Answers
Part 3 Examination – Paper 3.1 (INT)
Audit and Assurance Services (International Stream)
1 HYDRASPORTS
(a) (i) Business risks
Tutorial note: As part (ii) is clearly related in the requirement to part (i), it is appropriate that a ‘tabular’ approach be
adopted.
■ The standard design of facilities increases operational
risk as any difficulties encountered in one facility will be
compounded by the number of other facilities (potentially
all) which are similarly affected. This is illustrated by the
closure of the saunas.
■ Tutorial note: Standard design may also reduce risk as
it results in a higher quality ‘product’.
■ Centralised control through company policy is resulting
in inefficient and ineffective operations as managers
cannot respond on a timely basis to local needs.
■ Business reporting risk is likely to be increased by centre
managers preparing monthly accounting returns.
Operational risk may be increased if centre managers
cannot fulfil their day-to-day responsibilities (e.g. relating
to customer satisfaction, human resources, health and
safety).
■ Advanced payments contribute to business reporting and
financial (cash flow) risk. Cash received must be
available to meet the costs of providing future services.
■ Hydrasports cannot operate a centre if a licence is
suspended, withdrawn or not renewed (e.g. through
failing a local authority inspection or failing to apply for
renewal).
■ Closure may result in customers finding alternative
facilities with permanent loss of fee revenue.
■ ‘Early bird’ customers disatisfaction similarly increases
operational risk.
9
December 2003 Answers
(ii) Financial statement risk
■ The carrying amount of the associated non-current
assets (i.e. equipment, fixtures and fittings) is likely to be
overstated as they are likely to be impaired if they are not
in use.
■ Management circumvention or override of control
procedures laid down by head office may result in
system weaknesses. If errors arising are not detected
and corrected the risk of misstatement in the financial
statements is increased.
■ Information processing risk is increased as accounting
information flowing into the financial statements may not
be properly captured, input, processed or output by the
centre managers.
■ Inherent risk, of errors arising, in monthly ‘branch’
returns is high.
■ Revenue may be overstated if an accurate cutoff is not
achieved. In particular, there is an estimate risk in
determining the amount of deferred income at the
balance sheet date.
■ An error of principle may also arise if Hydrasports’
revenue recognition policy does not comply with IAS 18
‘Revenue’.
■ An error of principle arises if licences are not capitalised
as intangible assets (but instead written off as expenses
when incurred).
■ Intangible assets (licences) should be reviewed for
impairment at each balance sheet date (e.g. for centres
which are closed).
■ Failure risk (i.e. that Hydrasports will not continue to
operate as a going concern) is increased.
■ This creates disclosure risk if the disclosures relating to
going concern as the basis of accounting do not meet the
requirements of IAS 1 ‘Presentation of Financial
Statements’.
■ Serious accidents may prompt investigation by local
authority – resulting in penalties, fines and/or withdrawal
of licence to operate.
■ Although fees are non-refundable, suspension of a
facility (e.g. sauna) may result in customers asking for
partial refund. In particular Hydrasports may have an
obligation to refund fees paid in advance when centres
are closed (e.g. the Verne centre from July–September
2003).
■ Permanent loss of customers requiring childcare facilities
increases operating risk. Compliance risk is increased if
the new guidelines are not met.
■ Similarly, inability to retain lifeguards increases
operational risk that pools cannot open (due to health
and safety regulations). Compliance risk is increased by
the possibility that pools may be operated without a
lifeguard being on duty.
■ High staff turnover indicates increased operational risk
(poor human resource management, inefficiency in
working practices, reduced capacity, etc).
■ Limitations on centre managers’ levels of authority may
not be commensurate with their responsibilities.
Empowerment risk arises if managers are not properly
led (and if they, in turn, do not properly lead their centre
staff).
■ More centres may become loss-making if the reasons for
falling membership are not addressed.
■ The hydrotherapy pool cannot operate until construction
is completed and completion may be threatened by cash
flow difficulties.
■ Cash flow difficulties increase liquidity/financial risk.
■ Obsolete gym equipment increases operational risk as
customer satisfaction decreases and health and safety
risks are increased.
■ The reduction in insurance cover reduces the recoverable
amount of assets in the event of loss through fire (for
example). Inability to replace lost/damaged assets
increases operational risk (see obsolete gym equipment
above).
■ Operational risk is increased if the substantial increase in
liability insurance premiums is a reflection of an increase
in the level of claims being made.
10
■ If licences are withdrawn, the intangible asset (amounts
prepaid) should be written off to the extent that monies
are not refundable.
■ The likelihood of contingent (if not actual) liabilities
increases disclosure risk.
■ Provisions may be understated at 31 December 2003 if
Hydrasports has a legal obligation to refund fees where
it has failed to provide services.
■ Disclosure risk is (again) increased if fines/penalties
arising are material and not disclosed.
■ Staff costs may be overstated as the risk that payments
may be made to leavers is increased.
■ Any lack of integrity may increase the risk of
management and/or employee fraud, illegal acts and
unauthorised use of company assets. In particular the
assertion of existence of assets may be at risk (resulting
in overstatement).
■ Loss-making centres should be tested for impairment as
cash-generating units.
■ The value of the asset in construction should be written
down if it is impaired (even though it has not yet been
brought into use).
■ See above reference to going concern and disclosure
risk.
■ Depreciation may be overstated if Hydrasports continues
to calculate depreciation on fully-depreciated assets.
■ Disclosures for capital commitments (e.g. to replace
equipment) in the financial statements may be
inappropriate if Hydrasports does not have funds to
finance such commitments.
■ See above reference to going concern and disclosure
risk.
■ Disclosure risk is increased in relation to contingent
assets (for reimbursement under insurance policies).
(b) Principal audit work
Deferred income

■ Agreeing Hydrasports’ analysis of joining fee and peak/off-peak membership fees on a sample basis.
■ Tutorial note: Initial joining fees should not be deferred but recognised when received.
■ Reconciling membership income to fees paid. If customers can renew their membership without payment there should
be no deferral of income (unless the debt for unpaid fees is also recognised).
■ Assessing the collectibility of unpaid fees (if any) by reviewing after date receipts and correspondence with members.
■ Recomputing the deferred income element of fees received in the three months before the balance sheet date.
■ Comparison of year-end balance with prior year and investigation of variance.

