SUGGESTED SOLUTION (APRIL 2007)

AUD 610/560
Question 1
A

a) The By-Laws (On Professional Conduct and Ethics) are not clear as to what
constitutes a violation in these three situations. A central point is that Iqmal
must maintain independence in fact and appearance. He is not an employee
of the company and must not give the impression that he is one.
1. Iqmal has likely not violated the rules; the discount is available to
customers on a widespread basis. Presumably many of the employees of
the CPA firm buy cars from the agency. Iqmal should discuss the discount
with the firms managing partner if he intends or wants to buy the car. He
should certainly not feel compelled to buy the car but he should also not
automatically turn it down. The situation would be entirely different if the
sale were limited to employees. In such a case it would likely be a
violation.
(3 marks)
2. Iqmal engagement to the secretary might not violate the By-Laws
assuming that she is not involve in any management functions and is not
able to exert any significant influence over the company. However this
relationship might affect Iqmals objectivity in performing the audit.
(3 marks)
3. Accepting such a gift is likely to be a violation of the rules of conduct. That
gift is reasonably large and would be considered by many employees as
equivalent to a bonus. The acceptance of a gift which is material in value
might fall outside the level of normal social courtesies acceptable under
the BY-Laws. Ideally, Simon should not accept the gift and state that since
he is not an employee, he would prefer not to take it. If he believes that it
would be embarrassing to the company, he should graciously accept it
and return it with an explanation of his reasons as soon as practical.
(3 marks)
b) The auditor should always strive to be objective in his professional judgement.
He should not only be independent in fact but he must be clearly seen to be
independent in practice. There is no objection in principle to a practice providing
services to a client, additional to the audit.
Care must be taken not to perform management functions or make management
decisions. The auditor should not assist in the preparation of financial statements
for public company clients unless the work is of a routine clerical nature or in
emergency situations. Any fee paid to the auditor for non-audit services should
be shown in the financial statements in addition to amounts paid for audit work.
Under the provision of the Companies Act 1965, an auditor may not be an officer
or employee of a client company. Thus it is necessary for the auditor to ensure
that he does not make executive decisions.
(6 marks)

Circumstances where disclosure of confidential information is allowed:

With clients consent

In accordance with the provisions of any written law
For the purpose of discharging his duties to the client
Required by the court
To protect members interest
(5 marks)
(Total: 20 marks)

Question 2
A

a) Professional standards provide very little specific guidance on how to assess

what is material to a reasonable user. As a result, auditing firms should develop
policies and procedures to assist their auditors in establishing materiality
judgements for clients in order to minimize the variability of such judgements by
firm personnel. In other words, firm would prefer to have their auditors establish
similar materiality judgements for clients with similar circumstances.
(2 marks)
b) The scope of the audit will be affected by the auditors concept of materiality
because there should be stronger evidence to support an opinion with respect
to financial statement accounts that are relatively more important and financial
statements accounts in which possibilities of material misstatement are greater
than with respect to financial statements accounts of lesser importance of
financial statements accounts in which possibility of material misstatement is
remote. Materiality is used as a criterion for determining the items that are to
receive limited attention in terms of either the conclusiveness of evidence
gathered or the extent of the items examined. In the execution of the audit
program, materiality is used to evaluate any misstatements discovered.
(5 marks)
c) Acceptable Audit Risk is a measure of how willing the auditor is to accept that
the financial statements may be materially misstated after the audit is
completed and an unqualified opinion has been issued.
Acceptable audit risk has an inverse relationship to evidence. If acceptable
audit isk is reduced, planned evidence should increase.
(4
marks)

B.

a) Inherent risk should be increased for the Saga Finance Bhd. for the following
reasons. First, the audit firm has been the companys auditors for only two years.
Second, there has been contentious accounting issues related to provision for loan
loss and the value of collateral. Third, prior audits have indicated the presence of
misstatements in the doubtful loan provision. Based on these inherent risk factors,
detection risk should be set lower and increased substantive tests performed.
(3 marks)

b) Two factors are particularly important in assessing inherent risk for Megat
Services:
Firstly, the decision making in the company is dominated by one individual who
also has majority control of the shares. This factor should lead to a higher
assessment for inherent risk because there is no review of important decisions
and actions may be taken that are not in the best interest of the company or its
shareholders.
Secondly, Megat Services is expanding rapidly. Such expansion may result in
material misstatements since decision-making may become decentralized
without adequate monitoring. This expansion may also affect control risk, since
the companys control systems may be unable to keep up with the expansion of
operations. The increase in inherent risk due to these two factors will result in a
lower determination of detection risk and an increase in the scope of auditors
work.
(3 marks)
c)

