ACCA noter answer paper f8 acca f8 int aa interim assessment answers

c Goodfoot i Audit work on receivables and bad debts • Comfort can be taken from the proper operation of internal controls over receivables and it is therefore possible to reduce the l

ACCA Paper F8 (INT)

Audit and Assurance

June 2009

Interim Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the interim assessment questions and submitted them for marking

© Kaplan Financial Limited, 2008

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ANSWER 1

(a) Confirmations

(i) Positive and negative confirmations Negative confirmations request a reply

from the customer only if the customer disagrees with the amount Positive confirmations request a reply in any case Negative confirmations are generally only used with a representative sample of a large number of small accounts where internal controls are strong

(ii) Positive confirmations There are two types of positive confirmations In the

first type, the amount owed is stated by the client and the customer is asked

to agree or disagree If the customer disagrees, he is asked to provide an explanation of why he disagrees in the form of reconciling items In the second type, the customer is asked to fill in the balance The advantage of the first type is that the customer may perform the reconciliation The principal disadvantage is the fact that the customer may simply agree with any amount stated, particularly if it is understated With the second type, the customer is less likely to reply as more work is involved, but the amount stated represents what is in the customer’s records It is not possible for the auditor to perform the reconciliation in this case

(iii) Reconciling items Reconciling items include: cash, goods and credit notes in

transit and other timing differences, debit notes, contras, journal entries, disputed items, and simple errors on the side of either customer or supplier

(b) Financial statement assertions – receivables

Assets are generally more at risk from overstatement than from understatement

There is a risk that receivables are overstated by the under-provision for bad debts If

assets are overstated, profits are likely to be overstated and it is therefore sometimes

tempting to under-provide for bad debts in order to show a better profit figure, as well

as for management purposes

Bad debts can sometimes be hidden by the use of credit notes and similar devices;

whilst this does not affect the overall profit figure, it can affect the presentation of the

financial statements

(c) Goodfoot

(i) Audit work on receivables and bad debts

• Comfort can be taken from the proper operation of internal controls

over receivables and it is therefore possible to reduce the level of substantive testing

• The primary focus of substantive testing will be the 30 largest

accounts can be circularised together with a representative sample of the remainder, paying particular attention to old accounts, nil balances and credit balances

• For those accounts where there is no reply, and for any other

accounts selected for testing, it will be necessary to gain comfort on the amount receivable by reviewing cash received after the period end Where cash has not been received, it will be necessary to review signed delivery notes, contracts, the pattern of payments, etc

• For accounts confirmed, any differences should be thoroughly

investigated and followed up, with the help of the client if necessary

It should be remembered that, where a customer agrees that an amount is owed, it does not automatically follow that the amount will

be paid

• The bad debt provision should be reviewed in the light of past

experience and current period conditions Generally, specific provisions are permissible for tax purposes but not general provisions and the tax computation should be checked

• The arithmetical accuracy of the ledger should be checked as should

the correct presentation of the amounts in the financial statements

• A review of invoices and credit notes around the period-end may

highlight the need for additional provisions

• Analytical procedures on the ageing of receivables by comparison

with prior periods will give comfort on bad debt provisions

• Receivables cut-off testing should be performed to ensure that

amounts have been correctly recorded in the correct period

(ii) Lead schedule for receivables

Client: Goodfoot Reference: J1 Year end: 31 December 2008 Prepared by: AB Date:

Subject: Receivables Reviewed by: Date:

This year Last year Ref Draft Adjustments Final Final

Trade receivables Less irrecoverable debt provision

Other receivables Prepayments

Summary of work done Ref

Confirmations of material receivables carried out J10 Receivables ageing reviewed and discussed with xx J20 Correspondence with disputed accounts reviewed J21 Material other receivables agreed to confirmation or

Material invoices agreed to invoices and payment and

Conclusion

Subject to satisfactory resolution of dispute with CDE Ltd (J2) receivables are fairly stated

MARKING GUIDE

(b) Financial statement assertions – receivables 3

(c) (i) Audit work on receivables and bad debt (1

mark per test if well explained) 12 (ii) Lead schedule for receivables 8

ANSWER 2

'Sufficient' audit evidence means 'enough' evidence to enable the auditor to form his opinion