Hydrotherapy pool
■ Verifying the initial cost of this constructed asset will include an examination of:
– the contract with the builder
– contractors billings; and
– stage payments.
■ Hydrasports is likely to be advised by its own expert (a quantity surveyor) on how the contract is progressing. Audit work
will include a review of the expert’s assessment of stage of completion as at the balance sheet date, estimated costs to
completion, etc.

■ Physical inspection of the construction at the year end to confirm work to date and assess the reasonableness of stage of
completion.

■ Borrowing costs associated with this substantial (‘heavy’) investment should be agreed to finance terms and payments.
The calculation of any amount capitalised should be recomputed to confirm accuracy.

■ The basis of capitalisation, if any, should be agreed to comply with IAS 23 ‘Borrowing Costs’ (e.g. interest accruing during
any suspension of building work should not be capitalised).

■ As the construction has already cost twice as much as budgeted, its value in use (when brought into use) may be less
than cost. Management’s assessment of possible impairment (of the hydrotherapy pool and the centre) should be critically
appraised.

Tutorial note: The asset should not yet be subject to depreciation as it has still to be brought into use.

(c) Performance indicators – social/environmental responsibility

Member satisfaction
■ Number of people on membership waiting lists (if any).
■ Number of referrals/recommendations to club membership by existing members.
■ Proportion of renewed memberships.
■ Actual members: 100% capacity membership (sub-analysed between ‘peak’ and ‘off-peak’).

Membership dissatisfaction
■ Proportion of members requesting refunds per month/quarter.
■ Proportion of memberships ‘lapsing’ (i.e. not renewed).

Staff
■ Average number of staff employed per month.
■ Number of starters/leavers per month.
■ Staff turnover/average duration of employment.
■ Number of training courses for lifeguards per annum.
■ Average hourly (weekly) wage: average national hourly (weekly) wage (or national minimum).

Predictability
■ Number of late openings (say more than 5, 15 and 30 minutes after advertised opening times).
■ Number of days closure per month/year of each facility (i.e. pool, crèche, sauna, gym) and centre.

11
Safety
■ Incidents reports documenting the date, time and nature of each incident, the extent of damage and/or personal injury,
and action taken.
■ Number of accident free days.

Other society
■ Local community involvement (e.g. facilities offered to schools and clubs at discount rates during ‘off-peak’ times).
■ Range of facilities offered specifically to pensioners, mothers and babies, disabled patrons, etc.
■ Participation in the wider community (e.g. providing facilities to support sponsored charity events).

Environment
■ Number of instances of non-compliance with legislation/regulations (e.g. on chemical spills).
■ Energy efficiency (e.g. in maintaining pool at a given temperature throughout the year).
■ Incentives for environmental friendliness such as discouraging use of cars/promoting use of bicycles (e.g. by providing
secure lock-ups for cycles and restricted car parking facilities).

Evidence
Tutorial note: As there is a wide range of measures of operational performance which candidates could suggest, there is
always a wide range of possible sources of audit evidence. As the same evidence may contribute to providing assurance on
more than one measure they are not tabulated here, to avoid duplication. However, candidates may justifiably adopt a
tabular layout.
■ Membership registers clearly distinguishing between new and renewed members, also showing lapsed memberships.
■ Pool/gym timetables – showing sessions set aside for ‘over 60s’, ‘ladies only’, schools, clubs, special events, etc.
■ Staff training courses and costs.
■ Staff timesheets – showing arrival/departure times and adherence to staff rotas.
■ Documents supporting additions to/deletions from payroll standing data (e.g. new joiner/leaver notifications).
■ Engineer’s inspection reports – confirming gym equipment, etc is in satisfactory working order. Also, engineer and safety
check manuals and the maintenance program.
■ Levels of expenditure on repairs and maintenance.
■ Energy saving equipment/measures (e.g. insulated pool covering).
■ Safety drill reports (e.g. alarm tests, pool evacuations).
■ Accident report register – showing date, nature of incident, personal injury sustained (if any), action taken (e.g. emergency
services called in).
■ Any penalties/fines imposed by the local authorities and the reasons for them.
■ Copies of reports of local authority investigations.
■ The frequency and nature of insurance claims (e.g. to settle claims of injury to members and/or staff).

12
2 PACIFIC GROUP
(a) Applicable vs non-applicable risks
(i) Lack of investment – Applicable risk
PG has a strategy of following developments rather
than setting the pace for the industry (by keeping
the product up to date with competitor products).
PG’s business success therefore depends on a
timely awareness of competitors’ activities.
Failure to respond to innovations in the market
place (e.g. in graphic design) will threaten
advertising revenues.
(ii) Uncreditworthy customers – non-applicable
It is in the nature of providing goods/services on
credit terms that a proportion of revenue will not be
collectible (i.e. the risk of bad debts is one which
can be reasonably borne).
Given the large number of advertising customers it
is unlikely that additional controls would be cost
effective.
(iii) Incomplete data transfer – Applicable risk
Invoices will be incomplete/inaccurate if data
transfer is incomplete. There is a lack of controls to
prevent what should be judged to be potentially
significant (as advertising revenues are very
material).
(iv) Non-charges – Applicable risk
Individual advertisements are not significant (being
<$5,000). However, failure to recognise four
pages of advertising negotiated as ‘barter
transactions’ (even allowing for 25% discounts)
would exceed this amount.
As barter transactions become increasingly popular
within the advertising industry, controls will be
required to ensure that revenues and costs are not
understated.
If material, there is a risk of non-compliance with
financial reporting requirements (SIC 31).
13
(b) Internal controls (only FOUR appplicable risks
are required to be addressed)
Tutorial note: Remember that not all controls are
preventative! Some should detect (so as to correct!) things
that have ‘gone wrong’.
■ Monthly review and monitoring of developments in
competitor publications (e.g. ‘The Deep’) relating to the
presentation of advertisements.
■ Monthly comparison of actual development expenses
against budget – to see the extent to which the expected
level of investment in development is being made.
Tutorial note: If, alternatively, this is judged to be an
applicable risk additional internal controls suggested might
include:
– independent creditworthiness checks (e.g. against
agency credit ratings);
– authorisation of credit limits to ensure they are not set
too high;
– independent review of aged-debt analysis to identify
slow-payers;
– monitoring of the bad debt expense in relation to
turnover.
■ Serial numbering of advertisements by editorial
department and sequence checking by invoicing
department.
■ Monthly reconciliations of actual invoiced amounts to
expected advertising revenue (based on number of pages
of advertisements) and investigation of shortfalls.
■ Monitoring of instances of incomplete/inaccurate data
transfer – how identified, reason for occurrence,
amounts involved, how rectified.
■ Monitoring of advertising ‘yields’ (i.e. revenue generated
to advertising space available).
■ Comparison of PG’s own advertising expenditure against
budget (to identify potential for unrecorded costs).
 (v) Inaccurate production – non-applicable Tutorial note: Advertisements cannot be guaranteed to be
error-free as ‘typos’1 cannot be wholly avoided. This is
Individual advertisements are less than $5,000
therefore another example of a risk that can be accepted at
(even if a multiple placement is wrong in the first
a level commensurate with the level of day to day business.
instance it should be corrected for any repeats).

