53455077 acca f8 int practice questions

QUESTIONS

P A PER F8 ( INT) : AUDIT AND ASSURANCE

2 KAPLAN PUBL ISHI NG

AUDIT FRAMEWORK AND REGULATION

ASSURANCE ENGAGEMENTS

(a) Outline the importance of the external auditor as a verifier of financial information. (12 marks)

(b) Compare the level of assurance provided by an audit and a review engagement. (8 marks)

(Total: 20 marks)

LECTURER RESOURCE PA CK: QU ESTI ONS

KAPLAN PUBL ISHI NG 3

LEE KEY CO

Lee Key Co has undergone a period of substantial growth following its establishment five years ago by two plumbers who pooled their redundancy pay. Because of a lack of accounting expertise within the company it has traditionally looked to its auditors, Tickit and Hopit, for accounting services in the preparation of annual financial statements as well as for the statutory audit function. Tickit and Hopit have also provided advice in connection with the company’s accounting and internal control systems.

Tickit and Hopit is a two partner firm of certified accountants and registered auditors whose clients are mainly sole traders, partnerships and small limited companies. Although Lee Key Co was originally a typical small company client, its growth over the last five years has meant that it now accounts for approximately 20% of Tickit and Hopit’s gross fee income and the company has indicated that it may wish to issue shares on the stock market in the near future.

Required:

(a) Discuss the extent to which it is acceptable and desirable that Tickit and Hopit have in the past provided the three services of statutory audit, advice in connection with systems, and accountancy services in the preparation of annual financial statements to Lee Key Co.

(8 marks)

(b) Discuss the acceptability and desirability of Tickit and Hopit continuing to act in the future as auditors to Lee Key Co while continuing to provide the other services. (6 marks)

(c) If, despite having been re-elected as the company’s auditors, Tickit and Hopit decide to resign during the year state the procedures they should go through. (3 marks)

(d) What actions should Lee Key Co take on receipt of the letter of resignation from Tickit and Hopit? (3 marks)

(Total: 20 marks)



MANLY Mary Lee, partner in a firm of Chartered Certified Accountants, is engagement partner on the audit of Manly, a publicly quoted incorporated business. She is reviewing the audit file for the year ended 31 October 20X2. At the front of the file is a memo from the audit manager recommending the issue of a qualified audit opinion. Manly’s major customer is known to be in financial difficulties yet no provision has been made against the material debt owed to Manly. Manly’s financial director is arguing that their customer has nearly completed development of a new product, sales of which will enable them to repay all their debts. He claims to have consulted another firm of accountants who have indicated that a provision might not be necessary.

Mary is unhappy with the situation for the following reasons:

(a) She is reasonably certain that, if she issues a qualified opinion, the directors of Manly will recommend appointment of another firm as auditors.

(b) Her firm supplies many other non-audit services to Manly such as tax and consultancy which bring in twice as much revenue as the audit and are more profitable. It is highly unlikely the firm would continue to be asked to provide these services if the audit is lost. In total, fees paid by Manly for the audit and these other services amount to 9% of the audit firm’s revenues.

(c) She has been the engagement partner for ten years and has no reason to doubt the integrity of the finance director with whom she has worked closely over that period of time. She is prepared to believe his assertion that the debt will be repaid. However, she also accepts that evidence in the audit file is equally persuasive that the customer is, currently, in financial difficulty.

She calls the finance director to advise him that she will have no option but to issue a qualified opinion if the financial statements do not contain a provision against the debt.

Required:

(a) In connection with the threat of removal from office:

(i) describe actions auditors can take when being threatened with removal by the directors. (5 marks)

(ii) explain how an audit committee can provide additional safeguards to audit independence in such a situation. (3 marks)

(b) Point (b) in the scenario raises the issue of providing non-audit services to audit clients.

