no obligations to perform procedures after the financial statements have been

issued.

If the auditor becomes aware of a situation that if he had known at the date of the financial

statement would have cause the auditor to give alternative audit opinion, the auditor should

carry out the following procedures:

Discuss the matter with management

Discuss the need to amend the financial statements with management

On management’s revision of the financial statements, the auditor should carry out further

procedures as follows:

Carry out further procedures on the amendments made

Ensure management have taken necessary measure to prevent reliance on the

previously issued financial statements

Issue new auditor’s report

Audit procedures for restructuring cost discovered after the year end (Non-adjusting event)

Verify that management has included a note disclosing this event in the financial

statements as required by IAS 10

Agree the estimated cost of the restructuring to related calculations and supporting

documentation

Review the details of the announcement made on the restructuring and agree the details

to the disclosures made in the financial statements.


Review board’s minutes for details of the plan and verify that it has been approved by

the board

A fall in demand after year end is an adjusting event. This is because:

It provides evidence about the valuation of the brand at the reporting date (the brand as

an intangible asset may be overvalued).

The net realizable value of inventory may be less than cost

The value of the brand may be impaired

Audit Evidence regarding fall in demand after year end

Analytical review of sale against budget

Board minute regarding any decision taken

Note: Increase in tax rate merely announced is a non-adjusting event

Deferred tax

IAS 12 Requires that deferred tax is calculated at a rate of tax that is substantively enacted and

expected to apply to the period when the deferred tax is to be settled, it must have been passed

into law, not merely suggested or announced.

Audit concern

Check that the increase or decrease in provision will not be material to profit in order to explain

the implication for the audit

Audit Evidence to sought

A copy of all the calculations made in relation to the tax balance


Agreement of tax rate to tax legislation

Schedule of Non-current asset in tax calculations agreed to Non-current Asset

registrar/ledger

Minutes of directors meetings confirming detail of any major additions in Non-current

asset

Audit Procedures in Respect of Recoverability of Deferred Tax Assets.

Check the arithmetical accuracy of deferred tax and corporate tax computations.

Agree the figures used to any tax correspondence and financial statements.

Obtain profitability forecasts and ensure there are enough forecast taxable profits for the

losses to be offset against.

Evaluate the reasonableness of the assumptions used in the profitability forecast.

Assess the length of time it will take to generate enough profits to offset the tax losses

and judge whether recognition of the asset should be restricted.

Fair value measurement

The fair value of an asset or a liability is the price that would be received to sell an asset or paid

to transfer a liability in an orderly transaction between market participants at the measurement

date.

According to IFRS 13 fair value measurement entity should follow the following hierarchy in

order to determine the fair value of an asset:

Quoted prices in an active market for identical assets or liability that the reporting entity

can assess at the measurement date.

Quoted price for similar asset in active markets or for identical or similar assets in non-

active markets.

Using the entity’s own assumptions about market exit value.


Audit Risk associated with IFRS13

In a situation where the market is illiquid, it will be difficult to apply fair value because of

unavailability of information. This constitutes area of great audit risk.

Audit risks associated with the application of IFRS 13 will be grouped as follows:

Inherent risk

Measurements of fair value are subjective in nature because they generally involve

making estimates based on a number of assumptions, management may not be

sufficiently experienced or skilled to make these assumptions

Deliberate manipulation by management in order to obtain a favorable figure for fair

value in the financial statement making them inherently more difficult to audit

The estimates of fair value involve complex calculations making them inherently difficult

as the likelihood of an error is higher in complex calculations.

CONTROL RISK

Making estimate for fair value is likely to fall outside the system of controls set up by the entity to

deal with regular transactions since they are likely to take place once in a year.

DETECTION RISK

There is risk that the audit team may lack the knowledge to make assessment of the fair value

measurement and may rely too heavily on the work of auditor’s expert.


Non current asset

According to IASB framework, an asset is a resource controlled by an entity as a result of past

events and from which future economic benefits are expected to flow to the entity.

For an asset to be recognized in the financial statement, it must be probable that the economic

benefit associated with the asset will flow to the entity and the cost can be measured reliably.

Initial recognition

Recognized Asset should be initially measured at cost. The cost of an asset includes the

followings:

Purchase price minus any trade discount

Directly attributable cost. This includes:

Cost of bringing the asset to its location in its workable condition

Cost of testing the asset

Initial estimate of the costs of dismantling and removing the asset and restoring the site

on which it is located.

Measurement subsequent to initial recognition

After the initial recognition, an entity may adopt any of the following recognition models:

Cost model. This refers to the cost of asset minus the accumulated depreciation

Revaluation model. This refers to the fair value of the asset minus subsequent

accumulated depreciation and impairment losses. The revaluation model can only be

used if the fair value of the asset can be measured reliably.

According to IAS 16:

assets should be recognized at cost and depreciated over their useful

Economic lives.

If asset is revalued, the excess of the revalued amount over the carrying amount should

go to revaluation reserve in the equity


If revalued asset is disposed, the balance on the revaluation reserve should be

recognized as income in the statement of changes in equity and should not be

recognized as current profit

Audit procedures regarding tangible assets:

Take a sample of assets from the asset register and trace to physical location to confirm

existence

Take a sample of assets from physical location and trace to assets register to confirm

completeness.

Inspect purchase invoices to confirm the cost of assets and the dates on the invoice

should confirm the cut-off is proper.

Recalculate the depreciation

Check consistency of the depreciation policy by comparing the current rate with prior

years.

Check to confirm any disposed asset has been removed from the asset register and

ledger properly updated

Dismantling costs

Dismantling costs should be capitalized as non-current assets, and a provision created against

them.

Audit concern in respect of dismantling cost:

Provision may not have been created

Asset and Liabilities might have been understated

The provisions may not have been measured correctly according to IAS

37,provisions,contigent liabilities and contingent assets

NOTE: Account should be taken care of the effect of discounting if it is material to the account,

and should be included in the statement of profit or loss to represent the unwinding of the

discount.


Principal Audit work in respect of the carrying amount of Plant, Property and equipment (PPE)

under construction

Verify cost of the PPE by reviewing the contract with the contractor

Agree cost of the PPE to invoice

Inspect the asset at year end to assess the stage of completion. Use this to confirm the

reasonableness of the management’s expert report

Review the management’s expert report concerning stage of completion at the end of

reporting period and estimate cost of completion

Agree finance cost to the terms of the finance contract and payment made

Recalculate capitalized amount to ensure accuracy

Ensure the basis of capitalization agrees with IAS 16

Discuss with management on the consideration of possible impairment

Leases

A lease is a finance lease if it transfers the majority of the risks and rewards relating to the

ownership of the asset to the lessee. If this is not, it is an operating lease.

Finance lease:

At the start of the lease, the lessee should recognize the leased asset as a non-current asset,

valued at the lower of:

Fair value of the asset, and

The present value of the minimum lease payments

The asset should be depreciated over the shorter of:

The period of the lease, and

The useful life of the asset


Each year, the lease payment is divided into two as follows:

Finance charge

Partial repayment of the lease obligation

Both the depreciation and finance charge should be accounted for as period charges in the

statement of profit or loss.

Operating lease

Lease payment under operating lease is treated as rental expense in the statement of profit or

loss.

The asset should not be recognized in the statement of financial position of the lessee. Also, the

leased asset should not be depreciated.

Matters to consider for audit include:

Materiality

Classification whether leases have been correctly classified as finance or operating

lease according to IAS 17 leases.

Whether calculation of finance charge using the actuarial method has been done

correctly.

Note: For lease of land and building, according to IAS 17 leases, only the buildings element of

the lease can be capitalized as land is always an operating lease. The risk here is that both land

and building may be wrongly capitalized.

Audit Evidence in respect of lease amount recognized:

Copy of client’s workings in relation to the amount recognized as finance lease charge.

Recalculation of the present value of the minimum lease payment and compare to fair

value.

Recalculation of finance charges.

Agreement of interest rates used in calculation to lease agreement.

Recalculation of depreciation charges applied to the assets


Verify that land element is classified as operating lease and there is no non-current

asset recognized in respect of land.

The discount rate used in the above calculation should be agreed as appropriate.

Recalculation of operating lease expenses on a straight line basis over the lease term

Sale and lease back transaction

If the transaction results in a finance lease, any associated profit or loss should not be

immediately recognized. The profit/loss should instead be deferred and amortised in the

financial statement of the seller over the term of the lease.

If the transaction results in operating lease, the associated profit/loss should be recognized

immediately. In a case where the transaction does not occur at fair value, one of following

treatments applies:

If the sales price is above the fair value, the excess of the price over the fair value

should be deferred and amortised over the lease term to match the lease payments.

If the sale price is below the fair value, any profit/loss should be recognized immediately

Revenue

Sale should only be recognized when risk and benefit associated with goods have been

transferred to the buyer.

Deposits made when the customer is yet to enjoy the service is treated of deferred income and

shown as liability on the statement of financial position.

Consignment Inventory: this refers to inventory held by one party but legally owned by another

party. Items should be accounted for according to the substance of the transaction rather than

legal form. Consignment inventory should never be recognized as a sale. It is otherwise known

as agency sale


Note: if the agent never exercises his legal right to return the goods before payment the

commercial reality is that the consignment is a purchase from the date of delivery.

Audit procedures

The auditor should examine the terms of the sale in order to establish whether:

The buyer has the legal right to return the goods.

The seller has the legal right to cancel the sale and order the return of the goods

Government Grant

IAS 20 Accounting for Government Grants and disclosure of Government Assistance requires

that the Grant income is matched to the cost it is intended to compensate for

Audit implications regarding IAS 20

Just as we systematically allocate the cost of a non-current asset over the useful life in line with

the matching concept, IAS 20 requires that Govt. grant should be recognized as deferred

income in the statement of financial position. There is risk that this may not be done leading to

liabilities being understated and profit being overstated.

IAS 20 Requires that a grant is recognized only when there is Reasonable assurance that the

company will meet the condition attached to the grant. Where there is doubt over this, a

provision should be recognised in line with IAS 37. There is risk that this will not be done

thereby understating liabilities and overstating profits.

Audit Procedures on the receipt of Government Grant

Obtain the grant document and review the terms to verify the amount of grant.

Determine the period the grant covered.

Revision of the terms and condition attached from the grant document to determine the

consequence of any breach on terms.


Review correspondences with relevant government agencies to determine if there has

been any breach of terms.

Obtain representation from management that the condition of the grant will be met.

Provisions and Contingencies

IAS 37 requires that a company set up a provision where there is a present obligation as a

result of past event from which it is probable that a transfer of economic benefit will be required

to settle the obligation and reliable estimate can be made.

In a situation where the future payment is only possible but not probable, no provision is

required but there should be adequate disclosure in the notes to the account. This is called

contingent liability.

Examples of cases where provision may be required include:

Warranty cost on products already sold

Legal case brought against the company, the outcome of which may turn out

unfavourable

Breach of law and regulation which may likely lead to fines and compensation

Obligation to decommission a site after use

Audit risks here include:

Not making adequate provision

Not making provision when it is required

Contingent liability may not be disclosed

Audit procedures:

Discuss with management on the need to make provision

Discuss with management the suitability of the method used to arrive at the provision


Assess the reasonability of management’s method of making the provision

Review notes to the account to assess the adequacy of disclosures

Inspect Correspondence with the other parties involved

obtain direct confirmation from company’s lawyer

analytically compare current’s year provision with that of prior years, obtain explanation

for any unexpected result

Note the following specific cases:

No provision should be made in respect of future spending on a damaged property that

has adequate insurance cover.

No provision should be made for an intention to incur expenses in the future. Mere

intention does not create present obligation from past event.