What is 'enough' is a matter of professional judgement

'Appropriate' breaks down into two qualities: reliable and relevant

And 'sufficient', 'reliable' and 'relevant' are all interlinked

There is a link between sufficient and reliable: usually the more reliable the evidence, the less

of it the auditor will need However, if the evidence is found to be unreliable, looking at a

greater quantity of such evidence will never be sufficient

The nature of the evidence the auditor wants (its relevance) depends on the nature of the

transaction or balance being tested and the assertion being tested However, there are some

general characteristics of evidence:

The best evidence is:

• independent external evidence

• internal evidence subject to effective internal controls

• evidence obtained directly by the auditor

• documentary evidence

• original evidence

Less reliable evidence is:

• internally generated

• internal evidence not subject to internal controls

• evidence obtained indirectly or by inference

• oral evidence

• photocopies or facsimiles

So, to summarise, appropriate evidence is relevant to the transaction, balance and assertion

being tested and it has the characteristics of the best evidence; sufficient evidence means

enough evidence to enable the auditor to form his opinion and that is a matter of professional

judgement

10

Total marks available

Marking guide – up to 1 mark per point, ½ mark if explanation is weak

ANSWER 3

(a) Meanings

Audit risk is the risk of forming the wrong conclusion from audit procedures This

means giving an unqualified opinion when a qualified opinion would be most appropriate (or vice versa)

Inherent risk is the risk that material errors may arise from the nature of the

business, its transactions, or its industry, irrespective of the control system in place For example, any cash-based business is inherently risky because it is difficult to guarantee completeness of recording with such a weak audit trail

Control risk is the risk that a company’s internal control system may fail to prevent,

detect, and correct errors and omissions For example, a company with high staff turnover may suffer higher control risk because the staff are not in place long enough

to be fully aware of necessary procedures

Detection risk is the risk that the auditor’s substantive procedures fail to detect

material errors and omissions Detection risk is likely to increase as sample sizes are reduced Also, detection risk can be reduced by increasing the experience and general quality of the audit team

(b) Factors to consider

Going concern

Perfumes are a luxury product and are

therefore more likely to suffer reduced

demand in a recession

Will need to assess the current economic environment and consider recent trends

in perfume sales

Declining profits suggest the company’s

future prospects may be in doubt

Need to assess company’s future plans for evidence that this trend can be reversed

Need to assess company’s financial resources to assess how long company can continue to finance such losses The loss of such a key member of staff

(the former MD) may have implications

for the company’s long-term health

Assess level of involvement of previous

MD, and discuss board changes with the client Monitor trend in performance since changes made

Financial statements

Declining profits, combined with a desire

to achieve a listing, will increase the

pressure to overstate the profits of the

company

Audit team will need to consider all areas

of estimation and judgement with care (and a certain amount of scepticism)

Factor Explanation

Inventory

The incentive scheme may lead to

over-production, which may suggest that

inventories are over valued

Monitor the trend in inventory balances, and compare with sales figures to assess over-stocking

If sales continue to decline, this may

further suggest that inventories cannot

be sold and are therefore over valued

The inventory provision may be inadequate, therefore will need to understand management’s process for calculating the provision and review for

reasonableness

Products are made for specific

customers If any customers leave,

some inventories may be unsaleable to

anyone else, suggesting they are over

valued

Discuss how client-specific product lines are, and establish extent of write-offs when previous customers have left

The Finance Director’s move to

part-time status may result in a greater level

of errors in general

Monitor trend in accounting adjustments since this change to establish extent of any problem May need to bias audit work towards latter part of the year

Multiple locations are likely to require a

visit, especially for inventory count

attendance and asset verification

purposes

Establish likely inventory levels/key assets at each site, and plan visits accordingly

Control risk

Recent board changes are likely to

result in the control systems being

changed In the short term, changes in

management may lead to a weakening

of controls until new systems are in

place

Will need to assess controls over the year to establish whether they have weakened since the changes

