Answers

Part 2 Examination Paper 2.6(INT) Audit and Internal Review (International Stream) 1 (a) Ethical threats Self review threat

June 2007 Answers

If Lime & Co provides audit and other professional services to Green Co, then they will be preparing the financial statements and also auditing those financial statements. This will provide a self-review threat to Lime & Co as they will be auditing their own work. Lime & Co would be advised to tender only for the audit work. Management threat There is a risk that Lime & Co will make decisions that the managers of Green Co should make (for example which accounting policies should apply to the financial statements). It is possible that these type of decisions have been made before, on an informal basis, as the partners in Lime & Co already know and give advice to the managers of Green Co. Advocacy threat This threat arises because Lime & Co may be asked to present details of Green Cos financial statements and profit forecasts in court to support its application to stop Black Co growing genetically modified (GM) crops. Lime & Co may be seen to support their client in court, which may limit their independence in relation to the audit work. Familiarity threat You have been friends with the managers of Green Co for some time. This means that you may not question the decisions of the managers due to this close personal relationship. As a partner in Lime & Co you will in effect not be independent from your client. Fee income Acceptance of audit and professional services work from Green Co, will result in an increase in fee income. To retain independence, Green Co need to ensure that fee income does not exceed 10% of the total practice income. Association threat The managers of Green Co, while not being criminals, they appear to lack integrity in their business affairs. The partners in Lime & Co need to decide whether they want to be professionally associated with Green Co; any criminal activity in the future may have an adverse effect on Lime & Cos reputation and image. Specifically Lime & Co will not want to be seen to be associated with or advising a firm which is breaking the law. Cease trading payment of fees The farm may lose organic certification if the genetically modified crops continue to be grown next to Green Cos farm. There is a risk that Lime & Co may not be paid for services provided should Green Co cease trading. (b) (i) Going concern IAS 1 Presentation of Financial Statements defines the going concern concept as the assumption that the enterprise will continue in operational existence for the foreseeable future. The farm may lose organic certification if the genetically modified crops continue to be grown next to Green Cos farm. This means that Green Co may not be a going concern. An entity will normally use the going concern basis unless: (ii) It is being liquidated or has ceased trading, or The directors have no realistic alternative than to liquidate the company or to cease trading.

Responsibilities The directors responsibilities regarding going concern is to prepare the financial statements of an entity ensuring that the going concern basis is reasonable. They may also prepare cash and/or profit forecasts for at least 12 months into the future to demonstrate that the entity is likely to continue to trade during this time. The auditors responsibility regarding going concern is to form an opinion on the appropriateness of managements assessment of the going concern status of the entity and the adequacy of disclosures, if any. The auditor will collect sufficient and appropriate audit evidence to ensure use of the going concern assumption is valid. To be clear, the auditors are not responsible for ensuring that the company is a going concern; this is a responsibility of the directors.

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(c)

Audit procedures In the case of Green Co, audit procedures on going concern will include: Obtaining cash and profit forecasts from the directors. Ensure that these have been properly prepared (for example are arithmetically correct) and show that Green will continue trading. Appropriate adjustments should have been made for the decrease in sales resulting from contamination of Green Cos farm. Review the order books for Green Co to determine the level of future sales. Contacting Green Cos lawyers to determine the progress, if any, on the court case against Black Co. Review the financial status of Green Co during the audit to identify other indicators of a going concern problem such as failure to repay loans or decrease in sales. Review correspondence, if any, with the organic certification authority to determine whether Green Cos organic status has been withdrawn. Contacting Green Cos bank to ascertain whether any loan or overdraft agreements are due for renewal and whether these will be renewed. Obtaining written representation from the directors confirming that they are not aware of any circumstances other than those evaluated by the auditor, so they expect Green Co to continue as a going concern.