No provision is required for expected future changes in tax rate. This does not create

present obligation as a result of past event because the tax rate will be applicable in the

year of the change

Note: A provision for restructuring costs (e.g. the closure of a business segment) should only

be recognized if a formal plan had been in place and there has been a public announcement

regarding the plan. If these conditions are not satisfied, the plan should only be disclosed in the

note to the account as a non-adjusting event in line with IAS 10 Events after reporting period

Intangible asset

Intangible assets are business resources that have no physical form, items that cannot be seen

nor touched but capable of been used to generate economic benefits.

Research and development cost

Research cost should be written off as an expense as they are incurred.

Development costs may qualify for recognition as intangible assets provided the following

criteria are met:


There is technical feasibility of completing the intangible asset

There is management commitment to complete the intangible asset

The entity has the ability to use or sell it

It is probable the asset will generate future economic benefits

The expenditure attributable to the intangible asset can be measured reliably

Audit procedure in respect of research and development cost

Inspect Board Minutes to assess company’s commitment to complete the project.

Inspect results of the entity’s market research to assess future marketability of the

product.

Assess the capitalized cost to be sure they meet the recognizing criteria

Obtain direct confirmation from the entity’s bank to confirm availability of finance to

complete the asset

Obtain written management’s representation to confirm commitment.

Assess the result of any test carried out on the asset to confirm the technical feasibility

of the asset

Agree period of capitalization correct by reference to date of completion of the capital

project to be sure capitalization is in line with IAS 38

Purchased intangible assets

The following recognition criteria must be met before an intangible asset can be recognized in

the financial statements:

it must be probable that the company will gain future economic benefit attributable to the

asset

The cost of the asset must be capable of being measured reliably.

If an item does not meet both the definition of intangible asset and recognition criteria given

above, the expenditure on such item should be recognized as expense in the period


Audit Procedure for Capitalized cost

Agree cost to invoice- a sample of costs capitalized should be agreed to supporting

documents, labour costs should be agreed to payroll and material cost should be agreed

to purchase invoice

Agree finance cost to loan contracts - interest rate should be agreed to finance

agreements, recalculation of the finance charge should be carried out.

Agree classification between revenue and capital expenditure.

Check that staff training cost is not capitalized.

Review list of items capitalized to ensure all are capital in nature

The following specific cases should be noted:

Intangible asset (e.g. operating license) granted at no cost can be recognized at its fair

value if the fair value can be correctly measured.

If there is a legal or constructive obligation to dismantle an asset after its useful life,

provision should be made and should be included in the cost of the asset.

Internally generated goodwill should not be recognised

Impairment

Impairment refers to a fall in the value of an asset. An asset is impaired when the recoverable

amount of such asset is less than its carrying amount.

If an asset is impaired, the value of the asset as recognized in the financial statement should be

reduced by the value of the impairment. The amount of the impairment should be debited to the

statement of profit or loss to reduce the profit.


Indicators of impairment

Fall in market value of the asset.

Technological change that may restrict the use of the asset by the entity.

Evidence of obsolescence or physical damage of the asset

Specific procedures on impairment

Assess whether an impairment review has been undertaken by management

Review the impairment test carried out by the directors

Obtain written representation that the estimate of the useful life is valid

Review board minutes for any major decision regarding the intangible asset

Assess the present value of future cash flows associated with the asset and compare

with carrying value.

Inspect board minutes to see any evidence of change in operation plan that may render

some asset obsolete

Earnings per share

IAS 33 requires disclosure of earning per share figure. Both basics EPS and diluted EPS should

disclosed. Non disclosure will always amount to a material misstatement. This is because the

earnings per share figure are material by nature.

If there is Non disclosure of the earnings per share figure in the financial statement, the auditor’s

report will need to be modified.

Audit procedures

Recalculate both the basic and diluted EPS figures

Ensure adequate disclosure of the EPS figures in the financial statement

Recalculate any prior year adjustment of EPS figures and access adequate disclosure to

this effect in the current year financial statements


Share based payment

The model used to assess the fair value of the share options must comply with IFRS 2 share

based payment.

Fair value must be measured at the grant date in order to calculate expense otherwise the

financial statements will be inaccurate.

Principal Audit Procedure in Respect of Share Based Payment.

Review contractual documentation for the share-based payment scheme and agree the

following to the management calculation of the expense:

Number of employees in scheme

Number of options per employee

Length of vesting period

Grant date of the share options

Any performance condition attached to options

Re-perform the management calculation of the share-based payment expense, ensuring

fair value is spread correctly over the vesting period.

Agree fair value of the options to a specialist report calculating the fair value.

Compare methods used for estimates with prior years to ensure consistency

Assess whether the specialist report is reliable and objective.

Check that the fair value is calculated at the grant date.

Discuss the reasonableness of the percentage staff turnover assumption with human

resources department.

Obtain written representations from management confirming that the assumptions used

in measuring the expense are reasonable and that there are no share-based payment

schemes in existence that have not been disclosed to the auditors.


Business combination

Audit risk associated with consolidation process

Subsidiaries Acquired mid Year

There is risk that its results have not been consolidated from the correct date leading to the

group profits being overstated.

Goodwill

There is risk that goodwill has not been calculated correctly. The fair value of subsidiary’s

assets and liabilities may not have been estimated reliably.

Accounting polices across the group may not be the same

When a subsidiary does not prepare accounts in line with IFRS the accounts of the subsidiary

should be restated to be in line with group accounting policies.

Intra-group trading

Intra-group transactions must be eliminated during the consolidation process. There is risks this

is not done. Inventories may as a result contain unrealized profit thereby overstating revenues,

expenses, assets and liabilities.

Principal Audit Procedure in Respect of Non-Controlling Investment

Determine the percentage of shareholding acquired using purchase documentation.

Confirm that percentage shareholding is between 20 and 50% of equity shares.

Obtain list of directors of the companies to confirm whether the company has appointed

director(s) to the boards.

Discuss with the directors of the company the level of involvement in policy decision made at

the companies.

Obtain a written representation detailing the nature of involvement and influence exerted over

the companies.


Question ABACUS LEASING

Your firm has been approached by the managing director of Abacus Leasing to tender for the

audit. The company is a small non-listed incorporated enterprise. The previous auditors have

resigned after a loss of confidence in them by the board of Abacus Leasing. This concerned the

disapproval by the board of a qualified auditor’s report issued by the outgoing auditors which

referred to inadequate internal controls in Abacus Leaning’s systems.

The company leases equipment to building contractors, many of whom have insufficient cash

resources to purchase the equipment outright. Some lessees have been refused credit

elsewhere. Since formation three years ago Abacus Leaning’s sales revenues have doubled

each year and lease receivables now represent over 80% of the company’s gross assets. The

company is now experiencing difficulty in collecting a substantial amount of overdue lease rental

payments. The company has no formal system for approval of new customers or any laid down

procedures for repossession of assets where the terms of the lease agreements have been

broken.

Although the terms and conditions of the leases vary considerably all of them had been treated

by Abacus Leasing as finance leases.

The company is managed by a Board of three directors with a dominant managing director who

owns 93% of the share capital. The directors and senior management are largely remunerated

by a “performance bonus” based on new sales. The company does not have an audit

committee.

Required:

(a) Describe the procedures an audit firm should undertake before accepting a potentially

high risk audit such as that of Abacus Leasing. (5 marks)

(b) Describe the factors in relation to the audit of Abacus Leasing that would affect your

assessment of risk. (7 marks)


(c) Describe the audit work that you would undertake to determine the correct accounting

treatment and disclosure of:

(i) the leases;

(ii) the bad debts allowance in respect of lease receivables. (8 marks)

Ans

(a) Procedures before accepting a high risk audit client

It should be apparent to a prospective auditor that the audit of Abacus Leasing is a high risk

audit and therefore the quality control procedures to be adopted before tendering for such an

audit would include:

A request to communicate with the previous auditor. A refusal of this would inevitably

lead to a refusal by the auditor to tender.

The previous auditor should be asked if there are any circumstances of which they are

aware that would have a bearing on the prospective auditor’s willingness to tender. In

particular, details of the reason for their resignation would be relevant.

A visit to the firm to make a preliminary assessment of the audit risk with particular

attention being focused on the system of controls and activities of the company.

A commercial assessment must be made. The prospective client appears to have weak

controls and several high risk areas. This may entail a large amount of audit time making

the audit fee expensive. The financial position of the client may not be sound and there

may be a serious risk of non-payment of the audit fee. The risk of an incorrect audit

opinion being given increases the possibility of legal action against the auditor as well as

the possibility of bad publicity and implications for future insurance indemnity premiums.


(b) Assessment of risk

The following factors would need to be considered in assessing the level of risk in Abacus

Leasing:

The suspicious circumstances in which the previous auditors resigned, particularly the

reasons for the audit qualification. It would appear that there are poor internal controls at

Abacus Leasing, and further, it seems management are reluctant to improve them.

The domination by the managing director.

The company is a new’ company with little history and the growth of the company is

spectacular.

There may be an element of overtrading causing the company to be over borrowed,

highly geared and experiencing liquidity problems.

The bonus incentive for management may have caused high risk sales (leases) to have

been made, or the sales revenue figure may have been falsified.

The nature of the products, building equipment, can have high associated risks. There is

frequent theft of this type of equipment and as the equipment is often abused in its use it

may not last the length of the lease, making default more likely.

The high proportion of assets in the form of lease receivables which appear to be difficult

to collect and the lack of a formal system of collection.

(c) Audit work

(i) Leases

The principal aim is to determine whether a tease falls to be treated as a finance lease or an

operating lease. IAS 17 Leases says that a finance lease occurs when substantially all the risks

and rewards of ownership are transferred to the lessee. This is deemed to occur where:

ownership is transferred to the lessee at the end of the lease;

the lessee has an option to purchase the asset at a bargain price; or


the present value of the minimum lease-payments amounts to more than, or

substantially all of, the fair value of the asset.

As a result of this the auditor must perform the following work:

Obtain and inspect copies of all different types of lease agreements.

Determine the fair value of the asset. In practical terms this will be the purchase price,

but it would be net of any trade or large quantity discounts and any grant assistance for

the purchase. The auditor must identify the specific asset being leased in the

agreements and determine its original cost by tracing the purchase invoice and the

payment made. If any grants have been received by Abacus Leasing during the year the

documentation relating to them must be inspected to determine which assets had grant

aid and how much this was.

The minimum lease payments (MLP) should be readily determinable from the

agreement. The auditor would then calculate the present value of the MLP using an

appropriate discount rate. The discount rate should be confirmed by management and

the auditor would use his experience of similar agreements and market interest rates to

confirm the appropriateness of the rate.

The results of the above tests should determine whether the agreement is a finance lease or an

operating lease (as per the definition above). If it is a finance lease the outstanding net

investment in the finance lease should be shown in receivables. The rental income should be

allocated partly to finance charges and credited to profit or loss with the balance being treated

as a repayment of the lease receivable. If it is an operating lease the assets should be shown

under non-current assets and depreciated over their estimated lives, with the rental income

credited to profit or loss.

If a lease has been incorrectly classified there may not be a material error in the total value of

the assets in the statement of financial position. However the presentation of the statement of

financial position would be incorrect.


(ii) Bad debts allowance

The work the auditor would do to confirm the estimate of the bad debts allowance is:

Confirm the gross lease receivables by the tests above and, using an appropriate

sample, perform a positive circularisation of lease receivables.

The auditor should focus his attention on recent lease receivables as these are likely to

be of greater value and at more risk of non-payment. Leased receivables differ from

normal trade receivables in that they are not receivable within a short period of time.

The auditor should check to see if any receivables contain overdue instalments: Such

receivables are more likely to be bad. Some of the lessees may be in dispute and the

payments have been stopped. This should be investigated by the auditor:

The auditor should review the company’s procedures for recovery of receivables which

have breached the terms of the agreements. As these procedures are known to be weak

further tests of detail (substantive procedures) should be performed to confirm the value

of the lease receivables.