(i) State the requirements of the ACCA’s Rules of Professional Conduct relating to the supply of non-audit services to public company audit clients. (4 marks)

(ii) Explain why the provision of non-audit services to audit clients might be seen as a problem and why it is sometimes suggested that auditors should not provide such services. (4 marks)

(c) Point (c) in the scenario raises the issue of ‘audit rotation’. What is meant by audit rotation and what are its supposed benefits and drawbacks? (4 marks)

Where appropriate, your answers should be illustrated by reference to the situation described.

(Total: 20 marks)



OTHER ENGAGEMENTS

ISRE 2400 Engagements to Review Financial Statements and ISRS 4410 Engagements to Compile Financial Information refer to audit related services.

Required:

Compare and contrast the assurance and work done on audits, reviews, and compilation engagements. (10 marks)



INTERNAL AUDIT

EXTERNAL AND INTERNAL AUDITORS In the interest of efficiency, the external auditors may seek to rely on work carried out by the internal audit department of their clients.

Required:

(a) Describe the matters which the external auditor should consider at the planning stage to assess the effectiveness of a company’s internal audit department. (10 marks)

In recent years there has been an increase in the number of larger companies outsourcing their internal audit function, often to their external auditors.

One of your audit clients is considering establishing a new internal audit function, either by recruiting its own internal auditors or by contracting with your firm for the provision of internal audit services.

Required:

(b) Describe the advantages and disadvantages of the external auditors providing an internal audit service to their clients. (10 marks)

(Total: 20 marks)



EASTFIELD DISTRIBUTORS Your firm is the external auditor of Eastfield Distributors, a company, which has sales of $25 million and a profit before tax of $1.7 million. The company operates from a head office at Eastfield and has sales and inventory holding centres in different parts of the country. The directors have decided the company has reached a size when it needs an internal audit department. As is becoming increasingly common, the directors have asked your firm to provide this service to the company as well as being the statutory auditor of the company’s annual financial statements.

In answering the question, you should consider:

(i) the effects of the Association of Chartered Certified Accountants’ Rules of Professional Conduct in relation to providing an internal audit service to Eastfield Distributors.

(ii) the extent to which your audit firm can rely on the internal audit work when carrying out the statutory audit of Eastfield Distributors.

(iii) the arrangements over control of the work and reporting of the internal audit staff:

− the extent to which the internal audit staff should be responsible to Eastfield Distributors, and who should control their work.

− the extent to which the internal audit staff should be responsible to a manager or partner of the external audit firm, and whether the same manager and partner should be responsible for both the internal audit staff of Eastfield Distributors and the external audit.

Required:

In relation to your audit firm becoming internal auditors of Eastfield Distributors:

(a) Describe the matters you should consider and the action you will take to ensure your firm remains independent as external auditor of the annual financial statements. (8 marks)

(b) Describe the advantages and disadvantages to Eastfield Distributors of your firm providing an internal audit service (7 marks)

(c) Describe the advantages and disadvantages to your audit firm of providing an internal audit service to Eastfield Distributors. (5 marks)

(Total: 20 marks)



ZX COMPANY

You are a recently qualified Chartered Certified Accountant in charge of the internal audit department of ZX, a rapidly expanding company. Turnover has increased by about 20% p.a. for the last five years, to the current level of $50 million. Net profits are also high, with an acceptable return being provided for the four shareholders.

The internal audit department was established last year to assist the board of directors in their control of the company and to prepare for a possible listing on the stock exchange. The Managing Director is keen to follow the principles of good corporate governance with respect to internal audit. However, he is also aware that the other board members do not have complete knowledge of corporate governance or detailed knowledge of International Auditing Standards.

Required:

Write a memo to the board of ZX that:

(a) Explains how the internal audit department can assist the board of directors in fulfilling their obligations under the principles of good corporate governance. (10 marks)

(b) Explains the advantages and disadvantages to ZX of an audit committee. (10 marks)

(Total: 20 marks)



PLANNING AND RISK ASSESSMENT

PHONES ANYWHERE You are the partner in charge of a four partner firm of Certified Accountants. Your firm has been invited to tender for the audit of Phones Anywhere for the year ended 31 December 20X2.