(vi) Misappropriated cash – Applicable risk

Cash receipts are significant and prone to theft –
resulting in the loss of assets. Also, accounts
receivable may be overstated if cash receipts from
credit customers are unrecorded – resulting in loss
of customer goodwill if they are chased for non-
payment when they have settled amounts due.
Any lack of quality (integrity) in PG’s people may
damage PG’s reputation.
■ Two people should ‘man’ the front desk at all times.
A duty log should be kept (date, time, staff member).
■ The desk must not be left unattended while cash is held
there.
■ All cash received from customers should be counted and
recorded and a signed, pre-numbered receipt given to
the customer.

■ Cash and a copy of the signed receipt should be

transferred, securely, to cashiers.

■ The existence of CCTV at the front desk should be made

evident, to act as a deterrent.

(vii) Unauthorised access – non-applicable
The potential for deliberate or intentional error
arising from unauthorised access to the editorial
and invoicing systems is relatively unlikely as basic
CIS controls should be expected to be in place.
Tutorial note: If, alternatively, this is judged to be an
applicable risk suitable controls might include:
– physical and logical access controls; and
– computer logs of attempted and unauthorised access
(e.g. outside normal working hours).

(viii) Systems not available – Applicable risk

Unavailability of the editorial system is judged the
more significant as, if advertisements do not get
published on a timely basis, customers may not pay
and/or take their future business elsewhere.
■ Back up/recovery/contingency plans must be in place to
ensure that PG can receive and process advertisements
even when its computer systems are unavailable.
■ Salvage plans for continuing operations should be tested.
For example, in the event of an office fire, PG may have
an arrangement with a third party to outsource the
editorial production of the advertisements (and
magazine) to them.

(ix) Transfer accounting information – non-applicable 2 Tutorial note: If judged to be applicable suitable controls
might (again) include such monitoring controls as sales
Although potentially significant to reported results it
control account reconciliations and a review of gross
is unlikely to affect PG’s financial strength (for
margins.
example). Also the process is computerised and
there are no other potential risks which suggest a
lack of programmed controls.

(x) Risk of litigation – Applicable risk

Although PG might be expected to have insurance
adequate to cover the financial costs of being sued
for printing advertisements which do not meet the
‘Code of Advertising’, it is unlikely that this would be
sufficient to cover reputational risk.
■ PG’s policy on adhering to the ‘Code of Advertising’
should be communicated to all editorial staff.
■ Any doubts about the propriety of an advertisement
should be raised with a responsible official before it is
authorised for publication.

Tutorial note: Some of the potential risks are more clearly ‘applicable’ than others. Candidates will be given credit for all
well reasoned arguments.
——————
1 Typographical errors
2 It could be argued that although this is likely to be non-applicable in an ‘off-the-shelf’ system it is more likely to be applicable in a
2 bespoke (i.e. tailored) system.

14
3 VEMA

(a) Change in depreciation method

(i) Matters
■ The depreciation charge for the year has been reduced by $1·3m ($4·2m – $2·9m) as a result of the change,
therefore reported profit before tax has been increased by 10·5% ($1·3m ÷ $12·4m
0·105) and is therefore
material.
Tutorial note: Alternative calculation, $1·3m ÷ $(12·4m – 1·3m) ⇒ 11·7%
■ The write back to reserves (prior period adjustment) is 4·3% ($4·7m ÷ $110m
0·043) of total assets and
therefore material.
Tutorial note: It is not appropriate to gauge the materiality of this item against PBT as it represents a balance sheet
adjustment and has no bearing on the income statement.
■ The net book value of tangible non-current assets has been uplifted by $6·0m ($1·3m + $4·7m) which is 5·5% of
total assets and, again, material.
■ Management is responsible for reviewing the useful life of tangible non-current assets periodically and, if significantly
different, adjusting the depreciation charge for the current and future periods (IAS 16 ‘Property, Plant and
Equipment’).
Tutorial example: Two-year old vehicles at the beginning of the period, which management now estimate to have
a remaining useful life of a further two years from the end of the current period (i.e. five years in total):
– opening balance = 1/3 of cost (2/3 having already been depreciated)
– current period charge = 1/3 opening balance (writing off balance over next three years).
■ Management is also responsible for reviewing the depreciation method periodically and changing it, if necessary, to
reflect the change in expected pattern in economic benefits. This is accounted for as a change in accounting estimate
(i.e. adjusted through current and future periods’ depreciation charge).
■ Management’s restatement of opening reserves is the treatment for a change in accounting policy or the correction
of a [fundamental] error (IAS 8 ‘Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting
Policies’). This is incorrect. The change in depreciation method is a change in accounting estimate, which, by
nature, is an approximation.
Tutorial note: The measurement basis ‘depreciated cost’ has not changed.
■ The audit opinion should be qualified ‘except for’ non-compliance with IASs 8 and 16 unless the write back to
opening reserves is removed and the current year charge is recalculated on the remaining useful lives (and not as
currently calculated, retrospectively, as though the new method had always been applied).