The above tests should give the auditor a basis for estimating the total allowance required for

bad debts. From the information in the question this is likely to be a high figure due to the credit

standing of some of the customers and the sales policy encouraged by the bonus scheme.

Lease receivables again differ from most normal trade receivables in that Abacus Leasing

retains ownership of the related assets. Where an agreement is in default such assets could be

repossessed by the company.

If Abacus Leasing has reduced the total allowance by an estimate of the recoverable amount of

leased assets the auditor must do farther work. The auditor should try to obtain proof of the

physical existence of the assets to confirm they are still in the possession of the lessee and-to

determine their condition. This may be very difficult in practice. The auditor would then form an

opinion of the recoverable amount of the assets. This would either be an estimate of their net

selling price or their fair value if leased to another builder. The value to be used would be


dependent upon the intention of management and the auditor agreeing with its appropriateness.

.

Question SUNSHINE STORES

The opportunity has arisen for your firm to seek appointment as auditors of Sunshine Stores, a

supermarket chain of twenty stores which operates a sophisticated computerised inventory

control and re-ordering system. You learn that Sunshine Stores has also invited four of your

competitors to produce a written presentation, the standard of which is crucial to progressing to

the next stage when the company will select two firms to make an oral presentation.

Sunshine Stores has a centralised purchasing system and individual stores transmit electronic

point of sale (EPOS) information each night to the head office for processing the following day.

All other accounting functions are also carried out centrally with the exception of casual wages

and petty cash expenditure. Each day’s takings are banked daily to one single bank account.

Sunshine Stores is particularly anxious to establish the ability of your auditing procedures to

deal with the business risks and has asked you to set out, as part of your presentation, your

approach concerning:

(1) audit risk (that is, the degree of risk of misstatement through errors or irregularities) and

how your procedures would seek to address it in the business of Sunshine Stores;

(2) materiality, and how this might be applied;

(3) sampling, and the extent to which it might be appropriate to use this technique; and

(4) analytical procedures and its contribution to the efficiency of your audit process.

You understand the need for Sunshine Stores to have a high level of confidence in your firm’s

approach to highly computerised clients, and you have the task of drafting the sections of your

firm’s written presentation to demonstrate how your procedures would be likely to apply to this

client.


Required:

Draft the sections of the written presentation to Sunshine Stores which deal with these four

aspects of the audit approach and the inter-relationships, if any, between them.

(15 marks)

Ans

(1) Audit risk

Audit risk, defined as the degree of risk of material mis-statement through errors and

irregularities, is a fundamental determinant of the sufficiency of audit evidence. It is ascertained

at:

the overall financial statement level (e.g. the knowledge that accounts are likely to be

used partly to defend a takeover bid would be considered to increase audit risk); and

at the individual account level (e.g. in many organisations, the sales/receivables/cash

cycle would be considered to have higher audit risk than, say, executive salaries).

Our approach involves assessing audit risk at both levels under the two headings of inherent (or

business) risk, and control risk. Inherent risk arises due to the nature of the company’s

operations and industry within which it operates, and control risk is the risk that the accounting

and internal control system will fail to prevent or detect any errors or irregularities that do occur.

In the particular context of Sunshine Stores, inherent risk can be identified in the following

areas:

the large volumes of cash handled;

the likelihood of shoplifting (‘shrinkage’);

the problems arising from shelf lives for foodstuffs; and

at the time of writing, the losses arising from excess inventory of eggs and poultry.

Control risk is minimised by a comprehensive system of internal controls, especially where a

well constituted system of internal audit is involved. In the particular context of Sunshine Stores,


the centralisation of the majority of the accounting functions together with the use of EPOS

techniques for inventory recording will make a valuable contribution to minimising control risk.

The detailed assessment of audit risk is made by using the techniques of interviews and

completion of internal control questionnaires (ICQs). Inherent risk is assessed primarily by

discussion with senior staff coupled with our prior knowledge of operations in the retail sector

(we have a number of clients in this area). Control risk is assessed by obtaining a thorough

understanding and evaluation of the internal control system assisted by the use of pre- prepared

ICQs. Based on our judgement as to the likelihood of errors and irregularities arising due to

inherent risk, and the extent to which such eventualities are likely to be prevented or detected

by the internal control system, we assign numerical values to these elements based on a well

recognised model of audit risk, which leads us to the design of samples and sample size

calculations

(2) Materiality

Materiality is a concept fundamental to the auditor, the user of accounts and the preparer of

those accounts. To the preparer, the concept is applied in deciding on the applicability of IASs

(IASs are to be applied to all items which are material in determining the value of

assets/liabilities or the determination of profit/loss). To the auditor the concept is applied when

determining the areas of the financial statements to which especial effort should be devoted and

ultimately in adjudicating whether a true and fair view is shown. It is also relevant in designing

sampling plans. Finally, the user of accounts is concerned with the concept, since it is likely that

a material error, omission or mis-statement would have caused him to act differently had he

known the true position.

In the context of our audit approach to the financial statements of Sunshine Stores, materiality

will be assessed by the exercise of professional judgement. Our overall concern is that the

needs of users must be met, and thus materiality measures based on the “critical points” (e.g.

the amount that would change profit to loss, or net current assets to net current liabilities) would

be relevant. Furthermore, measures based on percentages of major elements of the accounts


(e.g. 1% of turnover, 5% of net assets) would be borne in mind. Based upon such

considerations, a numerical measure of acceptable monetary error is established.

Having set such a measure, we are not rigidly constrained by it. For instance, the nature of an

omission or mis-statement may, whilst being immaterial in amount, nevertheless be viewed as

critical to the ability of the user to reach an informed and justified conclusion. In a similar

manner, the trend demonstrated in financial results may, on occasions, suggest that smaller

monetary amounts be viewed as material.

Finally, we would be pleased to advise you on what we view as material in any particular

context so as to assist you in applying IASs and devoting appropriate effort to the determination

of amounts appearing in your accounts.

(3) Audit sampling

Audit sampling can be described as the application of an audit procedure(s) to less than 100%

of an accounting population in order to draw an inference, based on the sample, about the

population from which it was drawn. Two particular factors make it an appropriate technique for

use in many modern audits, and especially the audit of Sunshine Stores.

First, the sheer volume of transactions in most modern businesses make it an essential

technique to enable the audit to be completed in a reasonable time and at a realistic fee.

Secondly, and particularly in the case of Sunshine Stores, the homogenous nature of

transactions (many transactions of broadly similar size and nature) means that entirely

justifiable conclusions about a population can be made by examining a relatively small, though

representative, sample. Thus we would intend to make extensive use of the technique in the

audit of much of your business, most notably in the audit of the transactions cycle, year-end

liabilities, inventory valuations and shop fittings.

In certain areas of your financial statements, the use of sampling would not be appropriate. For

instance the audit of freehold/leasehold premises and directors’ emoluments would most likely

be subjected to 100% checking, as would any other area that was small in terms of number of

items but large in value, or of statutory importance. In a similar manner, those areas of high


audit risk (whether inherent or arising from weaker internal control) would be subject to a greater

degree of testing. And finally, those areas identified as being highly material would be subjected

to a greater degree of testing.

Our firm makes use of two techniques of sampling – judgement sampling and statistical

sampling. It is most likely that we will make extensive use of the latter method, especially since

our approach integrates numerical measures of audit risk and materiality, to ensure a high level

of confidence derived from the overall audit.

(4) Analytical procedures

Analytical procedures involve the systematic analysis of past results, budgets, trends, financial

and non-financial data and variations from predicted patterns in order to provide an efficient

approach to an audit. The efficiency is realised:

in the planning of the audit – since the method should serve to direct effort to critical

areas and/or those which do not conform to predictions; and

in the evidence collection stage where a degree of reliance can be placed on the results

of satisfactory substantive analytical procedures.

Analytical procedures are also very relevant in the final review of financial statements where it

both serves as corroborative evidence to that gathered by other techniques and supports the

review for fairness and credibility.

Our approach involves the use of manual techniques of comparison, and on occasion we make

use of sophisticated statistical techniques such as multiple regression analysis to determine

patterns and trends and project these to the current and future accounting periods. It is likely

that, in the case of a new client, the method is used in the first audit only at the planning and

overall review stages, since the amount of reliance placed on SAPs is necessarily limited when

we have little personal experience of the major features and account relationships to build upon.

However, we would seek at the earliest opportunity to build up a profile of past trading patterns

to use as a basis in later years in order to place greater reliance on this technique. We will thus

be able to future years to further reduce the time spent on traditional audit testing.


Inter-relationship between techniques

Our overall audit approach is designed to ensure that sufficient audit evidence is obtained to

enable us to form our opinion as to the truth and fairness of financial statements in the most

efficient manner possible. To this end the various elements of approach and the particular

techniques of risk assessment, materiality and sampling (and on occasion, analytical

procedures) are integrated via well recognised and tested models. It should be clear that such

relationships exist, and our approach specifically links the elements to ensure that, in total, we

achieve a high level of confidence in our opinion. Where inherent risk is high, though control risk

is low, audit risk is medium and thus sample sizes will be manageable. Highly material areas will

dictate larger sample sizes than immaterial areas, and those in which analytical procedures

showed no unexpected variations will correspondingly have smaller sample sizes (although

perhaps not in the first year of a new audit). When the opportunity exists (as appears at this

stage to be the case in the audit of Sunshine Stores) to make use of the EDP system to extract

samples in an expeditious manner, the greatest efficiencies are realised.

Question SELLERS

You are planning the final audit of the financial statements of Sellers, a manufacturing company.

The following events occurred shortly after the end of the reporting period:

(1) One of the company’s largest customers, Bramley, notified Sellers of its intentions to go

into liquidation with an outstanding debt of $260,000. Seller’s directors consider that the current

allowance for bad debts will cover any potential loss.

(2) A writ was issued against Sellers by a former sales director who is claiming $90,000 for

breach of his service agreement following his dismissal during the year under review. No

provision has been recognised in respect of this claim.


(3) A fire at the company’s warehouse destroyed all inventory held there. This inventory is

valued at the lower of cost and net realisable value amounting to $1,800,000 in the financial

statements.

(4) Half of the sales force was made redundant and a provision has been made for

redundancy payments amounting to $400,000.

Required:

For EACH of the four events:

(i) Explain the effect, if any, on the financial statements (8 marks)

(ii) State the matters you would consider and the audit evidence you would obtain to be able

to draw a reasonable conclusion on which to base the audit opinion. (12 marks)

(20 marks)

Ans

(1) Bad debt – $260,000

(i) Effect on financial statements

As Bramley is one of Sellers “largest customers”, the outstanding balance is presumably

material to trade receivables.

Specific allowance, calculated on a prudent basis, should be made against the amount due from

Bramley at the end of the reporting period. The year-end general allowance should be

recalculated in accordance with Sellers’s accounting policy.

However, an adjustment would not required if the amount of the specific allowance required was

found to be immaterial (e.g. if the balance at the end of the reporting period was considerably

less than $260,000 and/or the liquidator considered that a reasonable “dividend” would be paid

to creditors).


No allowance should be made, in the financial statements under review, in respect of any sales

made to Bramley after the reporting period. However, if material, such transactions may be

disclosed (as non-adjusting events after the reporting period).

(ii) Matters to consider

Steps being taken by Sellers to find new customers to lessen the impact of the loss of

this major customer (which may otherwise have implications for the appropriateness of

the going concern assumption).

Whether any goods have been manufactured to specific orders for Bramley. Such goods

should be separately identified in year-end inventory as their net realisable value may be

less than costs if an alternative customer cannot be found.

The steps which have been (are being) taken to recover the amount due (e.g. attending

the creditors meeting arranged by the liquidator).

Audit evidence

The make-up of Bramley’s account balance in Sellers’s receivables ledger (i.e. year- end

balance and post year-end transactions).

After-date (post year-end) cash receipts from Bramley.

Correspondence with the liquidator to establish the amount of debt (if any) most likely to

be recovered.