(a)

Factors affecting sufficiency Assessment of inherent risk As inherent risk increases, then more audit evidence will be required to reduce detection risk. Materiality of the item A decrease in materiality means that more audit evidence will be required to ensure that no material error has occurred. Nature of the accounting and control systems Where the accounting and control systems are poor then more audit evidence is necessary as less reliance can be placed on those systems. Control risk Determine the extent to which the directors have implemented a sound system of internal control; poor internal controls increase control risk, decreasing reliance that can be placed on those controls. Experience from previous audits Good experience from previous audits will decrease the amount of evidence required as the auditor can place reliance on previous review of clients systems. Result of audit procedures Where the results of different audit procedures agree with each other then overall less evidence is needed overall the evidence is more persuasive; however, where results are in conflict then more evidence is required. Quality of information available Some sources of audit evidence are more reliable than others meaning less evidence is needed when relying on those sources for example, documentary evidence is more reliable than oral evidence.

(b)

(i)

Trade payables Audit procedure Cast the list of trade payables and agree the total to the payables ledger and then to the general ledger. Test, on a sample basis that payables on the list agree to the individual ledger balance and from the ledger to the list. Compare trade payables individually and in total to prior year balances and explain any unusual changes. Reason for procedure To confirm that the list is complete, is accurately stated in the general ledger and contains no unusual or reconciling items which must be investigated. To confirm that the list agrees to the payables ledger. To explain changes in the balances. For example, the increase in payables could indicate cash flow problems and Metcalf & Co is delaying payment to suppliers in response to this. Comparison may also indicate lack of completeness of the list where payables balances have been omitted. Material balances should always be tested to ensure correctness and test a large amount of payables by value. Some zero balances are tested to ensure that invoices have not been omitted from one supplier.

Select a sample of individual payables accounts for testing, focusing on material balances, zero balances and a sample of other items.

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Audit procedure Select population from purchase invoices received after the year-end. Trace to evidence of goods receipt and where goods received prior year-end, ensure invoice amount included in purchase accrual.

Reason for procedure Confirm completeness of recording of purchase invoices.

Obtain year-end supplier statements (either from Metcalf & Agree the payables balance to independent third party Co or direct from the individual supplier via a circularisation evidence to confirm accuracy, completeness and letter). Agree the balance on the statement to the individual existence of the ledger balance. account in Metcalf & Cos payables ledger. Where necessary, reconcile the balances taking into account cash and invoices in transit. Take a sample of purchase invoices recorded in the purchase day book (PDB) just prior to the year end and trace to goods received note (GRN), ensuring that the goods were received prior to the end of the year. To ensure that liabilities recorded in the PDB are represented by goods received during that year, and recorded in the correct period (cut-off testing).

Take a sample of GRNs prior to the end of the year and To ensure completeness of recording of amounts trace to purchase invoice or the goods received not invoiced payable. accrual in the financial statements. Take a sample of GRNs just after the end of the year and trace to purchase invoice. Ensure that the invoice is recorded in the PDB after the year-end. List all debit balances and obtain an explanation from the client. To ensure that the purchases figure is not overstated in this years financial statements. To confirm why the balance arose and consider re-classifying the amounts as receivables. Debit balances may indicate control weaknesses with additional implications for audit testing.

(ii)

Accruals Audit procedure Cast the list of accruals and agree individual amounts to the general ledger accounts. Reason for procedure Confirm that the list is complete, the balances are accurately stated in the general ledger and contains no unusual or reconciling items which must be investigated. To account for unusual differences and identify omissions from the list this year. To help ensure the accuracy of the amounts paid and confirm that the accruals are genuine. To confirm completeness of the accruals listing.

Compare individual accruals with amount in the prior year accounts. Agree accruals to payments made after the end of the year for example, amounts payable for tax deducted from wages payments to remittance to the tax authority. Review payments after the year-end to determine whether any accruals are required. Where the need for an accrual is identified, ensure this is included in the accruals list.

Check calculations of individual accruals to supporting To check that the accrual has been calculated correctly documentation for example, tax deductions from wages to and therefore testing for over or understatement of each to the amount shown on the payroll as deducted from wages accrual. for the last month of the year. (iii) Provision for legal action Audit procedure Discuss the provision with the directors. Reason for procedure To attempt to confirm whether the company is liable for the payment and confirm that an out-of-court settlement is appropriate. To provide evidence on whether Metcalf may be liable for payment and check the amount provided is approximately correct. To help determine Metcalf & Cos liability and determine whether the customer may accept the out-of-court settlement. To confirm that the directors are considering settlement out of court.

Obtain a letter from Metcalf & Cos lawyers.