(ii) Audit evidence

■ Agreement of opening balances of cost, accumulated depreciation and net book value to prior year working papers
and financial statements.
■ Client’s schedules showing remaining useful lives with current year depreciation calculated at 25% of brought
forward reduced balance (25% cost on additions in the period).
Tutorial note: If Vema’s management was not prepared to provide these calculations, the auditor would need to
estimate what the correct depreciation charge for the current year should be, to quantify the extent of their
disagreement.
■ A ‘proof in total’ calculation of what the depreciation charge for the year under the new basis should be (i.e. 25% ×
(opening NBV + Additions – NBV of disposals)).
■ Test checking a sample of remaining useful lives per client’s schedules to the fixed asset register.
■ Review of Vema’s fleet vehicle replacement policy (e.g. as documented in an operational manual for fleet managers).
■ Review of age of fleet assets disposed of during the year – to check for consistency with assertion that this is now
every 4 to 7 years.
■ Scrutiny of profits/losses on disposals of vehicles – should expect to have consistently reported profits if they are
currently depreciated too quickly.

15
(b) Termination payment

(i) Matters
■ $786,000 represents 6·3% of profit before tax and is therefore material. (However, it is not material to the balance
sheet, being only 0·7% of total assets.)
Tutorial note: It is more meaningful to assess the impact of the gross amount on the financial statements rather
than the net payment to the former director.
■ Mr Z was made redundant in the previous accounting period (to 30 September 2002) and the after-date payment,
in December 2002, was therefore a subsequent event.
■ If the audit for the year ended 30 September 2002 was not finished when the termination payment was made, it
should have already been accounted for, i.e. the liability recognised (IAS 10 ‘Events After the Balance Sheet Date’).
■ If the liability should have been known about, but was omitted from the prior year financial statement, the error
should be corrected by a restatement of opening reserves.
■ It is not unusual that such a ‘sensitive’ transaction be accounted for using a journal entry, rather than processed
through a payroll, especially as Mr Z should have been removed from the payroll last year.
Tutorial note: This avoids drawing staff’s attention to the payment.
■ The ‘golden handshake’ has been ‘lost’ in administrative expenses. Although it may not be considered sufficiently
material to warrant separate presentation on the face of the income statement it appears sufficiently material to be
presented separately in the notes (IAS 1 ‘Presentation of Financial Statements’).
■ As a regional director Mr Z would have been a related party (key management personnel), making the payment to
him a related party transaction. The amount should therefore be disclosed in the notes to the financial statements
(IAS 24 ‘Related Party Disclosures’).
■ Whether the $194,000 included within ‘Other liabilities’ represents the accurate deduction of tax/social security
contributions or a balance due to Mr Z.

(ii) Audit evidence

■ Documentation in last year’s working papers concerning provisions made for redundancies arising from the regional
re-organisation.
■ The bank payment $592,000 in December 2002.
■ Settlement during the year to 30 September 2003 of $194,000. For example, inclusion of this amount in payments
of tax deducted at source/‘pay as you earn’ and a notification of receipt from the relevant taxation authority.
■ Mr Z’s employment contract and director’s service contract, in which the terms of the termination payment were set
out.
■ Any correspondence with Mr Z. For example, a letter accompanying the payment of $592,000 stating that it is in
full and final settlement of the termination of his employment.
■ Written management representation that there are no payments to current or former directors relating to the current
or prior period which have not been included in the financial statements.
Tutorial note: A management representation supporting the assertion of completeness of transactions and events.

(c) Legal liability

(i) Matter
■ Although Weddell contributes a mere 3·2% of Vema’s profit before taxation, it comprises 31% of total assets. The
subsidiary is therefore material to the consolidated financial statements.
■ The amount of the contingent liability disclosed is immaterial to Vema being 1·6% of Vema’s profit before taxation
and less than 0·2% of total assets.
Tutorial note: Although it is 50% of Weddell’s profit before taxation it may not be considered material even in
Weddell’s financial statements as it represents only 0·6% of the company’s total assets. Materiality in relation to
PBT is distorted because the company is reporting a near break-even position.
■ The amount of the legal liability for costs and damages not provided for is material to Vema, being 8·9% of Vema’s
profit before taxation (and 1% of total assets). (It is 3·2% of Weddell’s total assets and would turn its reported profit
into a loss.)
■ The court’s verdict in November was an adjusting post balance sheet event – providing additional evidence regarding
the amount and likelihood of settlement of a liability. It should therefore be adjusted for – i.e. the liability recognised.

16
 ■ The lodgement of an appeal is also a post balance sheet event – however it is non-adjusting – arising from a condition
that did not exist at the balance sheet date (the court hearing).
■ As Weddell is a subsidiary it is, by definition, controlled by Vema and the management of Weddell can be told to
adjust the subsidiary’s financial statements.
Tutorial note: It is unlikely that Weddell’s statutory accounts will have been finalised/filed before Vema’s.
■ If no adjustment is made in Weddell’s financial statements the auditor’s report thereon should be qualified ‘except
for’ on grounds of disagreement about the amount and nature of a liability (being actual rather than contingent).
Tutorial note: Although this is not the responsibility of the primary auditor – the ‘other’ auditor’s opinion is one
source of evidence available to the primary auditor.
■ If the amount is not adjusted in Weddell’s financial statements, an adjustment should be made by Vema’s
management on consolidation (otherwise the audit opinion on the consolidated financial statements would need to
be qualified ‘except for’ non-compliance with IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’).

(ii) Audit evidence

■ The official notification of the court’s ruling.
■ A copy of the appeal lodged with the court.
■ Legal advice regarding the possible success of the appeal.
■ Copy correspondence with legal advisers including a copy of the external confirmation letter obtained by Weddell’s
auditor.
■ Consolidation/reporting pack from Weddell and their local auditor’s report thereon (if applicable).
■ The local firm’s auditor’s report on the financial statements of Weddell, when available.
Tutorial note: This should be before the auditor’s report on Vema’s consolidated financial statements is signed.