Phones Anywhere was established two years ago, and it provides a mobile phone service for individuals and businesses. The system being established by the company comprises:

(a) small portable mobile phones, which allow subscribers (users) to contact or be contacted by any other telephone.

(b) the mobile phones can be used within range of a local relay station, which receives calls from and sends calls to the mobile phones.

(c) the local relay stations are linked to a central computer which connects the calls to other users. Frequently, this is through a competitor’s telephone network.

(d) currently, the local relay stations cover one large city with a population of about 1,000,000. Within the next year the system will cover all large cities in your country with a population of over 250,000. By 20X7, the system will cover all motorways and cities with a population of over 100,000. Extending the coverage of the system will involve considerable capital expenditure on new relay stations and require additional borrowings.

(e) the cost of the relay stations and central computer are capitalised and are written off over six years.

(f) the mobile phones are manufactured by other companies and sold through retailers. Phones Anywhere does not sell the phones, but it pays $200 to the retailer for each phone sold and subscription signed by the customer to Phones Anywhere. This payment is capitalised in the financial statements of Phones Anywhere and written off over four years.

(g) subscribers are invoiced monthly with a fixed line rental and a variable call charge. Other operators are charged for the time spent by their customers contacting Phones Anywhere’s subscribers (customers). These charges are logged and calculated by the company’s main computer.

(h) all the shares are owned by three wealthy individuals who are non-executive directors. They will receive a fixed salary. They do not plan to make any further investment in the company.

(i) establishing the network of relay stations and subscribers will result in the company making losses for at least three years. Current borrowings are about 20% of shareholders’ funds. Because of the substantial capital expenditure and trading losses, it is expected the company will be highly geared by 20X5.

(j) as the company will not be profitable, the non-executive directors have decided that executive directors should receive a basic salary and a bonus based on the number of subscribers to the system.

(k) the owners plan to float the company on the London Stock Exchange in 20X5. The flotation will involve:

(i) issuing new shares to the general public to provide funds for the company, and

(ii) the three non-executive directors selling some of their shares.

You are aware that Phones Anywhere has a number of very large competitors, each of which has a large number of users and comprehensive coverage (i.e. over 90% of the population are within range of a relay station).



Required:

(a) Consider the risks associated with the audit. (8 marks)

(b) Describe the ethical matters you should consider in deciding whether your audit firm should accept the audit. This should include considering whether your firm has the technical and logistical ability to carry out the audit. (8 marks)

(c) Come to a conclusion on whether you would advise your firm to accept or decline the audit, giving your principal reasons for coming to this decision. (4 marks)

(Total: 20 marks)



GRINDSBROOK CLOTHING The Grindsbrook Clothing Company is a family-owned company that manufactures and sells high quality clothes by mail order. It has been in business for nearly ten years and has made a small profit during the last five years. The company has a small, modern factory and employs some 150 staff including clerical staff who take orders over the telephone and prepare the accounting records. The accounting hardware and software are out of date and slow. Credit management and management of receivables and payables generally is poor.

The company out-sources the production of the company catalogue and does not spend a significant amount on other advertising because the managing director does not consider that it is necessary. He has consistently refused to employ a professional marketing manager. There are an increasing number of competitors in this profitable market and despite the fact that the market is growing overall, the company’s market share is declining, although sales revenue is rising slowly.

The company is financed partly by the managing director and his wife (who are the only shareholders), and partly by short and long-term bank loans. The managing director’s son does not have any investment in the business, because his father wishes to retain control of the company. The bank loans are small by comparison with the family’s investment. The long-term bank loan is small by comparison with the short-term bank loan. It is intended that control of the business will pass to the managing director’s wife, two daughters, and his son. The two daughters are not involved in the business. There are some disagreements among family members about how the business should be run.