Review any correspondence with the customer.

Obtain a letter of representation from the directors.

If possible, trace the payment made after the end of the To confirm the accuracy of the amount stated in year to receipt from the customer stating that the payment is accruals. accepted in full and final settlement i.e. no other payments are expected to be made.

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(a)

Report to audit committee Inventory control and Sales System Seed division 12 June 2007 The internal audit of the inventory and sales system identified the following weaknesses: Weakness Recording of orders Orders placed on the Internet site are transferred manually into the inventory and sales system. Manual transfer of order details may result in information being transferred incompletely or incorrectly, for example, order quantities may be incorrect or the wrong product code recorded. Control over orders and packing lists Each order/packing list is given a random alphabetical code. While this is useful, using this type of code makes it difficult to check completeness of orders at any stage in the despatch and invoicing process. Potential effect of weakness Customers will be sent incorrect goods resulting in increased customer complaints. Recommendation The computer systems are amended so that order details are transferred directly between the two computer systems. This will remove manual transfer of details limiting the possibility of human error.

Packing lists can be lost resulting either in goods not being despatched to the customer (if the list is lost prior to goods being despatched) or the customers credit card not being charged (if lost after goods despatched but prior to the list being received in the accounts department). Rhapsody Co will not be paid for the goods despatched where the credit company rejects the payment request. Given that customers are unlikely to return seeds, Rhapsody will automatically incur a bad debt. Entire orders may be overlooked and consequently sales and profit understated.

Orders/packing lists are controlled with a numeric sequence. At the end of each day, gaps in the sequence of packing lists returned to accounts are investigated.

Obtaining payment The customers credit card is charged after despatch of goods to the customer, meaning that goods are already sent to the customer before payment is authorised. Completeness of orders The computer system correctly ensures that order details are available for all charges to customer credit cards. However, there is no overall check that all orders recorded on the inventory and sales system have actually been invoiced. Summary

Authorisation to charge the customers credit card is obtained prior to despatch of goods to ensure Rhapsody Co is paid for all goods despatched.

The computer is programmed to review the order file and orders where there is no corresponding invoice for an order, these should be flagged for subsequent investigation.

We look forward to arranging a meeting to discuss these weaknesses with you in more detail. Note to candidates: the marking scheme shows other valid points. (b) Advantages of having an audit committee to Rhapsody include: It provides the internal audit department with an independent reporting mechanism compared to reporting to the directors who may wish to hide or amend unfavourable internal audit reports. The audit committee will assist the internal auditor by ensuring that recommendations in internal audit reports are actioned. Shareholder and public confidence in published financial information is enhanced because it has been reviewed by an independent committee. The committee helps the directors fulfil any obligations under corporate governance to implement and maintain an appropriate system of internal control within Rhapsody. The committee should assist in providing better communication between the directors, external auditors and management by arranging meetings with the external auditor. Strengthens the independence of Rhapsodys external auditor by providing a clear reporting structure and separate appointment mechanism from the board of Rhapsody.

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(a)

Audit report element Title of independent auditor Addressee (according to local regulations) Opening or introductory paragraph identifying the financial statements audited and responsibilities of entitys management and auditors Scope paragraph describing the nature of the audit in terms of ISAs followed and the work performed by the auditor Opinion paragraph referring to the financial reporting framework followed and expressing the auditors opinion Date of the report

Reason for that element To identify this as an audit report and distinguish it from other reports on financial statements that might be issued by others, directors, etc. To identify the person(s) who may use or rely on the report. To make it clear which pages of an annual report have been audited. To make clear that the directors prepare the financial statements and the auditors audit them following international standards on auditing (ISAs). To explain the scope of the audit so the standard of the auditors work is clear and other factors such as limitation of audit testing (for example, not tested all items) is known. To provide the auditors opinion on the financial statements in terms of true and fair view, to assure the reader that the audit has been carried out in accordance with established principles and practices. To inform the reader that the auditor has considered effects of transactions that the auditor became aware of on the financial statements up to that date. This is normally the city where the auditor responsible for the audit is located so he/she can be contacted, if necessary. This is normally the signature of the audit firm as the firm assumes responsibility for the audit, not the individual engagement partner.