4 FRAZIL

(a) Auditor’s responsibilities for reporting on compliance with IFRSs

It has long been established that:
■ the auditor’s principal responsibility for reporting (generally) is to express an opinion on whether the financial statements
are prepared, in all material respects, in accordance with an identified financial reporting framework (ISA 200 ‘Objective
and General Principles Governing an Audit of Financial Statements’);
■ the auditor’s report must clearly indicate the financial reporting framework used to prepare the financial statements (ISA
700 ‘The Auditor’s Report on Financial Statements’).
Specifically, auditor’s responsibilities for ‘reporting on compliance with IFRSs’ are set out in the International Auditing Practice
Statement ‘Reporting on Compliance with International Financial Reporting Standards’ (IAPS 1014) issued by IFAC’s
International Auditing and Assurance Standards Board (IAASB).

(i) Only IFRSs

The auditor should be alert to indicators of non-compliance. In the event of any material departure the auditor is
responsible for giving a qualified ‘except for’ or ‘adverse’ opinion, on the grounds of disagreement – unless management
changes the accounting policy and/or disclosure, as necessary, in order to comply with IFRSs.

(ii) Both IFRSs and national standards or practices

For an unqualified opinion to be justified, the financial statements will need to comply with both frameworks,
simultaneously, without need for reconciliation. (This will be rare. For example, where IFRS has been adopted as the
national reporting framework.)
The auditor is responsible for determining which is the predominant framework and encouraging management to report
only in that framework. If the problem is not removed in this way the auditor reports on each framework (qualifying the
audit opinion on at least one).

(iii) National standards or practices with disclosure of extent of compliance

As with any assertion the auditor must consider whether assertions made in the notes with respect to the extent of such
compliance are factually correct and not misleading. If disclosures are misleading, the auditor’s report expresses a
qualified or adverse opinion, unless the comment on compliance is removed.

17
(b) Implications for the auditor’s report
(i) Non-compliance with IAS 38
According to IAS 1 ‘Presentation of Financial Statements’, ‘fair presentation’ requires that financial statements should not
be described as complying with IFRSs unless they comply with all the requirements of each applicable:
■ standard; AND
■ IFRIC interpretation.
IAS 38 ‘Intangible Assets’ requires that development costs which meet all the specific criteria (e.g. technical feasibility)
for asset recognition MUST be recognised as an asset and not expensed.
Tutorial note: The question does not call for the regurgitation of those criteria.

Total development costs expensed during the year represent 45% of reported profit before tax and are therefore material.
The $1·4 million which should have been capitalised represents:
■ 1·3% of total assets;
■ 38% of development costs incurred during the year; and
■ 17% of PBT.
Although clearly material to PBT it is not particularly material to the balance sheet. However, this is only the amount
which should be capitalised for the current year. If not adjusted for this year, it would be an unadjusted error, the
cumulative effect of which should be considered in the subsequent year.
Therefore, as there is clearly non-compliance, which is material, the financial statements do not comply with IFRS.
Management should be asked to:
■ increase intangible non-current assets by $1·4 million;
■ reduce development expenses by $1·4 million (thereby increasing profit to $9·6 million);
■ change the accounting policy note for development costs to state that an asset is recognised when certain criteria are
met.
In the absence of which the audit opinion should be qualified ‘except for’ disagreement – unless the assertion of
compliance with IFRS is deleted.
Tutorial notes:
(1) As there is no reason to suppose that the prior year policy was other than to expense as incurred, there is no
brought forward balance and IAS 38 transitional provisions are not retrospective.
(2) If, having capitalised the intangible asset, it is apparent that it is impaired, an appropriate impairment loss should
be recognised (even 100%).

(ii) Reporting on the Internet

■ The auditor’s duty of care is not extended solely by virtue of the report being published in an electronic form as well
as hard copy (i.e. manually signed financial statements).
Tutorial note: Although some commentators may argue contrary to this, this is what is asserted by recently issued
guidance (e.g. by IFAC, in UK, Australian AGS, etc).
■ The directors are primarily responsible for web-published financial statements (e.g. signing them). Management
should have an internet reporting policy to ensure the same integrity of financial information as that published in
traditional (i.e. paper) form.
■ Frazil’s management should be in discussion with the auditors to agree the extent to which audited information will
be included on the website (rather than ‘informing’ that the annual report is to be so published).
■ Audit procedures to check the information being presented electronically should include:
– reviewing the process by which the financial statements to be put on the web are derived from the financial
information contained in the manually signed financial statements (e.g. by conversion to PDF or HTML format);
– proofing the content of the electronic version against the hard copy;
– confirming that the auditor’s signature copied into an electronic medium is protected from modification;
– checking that the conversion has not distorted the overall presentation of the financial information.

18
 ■ It will be particularly important that it should be clear to all users of the financial information available from the
website which information has been audited and which has not. (Identification of what has been reported on with
page numbers is possible with pdf format, but there are no page numbers for html presentation of annual reports.)
All hyperlinks in and out of the audited financial statements should be ‘flagged’ (e.g. through a ‘secure site’
entering/leaving notification).
■ If the auditor’s report on the hardcopy financial statements refers to page numbers which are not supported by the
web-based version it will require amendment.
■ Management’s responsibility for implementing an appropriate security infrastructure should be acknowledged in the
management representation letter. This should encompass control procedures to reduce, as far as possible, the risk
that changes are not properly authorised, and ensure that all changes can be detected and monitored.
Tutorial note: Management’s responsibilities are not diminished when the enterprise uses a third party to maintain its
website – even though the maintenance of the website has been put in the hands of a third party, management cannot
‘outsource’ its responsibilities.

5 SEPIA

(a) ‘Professional enquiry’

Professional issues raised
Krill has a professional duty of confidentiality to its client, Squid. If Krill’s lack of response is due to Squid not having given
them permission to respond, Sepia should not accept the appointment. However, in this case, Anton Fargues should have:
– notified Squid’s management of the communication received from Sepia; and
– written to Sepia to decline to give information and state his reasons.
Krill should not have simply failed to respond.
Krill may have suspicions of some unlawful act (e.g. defrauding the taxation authority), but no proof, which they do not wish
to convey to Sepia in a written communication. However, Krill has had the opportunity of oral discussion with Sepia to convey
a matter which may provide grounds for the nomination being declined by Sepia.
Steps by Sepia
■ Obtain written representation from Squid’s management, that Krill & Co has been given Squid’s written permission to
respond to Sepia’s communication.
■ Send a further letter to Krill by a recorded delivery service (i.e. requiring a signature) which states that if a reply is not
received in the next seven days (say) Sepia will assume that there are no matters of which they should be aware and
so proceed to accept the appointment. (Advise also that unless a response is received, a written complaint will be made
to the relevant professional body.)
■ Make a written complaint to the disciplinary committee of the professional body of which Anton Fargues is a member –
so that his unprofessional conduct can be investigated.