Insurance policy documents (if Sellers is insured against such losses).

Reservation of title clauses (if any) on sales invoices which may give Sellers the right to

repossess goods sold to Bramley.


(2) Legal claim – $90,000


If settlement of the claim is probable (e.g. because the former sales director’s action is

likely to succeed or an out of court settlement is envisaged) a prudent estimate of the

full amount of the liability (including legal costs) should be provided in the financial

statements.

If the outcome is less certain, any part of the contingent loss which is not provided for

should be disclosed by way of a note to the financial statements (IAS 37). However, as

the amount involved ($90,000) makes this the smallest of the events (in financial terms)

it may not be considered sufficiently material to warrant or require disclosure.


The reason(s) for which the former sales director was dismissed. If he was guilty

of wrongdoing or misconduct he may be the one in breach of contract.

The nature of the alleged breach of the service agreement. For example, if

Sellers did not follow specified procedures for dismissal, the sales director may

have good grounds for his claim (even though Sellers may be justified in

dismissing him).

Whether the company intends to contest or counter the claim or negotiate an out-

of- court settlement.

Audit evidence

The service agreement, to ascertain whether actions of the former sales director

were “sacking” offences.

Board minutes discussing how Sellers is planning to proceed (e.g. by offering an

out-of-court settlement).


Legal correspondence to assess the most likely outcome and amounts involved

(including legal costs).

Former director’s personnel records including dismissal notice etc.

Post year-end cash book payments to the former director, if any.

(3) Inventory loss ($1,800,000)


The destruction of warehouse inventory was not a condition existing at the end of the

reporting period and therefore is a non-adjusting event (IAS 10 “Events After the

Reporting Period”). No adjustment is required to the financial statements (unless, for

example, the loss was uninsured and Sellers is no longer a going concern).

However, the matter should be fully disclosed in a note to the financial statements as

the amounts involved are very material. Even if there is no financial loss in respect of

the inventory destroyed (e.g. because it is fully insured), some disruption to trading is

likely (with consequent reduction in next year’s reported profit).

As non-disclosure would affect the ability of users to make proper evaluations and

decisions, the financial statements should disclose:

that there was a fire on [date];

that $1.8m of inventory included in the statement of financial position was

destroyed;

the financial effect (e.g. amount of any uninsured loss).


To what extent have inventories have been replaced since the fire.

To what extent the manufacturing processes were disrupted (if at all) by the loss

of raw materials.


Whether orders or customer goodwill been lost due to delays in despatching

goods to customers.

Whether the cause of the fire was accidental or arson is suspected (in which

case the insurers may not pay up).

Audit evidence

Insurance policy to confirm the extent to which loss of inventory, trade and

warehouse fixtures and fittings were covered and on what basis (e.g.

replacement cost, historic cost or some “depreciated” amount).

Correspondence with insurers/loss adjusters to ascertain whether the claim will

be settled in full.

Sales order books to identify any significant loss of customer goodwill.

Cash book payments to suppliers for “emergency” purchases of raw materials.

Any cash book receipt of insurance monies.

(4) Redundancy payments – $400,000


Assuming that the sales “force” is more than a handful of employees, making half of it

redundant is likely to be material. It may be appropriate to disclose the redundancy

expense separately to explain the performance of Sellers (IAS 1). If the redundancies

relate to the closure of a business segment, separate disclosure under discontinued

operations would be required (IFRS 5).

If the decision to make personnel redundant was made after the reporting period, the

matter is a non-adjusting event (IAS 10) which should be disclosed if material. That a

provision has been recognised means that the obligation existed at the year end

(IAS37). The provision should include all related tax, social security and pension

contributions (less any statutory recoveries).



Whether further similar redundancies are likely in the foreseeable future.

The reason(s) for the redundancies (e.g. rationalisation of operations or closure

of a business segment).

Audit Evidence

Schedule showing the make-up of the provision for agreement to payroll and

personnel records.

Post year-end cash book payments to confirm amounts originally provided.

Redundancy notices/board minutes to confirm the date on which the decision

was made.

Sales order books to establish the impact, if any, on sales levels in the wake of

the


Group audit issues

Responsibility of being Appointed as Group Auditor

Communicate clearly with the component auditors about the scope and timing of their

work on financial information related to components and their findings

To obtain sufficient appropriate evidence regarding the financial information of the

components and the consolidation process

To express an opinion whether the group financial statement are prepared, in all material

respects, in accordance with the applicable financial reporting framework

If the engagement partner concludes that it will not be possible to obtain sufficient

appropriate evidence due to restriction imposed by group management and that the

possible effect of this will result in a disclaimer of opinion, then they must not accept the

engagement.

Group Auditor has to obtain Understanding of:

The group structure.

The components.

Group-wide controls.

The consolidation process.

The risk of material misstatement in the component and group financial statement.

If an acquisition is in planning made

Business understanding should be obtained for the new component.

Liaising with new component auditor should be considered.

If a disposal is made by the group

The auditors need to audit the disposal transaction.

The group auditor has to determine the type of work to be performed on the financial

information of the components, whether performed by the group team or another auditor.


Significant components

If significant risk of material misstatement of the group account has been identified in a

component that is audited by another auditor, the group auditor shall evaluate the

appropriateness of further audit procedures performed in response to the assessment.

If the component it not considered significant then the group auditor shall simply performed

analytical procedures at group level.

ISA 600 co-operation between auditors in respect of group audit

The group Engagement team has the right to require from auditors of subsidiaries the

information and explanations they require, and to require the group management to obtain the

necessary information and explanations from subsidiary. if The degree of corporation is limited

by factors such as the component auditor not being subject to the requirement of ISA,s, but of

different national practice.ISA 600 states that the group auditor should not accept a group audit

if there are restriction on his communication with component auditors.

Factors to be considered by the group auditor in relying on the work of component auditor

Ethics: the group auditor should consider whether the component auditor complies with required

ethical requirements. The component auditor should be subjected to the same ethical

requirements as the group auditors irrespective of the local regulations applicable.

Professional competence: The group auditor should check whether the component auditor

understand IAS and must make sure the work performed by the component auditor is in

conformity with international standards. He must make sure the component auditor understand

IFRS and have sufficient resources and skills to perform the required work.

Procedures that should be performed to determine the extent of reliance to be placed on the

work of component auditor:

Obtain and review the ethical code adopted by the auditor

Obtain statement from the auditor that it has adhered to the ethical code


Enquire from the auditor if it is a member of an auditing regulatory body, and the

professional qualification issued by the body

Obtain confirmation from the professional body which the auditor belong to

Discuss the audit methodology used by the auditor and compared to international

standards

Review the quality control policies and procedures used by the auditor at firm level and

those applied to the audit engagement.

Request the result of monitoring visits conducted by the regulatory authority under which

the auditor operates

Audit procedures to carry out as part of the planning and evaluation of the work of the

component auditors

The group auditor should review the component auditor’s working papers to determine

the adequacy of work performed by component auditor.

The group auditors is responsible for setting the materiality level for the group financial

statements as a whole, and for components which are individually significant, this would

be set at a lower level than the materiality level of the group as whole. The component

auditor will then perform a full audit based on the component materiality level.

Depending on whether the component is significant or not to the group’s financial

statements, the group auditor should review the component auditor’s overall audit

strategy and audit plans and perform risk assessment procedures to identify and assess

risks of material misstatement at the component level.

The group auditor should discuss with the component auditor on the component’s

business activities that are significant to the group, and the susceptibility of the

component to material misstatement of the financial statement due to fraud or error.

The group auditor should review the component auditor’s documentation of identified

significant risks of material misstatement.

The group auditor should review a questionnaire completed by the component auditor

highlighting key issues identified during the audit.


The group auditor should evaluate the effect of any uncorrected misstatements on the

group’s financial statements

After reviewing the component’s auditor’s work, the group auditor should determine

whether any additional procedures are necessary to gather audit evidence.

Support or comfort letter

The parent and subsidiaries are seen to be a single entity, so if the group as a whole is a going

concern then this is sufficient. When a subsidiary is not a going concern, auditor may request a

support letter from the directors of the parent company. This letter represents documentary

evidence and is normally approved by the parent company board. If there is a limitation on the

time for which the support is to be provided, other evidence may be required that the subsidiary

will be able to continue as a going concern.

The auditor will need to ensure that the parent company is in a position to provide the support

which it is claiming to give in the comfort letter. The auditor should confirm this promise by

reviewing the group statement of cashflows for availability of needed finance.

Effects of Acquisition of a subsidiary on Audit planning

Always relate your answer to the given scenario in the examination question. However, the

following points may be of immense guidance:

The revised group structure will need to be ascertained to ensure all relevant entities are

consolidated.

The issue of component auditor should be discussed. Before reliance can be placed on

the work of the component auditor, Independence and competence of the auditor need

to be assessed.

Materiality of the new company will need to be assessed in relation to the group as a

whole in order to determine the extent and nature of work to be done.


The audit plan will need to address the calculation and accounting treatment of goodwill.

Goodwill must be calculated by comparing the cost of the investment with the fair value

of the net assets of the subsidiaries at the acquisition dates.

The auditor will need to assess the method used by management to obtain the fair value

of net assets acquired.

Impairment of goodwill should be assessed.

Information regarding accounting policies of the new subsidiary should be obtained as

this will need to be reconciled so that the consolidation adjustment can be quantified.

The way in which the group identifies intercompany balances/transactions will need to

be established.

The audit plan should contain a list of all the companies within the group so that

completeness of intercompany balances can be confirmed.

Business Risks Relating to Acquisition of a subsidiary

The acquisition may result in the group incurring additional cost.

Customer and key staffs may be lost.

Key staff may be lost as a result of the inability to integrate the culture of the company

In the case of a foreign acquisition the company may not be familiar with local legislation

which is critical to the survival of the business.

The business is exposed to foreign exchange risk (foreign acquisition)


Question CUCKOO GROUP

You are currently auditing the consolidated financial statements of the Cuckoo Group and are

scrutinising the accounting policies being used by the group for the valuation of inventories. The

group has three principal subsidiaries which are Loopy, Snoopy and Drake Retail. You are not

currently the auditor of Loopy as Cuckoo only recently acquired this subsidiary company.

Cuckoo, the holding company, carries on business as a dealer in gold bullion and other precious

metals. It purchased the three subsidiaries in order to diversify its activities. It felt that dealing in

commodities was quite risky and wished to spread the operating risk. The following are the

accounting policies proposed by Cuckoo Group regarding the valuation of inventories:

Cuckoo proposes to recognise the bullion and other precious metals in the statement of

financial position at the year-end market values. It does not enter into any contracts for the

forward purchase or sale of precious metals. Cuckoo does not manufacture products from the

precious metals but simply buys and sells the metals on the bullion markets.

Loopy manufactures domestic products such as cutlery, small electrical appliances and

crockery. The inventory is valued at the lower of cost or market valued applied to the total of the

inventory. Cost is determined by using the last in, first out (LIFO) method of inventory valuation.

Overhead costs are allocated on the basis of normal activity and are those incurred in bringing

the inventory to its present location and condition.

Snoopy manufactures similar domestic products to Loopy. The inventory is valued at the lower

of cost and net realisable value for the purpose of the group statement of financial position.

However, inventory is further reduced to its standard value for the purpose of the group profit or

loss. This reduction is not material in the context of the group accounts. Overheads are

allocated on the basis of normal activity levels and the costs incurred in bringing the inventory to

its present location and condition.


Drake Retail acts as the retail outlet for approximately 60% of the combined output of Loopy and

Snoopy. It values its inventories at the lower of cost and net realisable value. Inventories mainly

consist of goods held for resale. Cost is computed by deducting the gross profit margin from the

selling value of inventory. When computing net realisable value, an allowance is made for any

future mark downs to be made on inventory.