The company’s accounts have been prepared and audited by a series of firms of auditors. The managing director has refused to employ a qualified accountant. The company’s budgets and statutory financial statements have been of poor quality and have often been produced late.

You are a very busy Chartered Certified Accountant working in practice on your own and the managing director’s wife is your sister. You have considerable experience of providing advice to this type of business because you were once employed as internal auditor to a similar, but larger, clothing company. Your sister has decided that if the business is to prosper, outside professional help is needed.

The managing director’s wife, your sister, considers that your previous experience as an internal auditor may be useful to the Grindsbrook Clothing Company. She has asked you to assess the risks facing the business and to make suggestions as to how these risks should be managed.

Required:

(a) List the factors you will take into account in deciding whether or not to accept the assignment from your sister. (6 marks)

(b) List the specific issues facing the business under appropriate headings such as external risks, financial risks, operational risks, and compliance risks. Describe the actions that could be taken by the company to deal with each issue you identify.

Note: You may use headings other than those suggested in the question. (14 marks)

(Total: 20 marks)



BRIDGFORD PRODUCTS Your firm has been the auditor of Bridgford Products, a listed company, for a number of years. The engagement partner has asked you to describe the matters you would consider when planning the audit for the year ended 31 January 20X2.

During a recent visit to the company you obtained the following information.

(i) The management accounts for the 10 months to 30 November 20X1 show sales of $130 million and profit before tax of $4 million. Assume sales and profits accrue evenly throughout the year. In the year ended 31 January 20X1 Bridgford Products had sales of $110 million and profit before tax of $8 million.

(ii) The company installed a new computerised inventory control system which has operated from 1 June 20X1. As the inventory control system records inventory movements and current inventory quantities, the company is proposing:

− to use the inventory quantities on the computer to value the inventory at the year end, and

− not to carry out an inventory count at the year end.

(iii) You are aware there have been reliability problems with the company’s products, which have resulted in legal claims being brought against the company by customers, and customers refusing to pay for the products.

(iv) The sales increase in the 10 months to 30 November 20X1 over the previous year has been achieved by attracting new customers and by offering extended credit. The new credit arrangements allow customers three months credit before their debt becomes overdue, rather than the one month credit period allowed previously. As a result of this change, receivables age has increased from 1.6 to 4.1 months.

(v) The chief financial officer and purchasing manager were dismissed on 15 August. A replacement purchasing manager has been appointed but it is not expected that a new chief financial officer will be appointed before the year end of 31 January 20X2. The chief accountant will be responsible for preparing the financial statements for audit.

Required:

(a) Describe the reasons why it is important that auditors should plan their audit work. (5 marks)

(b) Describe the matters you will consider in planning the audit and the further action you will take concerning the matters listed in (i) to (v) above. (18 marks)

The new inventory control system has been designed with password controls.

Required:

(c) Explain the purpose of password controls and list the tests of control you would carry out in order to ensure that the control objective was being achieved. (7 marks)

(Total: 30 marks)



INTERNAL CONTROL

WICKETS Your firm has been appointed auditor of Wickets, a company which manufactures furniture. The company employs 60 weekly-paid employees comprising upholsterers, carpenters, joiners and general labourers. All employees are paid by credit transfer directly into their bank accounts.

The payroll is processed using a microcomputer with a hard disk which stores the payroll program, standing and transactions data relating to employees. On completion of payroll processing, the hard disk is copied onto a CD which is stored in one of the filing cabinets in the accounts office.

Hours worked are recorded on clock cards. Employees clock in and out on arrival at and departure from the premises. At the end of each week, the factory manager, Mr Lamb, gives the accounts supervisor, Mrs Gooch, the clock cards for that week and collects the clock cards for the following week. Each employee’s name and number is entered on the card by Mrs Gooch.