(b) Take-over bid

Professional issues raised
■ Sepia has a professional duty of confidentiality to its existing audit client, Vitronella.
■ Vitronella may ask Sepia to give corporate finance advice on Hatchet’s take-over bid which would be incidental to the
audit relationship. Providing Sepia can maintain and demonstrate integrity and objectivity throughout, there would be
no objection to Sepia providing such an additional service, to advance their existing clients’ case.
■ It is often in a company’s best interests to have financial advice provided by their auditors, and there is nothing ethically
improper in this. So it seems unusual that Hatchet should have approached Sepia, rather than their current auditors.
■ ACCA’s ‘Rules of Professional Conduct’ consider that it would not be improper for an audit firm to audit two parties, even
if the take-over is contested, and that to cease to act could damage the client’s interests. However, the situation is
different here in that Sepia is not Hatchet’s auditor.
■ Sepia should take all reasonable steps to avoid conflicts of interest arising from new engagements and the possession
of confidential information. Sepia cannot therefore resign from Vitronella in order to undertake the advisory role for
Hatchet. (A relationship which has ended only in the last two years is still likely to constitute a conflict.)
Steps by Sepia
■ As it is clear that a material conflict of interest exists, Sepia should decline to act as adviser to Hatchet.
■ Advise Vitronella’s management that Hatchet’s approach has been declined.

19
 (c) Lowballing
Professional issues raised
‘Lowballing’ is a practice in which auditors compete for clients by reducing their fees for statutory audits. Lower audit fees
are compensated by the auditor carrying out more lucrative non-audit work (e.g. consultancy and tax advice).
The fact that Keratin has quoted a lower fee than the other tendering firms (if that is the case) is not improper providing that
the prospective client, Benthos, is not misled about:
– the precise range of services that the quoted fee is intended to cover; and
– the likely level of fees for any other work undertaken.
Although an admission to lowballing ‘Setting the early price in an arrangement at a low amount to secure business with the
intent later to raise the price’ may sound improper, it does not breach current ethical guidance providing Benthos understands
the situation. So, for example, Keratin could offer Benthos a ‘free’ first-year audit, providing Benthos appreciates what the
cost of future audits would be.
The risk is, that if the non-audit work does not materialise, Keratin may be under pressure to cut corners or resort to irregular
practices (e.g. the falsification of audit working papers) in order to ‘keep within budget’. If a situation of negligence (say) were
then to arise, Keratin could be found guilty of incompetence.
As the provision of other services is under scrutiny and becoming increasingly restricted this risk is likely to be high. For
example, non-audit services which are prohibited in the US include bookkeeping, financial information systems design and
implementation, valuation services, actuarial services, internal audit (outsourced), human resource services for executive
positions, investment and legal services.
Keratin may not be just lowballing on the first year audit fee, but in the longer term. Perhaps indicating that future increases
might only be in line with inflation. In this case if, rather than comprise the quality of the audit, Keratin were to substantially
increase Benthos’ audit fees, a fee dispute could arise. In this event Benthos could refuse to pay the higher fee. It might be
difficult then for Keratin to take the matter to arbitration if Benthos was misled.
Edwin is likely to be in breach of a duty of confidentiality to his employer.
Steps by Sepia
■ There are no steps which Sepia can take to prevent Benthos from awarding the tender to whichever firm it chooses.
■ If Keratin is successful in being awarded the tender, Sepia should consider its own policy on pricing in future competitive
tendering situations.
■ Sepia could report Edwin to ACCA for misconduct (breach of duty of confidentiality to employer).

6 PROFESSIONAL RESPONSIBILITIES AND LIABILITY

Tutorial note: The answer which follows is indicative of the range of points which might be made. Other relevant material will
be given suitable credit.

(a) External audit opinion

Responsibilities
Management is primarily responsible for the proper preparation and presentation of financial statements – and this is clearly
stated in the auditor’s report. The statutory auditor’s duty is to report, expressly, an opinion on a ‘true and fair view’ (or
‘presents fairly in all material respects’). In some jurisdictions this duty may extend to reporting expressly (as in the Republic
of Ireland) or by exception (as in Great Britain) on matters such as whether or not all information and explanations necessary
for audit purposes have been received.
The auditor’s report is addressed (usually) to the shareholders and it has long been established that the auditor is liable to
shareholders in cases of negligence.
Tutorial note: Cases which could be cited here include London and General Bank Ltd (1895); Re Kingston Cotton Mill
(1896); Re Thomas Gerrard & Son Ltd (1967).
Cases on liability to third parties have focused on the question of whether a duty of care is owed and the issue of foreseeability
(e.g. Donoghue v Stevenson (1932); Candler v Crane Christmas (1951); Hedley Byrne v Heller & Partners (1963); JEB
Fasteners v Marks Bloom (1981); Twomax Ltd v Dickson, McFarlane & Robinson (1983), Al Saudi Banque v Clarke Pixley
(1989)).
However, the case of Caparo Industries plc v Dickman and Others (1990) narrowed the scope of liability by introducing a
condition of ‘proximity of relationship’ into duty of care.