The directors of Cuckoo Group wish the following accounting policy note to be included in the

group financial statements regarding inventory: “Inventories are stated at the lower of cost and

net realisable value and comprise raw materials (including bullion), work in progress and

finished goods.”

Required:

(a) Describe the audit procedures which you would carry out before placing reliance upon

the work of the auditors of Loopy. (7 marks)

(b) Discuss whether you feel that the current accounting policies adopted by Cuckoo and its

three subsidiaries regarding inventory and work in progress are acceptable to you as group

auditor. (7 marks)

(c) Discuss the problems which may arise when determining which overhead costs are to

be incorporated into the inventory valuation of manufacturing companies such as Loopy and

Snoopy. (6 marks)

(d) Discuss whether you feel that the accounting policy note regarding inventory and work in

progress provides adequate information to the users of the group financial statements. (5

marks)

(25 marks)


Ans

(a) Reliance on the work of component auditors

Reliance will not be placed upon the financial statements of Huey until the audit procedures

carried out by their auditor (the component auditor) have been reviewed by the parent

company’s auditor (the group auditor). Before any approach is made to the auditor of Huey plc,

the directors of Donald plc will be informed of the intention to communicate with the component

auditor. The component auditor is under a statutory duty in this case to co-operate with the

group auditor.

The auditors of Loopy should be informed in advance of the standard and scope of the work

required and any reporting deadlines, and the component auditor should discuss any potential

problems they foresee with the group auditor.

An assessment of the materiality of amounts in the financial statements of Loopy should be

made and this will determine the nature of the procedures to be carried out by the group auditor.

Further an assessment of the risk inherent in the audit of Loopy will be made. This will involve a

review of the following:

the previous and current financial statements of Loopy (including analytical procedures);

the terms of the component auditor’ engagement and any restrictions placed upon their

work;

the standard of the work of the component auditor and the nature and extent of their

audit examination;

the independence of the auditor of Loopy

It is unlikely that the group auditor will have dealings with the component auditors prior to taking

over the audit of Cuckoo. Therefore, the above items can best be dealt with by a meeting of the

auditors. If this is not possible, then a questionnaire may be sent to the component auditors,

covering the above areas. The questionnaire will cover such areas as the nature of the interim

audit, the audit of non-current and current assets, liabilities, profit and loss account and the


areas which required audit judgement. The audit procedures used by the component auditors

will be reviewed also in this questionnaire.

If Loopy is of material significance a review of the working papers of the component auditor may

be required. This may involve a further visit to the subsidiary company as it is important that the

group auditor is satisfied that the audit has been carried out in accordance with acceptable

auditing standards, and that the component auditor’ audit opinion is reasonable and reliable.

If the auditor is not satisfied with the work carried out, the auditor should arrange for additional

tests to be performed by the auditor of Loopy. Only in exceptional circumstances will the group

auditor perform more tests as the component auditor is responsible for the auditor’s report on

Loopy’s financial statements.

(b) Accounting policies for inventories

(i) Cuckoo

This practice is quite common place when dealing with commodities. It represents a departure

from the usual valuation rules as inventories are stated at above their cost. IAS 2 “Inventories”

does not deal with this issue and the requirement of the standard to show inventory at the lower

of cost and net realisable value has obviously been dispensed with. It can be argued that in the

case of commodities, it is necessary to depart from IAS 2 and apply alternative accounting

practices. The financial statements are more helpful to users if the commodities are shown at

market value and this is generally justified in order to show a true and fair view. However, it will

only be acceptable as a valuation model where the company’s principal activity is the trading of

commodities, the commodities do not alter in character between purchase and sale, the

commodities can be traded on an organised market and the market is sufficiently liquid to allow

the company to realise its inventory close to the valuation price. It would appear therefore that in

the case of Donald plc, the policy is acceptable.


(ii) Loopy

IAS 2 requires that the comparison of cost and net realisable value should be done on an item

by item basis or by groups of similar items. In the case of Huey plc the comparison has been

carried out on a total inventory basis. Thus the group auditor will request the component auditor

to carry out a net realisable value test on an item by item or group basis. Further, the LIFO (last

in, first out) method of inventory valuation is not acceptable by IAS 2 and therefore inventory will

need to be revalued in order to conform with the standard if the financial statements are not to

be qualified. (This is dependent upon the materiality of the amount in the context of the group

accounts.)

(iii) Snoopy

This accounting procedure is effectively showing inventory at base inventory value in profit or

loss and at FIFO (first in, first out) valuation in the statement of financial position. Base inventory

is not an acceptable method of valuing inventory under IAS 2. Inventories should be stated at

the same value in both the statement of comprehensive income and statement of financial

position under existing accounting conventions. The presentation in the statement of financial

position takes the form of “reserve accounting” with the base inventory write-down presumably

being charged against retained earnings without being shown in profit or loss. It is a practice

which would be discouraged by the auditor but because the amount is immaterial, the error may

be summarised along with other errors found in order to ascertain the collective materiality of

those items. Alternatively, because the item can be adjusted easily on consolidation, the

financial statements of Snoopy may be adjusted.

(iv) Drake Retail

This company sells high volumes of various small items of inventory. Invariably in this type of

trade, similar mark-ups are applied to groups of inventory items. In this situation, a

disproportionate amount of time can be spent determining the cost of the year end inventory.

The most practical method of valuing year end inventory is to record inventory at selling price

and convert it to cost by removing the mark-up.


It is important that Fooey Retail plc keeps a record of the mark-up on each product and those

items which have been marked down otherwise the calculation of original cost will be

inaccurate. IAS 2 says that this method is acceptable only if it can be demonstrated that the

method gives a reasonable approximation to actual cost.

(c) Overheads in inventory valuations

Problems arise under IAS 2 with regard to how overheads are to be incorporated into inventory

valuation. IAS 2 defines costs as “that expenditure which has been incurred in the normal

course of business in bringing the product to its present location and condition”. Certain costs

are not costs of bringing the inventory to its present location and condition. These include

storage costs, selling costs and administrative overheads. However, in certain circumstances it

is possible to argue a case for their inclusion in inventory valuation. For example if firm sales

contracts have been entered into for the sale of inventories, the inclusion of selling costs

incurred before manufacture can be justified under IAS 2. Storage costs may be incurred prior

to further processing and these costs should be included in the cost of production. The standard

recognises that in the case of smaller organisations there may not be a clear distinction of

management functions and that this cost may be allocated to production on fair basis.

Thus it can be seen that the allocation of costs to inventory will vary from organisation to

organisation and the accounting policy of valuing inventories at “cost” is fraught with difficulty. It

leads to a situation where companies may ostensibly have the same accounting policy but the

overhead cost allocation may be quite different.

Another problem is that IAS 2 requires overheads to be included in inventory on the basis of a

company’s normal level of activity. “Normal” is not defined in the standard but normal level of

activity is established by reference to the budgeted or expected level of activity over several

years. What is “normal” is obviously left open to subjective assessment particularly during the

initial years of a business or in a recession. The standard is unhelpful in this area and the

acceptability of the overhead allocation based on normal activity is effectively left to mutual

agreement between the auditor and the client.


(d) Accounting policy note

IAS 2 states that the accounting policies that have been applied to inventories and work in

progress should be stated and applied consistently from year to year. The degree of detail given

by companies varies considerably. Some companies provide comprehensive and informative

information, others provide very brief statements. Companies need only state that inventories

and work in progress are valued at the lower of cost and net realisable value in groups of similar

items.

The directors of Cuckoo Group appear to have adopted the latter viewpoint as the information to

be given to users has little interpretational value. Hence the bullion inventories, retail goods and

the trading inventories should be suitably described.

Different accounting policies have been used to value the bullion, retail goods and the trading

inventories and these should be detailed in the notes to the accounts. Further it would be useful

to users if the accounting policy relating to a specific category of inventory was set out in some

detail. Examples of this are set out below:

Raw materials –Purchase cost on a first in, first out basis

Work in progress and finished goods –Cost of direct materials and labour plus attributable

overheads based on a normal level of activity

Retail inventories–Cost is computed by deducting the gross profit margin from the selling value

of inventory for the different product lines

Bullion inventories–Assets in bullion and other metals are stated at year-end market values in

the statement of financial position.


Question BEESTON INDUSTRIES

Your firm is the auditor of Beeston Industries Inc, which has a number of UK subsidiaries (and

no overseas subsidiaries), some of which are audited by other firms of professional

accountants.

You have been asked to consider the work which should be carried out:

■ to ensure that inter-company transactions and balances are correctly treated in the

group accounts;

■ to check the auditors’ work and the accounts of companies not audited by you.

Required:

(a) List and briefly describe the audit work you would perform to check that inter-company

balances agree; state why inter-company balances should agree and the consequences of them

not agreeing. (7 marks)

(b) Describe the audit work you would perform to verify that inter-company profit in inventory

has been correctly accounted for in the group accounts. (5 marks)

(c) List and briefly describe the audit work you would perform to verify that the work carried

out by other audit firms, who are auditors of subsidiaries of the group, is satisfactory. (8

marks)

(d) Briefly describe the effect the following would have on your review of the work of the

subsidiaries’ auditors and on your opinion on the group accounts:

(i) the size of the subsidiary – whether it is small or large;

(ii) if the auditor’s report on the subsidiary’s accounts is qualified;

(iii) if the subsidiary is a banking company. (5 marks)


Ans

(a) Inter-company balances

A group company will have the following types of inter-company balances:

A sales ledger balance. This will be represented by a corresponding purchase ledger

balance in the supplier company books.

A purchase ledger balance this will be a sales ledger balance in the receiver company

books.

Short-term general ledger debit balances in respect of dividends receivable or loans.

Long-term general ledger debit balances which are effectively investments in group

companies and are shown as part of non current asset investments.

Short-term general ledger credit balances which are loans or advances repayable within

twelve months and long term non ledger credit balances which are loans repayable after

twelve months.

There should be an agreed procedure laid down by the group accountant’s department for the

following matters:

Goods in transit – Some companies follow the convention that the supplier company’s

record is the definite record; therefore the consignee should make an accrual to agree

the inter-company balance.

Cash in transit – A convention which is often adopted is that the paying company’s

record is the definitive record and agreement should be made on that basis.

There should be a timetable laid down for the agreement of inter group balances and for

the publication of a return to head office so that inter-company balances are clearly

agreed.

General ledger balances described above should be confirmed in writing at the year-

end and if necessary validated by reference to an auditor’s certificate. There should be


no setting off of inter-company balances. The individual balances should be capable of

being eliminated on consolidation. It is important that all inter-company balances agree.

Failure to agree inter-company balances may result in double counting with the result

that either profits or net assets could be over stated. If this is done to any material extent

the group financial statements may not give a true and fair view.

(b) Profit in inventory

Inter-company profit from inventory must be eliminated in group accounts as this is effectively

unrealised profit in the context of the group. In order to eliminate inter-company profit from

inventory the group accounting procedures should be so designed so as to identify year-end

inventory balances which are the result of inter-group trading. If the group follows a policy of

trading at arms length these amounts of inventory will be stated at cost and there will obviously

be an element of unrealised profit in the context of the group. The procedure adopted by

companies to reduce this inventory to true cost would include the following:

Identification of inventory which is part of inter-group trading by a suitable analysis of

inventory balances in a supporting schedule.

The auditors, who wish to check the provision for unrealised profit, should review the

transfer pricing arrangements between the individual companies by examining the

invoices for the items concerned and making enquiries of the supplier companies of the

basis of cost structure. The calculations used by the group accountant or the individual

subsidiary accountant to eliminate the profit should be validated by reference to the data

on transfer pricing and inter-group trading. The volume of inter-company inventory

should be reviewed from one year to the next and any significant variations investigated.

The inter-company inventory thus reduced to true cost should be traced to the final

inventory summary to verify that it has been included. Lastly the auditor should verify

that the provision for inter-company profit is appropriately increased or reduced in order


to provide the correct closing balance that is necessary to reduce inter-group inventories

to a figure of cost.