Auditors address Auditors signature

(b)

Issue one Understatement of sales income (i) (ii) If possible, conduct day-by-day analytical review to determine the extent of the misappropriation. Discuss the situation with the other directors to ascertain their knowledge of the situation. Ask the other directors what action they will take regarding the director who appears to have misappropriated money from the company. Recommend in the management letter that strict numeric sequence is maintained over sales invoices and that two directors are always on duty to prevent misappropriation of income. Obtain a letter of representation to confirm the directors estimate of the extent of the fraud and confirm that the directors are not aware of any other instances of fraud.

The misappropriation is material, being about 5% of income for the year. Therefore: Modify the auditors report with an except for opinion on limitation of scope of audit work on sales income. Explain the reason for the understatement of income in the basis of opinion paragraph above the opinion paragraph.

Issue two Directors use of yacht (i) (ii) Ask the director why the yacht is located at his house. Ask the director whether any payment was made for the yacht confirm payment to the cash book and company bank statements. If the yacht is for private use only, check that disclosure of the benefit has been made in the directors emoluments note in the financial statements. Depending on the law of your jurisdiction, recommend to the director that any tax return clearly shows the benefit in kind derived from the companys asset. Ensure the company has provided relevant information to the benefit authority and accrued any penalty for nondisclosure. Consider additional audit work to determine whether or not any other company assets have been used in a similar fashion.

Assuming that disclosure of the benefit has not been shown in the financial statements then: Modify the auditors report using an except for opinion disagreeing with the amount of information disclosed. As the lack of disclosure relates to directors emoluments, provide information on the benefit in the audit report itself.

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(a)

The purposes of audit working papers include: To assist with the planning and performance of the audit. To assist in the supervision and review of audit work, and To record the audit evidence resulting from the audit work performed to support the auditors opinion. Information obtain Details of the objectives of Specs4You, its permitted capital structure and the internal constitution of the company. Provide detail on the size of the company, profitability, etc as well as any unusual factors such as loans due for repayment. Determine the current status of the company including ongoing profitability, ability to meet budget, etc as well as identifying any potential going concern problems. To identify the key managers and employees in the company and other people to contact during the audit. To find out how Specs4You is performing compared to the industry standards. This will help to highlight any areas of concern for example, higher than expected cost of sales, for investigation on the audit. To compare the accounting policies of Specs4You and obtain additional information on industry standards. To establish what problems were encountered in last years audit, how those problems were resolved and identify any areas of concern for this years audit. To find out whether the company has any significant news stories, (good or bad) which may affect the audit approach.

(b)

Documentation Memorandum and articles of association Most recent published financial statements Most recent management accounts/budgets/ cash flow information Organisation chart of Spec4You Industry data on spectacle sales

Financial statements of similar entities Prior year audit file

Internet news sites

(c)

The audit working paper does not meet the standards normally expected in a working paper because: The page reference is unclear making it very difficult to either file the working paper in the audit file or locate the working paper should there be queries on it. It is not clear what the client year end date is the year is missing. The working paper could easily be filed in the wrong years audit file. There is no signature of the person who prepared the working paper. This means it is unclear who to address queries to regarding the preparation or contents of the working paper. There is evidence of a reviewers signature. However, given that the reviewer did not query the lack of preparers signature or other omissions noted below, the effectiveness of the review must be put in question. The test objective is vague it is not clear what correct means for example, it would be better to state the objective in terms of assertions such as completeness or accuracy. The test objective is also stated as an audit assertion. This is not the case as no audit assertions are actually listed here. It is not clear how the number for testing was determined. This means it will be very difficult to determine whether sufficient audit evidence was obtained for this test. Stating that details of testing can be found on another working paper is insufficient time will be wasted finding the working paper, if it has, in fact, been included in the audit working paper file. Information on the results of the test is unclear the working paper should clearly state the results of the test without bias. The preparer appears to have used personal judgement which is not appropriate as the opinion should be based on the facts available, not speculation. The conclusion provided does not appear to be consistent with the results of the test. Five errors were found therefore it is likely that there are some systems weaknesses.