The declining profits themselves may be

an indicator of poor controls

Historically, this is a family-run company

and formal controls may therefore be

lacking

In general, controls will need to be analysed and any changes documented

If controls appear strong, they will be tested If tests suggest they are operating effectively throughout the year,

substantive testing can be reduced

Multiple locations make it harder for

centralised management to control the

business

It may be possible to follow a controls based approach for part of the year (e.g

until the management changes), then follow a substantive approach from then

on

Audit strategy

There is likely to be a high volume of

transactions in sales, purchases and

inventory

Suggests that a controls-based approach, backed up by analytical substantive procedures, would be most efficient

Factor Explanation

Other

In a privately-owned family company,

directors may be treating personal

expenditure as business expenditure,

leading to an understatement of

directors’ emoluments

Careful review of any unusual payments,

or payments to directors, to ensure personal and business expenditure separated

(c) If inherent risk is high, and controls are not considered strong enough to deal with

these inherent risks (i.e control risk is high), then detection risk will need to be lowered This can be achieved by:

• increased substantive testing (larger samples)

• better sample selection (e.g using statistical sampling)

• using a more experienced audit team

ANSWER 4

(a) Issue

• Largest fee income/additional services give rise to fee

dependency/self-interest threat

• Fear of losing fee may influence auditor’s judgement

Safeguards

• Regular review to ensure recurring fees below recommended thresholds/

firm's own threshold

Issue

• Acting for 20 years gives rise to familiarity/trust/complacency threat

• Auditor may be over-influenced by the personality and qualities of directors

and management, and consequently too sympathetic

• Auditor may become too trusting of management representations so as to be

insufficiently rigorous in testing them because he knows the issue too well

Safeguards

• Periodic rotation of senior staff

• If listed, audit partner required to be rotated after five years

Issue Marks

Additional services also give rise to:

• Self-review threat – reluctant to challenge the outcome of a previous

engagement/report adversely on colleagues' work

• Possible low-balling – low audit fee to retain lucrative consultancy work

• Conflict of interest by acting for individual directors and the company – may

be tempted to favour one party at the expense of the other

Safeguards

• Use of different teams with separate reporting lines

• Independent partner review

Issue

Former employee having joined client gives rise to:

• Familiarity threat – too much reliance on representations of former employee

• Former self-interest threat – manager may have been too sympathetic

Safeguards

• The former employee should not derive benefits from the firm/participate in

the firm's business or professional activities

• The firm should review any significant judgements made by the manager

prior to leaving the firm

• Quality control procedures in place to ensure healthy professional scepticism

10

(b) (i) The statutory audit

The Code of Ethics and Conduct states that it is important that the firm is competent to undertake the audit; it must have adequate resources in terms

of staff with sufficient experience in this sector The fact that the services to

be provided would constitute a substantial amount of fee income in a new area of business indicates that the firm might not, at present, have those resources

It may be appropriate to consider whether experience in this sector can be bought in by the recruitment of additional staff

The firm should consider whether staff are available at the right time of year and whether the work fits in with the firm’s existing obligations

The Code of Ethics and Conduct also states that the firm must be independent of its clients; in particular, this means that it must not take too much of its fee income from one client (or group of clients)

Marks

Generally, for non-public interest clients, the fee income (including income from additional services) should not exceed 15% of the gross practice income If that figure is exceeded, it may be possible to consider providing some, but not all, of the services requested

5

(ii) The provision of other services

Preparation of financial statements

It is generally acceptable under the Rules of Professional Conduct for auditors to provide assistance with the preparation of financial statements for private company clients, provided that the client takes full responsibility for the accounting records and financial statements

It is important to know why the company needs assistance in this area and it would be preferable in the long run for the company to be able to prepare its own financial statements

It is important that those preparing the financial statements are independent

of those performing the audit as far as possible, in order that the firm is seen

to remain independent

Systems review

The external auditor is often well placed to provide assistance with such reviews as the firm obtains a working knowledge of systems during the course of the audit

However, there is always the danger that the firm finds itself in the position of having to report on a system that it has helped to improve, and it may be difficult in such circumstances to be critical of the system This detracts from the firm’s ability to remain independent and, in this case, given that it is the first year of audit and that assistance is also needed with the preparation of financial statements, it seems preferable not to tender for the systems review this year

5

20

Marking guide – 1 mark per point (½ mark if not well explained)