Mrs Gooch calculates for each employee the hours worked, split between basic and overtime. The cards are then passed to Miss Smith, the payroll clerk, who enters the details into the computer. The figures for gross and net pay are calculated by the program and the following reports are generated:

Payroll: details per employee of gross pay, deductions and net pay; totals thereof and total hours split between basic and

overtime;

Summary: cumulative details to date per employee;

Payslips: details of gross pay, deductions and net pay;

Giro list: bank account details, net pay per employee and total net pay.

The finance director, Mr Lewis, signs the cheque after agreeing it to the total net pay on the giro list and passes the cheque to the managing director, Mr Stewart, who countersigns it.

Mr Lamb gives a list detailing starters and leavers to Miss Smith who enters these changes into the computer as and when the situation arises. She uses the same password as for payroll preparation even though there is a facility within the software for hierarchical passwords. Miss Smith then files the list with the personnel records in her filing cabinet.

Your enquiries about the system indicate that there are no relevant procedures or controls other than those described above.

Required:

Identify the internal control deficiencies in the wages system. For each deficiency you should include: a description of the deficiency, the possible consequences of the deficiency and recommendations to remedy the deficiency. (20 marks)



DEAN MANUFACTURING You are the senior in charge of the audit of Dean Manufacturing. To assist you in your audit planning, one of the audit team has provided the following description of the purchasing system. No other controls exist apart from those described.

‘The company has no buying department so employees place orders in their own area of responsibility. A three part order form is used; copy 1 is retained by the originator, copy 2 is sent to the goods inward department and copy 3 is sent to the supplier.’

‘Goods are received, but not checked, by the goods inwards clerk. Once received, the advice note and purchase order for those goods are sent to the purchase ledger clerk.’

‘When the supplier’s invoice is received the purchase ledger clerk checks the calculations on it, initials it and staples the advice note and purchase order to it. She enters the invoice on to the purchase ledger.’

‘The invoice is then sent to the manager responsible for the employee who ordered the goods. The manager codes the invoice and returns it to the purchase ledger clerk. Purchase invoices are coded, entered on an analysis sheet and posted to the nominal ledger monthly by journal entry.’

‘The cashier pays suppliers monthly on instructions from the purchase ledger clerk. The purchase ledger control account is reconciled monthly by the purchase ledger clerk who also reconciles suppliers’ statements.’

Required:

For each internal control deficiency in the purchasing system:

(a) identify the deficiency and explain briefly its audit significance (if any), in terms of the type of errors that could result from it; and (14 marks)

(b) describe the effect it would have on your normal audit procedures in terms of any additional or extended procedures required. (6 marks)

(Total: 20 marks)



LINKS FAMINE RELIEF You have recently been appointed auditor of Links Famine Relief, a small registered charity which receives donations from individuals to provide food in famine areas of the world.

The charity is run by a voluntary management committee, which has monthly meetings and employs the following full-time staff:

(a) a director, Mr Roberts, who suggests fund raising activities and payments for relief of famine and implements policies adopted by the management committee, and

(b) a secretary (and book-keeper), Mrs Beech, who deals with correspondence and keeps the accounting records.

You are planning the audit of the charity for the year ended 5 April 20X2 and are considering the controls which should be exercised over income.

The draft accounts show the following income:

$

Gift Aid Declarations (by standing order) 25,874 Postal donations 52,436 Autumn Fair 5,687 Legacies 8,300 Bank deposit account interest 3,714 ______

96,011 ______

Notes:

(a) Gift Aid Declarations are completed by each person who intends to make contributions during the year. These are paid directly into the charity’s bank account on a monthly basis by standing order. Gift Aid Declaration forms are kept by Mrs Beech. (Gift Aid Declarations are used in the UK. Tax on these payments can be reclaimed but this should be ignored for the purposes of this question.)

(b) Postal donations, which can be cash or cheques, are dealt with by Mrs Beech who prepares a daily list of donations. She also updates the cash book and prepares the bank paying-in slip.

(c) The Autumn Fair takes place every year on a Saturday in October. Supporters of the charity provide items to sell (e.g. cakes, plants, clothing), a charge is made for entrance and refreshments are sold. Mrs Beech collects the takings from each of the stalls, prepares a summary of receipts and banks them the following Monday.