A number of inherent risk factors are present for Good Stores. First, the
company is experiencing a slowdown in sales. Seconds, there has been
turnover in two financial positions within the company. Third, the chairman of
the company is aggressive and places undue emphasis on meeting earnings
expectations. These factors lead to an increased assessment for inherent risk,
resulting in a lower assessment of detection risk and more substantive testing.
(3 marks)
(Total: 20

marks)
Question 3
A.

a) Major internal control deficiencies in the above system

Cash receipt from customer must be approved by an officer.
Daily reconciliations was inefficient
Borrowing arrangement of Cashiers personal cash.
Lack of physical control over cash whereby the pad lock used by the cashier
was previously used by other staff, who could have duplicated the key.
Staff with previous track record of cash shortages and currently facing
financial difficulties was still allowed to handle cash transactions.
Cashier was allowed to keep huge amount of cash without proper control.
Cash count conducted by the internal auditor was not witnessed by the
custodian i.e., the Cashier.
(Any 5 x 1m = 5 marks)
b)

Additional audit procedures:

c)

Review the procedures for processing of cash payments & receipts,

balancing of cash and cash transfer between the Chief cashier and the
Cashier.
Inquire the other staff on whether they are aware that the Cashiers cash
was conducted by the internal auditor in his presence or not.
Perform analytical review to identify the usual cash balance held by the
Cashier at the end of the day.
Review the video recording on the day of the incident if a surveillance
camera is installed near the Cashiers work area.
Review the audit trail of all cash payments and cash receipts during the day
and identify unusual transactions of the same amount.
Review the supporting documents for unusual transactions noted.
Trace evidence of acknowledgement of cash by the customer.
Check whether cash receipts were duly recorded by the Cashier on the
relevant documents.
(Any 5 x 1m = 5 marks)
Preventive measures:
There should be clear written procedures regarding the handling of cash.
Staff with previous track record of cash shortages should not be assigned to
undertake the responsibility as a Cashier.
The company should refrain from assigning staff with financial difficulties to
be the custodian of cash.
Transfer of cash between Chief Cashier and the Cashier should be updated
in the computer system immediately.
Approval for cash payment should not be made on a post-fact basis.
Surprise cash count should always be conducted in the presence of the cash
custodian.
Surveillance camera should be installed in the work area of the cashier to
facilitate fraud investigation.
(Any 5 x 1m = 5 marks)

The potential benefits for using microcomputer software in an audit include the
following:
Time may be saved by eliminating manual casting, cross-casting and other
routine calculations.
Calculations, comparisons and other data manipulations are performed
more accurately.
Analytical procedures calculations may be performed more efficiently.
The scope of analytical procedures may be broadened.
Preparation and revision of flowcharts depicting the flow of financial
transactions in a clients system may be facilitated.
Supervisory review time may be reduced.
Computer-generated working papers are generally more legible and
consistent.
(OR any other acceptable answers @ 5 marks = 5 marks)

(Total: 20 marks)

Question 4
A.

a) Circumstances that may affect the auditors opinion on the financial

statements are:
1.
Inability to carry out the necessary audit procedures thus resulting in
lack of audit evidence. Inability to obtain all the required information and
explanations will require auditor to issue qualified or disclaimer report.
2. Non compliance with approved accounting standards, depending on
materiality, the auditors report would be qualified or adverse.
3. Going Concern and significant uncertainty.
4. Departure from an approved accounting standard.
5. Accounting and other records not properly kept adverse opinion on the
accounting and other records.
(5 marks)
b) The purpose of the scope paragraph in the auditors report is to inform the
financial statement users that the audit was conducted in accordance with
approved auditing standards and whether the audit provides a reasonable
basis for an opinion.
The information in the scope paragraph includes:
1. The auditor followed approved auditing standards.
2. The audit is designed to obtain reasonable assurance about whether
the statements are free of material misstatement.
3. Discussion of the audit evidence accumulated.
4. Statement that the auditor believes the evidence accumulated was
appropriate for the circumstances to express the opinion presented.
(4 marks)
c) The audit report date indicates to the user the last day of the auditors
responsibility for the review of significant events, such as sale of a division or
the issuance of bonds, that have occurred after the date of the financial
statements.
(2 marks)

B.