(c) Reviewing the work of other auditors

The audit work that would be done to verify that the work of the subsidiaries’ auditors has been

properly carried out would include the following:

An assessment of materiality: The group auditor should establish the materiality of the

individual subsidiary within the group context as a whole. In evaluating materiality he will

add regard to contribution towards profit for tax, net assets and turnover. Those

subsidiaries which are material or if not material which possess risk factors out of

proportion to their size will be subjected to greater audit effort that those which are not

material and do not present any great problem.

Group accounting policies: The group auditor should enquire into group accounting

policies and in particular should review those key accounting policies to ensure that they

are harmonious within the group. The key accounting policies are those on turnover,

inventories, deferred tax, depreciation, common occurrences, leasing. The most usual

way of doing this is to send the component auditors a questionnaire specifically dealing

with accounting policies and on receipt to review the questionnaire to establish that the

policies are harmonised. Where policies are not harmonised it may be necessary for the

group company to harmonise them by means of a consolidating adjustment.

Adequate information: In addition to the questionnaire dealing with accounting policies

the group auditor should ensure that the parent board have made available adequate

information for audit purposes. Adequate information will generally mean:

the full audited accounts;

the audited accounts restated on consolidation pro forma schedules to facilitate

the preparation of consolidated accounts; and

Schedules of all supplementary information required for disclosure or taxation

purposes.


This availability of information is exceedingly important in approaching and appraising the work

of the component auditor. When appraising the work of the component auditor the group auditor

will determine the depth of appraisal by reference to materiality or risk factors which were

mentioned earlier. All companies immaterial or otherwise who are audited by other firms will

receive an audit policies and procedures questionnaire from the group auditor.

This policies and procedures questionnaire will seek to examine auditing standards

employed by subsidiary company auditors. They would include consideration of the

following.

The audit strategy and the relying or otherwise on the companies system of

internal trouble.

The procedures used to verify assets (e.g. attendance to physical inventory

counting, verification of bank and cash balances, circularisation of receivables

and verification of research and development).

The procedures used to verify liabilities.

The identification of contingencies and any events after the reporting period.

The management letters sent by the component auditors to the management of

the subsidiary.

The auditor’s report and the scope of any qualifications. It would be necessary to

consider the scope of the qualifications in the context of the group. A review of

working papers of the subsidiary company auditors will be carried out by the

group auditor where the subsidiary is a material subsidiary or possesses risk

factors out of proportion to its size.

(d) Factors affecting review and opinion

In considering the accounts of a subsidiary audited by another firm the following matters are

relevant.

(i) Materiality


If the subsidiary contributes a large proportion of group turnover, profit before tax and net

assets, the work of the auditor of the subsidiary will be examined in much greater detail.

(ii) Qualified opinion

If the auditor’s report of a subsidiary is qualified the qualification may be significant in the

context of the group. A material and fundamental qualification of a significant subsidiary will

almost certainly involve some form of qualification in the auditor’s support of the group. In many

cases where the subsidiary is not material the group context of qualification issued by the

component auditors would not need to be reflected in the group auditor’s report.

(iii) Banking subsidiary

If the subsidiary is a bank it will be necessary to make additional disclosures relating to

segmental information under IFRS 8 Operating Segments.

AUDIT REPORT

Elements of Auditor’s report

The following elements must be present in an audit report:

Title: The title should clearly indicates that it is the report of the independent auditor

Addressee: the report should be addressed to the legal recipient of the report

Introductory paragraph: this paragraph contains the name of entity being audited, the sets of

financial statements that have been audited, period covered by the audit, and brief statement of

accounting policy.

Section describing management’s responsibility for the financial statements: This section

describe responsibility of management regarding preparation of the financial statements


Section describing Auditor’s responsibility: this section must state that the auditor is responsible

for expressing an opinion based on the audit. This section gives brief explanation of Audit and

describes the strength of the audit evidence obtained.

Opinion paragraph: for unmodified opinion

Auditor’s signature: the signature of the person signing for the firm and the name of the firm

Date: the report must be duly dated

Auditor’s address: the report should include the address of the auditor

Meaning of unmodified audit report

Unmodified report means:

The financial accounts of the audited entity give true & fair view.

The financial accounts of the entity have been prepared in accordance with the

applicable financial reporting framework

Modification of auditor’s report

Circumstance Material but not pervasive Material and pervasive

Financial statements are

materially misstated

QUALIFIED OPINION ADVERSE OPINION

Inability to obtain sufficient

appropriate evidence

QUALIFIED OPINION DISCLAIMER OF OPINION

The basis of opinion should be shown immediately above the opinion paragraph.ISA 705

requires them be headed as:

“Basis for Disclaimer of Opinion”, and “Disclaimer of Opinion”


“Basis for adverse opinion”, and “Adverse of opinion”

“Basis for Qualified Opinion”, and “Qualified opinion”

Notes on ‘Basis of opinion’ paragraph:

The paragraph should not include argument credited to the directors

Full name of IAS should be provided in the paragraph e.g. IAS 33 Earnings per share

The paragraph should be precise

Where management imposes restriction and the auditor is unable to obtain sufficient

evidence, the paragraph should refer to the relevant accounting standard and should

state that a limitation has been imposed by management in respect of the specified

issue. It should state that management did not allow access to evidence and that the

auditor has been unable to determine whether the accounting treatment of the issue is

correct.

The paragraph should not contain unprofessional words e.g. abusive words should be

particularly avoided, it should not contain any form of accusation against management

Note on opinion paragraph where there is insufficient audit evidence:

The opinion paragraph should use the specific form of words sets out in ISA 705 and the

statement that the auditor has been unable to obtain sufficient appropriate audit evidence, and

that it is therefore unable to express an opinion


Management imposed limitation on the scope of audit; matter to consider and action to be taken

by the auditor

Any significant difficulty encountered should be communicated to those charged with

governance(ISA 260 communication with those charged with governance)

The auditor should consider whether evidence can be obtained by any alternative

procedures

The auditor should consider the integrity of the management. Any representation made

by the management on the issue should be reconsidered.

Where the restriction will lead to modification of opinion, the circumstances surrounding

this should be communicated with the expected wording to be used

The audit firm should consider withdrawing from the audit engagement to protects its

integrity

Emphasis of matter paragraph (EOM)

This is a paragraph in the auditor’s report that explain matter that is appropriately presented or

disclosed, but which is so important that special emphasis is needed for users of the financial

statements.

NOTE: emphasis of matter paragraph does not qualify the opinion. Auditor should only include

an EOM if there is sufficient and appropriate audit evidence that the matter is not materially

stated

Examples of situations when EOM can be used:

An uncertainty relating to the future outcome of an exceptional litigation

Early application of a new accounting standard that has pervasive effect on the financial

statements

A major catastrophe that has had a significant effect on the entity’s financial position

Significant going concern issue


Other matter paragraph

This explains information that is rightly not present in the financial statements but which is so

important for user’s understanding of them that it needs to be highlighted in the auditor’s report.

Examples of when other matter paragraph is used:

When the legislation specifically requires auditor to provide further explanation on

auditor’s responsibilities

When auditor is reporting on more than one set of financial statements e.g. using both

IFRS and local GAAP

When prior period’s financial statements have not been audited at all or audited by

another auditor

Group audit report

The following matters are to be considered by the group auditor if the account of a component is

qualified:

Materiality of the component to the group financial statements. According to ISA 600, a

component is significant to the group where a chosen benchmark is more than 15% of

the same figure for the group. Possible benchmark includes: profit before tax %; total

assets %; and sales %. Materiality must be determined at both the component and

group level

The group auditor should consider whether there is sufficient and appropriate audit

evidence to support the qualified opinion

If the entity is a material component, the group auditor should review the component’s

auditor’s evidence in relation to the qualified opinion

The group auditor should determine if there is need for further audit evidence.

If evidence showed that the qualification is inappropriate, the group auditor should

request the component auditor to redraft its auditor’s report.


The group auditor should consider the impact of the qualification on the group’s audit

report

If the qualification of the component’s report is deemed appropriate by the group auditor, the

following steps should be taken:

The group auditor should discuss the issue with the group management

The group auditor should request that the group management ask the component’s

management to adjust its financial statement. If this is done, the auditor will perform

further audit procedure on the adjustment, if the adjustment is adequate, the component

auditor will re-issue its audit report.

If the component’s management refuse to correct the material misstatement but the

effect of the misstatement has been corrected in the group financial statements, the

components audit report will remain qualified, but the group’s auditor’s report will not be

qualified

If there is no adjustment in both the components’ account and the group’s account in

respect of the material misstatement, the group’s audit opinion will be qualified ‘except

for’ because of the material misstatement.

NOTE: should there be any need to qualify the group’s opinion in respect of a material

misstatement in the account of a component, the work of the component auditor should

never be referred to in the group auditor’s report


Question THETA

In January 2009, the head office of Theta was damaged by a fire. Many of the company’s

accounting records were destroyed before the audit for the year ended 31 March 2009 took

place. The company’s financial accountant has prepared financial statements for the year ended

31 March 2009 on the basis of estimates and the information he has been able to salvage. You

have completed the audit of these financial statements.

Required:

(a) Draft, for inclusion in the auditor’s report, wording appropriate to Theta. (5 marks)

Note: You are not required to reproduce the auditor’s report in full.

(b) Explain the reasons for your audit opinion. (3 marks)

(c) Explain and distinguish between the following forms of modified report:

(i) Emphasis of matter


(iii) Disclaimer of opinion

(iv) Adverse opinion. (8 marks)


Ans

Introductory paragraph

We have audited the accompanying financial statements of Theta, which comprise the

statement of financial position as at March 31 2009, and the statement of comprehensive

income, statement of changes in equity and statement of cash flows for the year then ended,

and a summary of significant accounting policies and other explanatory notes.

Auditor’s responsibility

Our responsibility is to express an opinion on these financial statements based on conducting

the audit in accordance with international standards on auditing. Because of the matter

described in the basis for Disclaimer of opinion paragraph, however, we were not able to obtain

sufficient appropriate audit evidence to provide a basis for an audit opinion

Basis for Disclaimer of Opinion

The evidence available to us was limited because many of the company’s accounting records

were destroyed by fire in January 2009. The financial statements therefore include significant

amounts based on estimates. In these circumstances there were no satisfactory audit

procedures that we could adopt to obtain all the information and explanations we consider

necessary.

Disclaimer of Opinion

Because of the significance of the limitation on the evidence available described in the Basis for

Disclaimer of Opinion paragraph, we do not express an opinion on the financial statements.

(b) Reasons for audit opinion

The fire has resulted in limitations in audit work and evidence necessary to form an

opinion cannot be obtained.


It is a matter of fact that accounting records adequate for audit purposes have not been

kept and all information and explanations necessary for audit purposes have not been

received.

The effect of the limitation is so material and pervasive that it is not possible to express

an opinion on the financial statements.

(C) Forms of modified audit opinion

(i) Emphasis of matter

An emphasis of matter is clearly distinguishable from other modifications in that it does

not affect the auditor’s opinion.

An emphasis of matter paragraph highlights a matter affecting the financial statements

which is discussed in note to the financial statements, for example, going concern.

The paragraph is included after the opinion paragraph


An “except for” opinion is expressed when the auditor cannot express an unqualified opinion but

the effect of the matter (disagreement or limitation on scope) is not so material and pervasive as

to require an adverse opinion or disclaimer of opinion.

(iii) Disclaimer of opinion

An auditor is unable to express (i.e. “disclaims”) an opinion when the effect of a limitation on

scope is so material and pervasive that the auditor has been unable to obtain sufficient

appropriate audit evidence (which may be reasonably expected to be available).


(iv) Adverse opinion

The effect of a disagreement is so material and pervasive that the auditor concludes that a

qualification is not adequate to disclose the misleading or incomplete nature of the financial

statements.