(a)

Advantages of perpetual inventory systems There is no disruption caused by an annual inventory count. There is more accurate and regular inventory counting, which enables errors and slow moving or damaged inventory to be identified earlier. Actual inventory balances are known at any time, allowing re-ordering of best selling books to take place on a timely basis. There will also be fewer causes of inventory reaching zero causing stockouts with orders not being fulfilled.

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Increased control over storekeepers because inventory is being reviewed regularly; this should decrease any pilferage. Auditors can rely on the computerised inventory system, reducing substantive audit tests of inventory during the year and at the year end.

(b)

Audit procedures Audit procedure Physical count Arrange a meeting with the internal audit department. Discuss the procedures carried out and review working papers produced during the continuous inventory checks. For any errors identified, ensure that appropriate adjustments were made to the perpetual inventory system. Visit the warehouse and: Obtain a sample of inventory items already recorded on the perpetual inventory system and agree to the book inventory. For a sample of books in the warehouse, obtain details and agree perpetual computer system records. Review the condition of the books, taking details of any which appear to be old or damaged. Form an opinion regarding the overall accuracy of the perpetual inventory system. Ensure all inventory lines are counted at least once per year in discussion with the internal audit department. To ensure that the inventory recorded on the computer system actually exists. To ensure that all inventory is recorded on the inventory computer system and there is completeness of recording. To confirm that any inventory which is damaged or unsaleable is correctly valued. To confirm that inventory quantities have been correctly recorded. To confirm that all inventory is counted regularly. Reason for procedure Determine the extent to which reliance can be placed on the work of the internal audit department.

(c)

Fundamental ethical principles Integrity Integrity is essential for all people operating in the public interest. Integrity implies not only honesty, but also related qualities of fairness, candour, intellectual honesty and confidentiality. During an audit it is essential that directors can rely on an auditor to keep information about the company confidential. If this was not the case then directors may be less forthcoming with essential information, decreasing the effectiveness of the audit. Objectivity Objectivity is a state of mind that excludes bias, prejudice and compromise and that gives fair and impartial consideration to all matters that are relevant to the task in hand, disregarding those that are not. Accountants have to be objective because many of the factors which make up an opinion on a set of financial statements relate to questions of judgement rather than fact. Accountants therefore need to be unbiased and impartial in making their decisions, especially where they may need to challenge assumptions already made by the directors. Independence Independence is freedom from situations and relationships which make it probable that a reasonable and informed third party would conclude that objectivity is either impaired or could be impaired. Independence is therefore related to and underpins objectivity. Accountants will therefore not participate in any activity or relationship that may impair, or appear to impair, their judgement. They will also not accept anything which may appear to impair their judgement.

(d)

Actions in respect of the engagement letter not being signed Discuss the matter again with the directors in an attempt to reach a suitable compromise. Remind the directors that statutory audits require the directors to make all the necessary information and explanations available to the auditor. Explain that lack of information on the website will result in a limitation in scope of the audit work. Further explain that because the lack of evidence appears to relate to a material amount that the auditors report will have to be modified with an except for qualification due to the lack of information and the possibility of misstatement of non-current assets. Finally note that auditor may have to decline to work for MistiRead unless suitable terms of engagement can be agreed.

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Part 2 Examination Paper 2.6(INT) Audit and Internal Review (International Stream)

June 2007 Marking Scheme Marks

(a)

05 for identifying threat, 1 mark each for point (05 where not explained) Self-review threat Management threat Advocacy threat Familiarity threat Fee income Association threat Other relevant points (each) Maximum marks

(b)

Key points 1 for each point (i) State going concern (enterprise operational existence) Not used when liquidation or ceased trading Not used when directors will liquidate or cease trading Maximum marks (ii) Directors responsibilities prepare FS Evidence produce Auditor responsibilities check GC concept Collect audit evidence Disclosure of going concern concept if necessary Maximum marks 1 1 1 3 1 1 1 1 1 4

(c)

Key points 1 for each point Profit and cash flow forecasts Review order books Contact lawyers Review financial status other GC indicators Correspondence organic certification Contact bank Representation letter Other good relevant points Maximum marks