(d) Legacies are received irregularly, are usually sent to the director of the charity, who gives them to Mrs Beech for banking.

(e) Bank deposit interest is paid gross by the bank, as the Links Famine Relief is a charity.

Required:

List and describe the deficiencies in the accounting systems, additional controls that you would like to see in operation and audit work you would perform over the following sources of income:

(a) Gift Aid Declarations (4 marks)

(b) Postal Donations (5 marks)

(c) Autumn Fair (5 marks)

(d) Legacies (3 marks)

(e) Bank Interest (3 marks)

(Total: 20 marks)



PYRMONT For several years Pyrmont, a listed company, has maintained perpetual inventory records at each of its ten shoe shops. Nevertheless, it has continued to determine closing inventory by physical count at or near period end. As the senior in charge of Pyrmont’s external audit for the year ending 31 December 20X2, you are in the process of planning the audit. In discussions with the company’s chief accountant, she informs you that the company is intending to dispense with the annual physical inventory count and to rely on the perpetual records in determining closing inventory.

The computer operates a centralised computer system networked to terminals and point of sale registers in each shop. Last year’s audit file indicates that control risks over purchase and sale transactions were assessed as low for occurrence, completeness and measurement assertions. However, the control risk assessment did not extend to the recording of sale and purchase transactions into the inventory records since inventory was determined by physical count. The description of the accounting system shows inventory as being delivered directly to each shop. The manufacturers attach a bar-coded tag to each pair of shoes. On delivery, shop personnel physically check each pair of shoes with the description coded on the tag. They then scan the tags. The networked computer verifies the goods against the order and records them on the shop’s inventory. At the point of sale the tag is again scanned which both records the sale and removes the item from inventory records.

During the past year the company’s computing department has rewritten the inventory control system to incorporate inventory costs as well as quantities. The computer system now records cost at the point of delivery. On sale, the computer determines cost of sale on a first in first out (FIFO) basis and recalculates the cost of inventory on hand at each shop.

Required:

(a) (i) Describe the control procedures you would need to identify in order to accept book inventory as the basis for determining the quantity of inventory on hand at period end. (5 marks)

(ii) Describe how you would test those controls. (3 marks)

Assume that your assessment of control risk over recorded inventory is sufficiently low for you to plan substantive procedures that do not require observation of inventory count at or near the year end.

(b) Describe the substantive procedures you would perform, both during the year and as at the year end, in order to verify the completeness and existence of inventory. (8 marks)

(c) State the systems development controls you would expect to find applied to the rewriting of the inventory control system. (4 marks)

(Total: 20 marks)



AUDIT EVIDENCE

REPRESENTATIVE SAMPLES During an audit, the auditor must be satisfied that the financial records are complete and accurate. One of the ways that the auditor obtains such satisfaction is to select representative samples of transactions and balances for detailed testing, such samples being selected using either statistical or non-statistical methods.

Required:

(a) Describe the main factors which influence the auditor in determining the size of the sample he will use for his detailed testing. (8 marks)

(b) Describe three areas where judgement will be exercised by the auditor when using statistical sampling. (6 marks)

(c) Explain the factors which the auditor must consider in making the choice between a statistical and a non-statistical sampling procedure. (6 marks)

(Total: 20 marks)



POWERFAST During the final audit of Powerfast, the following points arose in the audit manager’s review of the audit of inventories for the year ending 31 May 20X1.

(a) No audit work had been conducted in order to ascertain whether any inventory items should be written down to net realisable value. (12 marks)

(b) The client utilises large quantities of coal in order to produce their output. The coal is stored in large piles and is transported to the factory units by means of a conveyor system. Perpetual inventory records are maintained showing the amount of coal on hand, and receipts and withdrawals of coal. No audit work has been carried out in this area, the perpetual inventory records having been accepted for financial statement purposes. (8 marks)

Required:

Describe the audit procedures which would be carried out at this late stage of the audit in order to satisfy the audit manager’s review points and ensure that inventories are accurately stated in the financial statements.