Nita has an obligation to make inquiries or conduct audit procedures to identify or

search for subsequent events between the balance sheet date and the date of
the auditors report. A major customer, Chen Construction went into bankruptcy
after the year end and since management has indicated that no amendments
would be made to the financial statements, Nita should issue an except for
opinion. This is due to the fact there is a disagreement between the auditor and
the client in providing for the material understatement amount of uncollectible
debts (bankruptcy of Chen Construction). 10% of total accounts receivable and
13% of income before tax hence material.
(5
marks)

C.

Courses of action

Auditor should discuss the matter with the management and obtain
further clarification on the amount of inventories held at year end.

If after the discussion it is established that the facts are correct, then the
auditor should determine whether the financial statement need to be amended.

If amendment is necessary and management amends accordingly, then

the auditors opinion will not be affected. However, an emphasis of matter might
be rendered if the amount of inventories results in significant uncertainty to the
auditor.

If management does not amend the financial statements accordingly, this

will result in the auditor rendering a qualified opinion due to limitation on the
scope of audit (unable to verify the amount of inventories by the usual and other
audit procedures.
(4
marks)
(Total: 20 marks)

Question 5
A.

(a) The public accounting firm, Mokhtar, Leong & Co., is potentially liable to its
client because of the possible negligence existed. The audit senior-in-charge
apparently has failed in carrying out his duties within the scope of his
employment. To be successful in a legal action for negligence, the following 4
elements must be proven:
The auditors owed a duty of care
The auditors breached the duty of care
Plaintiff suffered financial loss
There is a causal relationship between the breach and his financial loss
The main issue here is whether the duty of reasonable care was breach when
the senior-in-charge failed to probe further the twenty disbursements without
receiving reports. The senior-in-charge of the audit is governed by the usual
professional standards in auditing, that is, he should perform his duties according
to the requirements of the prevailing standards. However, when the exceptions in
the purchase and disbursements transactions were brought to his attention, he
did not investigate further. The exceptions in this case constituted 8 % of the
vouchers payable examined, it is therefore questionable whether he has
conducted the audit properly and obtained the necessary audit evidence.
On the question of causal relationship, the plaintiff would have to substantiate
whether further actions by the senior-in-charge would have disclosed the fraud. If
the plaintiff can establish both the lack of due care and causal relationship,
recovery for negligence will be available. If there were a finding of negligence,
liability would be limited to those losses that would have been avoided if
reasonable care has been exercised by the senior-in-charge.
(8 marks)

(b) A privity letter is one issued by an auditor, acknowledging a third partys

reliance on an audited financial report. The purpose of the letter is to establish a
relationship with required foreseeability and proximity and thus a duty of care by
the auditor to the third party. A decision to issue such a letter is an individual
business risk and management decision.
(4
marks)
B.

The independence of the auditor might be strengthened and improved in several

ways and there has been much recent discussion among the accountancy
bodies on this subject. One area for discussion is, whether the provision of
other services detracts from an objective approach to an audit.
These other services could include accountancy, consultancy, taxation etc. Such
services should be charged separately from audit work and the auditors
involvement must be advisory only. He must not perform executive functions or
make executive decisions. The prohibition of other services would clearly affect
the small company particularly in a detrimental way as it often relies on its
auditors for this type of support.
Other changes proposed include:
the rotation of auditors on, say, a 3years cycle. However, this would prove
costly as additional time would be required at the start of each new cycle
for each firm to familiarize itself with the client and its systems, staff etc.
the compulsory peer review of the work of one audit firm by another audit
firm. This raises questions of possible breaches of the confidentiality
principle as well as uncertainty as to who will pay for the review.
Compulsory audit committees for every company subject to audit. It is
common for large listed companies to operate an audit committee of nonexecutive directors supervising the audit process, but less common
among smaller and unquoted companies.
(OR any other relevant suggestions. 3 x 2 marks each= 6 marks)
(8 marks)
(Total: 20 marks)