1 1 1 1 1 1 1 1 5

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Marks 2 (a) 1 mark per point (05 for point and 05 for explanation) Assessment of inherent risk Materiality of the item Nature of the accounting and control systems Control risk Experience from previous audits Result of audit procedures Source and reliability of information available Other relevant points Maximum marks (b) (i) Trade payables (05 for test and 05 for explanation) List of payables cast and agree to general ledger Agree list to payables ledger and ledger to list Analytical procedures Select sample for testing rationale for sample Supplier statement reconciliation agree balances Treatment of non-reconciling items Cut-off prior year end invoice to GRN GRN to invoice prior year end. Cut-off post year end Debit balances treatment Accruals (05 for test and 05 for explanation) Obtain list cast and agree general ledger Analytical procedures Payments made post year end Supporting documentation

(ii)

(iii) Legal provision (05 for test and 05 for explanation) Discuss with directors Lawyer letter Correspondence with customer Letter of representation Post year end payment (if possible) Maximum marks

4 16

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Marks 3 (a) Content of report 1 mark each for Identifying weakness Effect of weakness Recommendation to remove weakness Recording of orders Control over orders and packing lists Obtaining payment Completeness of orders No check on goods in inventory when ordered Two part packing slip insufficient Sales invoice not sent to customer Inventory only updated on despatch Other relevant points Maximum marks Format of answer appropriate headings Format of answer report format Maximum marks this section (b) 1 mark per relevant point Independent reporting Help internal audit implement changes Shareholder/public confidence Directors obligations Communication external auditors Independence external auditor Other relevant points (each) Maximum marks

3 3 3 3 3 3 3 3 3 12 1 1 14

1 1 1 1 1 1 1 6

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Marks 4 (a) Elements of audit report. 1 mark for each of the following (being 05 for the element and 05 for explanation for that element). Title of report Addressee of report Introductory paragraph Scope paragraph Opinion paragraph Date of report Auditors address Auditors signature Maximum marks (b) Maximum 14 marks this section (8 for (1) and 6 for (2)) (i) Additional audit procedures Issue one up to 6 marks Additional audit work Discuss with directors Action against director Management letter Letter of representation Other relevant points (each) Issue two up to 4 marks Talk with director Asset transferred to director? Ask whether any payment made for yacht Check disclosure financial statements Check tax return Other relevant points (each) Effect on audit report Issue one up to 3 marks Amount is material Modify except for uncertainty Explain why modified Issue two up to 3 marks Modify except for disagreement Provide disclosure Maximum marks

1 1 1 1 1 1 1 1 6

1 1 1 1 1 1 1 1 1 1 1 1

(ii)

1 1 1 1 1 14

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Marks 5 (a) 1 mark per point Assist planning Assist supervision Record of audit evidence Other relevant points Maximum marks (b) 05 for document, 05 for information obtained Memo and articles Financial statements Management accounts Organisation chart Industry data Financial statements similar companies Prior year audit file Internet news sites Permanent audit file Board minutes Other relevant points Maximum marks (c) 1 mark per relevant point (05 for area, 05 for explaining why working paper poor quality) Page reference Year end No preparer signature Poor job from reviewer Vague test objective Not an audit assertion Sufficient audit evidence obtained? Lack of appropriate referencing Test results unclear Conclusion not consistent with results found Other relevant points (each) Maximum marks 1 1 1 1 3

1 1 1 1 1 1 1 1 1 1 1 8

1 1 1 1 1 1 1 1 1 1 1 9

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Marks 6 (a) 1 mark each advantage No disruption Identify slow moving damaged inventory quicker Always have actual inventory details available Increased control storekeepers Limit audit tests Other relevant points Maximum marks (b) 05 for procedure, 05 for explaining purpose Meeting with internal audit Continuous inventory > book inventory Book inventory > continuous inventory Condition of books Opinion on accuracy continuous inventory system All lines counted once per year Computer record amendment to actual inventory levels Acceptable procedures on return of inventory Other relevant points Maximum marks (c) 1 mark for explaining concept and 1 for applying to accountants Integrity Objectivity Independence Maximum marks (d) 1 mark each Discuss with directors Requirement to make information available to auditor Limitation in scope of audit work Modification of audit report Possibly not work for client Other relevant points Maximum marks 1 1 1 1 1 1 4

1 1 1 1 1 1 1 1 1 6

2 2 2 6

1 1 1 1 1 1 4

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