(c) Another client of your firm is Camry Products. You are reviewing the plans for a physical inventory count at the company's warehouse on 31 May 20X1. The company assembles domestic appliances, and inventory of finished appliances, unassembled parts and sundry inventories are stored in the warehouse which is adjacent to the company's assembly plant. The plant will continue to produce goods during the stock count until 5 pm on 31 May 20X1. On 30 May 20X1, the warehouse staff will deliver the estimated quantities of unassembled parts and sundry inventories which will be required for production for 31 May 20X1; however, emergency requisitions by the factory will be filled on 31 May. During the stock count, the warehouse staff will continue to receive parts and sundry inventories, and to despatch finished appliances. Appliances which are completed on 31 May 20X1 will remain in the assembly plant until after the physical inventory count has been completed.

Required:

Describe the procedures which Camry Products Ltd should establish in order to ensure that all stock items are counted and that no item of stock is counted twice. (10 marks)

(Total: 30 marks)



AUDIT EVIDENCE ISA 500 requires that ‘The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion.’ The explanatory material contained within ISA 500 identifies a number of procedures for obtaining audit evidence. ISA 500 also offers guidance as to assessing the reliability of audit evidence.

Required:

(a) Identify and describe five of the procedures for obtaining audit evidence. (5 marks)

(b) For each of the procedures, describe an audit test using that procedure to obtain evidence as to the balance of plant and equipment including the related balances of accumulated depreciation and charges to income. (5 marks)

(c) For each of the procedures, discuss considerations affecting your judgement as to the reliability of the evidence with particular reference to the test described in your answer to (b). (10 marks)

(Total: 20 marks)



ISA 500 ISA 500 Audit Evidence requires auditors to obtain evidence that supports the relevant financial statement assertions. One of these assertions is that of valuation. Evidence is therefore required to ensure that assets or liabilities are recorded at an appropriate carrying value. Many audit failures are associated with difficulties experienced by auditors in verifying this assertion in the face of attempts by management to engage in creative accounting. In verifying valuation auditors need to determine that the basis of valuation is consistent with accepted accounting practice usually aided by reference to accounting or financial reporting standards. Additionally auditors need to obtain sufficient evidence as to the values themselves. Valuation problems likely to be encountered by auditors include those associated with determining:

(i) the appropriate amount of overhead carried forward as part of the cost of closing inventory

(ii) the written down value of property, plant and equipment having a limited useful economic life

(iii) development costs deferred in the year and recognised as an intangible asset.

Required:

For each of the three items:

(a) state the acceptable basis of valuation. (6 marks)

(b) state and explain the audit procedures to be performed in verifying the appropriateness of the basis of valuation and the correctness of the actual amounts. (14 marks)

Note: You are only required to consider audit procedures relevant to the valuation assertion.

(Total: 20 marks)



IAS 2 INVENTORIES IAS 2 Inventories requires that inventories are measured at the lower of cost and net realisable value.

Required:

(a) Explain why the audit of inventory is important to auditors. (5 marks)

(b) Define ‘cost’ and ‘net realisable value’ according to IAS 2 Inventories. (6 marks)

(c) Describe the audit evidence that you would obtain for the cost and net realisable value of finished inventory in a company that manufactures household furniture. (9 marks)

Note: You are not required to deal with inventory quantities. (Total: 20 marks)



INTERNAL CONTROL AND SAMPLING

(a) Internal controls over non-current assets are designed to ensure the orderly and efficient running of the business, adherence to management policies, safeguarding of assets, the prevention of fraud and error and the completeness and accuracy of the accounting records.