20
 Recent developments
In the US, the Sarbanes-Oxley Act, introduced in the wake of the Enron and Worldcom scandals, requires the principal
executives and finance officers (CEOs and CFOs) to certify that accounts of SEC-registered companies:
■ do not contain any untrue statements or omit anything that would be necessary for the report not to be misleading; and
■ fairly present the company’s financial position and results.
Such a demonstration of management’s responsibility may assist auditors in claiming that they are not liable in cases where
management is fraudulent. As a deterrent, wilful breach of this provision2 can result in a $5 million fine or 20 years
imprisonment (or both).
In the Bannerman case3, a Scottish court held that auditors could be held to have a duty of care to a third party (in this case
a lending bank) if they knew, or ought to know, that the bank would rely on audited accounts and they did not disclaim
liability. The ‘knew or ought to have known’ principle is the same as in pre-Caparo cases (above). What is different about
the Bannerman case is that the auditor’s failure to disclaim liability was what supported the existence of the duty of care.
Impact on professional liability
The auditor’s responsibility to conduct an audit in accordance with auditing standards is unchanged. However, liability to
third parties is clearly increased if the auditor does not disclaim such liability. This is not to be confused with:
■ a disclaimer of liability to shareholders; or
■ the disclaimer of an audit opinion in accordance with ISA 700 ‘The Auditor’s Report on Financial Statements’.
Auditors wishing to manage the risk of liability to third parties are advised to include a separate disclaimer of such
responsibility, at the same time stating that the auditor’s report is to the shareholders (as a body) and that audit work is
undertaken solely for that purpose.

(b) Internal financial controls

Responsibilities
Risk management is the primary responsibility of management – whose fiduciary duties include the safeguarding of assets
and ensuring the completeness and accuracy of financial records. Internal audit provides objective assurance and advice to
boards, especially the non-executive directors, on the effectiveness of the risk management processes and the ways in which
risks are managed and controlled.
In accordance with existing auditing standards, the external auditor is required to make a preliminary assessment of internal
controls and to test them if seeking to place reliance on them as audit evidence.
Developments
There has been much debate concerning reporting, in the public interest, statements by directors of listed companies. UK
Listing Rules (for example) require that auditors review the effectiveness of management’s systems of internal control.
However auditors are not required to provide assurance on internal control (as suggested by ‘The Combined Code’).
Tutorial note: As illustrated above, marks will be awarded for relevant reference to developments in corporate governance
(e.g. Cadbury, 1992; Hampel, 1998; Combined Code, 1998; Turnbull, 1999), in the context of the question set.
The spectacular collapses of Barings Bank/Enron clearly demonstrate the need for management to have risk management
practices and effective internal financial controls. It is unlikely that auditors can report on such matters in ‘short form’. The
judgements involved and the lack of generally accepted suitable criteria will require a lengthy narrative report to avoid
misunderstandings in communicating conclusions.
Post-Enron legislation in the US, the Sarbanes-Oxley Act, now requires4 that CEOs and CFOs certify that:
■ they are responsible for internal controls and have reported on their effectiveness; and
■ all significant control weaknesses and management frauds have been reported to the auditors and the audit committee.
Auditors are required to report on management’s report on internal control effectiveness.
Impact on professional liability
Reporting on the ‘effectiveness’ of financial internal controls is perceived to increase auditor’s liability if the auditor fails to
identify significant risks or potential weaknesses in the design and operation of a system of internal financial controls. In
particular, allegations of negligence may be directed to the auditor because of a lack of understanding that absolute assurance
is not possible due to inherent limitations of internal control (e.g. human error, collusion, and management override).

—————————
2 Effective on 20 July 2002 (when the Act was passed)
3 Royal Bank of Scotland v Bannerman Johnstone Maclay and others
4 Effective 29 August 2002

21
 (c) Management representation letters
Responsibilities
Management representation letters provide written evidence that management acknowledges its collective responsibility for
the preparation of the financial statements and that they have approved them. Auditors have a professional responsibility to
gather sufficient audit evidence to support their audit opinion, including obtaining written representations when appropriate.
ISA 580 ‘Management Representations’ requires that:
■ written representation be obtained when sufficient appropriate evidence cannot reasonably be expected to exist;
■ the reliability of representations be reconsidered if contradicted;
■ if management refuses to provide representation the implications for the auditor’s report be considered.
Also, auditors are required to consider whether the individuals making the representation can be expected to be well informed
on the particular matters.
Recent developments
The High Court decision in the Barings case5 raised some key issues in relation to the protection which management
representations afford to auditors. A director, having little knowledge or understanding of Nick Leeson’s activities (although
he was nominally his boss), made representations that there had been no irregularities and that the financial statements were
free of material errors and omissions.
The judge said that the external auditors’ (D&T) defence against the claim for damages which they faced, that the director
was recklessly fraudulent, would have succeeded if fraudulent misrepresentation could have been established. In some
jurisdictions it is a criminal offence for an officer of a company to knowingly or recklessly make misleading or false statements
to the company’s auditors.
It is already clear in ISA 580 that management representations cannot be a substitute for evidence that auditors expect to be
available and that uncorroborated representations do not normally constitute sufficient audit evidence. The Barings
judgement does not contradict the basic principles and essential procedures contained in ISA 580. However, it has
highlighted the need for emphasis of the guidance in this area.
To add substance to auditors considering whether individuals are well-informed on the matters about which they are making
representations, it is recommended6 that management include a specific representation that they can properly make their
representations.
Impact on professional liability
If more cases of criminal charges are brought against officers, as a deterrent to making deceptive statements, the reliability of
management representations as audit evidence should be increased. Professional liability is thereby reduced if there are fewer
cases brought or proved against the auditor.

—————————
5 Barings Futures (Singapore) Pte Ltd (BFS) v Deloitte & Touche Singapore [2002]
6 In a Technical Release

22
Part 3 Examination – Paper 3.1 (INT)
Audit and Assurance Services (International Stream) December 2003 Marking Scheme

Marks must only be awarded for points relevant to answering the question set. Unless otherwise indicated, marks should not be awarded
for restating the facts of the question.
For most questions you should award 1/2 a mark for a point of knowledge, increased to 1 mark for the application of knowledge and
11/2 marks for a point demonstrating the higher skill expected in Part 3.
The model answers are indicative of the breadth and depth of possible answer points, but are not exhaustive.
Most questions require candidates to include a range of points in their answer, so an answer which concentrates on one (or a few) points
should normally be expected to result in a lower mark than one which considers a range of points.
In awarding the mark to each part of the question you should consider whether the standard of the candidate’s answer is above or below
the pass grade. If it is of pass standard it should be awarded a mark of 50% or more, and it should be awarded less than 50% if it
does not achieve a pass standard. When you have completed marking a question you should consider whether the total mark is fair.
Finally, in awarding the mark to each question you should consider the pass/fail assessment criteria:
❏ Adequacy of answer plan
❏ Structured answer
❏ Inclusion of significant facts
❏ Information given not repeated
❏ Relevant content
❏ Inferences made
❏ Commercial awareness
❏ Higher skills demonstrated
❏ Professional commentary
In general, the more of these you can assess in the affirmative, the higher the mark awarded should be. If you decide the total mark is
not a proper reflection of the standard of the candidate’s answer, you should review the candidate’s answer and adjust marks, where
appropriate, so that the total mark awarded is fair.