Distinctions

There are three issues which distinguish the form of modified reports

EITHER the matter does not affect the auditor’s opinion as in case (i)) or it does affect the

opinion as in cases (ii), (iii) and (iv)

If the audit opinion is affected, then

EITHER there is sufficient appropriate evidence on a matter for the auditor to disagree with the

amount, treatment or disclosure in the financial statements as in case (iv));

OR there is insufficient evidence due to scope limitation as in case (iii)).

EITHER the matter is “so material and pervasive’ as in cases (iii) & (iv)

OR not so material and pervasive as in case (ii)) resulting in an “except for” opinion


Other assignment

Matters to consider before accepting any Non-audit assignment

Whether any conflict of interest exist

Whether level of risk involved is manageable

Independence

Whether deadlines can be met

Whether the auditor has the competency level required by the assignment

Staff availability

Integrity of clients

The followings should be discussed with management:

Content of report

Level of assurance. This will usually take the form of negative assurance as the work will

be less detailed compared to statutory audit. This type of work only rely on analytical

procedure and enquiry in gathering evidences

Deadlines

Limitation of liability. Liability to third party should be discussed

Distribution of report. The use of the report will normally be restricted to the intended

users

Types of evidence to be sought for

Engagement letter

Fess to be charged


Review Engagement

A review engagement is a professional engagement in which the auditor performs

procedures designed to enable the auditor to obtain the moderate level of assurance

required to provide a negative assurance report. Review engagement is an alternative

to audit for companies not required to carry out statutory audit.

In a negative assurance report the auditor states whether anything has come to the

auditor’s attention that causes the auditor to believe that the assertions do not present a

true and fair view, or otherwise comply with the criteria laid down for the engagement.

In review engagement, the auditor primarily uses enquiry and analytical review

procedures to gather evidence. Audit procedures in review engagement do not include

inspection, confirmation or observation procedures as in audit engagement, however,

the evidence gathered must be sufficient to enable the auditor to provide a moderate

level of assurance.

Agreed-Upon Procedures

An agreed-upon procedures engagement is one in which a practitioner is engaged by a

client to issue a report of findings based on specific procedures performed on subject

matter. The client engages the practitioner to assist specified parties in evaluating

subject matter or an assertion as a result of a need or needs of the specified parties

In an agreed-upon procedure engagement, the auditor does not express an opinion or

negative assurance. Instead, the auditor issues a report that details the specific

procedures performed and the results of such procedures. Users of the report assess

for themselves the procedures and findings reported by the auditor and draw their own

conclusions from the auditor’s work.


The report is restricted to those parties that have agreed to the procedures to be

performed since others, unaware of the reasons for the procedures, may misinterpret

the results.

Examples of situations in which agreed-upon procedures may be used include:

Licensing, contract and royalty compliance engagements

Cash balances verification

Security balances

Compliance with specified terms of an agreement

Due diligence review

Due diligence review refers to the work commissioned by a client involving enquires into

agreed aspects of the accounts, systems, and activities of the target company in

prospective business purchase.

This assignment mainly requires the auditor to make enquiries and perform analytical

procedures. A lower level of assurance will be provided on the review.

Unlike audit engagement, a financial due diligence review would not only look at the

historical financial performance of a business but also consider the forecast financial

performance for the company under the current business plan and consider the

reasonableness of such forecasts. A financial due diligence review will investigate

reasons for the trends observed in operation results of the company over a relevant

time period and report on this in terms of relevancy for the proposed transaction.


Due diligence review would typically involve a review of the following areas:

historical financial results;

current financial position

forecast financial results

working capital requirements

employee entitlements provisions

valuation implications

risks and opportunities

Taxation implications.

Matters to consider for due diligence assignment

Whether there are ethical reasons why the work should not be undertaken

Whether any conflict of interest exist

Whether the firm has the required level of expertise required

Reason for making the acquisition

Deadlines

Fess

The scope and extent of work to be performed

Enquiries to be made by auditor

Whether there are any contingent liabilities

Whether take over will precipitate any tax liabilities

Whether there any terms in the contract of employees which entitled them to

compensation in the event of any change in ownership

Whether any redundancy payment will be required

Whether any business contract with customers will be terminated on change of

ownership


Whether existing lease agreement give right of termination to the lessor on

change of ownership

Prospective Financial Information

According to International standard on Assurance engagements No. 3400 The

Examination of Prospective Financial Information, ‘Prospective financial information’

(PFI) means financial information based on assumptions about events that may occur in

the future and possible actions by an entity. It is highly subjective in nature and its

preparation requires the exercise of considerable judgment. Prospective financial

information can be in the form of forecast, a projection or a combination of both, for

example, a one year forecast plus a five year projection.

Forecast

ISAE 3400 defines a ‘forecast’ as prospective financial information prepared on the

basis of assumptions as to future events which management expects to take place and

the actions management expects to take as of the date the information is prepared (best

–estimate assumptions).

Projection

Projection is defined as prospective financial information prepared on the basis of:

(a) hypothetical assumptions about future events and management actions which are

not necessarily expected to take place, such as when some entities are in a start –up

phase or are considering a major change in the nature of operations, or

(b) A mixture of best-estimate and hypothetical assumptions.


In effect a forecast is an informed opinion on what will happen and a projection is an

opinion on what might happen in certain circumstances. Often a one-year forecast is

given together with a five year projection.

Prospective financial information can include financial statements or one or more

elements of financial statements and may be prepared:

As an internal management tool, for example, to assist in evaluating a possible

capital investment; or

For distribution to third parties in, for example:

A prospectus to provide potential investors with information about future

expectations.

An annual report to provide information to shareholders, regulatory bodies

and other interested parties.

A document for the information of lenders which may include, for example,

cash flow forecasts.

Management Responsibilities regarding PFI

Management is responsible for the preparation and presentation of the prospective

financial information, including the identification and disclosure of the assumptions on

which it is based. The auditor may be asked to examine and report on the prospective

financial information to enhance its credibility whether it is intended for use by third

parties or for internal purposes.


Auditor’s Responsibilities

In an engagement to examine prospective financial information, the auditor should

obtain sufficient appropriate evidence as to whether

Management’s best-estimate assumptions on which the prospective financial

information is based are not unreasonable and, in the case of hypothetical

assumptions, such assumptions are consistent with the purpose of the

information

The prospective financial information is properly prepared on the basis of the

assumptions

The prospective financial information is properly presented and all material

assumptions are adequately disclosed, including a clear indication as to whether

they are best-estimate assumptions or hypothetical assumptions

The prospective financial information is prepared on a consistent basis with

historical financial statements, using appropriate accounting principles.

General procedure on PFI

In performing an examination of prospective financial statements, the auditor should:

Assess inherent and control risk as well as limit his or her detection risk.

Consider the sufficiency of external sources and internal sources of information

supporting the underlying assumptions.

Assess the consistency of the assumptions and the sources from which they are

predicated.

Assess the consistency of the assumptions themselves.

Assess the reliability and consistency of the historical financial information used.

Evaluate the preparation and presentation of the prospective financial statements

to ensure conformity with relevant standards


Obtain a client representation letter to confirm that the responsible party

acknowledges its responsibility for the presentation of the prospective financial

statements and the underlying assumptions.

Acceptance of PFI engagement

Before accepting an engagement to examine prospective financial information, the

auditor would consider, among other things:

The nature of the assumptions, that is, whether they are best –estimate or

hypothetical assumptions

The period covered by the information

The intended use of the PFI

Whether the information will be for general or limited distribution. General use”

means that the statements will be used by persons not negotiating directly with

the responsible party. “Limited use” refers to situations where the statements are

to be used by the responsible party alone or by the responsible party and those

parties negotiating directly with the responsible party.

Competence and experience of the preparer

Level of assurance to be provided

Possible procedures for cash flow forecast

The following procedures, among others may be applicable:

Make enquiry of the preparer of the forecast and verify that they are competent


Perform analytical procedures on historical information to confirm

reasonableness of the forecast

Obtain direct confirmation from major trading partners of the client that they will

continue to deal with the client

Agree salary payment to payroll

Discuss sources of cash inflow in the forecast and evaluate the validity of the

reasons obtained

Obtain a written confirmation from loan provider if any

Obtain and review the financial statement of loan provider to assess whether it

has sufficient fund available

Should there be any claimed subsidy, inspect the application made for the

subsidy to confirm the amount of the subsidy

In addition to the above, inspect correspondence with the subsidy awarding body

to assess the likelihood of getting the subsidy

Cast the cashflow forecast

Agree the opening cash position to cash book and bank statement

Procedures on forecast made in support of loan application

Review the forecast and assess if the assumptions used reflects business reality.

Obtain written representation from management confirming that the assumptions

in the forecast are achievable.

Assess the sufficiency of the loan requested to cover the intended expenditure.

Discuss any other source of finance being considered by management and

assess the likelihood.


Forensic Auditing

Forensic Accounting

This refers to use of accounting, auditing and investigative skills to conduct an

examination into company’s financial affairs. Forensic accounting refers to the whole

process of investigating a financial matter, including potentially acting as an expert

witness if the fraud comes to trial. Forensic Accounting provides an accounting analysis

that is suitable to the court which will form the basis for discussion, debate and

ultimately dispute resolution.

Forensic Accounting includes:

Reconstructing records accidentally or intentionally destroyed

Vouching and tracing transactions and validation of supporting documentation

Analyzing financial results

Determining the completeness and accuracy of financial reports

Forensic Audit

Forensic auditing refers to the specific procedures carried out in order to produce

evidence. Audit techniques are used to identify and to gather evidence to prove

Forensic Investigation

The utilization of specialized investigative skills in carrying out an inquiry conducted in

such a manner that the outcome will have application to a court of law.


Matters to consider in forensic assignment

Whether the firm has staff with sufficient experience

Scope of work involved

Whether any independence issue arise

Reliance to be placed on the report

Procedures to carry out before accepting appointment

Review staff availability and timings

Discuss scope with client’s management

Discuss fees and deadlines

Draft an engagement letter

Forensic audit and its application to fraud investigation

The objectives of the investigation will include:

Identifying the type of fraud that has been operating, how long it has been

operating for, and how the fraud has been concealed.

Identifying the fraudster(s) involved.

Quantifying the financial loss suffered by the client.

Gathering evidence to be used in court proceedings.

Providing advice to prevent the reoccurrence of the fraud.

Steps involved in forensic investigation (fraud case)

establish the type of fraud that has taken place

determine for how long the fraud has been operating

determine how the fraud was conceal

collect evidence

produce report

show up in court proceedings if required


Forensic investigation being requested by an audit client: ethical consideration

Unless robust safeguards are put in place, the firm should not provide audit and forensic

investigation services to the same client.

A perceived threat to objectivity that may occur includes:

Advocacy threats. The audit firm may be promoting interest of the client in court as they

are concerned about losing their audit fees

Self review. The self review threat arises because the investigation is likely to

involve the estimation of an amount. If the amount as quantified by the auditor is

material to the financial statement, the auditor will be auditing his own work

Application of ethical principles to a fraud investigation

IFAC’s Code of Ethics for Professional Accountants applies to all ACCA members

involved in professional assignments, including forensic investigations. There are

specific considerations in the application of each of the principles in providing such a

service.

Integrity

The forensic investigator is likely to deal frequently with individuals who lack integrity,

are dishonest, and attempt to conceal the true facts from the investigator. It is

imperative that the investigator recognises this, and acts with impeccable integrity

throughout the whole investigation.

Objectivity

As in an audit engagement, the investigator’s objectivity must be beyond question. The

report that is the outcome of the forensic investigation must be perceived as

independent, as it forms part of the legal evidence presented at court. The investigator


must adhere to the concept that the overriding objective of court proceedings is to deal

with cases fairly and justly. Any real or perceived threats to objectivity could undermine

the credibility of the evidence provided by the investigator.