Required:

List the internal controls that a small printing company with office equipment, motor vehicles and plant and machinery should have in place to achieve the objectives described above. (10 marks)

(b) Audit sampling is a technique for drawing conclusions about the characteristics of a population by testing a sample drawn there from. Internal and external auditors use it for both tests of controls and substantive testing.

Required:

Describe the following:

(i) Non-statistical and statistical sampling;

(ii) A representative sample;

(iii) Tolerable error;

(iv) Two different methods of selecting a representative sample;

(v) The extrapolation of errors.

Note: Parts (i) – (v) carry equal marks. (10 marks)

(Total: 20 marks)



REVIEW

HOPE ENGINEERING You are auditing the financial statements of Hope Engineering for the year ending 31 March 20X8. The partner in charge of the audit instructs you to carry out a review of the company’s activities since the financial year end. Mr Smith, the chief executive of Hope Engineering, overhears the conversation with the partner and is surprised that you are examining accounting information which relates to the next accounting period.

Mr Smith had been appointed on 1 March 20X8 as a result of which the contract of the previous Chief Executive, Mr Jones, was terminated. Compensation of $500,000 had been paid to Mr Jones on 2 March 20X8.

As a result of your investigations you find that the company is going to bring an action against Mr Jones for the recovery of the compensation paid to him. It had come to light that two months prior to his dismissal, he had contractually agreed to join the board of directors of a rival company. The company’s solicitor had informed Hope Engineering that Mr Jones’ actions constituted a breach of his contract with them, and that an action could be brought against the former Chief Executive for the recovery of the moneys paid to him.

Required:

(a) List and explain the reason for the audit procedures which would be carried out in order to identify any material post statement of financial position events. (12 marks)

(b) Discuss the audit implications of the company’s decision to sue Mr Jones for the recovery of the compensation paid to him. (8 marks)

(Total: 20 marks)



WRITTEN REPRESENTATION Written representations are an important source of audit evidence. These representations may be oral or written, and may be obtained either on an informal or formal basis. The auditor will include information obtained in this manner in his audit working papers where it forms part of his total audit evidence.

Required:

(a) Explain the nature and role of written representations. (6 marks)

(b) Explain why it is important for the auditor to discuss the contents of the letter of representation at an early stage of the audit. (4 marks)

(c) Explain why standard letters of representation are becoming less frequently used by the auditing profession. (4 marks)

(d) Discuss the implications for the auditor of a small company, if the directors refuse to sign the letter of representation. (6 marks)

(Total: 20 marks)



REPORTING

DRUMMOYNE Reddy and Co, Chartered Certified Accountants, are the external auditors of Drummoyne, a listed company. On completing the audit for the year ended 30 September 20X3 the following list of matters was prepared for the partner’s attention.

(a) On 25 November 20X3 Drummoyne agreed to a pay rise of 5% for all of its employees backdated to 1 July 20X3. No provision for this has been made in the financial statements.

(5 marks)

(b) The draft Chairman’s Statement, to be included in the Annual Report, states that the profits have increased by 25%. It is true that operating profit has increased by 25% but, after deducting reorganisation costs and losses on disposals of property, plant and equipment, profit on ordinary activities, both before and after tax, has increased by only 4% over the previous year.

(5 marks)

(c) The audit revealed a major control deficiency in the management of investments. The company recently recruited a financial analyst, as an employee, to manage the investment of surplus funds. Company policy is to invest in the shares of large quoted companies. The audit discovered a number of situations where the financial analyst had made substantial profits for the company by speculating in risky investments such as derivatives. Such investments could result in massive losses. The matter was reported in writing to the chief financial officer four months ago but no action has yet been taken. (5 marks)

(d) One of the company’s oil tankers has just run aground on the coast of California. There is a risk of a serious oil spill which could have a significant effect on the future of the company. Further information will not be available until after the auditors’ report has been signed.

(5 marks)

Assume that each of these matters is potentially material and is to be considered independently of each of the others.

Required:

Consider what further action Reddy and Co should take with respect to each of the matters listed.

(Total: 20 marks)

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