Marks
1 (a) (i) Business risks
Generally 1/2 mark for identification + 1 mark each point of explanation max 8

Ideas
Operations risks
■ standard design
■ licences
■ alternative facilities/competition
■ customer satisfaction/poor service levels (e.g. staff lateness)
■ human resources
Empowerment risks
■ centralised control
Information for decision-making risks
■ business reporting risks
Financial risks
■ advance payments
■ loss of revenue
■ cash flow
Compliance risks
■ rights to operate
■ safety management (lifeguards, crèche facilities)

23
 Marks
(a) (ii) Financial statement risk
Generally 1 mark each point max 8

Ideas
Assets
■ impairment/overstatement (licences, tangibles and GCUs)
■ useful lives
■ existence assurance
Liabilities
■ understatement/non-disclosure (contingent and actual)
Income statement
■ revenue (overstatement/non-compliance IAS 18)
■ staff costs overstatement
Controls
■ control risk
■ fraud/illegal acts
Inherent risks
■ ‘branch’ accounting
Disclosure risk
■ going concern (IAS 1)
■ contingent liabilities/assets
■ capital commitments

(b) Principal audit work

Generally 1 mark each area of principal audit work
maximum 3 marks each (i) and (ii) 6

Ideas
Deferred income
■ accounting estimate
■ cutoff/accrual basis/matching
■ ‘test in total’
Hydrotherapy pool
■ initial measurement/cost
■ reliance on an expert (ISA 620)
■ borrowing costs (IAS 23)
■ Impairment (IAS 36) vs depreciation (IAS 16)

(c) Performance indicators

Generally 1/2 mark for each measure suggested
1/ – 1 mark each source of evidence max 8
2

Ideas
Performance measures
■ types of performance measure (e.g. efficiency, capacity)
■ numbers/proportions/%s
– facilities (available vs closed)
– members (lapsed, renewed, introduced)
– accidents (personal, chemical)
Audit evidence
■ oral vs written
■ internal vs external
■ auditor generated
■ procedures (‘AEIOU’)7

——
30
——

—————————
7 ISA 500 identifies five procedures for obtaining audit evidence: Analytical, Enquiry, Inspection, Observation and compUtation.

24
 Marks
2 (a) Applicable risks
Generally 1/2 mark for appropriate identification as ‘applicable’/‘non-applicable’ max 5
Up to 11/2 marks each point of explanation max 15
———
max 14

Ideas (types of risk)

Environment
■ competition
■ regulatory
Process
■ operations
■ financial
■ empowerment
■ information processing
■ integrity
Information for decision-making
■ process/operations
■ business reporting
■ environment/strategic

(b) Internal controls

Generally 1 mark each point, max 2 × 4 ‘applicable risks’ max 6

Ideas
■ control procedures/specific controls
■ control environment/pervasive controls
■ monitoring activities (including reconciliations)

——
20
——

25
 Marks
3 (i) Matters
Generally 1 mark each comment
maximum 5 marks each issue × 3 max 12

Ideas
■ materiality (assessed)
■ relevant IASs (e.g. 1, 8, 10, 16, 24, 37) and ‘The Framework’
■ risks (e.g. FS assertions – existence, completeness)
■ responsibilities (e.g. for consolidated financial statements)

(ii) Audit evidence

Generally 1 mark each item of audit evidence (source)
maximum 5 marks each issue × 3 max 12

Ideas (ISA 500)

■ oral vs written
■ internal vs external
■ auditor generated
■ procedures (‘AEIOU’)

———
max 20
———

(a) max 8
(b) max 6
(c) max 6
———
20
———

26
 Marks
4 (a) Auditor’s responsibilities for reporting on compliance with IFRSs
Generally 1 mark each comment max 5

Ideas
■ generally/background ISA 200 ± 700
■ new ‘authority’ – IAPS 1014
■ IFRSs only – disagreement ‘except’ or ‘adverse’
■ both IFRS and national – simultaneous compliance,
■ predominant framework
■ national with disclosure of IFRS compliance – assertion
■ factually correct or misleading

(b) Implications for auditor’s report

Generally 1 mark a comment max 10

Ideas
(i)i IAS 38 non-compliance
■ IAS 1 ‘fair presentation’
■ IAS 38 mandatory requirement
■ Materiality – current year vs cumulative effect9
■ Conclusion on compliance
■ Amendments required ⇒ unqualified opinion
■ If not amended ⇒ ‘except for’ disagreement
(ii) Reporting on the Internet
■ Responsibilities (auditor/management)
■ Extent of audited information
■ Audit procedures
■ Identification of audited information
■ vs unaudited information

——
15
——

—————————
9 Maximum 2 marks

27
 Marks
5 Professional issues
Generally 1 mark each comment
maximum 5 marks each of three matters

Ideas
Professional issues raised
■ Integrity (management and/or audit firm)
■ Objectivity/independence
■ Confidentiality
■ Relevant ethical guidance – i.e.
■ (a) Changes in professional appointment
■ (b) Corporate finance advice including take-overs
■ (c) Fees
■ Meaning of ‘lowballing’
Steps (i.e. ACTIONS)
■ Obtain . . . what? . . . why?
■ Ask/advise . . . who? . . . when?

——
15
——

6 Responsibilities and liabilities

Generally 1 mark a point

Ideas (illustrative)
■ Traditional responsibilities/liabilities of
– management
– internal audit
– external audit
■ Recent change (legal/professional)
■ What change has been in response to
■ Impact on professional liability of external auditors

(a) max 6
(b) max 5
(c) max 4
———
15
———

28