Professional competence and due care

Forensic investigations will involve very specialist skills, which accountants are unlikely

to possess without extensive training.

It is therefore essential that forensic work is only ever undertaken by highly skilled

individuals, under the direction and supervision of an experienced fraud investigator.

Any doubt over the competence of the investigation team could severely undermine the

credibility of the evidence presented at court.

Confidentiality

Normally accountants should not disclose information without the explicit consent of

their client. However, during legal proceedings arising from a fraud investigation, the

court will require the investigator to reveal information discovered during the

investigation. There is an overriding requirement for the investigator to disclose all of the

information deemed necessary by the court.

Outside of the court, the investigator must ensure faultless confidentiality, especially

because much of the information they have access to will be highly sensitive.

Professional behaviour

Fraud investigations can become a matter of public interest, and much media attention

is often focused on the work of the forensic investigator. A highly professional attitude

must be displayed at all times, in order to avoid damage to the reputation of the firm,

and of the profession. Any lapse in professional behaviour could also undermine the

integrity of the forensic evidence, and of the credibility of the investigator, especially

when acting in the capacity of expert witness.


During legal proceedings, the forensic investigator may be involved in discussions with

both sides in the court case, and here it is essential that a courteous and considerate

attitude is presented to all parties.

Question FLASHMARK

Flashmark is an audit client of your firm and manufactures household furniture. It has a year end

of 30 June.

On 13 November 2008, a fire destroyed the company’s factory complex, which included the

area used for storing raw materials. The fire was caused by an electrical fault. The factory has

now been rebuilt and the company recommenced trading in May 2009.

The finance director of Flashmark produces monthly management accounts; in these, inventory

and cost of sales are estimated, based on sales figures less assumed margins. At 30

September and 31 March, the company conducts full physical inventory counts for its own

purposes in addition to its year-end count. The results of these counts are compared with the

management accounts for September and March and adjustments are made to reflect the

physical quantities and their appropriate values.

The finance director has contacted your firm to provide a certificate in support of his claim for

losses of profits and loss of inventories arising as a result of the fire.

Required:

(a) Identify and comment on the issues raised as they affect the extent and scope of this

assignment. (8 marks)

(b) State the information you would seek and the procedures you would perform in order to

reach an opinion on the company’s claim for losses of profits and loss of inventory.

(7 marks)


(c) Outline the form and content of your report accompanying the claim. (5 marks)

Ans

(a) Issues raised

Prospective financial information

The financial information on which a certificate is required is for a period (not yet expired) in

respect of which the annual audit has yet to be undertaken. The losses of profits will essentially

be forecasts of the finance director’s best expectation of the most likely results of 6 months

trading after the fire.

Assumptions

The finance director will have had to make assumptions which reflect his judgment as to the

conditions prevailing during the period of non-trading activity. Some assumptions will be highly

subjective, for example, concerning the level of winter sales in a year in which the housing

market (to which household furniture sales will be related) has been in recession.

Scope

The investigation will encompass the raw material inventory valuation, loss of profits calculation

and statement of assumptions.

Management’s responsibilities

Management’s responsibility for the assumptions and other matters of judgement and opinion

should be confirmed in a letter of engagement.

Report required

Although the finance director has requested a “certificate”, it will not be appropriate for his

claims to be “guaranteed” in any way. The form and content of the report(s) required must be


established before the assignment can be accepted. It would be equally inappropriate for

opinions in “true and fair” terms to be required.

Timescale

As for all professional work, the assignment should be carried out with a proper regard for the

technical and professional standards expected. It is unlikely that the level of skill and care

necessary for forming opinions in these areas can be exercised within a restricted timescale.

Access to information

There should be unrestricted access to all information and explanations necessary to form an

opinion on the company’s claims. It may be necessary to discuss sensitive issues, for example,

relating to the cause of the fire and any police investigation.

Prior year audit

Some relevant information is probably included in the prior year audit working paper file as the

fire is likely to have occurred before the auditor’s report was signed (or even before the field

work was completed). Some verification work may have already been undertaken, for example,

for disclosure of the financial effect of this non-adjusting event after the reporting period.

Current year audit

It may be expeditious to perform certain audit work while undertaking this assignment (e.g. to

avoid having to repeat or extend tests at a later date). In particular, the insurance claim is likely

to constitute a receivable balance at 30 June 2009.

Engagement letter

All relevant matters concerning responsibilities, scope of work and reporting requirements,

should be set out in a letter of engagement which the finance director should acknowledge in

writing before work on the assignment commences.


(b) Information

Insurance cover, terms and conditions including sums insured and deductibles.

Specifically:

whether raw material inventory is insured for replacement cost or a written down

value;

how gross profit is defined (e.g. the amount by which turnover and closing

inventory exceed opening inventory and specified operational expenses)

Latest amounts declared for consequential loss cover (e.g. based on last year’s audited

financial statements).

Results of 30 September 2008 (and earlier) inventory counts. The quality as well as the

quantity of slow-moving items should have been noted (at least for last year- end).

Monthly profits for the 6 months of disruption, the previous 6 months and the

corresponding amounts for the previous year.

Industry statistics, for example, % increase/decrease of monthly trading compared with

prior year.

Procedures

Inspect the insurance policy and obtain details of any claims already submitted, for

example, in respect of damage to buildings (which could include cleaning costs which

might otherwise be claimed as consequential loss).

Compare inventory quantities claimed to have been lost against September inventory

count quantities. Substantiate significant increases, for example, to purchase invoices

dated in the period 1 October to mid-November.

Compare management’s assumptions and policies with those normally adopted for the

preparation of management accounts and annual financial statements. Confirm the

suitability of any significant departures (e.g. if insurance cover is for replacement value

of inventory).


Agree the client’s valuation of all significant raw material inventory to historic or current

purchase invoice data (as appropriate).

Agree the basis of the client’s loss of profits calculation to that specified in the insurance

policy.

Agree the make-up of costs deducted from lost sales and ensure they are

valid/allowable under the terms of the insurance policy.

(c) Form and content

Purpose of report and for whom it is prepared (e.g. to the directors of Flashmark).

The financial information investigated, i.e. the valuation of lost inventory and loss of

profits.

The date of the event (13 November) and the nature of the disruption, i.e. fire followed

by periods of closure and rebuilding.

Scope of investigation undertaken, for example, in accordance with the terms of the

letter of engagement and ISA 920 Engagements to Perform Agreed-Upon Procedures

Regarding Financial Information.

Principal assumptions and judgements relating to the valuations concerning, for

example:

the net realisable value or replacement cost of inventory:

the basis of verifying the quality of inventory destroyed

Summary of results and findings

Opinions e.g. “assumptions not contradicted”

Qualification, for example, “except for” all necessary information and explanations

having been received from the client.


Question PETER LAWRENCE

A new client of your practice, Peter Lawrence, has recently been made redundant. He is

considering setting up a residential home for old people as he is aware of an increasing need for

this service with the ageing population. He has seen a large house, which he plans to convert

into an old people’s home; each resident will have a bedroom, there will be a communal sitting-

room and all meals will be provided in a dining-room. No long-term nursing care will be

provided. The large house is in a poor state of repair, and will require considerable structural

alterations, and repairs to make it suitable for an old people’s home, and in particular new

furniture and fittings, decoration of the whole house, and specialised equipment.

Mr Lawrence and his wife propose to work full-time in the business, which he expects to be

available for residents six months after the purchase of the house. Mr Lawrence has already

obtained some estimates of the conversion costs, and information on the income and expected

running costs of the home.

Mr Lawrence has received about $30,000 from his redundancy, and expects to receive about

$30,000 from the sale of his house (after repaying his mortgage). The owners of the house he

proposes to buy are asking $50,000 for it, and Mr Lawrence expects to spend $50,000 on

conversion (i.e. building work, furnishing, decorations and equipment).

Mr Lawrence has prepared a draft capital expenditure forecast, a profit forecast and a cashflow

forecast which he has asked you to check before he submits them to the bank, in order to obtain

finance for the old people’s home.

Required:

(a) Identify and comment on the issues you would consider before undertaking such work.

(5 marks)

(b) Describe the factors you should consider in verifying each of the three forecasts.

(15 marks)


Ans

(a) Considerations before undertaking work

Before accepting such an engagement the accountant must ensure that he has sufficient

time, skilled staff and experience to perform the work.

If he is reasonably confident of the viability and stability of the proposed business and

foresees no limitations imposed on his work by management then he can accept the

engagement.

An engagement letter should be issued to confirm the nature, responsibilities and scope

of the work. The letter should emphasise that management are responsible for the

forecasts.

In planning his work the accountant needs to obtain a good understanding of the

residential home market.

(b) Factors to consider in verifying forecasts

(i) Capital expenditure forecast

The capital expenditure forecast will be split into monthly periods. The accountant would carry

out the following checks to establish that the forecast is reasonable.

House purchase – Inspection of correspondence between estate agent, solicitors and

Peter Lawrence. Consider estimates of solicitor’s fees, survey fees and stamp duty on

the purchase. The latter cost is unavoidable and maybe a significant part of the cost of

purchase.

Building and repairs – Review of the estimate and comparison to any architect’s

specifications, for reasonableness. It would be prudent to inspect the house and

examine those areas which are going to be subject to major renovations and repairs.


Estimates for fixtures, furnishings and equipment – consider the reasonableness of

estimates in the light of any Health Authority guidelines.

Agree capital expenditure to estimates and price catalogues for specialist equipment,

kitchen appliances and decoration.

The forecast should also include specialised plumbing for kitchens, bedrooms and

bathrooms which would be required for the type of clientele in the home.

The accountant would enquire whether Mr Lawrence intends to purchase any of these

items on Hire Purchase; alternatively whether any of the items are to be leased which

would have a bearing on the cashflow forecast.

(ii) Profit forecast

The profit forecast will include income and expenditure. The accountant will consider the

following:

Income – The majority of income will arise from room lettings. It will be unlikely that Mr

Lawrence will have 100% occupancy when the home becomes operational. Therefore it

will be necessary to establish that realistic estimates of income have been obtained.

There should obviously be no income in the period when the home is being renovated.

The reasonableness of the rate per room should be checked with any Health Authority

guidelines and brochures of homes of a similar type.

Staff costs – The major item of expenditure will be staff costs. The accountant should

enquire whether the ratio of residents to nursing staff is reasonable and complies with

what the Health Authority regard as desirable. The rates of pay for the staff should be

verified by reference to local newspapers, staff agencies and any other homes of a

similar type.

Rent and water rates – can be verified by reference to local authority data or from

surveyors correspondence.


Electricity and gas – this will be subjective and based upon the accountant’s experience

with similar types of business.

Food – an estimate of the cost of each day's meals per head should be obtained. This

should be reasonable in comparison with similar organisations.

Telephone – there will be an initial charge for installing the telephone and a reasonable

estimate of expenditure should be made.

Insurance – this will include public liability insurance, employer’s liability insurance and

fire insurance. Correspondence with Mr Lawrence’s underwriter should reveal estimates

for these.

Interest – the interest charge should be based upon Mr Lawrence’s capital requirements

at the rate applicable to overdrafts of unincorporated businesses.

Depreciation, advertising etc – verify by reference to the outlays on plant and equipment,

and advertising rates from the local press.

(iii) Cashflow forecast

Verifying the capital expenditure line in the outgoings part of the forecast with the capital

expenditure forecast.

Verifying the pattern of cash inflows with the profit and loss account income section.

Verifying the payment of overheads, telephone, electricity and gas, with the profit and

loss account and establishing that the total paid in the year is broadly equivalent to the

annual charge plus or minus a year-end accrual.

Verifying that rates are prepaid on the due dates and that the cash forecast makes

provision for taxation.

Checking that the computations on the cashflow forecast are consistent with the profit

forecast.

p7.Summary note.pdf

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