ACCA paper f8 auditiing and assurance F8AA(IntRQB as d08

However, internal and external auditors can also work together to ensure that the internal control system is sufficient; possibly by external audit delegating work to internal audit, and

Answer 1 AUDITORS AND AUDITING STANDARDS

(a) Development, role, and authority of ISAs

̈ ISAs set out the basic principles and essential procedures that auditors should

follow in the conduct of an audit of financial statements Auditing Standards are in bold type The grey type found in ISAs provides guidance on the application of ISAs

̈ Each Standard contains objectives and requirements (“shall”) with related guidance

(introductory, explanatory, application, definitions and other material, including appendices) The entire text of a Standard must be understood in order to apply the requirements of that Standard

̈ A current project is underway to redraft all ISAs – not to revise but to rewrite in

plainer language and an improved structure The differentiation between bold and plain text has been removed The structure of the redrafted standard will show the objective and requirements of the standard and will be supported by application and other explanatory material – all of which should be considered as an integral part of the standard

̈ International Standards on Auditing are set by the International Auditing and

Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC) The IAASB is made up of representatives (in practice, commerce, research and academic) of the profession who are members of IFAC

̈ ISAs and other documents issued by the IAASB are developed using a process of

exposure and consultation in order to obtain consensus and wide-spread acceptance

of standards Consultation is with interested parties outside the profession, as well

as within the profession itself

̈ Projects are identified by the members of the IAASB, the Consultancy Advisory

Group, the Forum of Firms, national auditing standard setting bodies and IFAC members

̈ The Consultancy Advisory Group gives representatives of the business community

and international organisations the opportunity to contribute to the development of international auditing guidance Members of the Group represent organisations that have an interest in international auditing

̈ The Task Force carries out the basic research and development of an Exposure

Draft (ED) This may be done as a joint project with a national auditing standard setting body

̈ ISAs apply to all audits of financial statements that are expressed in “true and fair”,

“fair presentation”, or similar terms Each of the objectives within a Standard must

be considered within the context of the overall objective of the audit as a whole If

an objective cannot be achieved, the auditor must use their judgement to evaluate the impact on their ability to achieve the overall audit objective

̈ By their very nature, ISAs require auditors to use their professional judgement when

applying them

̈ In exceptional circumstances, a professional accountant may judge it necessary to

depart from a basic principle or essential procedure of a Standard (and Practice Statement) to achieve more effectively the objective of the engagement When such

Project is proposed and input sought

If approved, project assigned to a Task Force

Research carried out and Exposure Draft prepared

ED placed on IFAC website and widely distributed for comment

to member bodies, interested parties and

general public

Comments received are considered, ED revised and re-issued if

substantive changes made

Revised ED approved and issued as a Standard

(b) The role of the ACCA in the regulation of auditors

̈ Auditors are regulated differently in different countries In some countries

governments regulate auditors directly, or through government organisations (eg the Public Accounting Oversight Board in the USA established by the Sarbannes-Oxley Act) In other countries the profession is self-regulating In most cases, there is some combination of self-regulation and government regulation

̈ In the UK, the monitoring of the quality of the audit function carried out by listed

company auditors is conducted by the Professional Oversight Board for Accountancy (POBA) of the Financial Reporting Council (FRC)

̈ The FRC is the UK’s independent regulator for corporate reporting and governance

and is responsible for:

̌ setting, monitoring and enforcing accounting and auditing standards

̌ statutory oversight and regulation of auditors

̌ overseeing the regulatory activities of the professional accountancy bodies

̌ promoting high standards of corporate governance

̌ operating an independent investigation and discipline scheme for public

interest (eg listed) cases

̈ Inspection of auditors under the monitoring of the POBA is carried out by the Audit

Inspection Unit (AIU) Such inspection incorporates a very thorough quality control review including reviews of audit working papers and audit procedures

̈ The regulation and inspection of auditors for non-listed companies is carried out

directly by the professional bodies, eg the ACCA

̈ Professional bodies such as the ACCA, seek to uphold professional standards, to

investigate complaints against auditors, and to assist auditors in the performance of their duties They have both investigative powers and sanctions against auditors who do not comply with professional standards These include fines, exclusion from membership, and the withdrawal of the licence to audit (audit registration)

Members of the ACCA are bound by its “Rules of Professional Conduct”

̈ The ACCA encourages high professional standards by setting academic

requirements for those wishing to study for the examinations, by setting the examinations and by requiring additional experience of those who wish to practice

as auditors This includes passing both Auditing papers (F8 and P7) in the ACCA examinations

̈ In addition, all members of the IFAC (this includes the ACCA) are required to

continue their development throughout their careers (CPD)

(c) How ISAs and national standards influence each other

̈ In a global market-place it is increasingly important that Auditing Standards are

harmonised across the world, particularly for multinational companies It is also important that Auditing Standards are applied consistently Over the last ten years, standard setters in those countries where the profession is mature have sought to harmonise their own standards with International Standards, and to influence International Standards

̈ In many countries, all new national Auditing Standards contain a statement to the

effect that compliance with the national standard will ensure compliance with the relevant International Standard in all material respects, if that is the case, or it will explain the difference(s)

̈ The requirements of the Standards do not override local regulations governing audit

and assurance in a particular country If local regulations have been followed and ISAs (and Practice Statements) that are applicable to the engagement have not been applied in their entirety, then compliance with ISAs cannot be stated as fact

̈ It is not always possible for local Auditing Standards to be the same as International

Standards because of local legal requirements Nevertheless, a number of countries have accepted International Standards in their entirety, or have accepted them subject to some minor local variations International Standards are thus extremely useful for countries where the profession is not strong and where government does not seek to detail Auditing Standards, and where there are few resources to develop local standards

̈ Standard setters in countries where the profession is mature make a significant

contribution to the development of ISAs by providing representatives to sit on IFAC Committees and working parties and by providing the resource to help draft

standards National standard setters comment on consultation papers and exposure drafts issued by the IAPC and help summarise responses on certain projects

̈ ISAs only have force internationally if they have the support of those countries who

lead the profession internationally It is therefore essential for both national standard setters and international standard setters to take account of each other’s work

Answer 2 JUMPER & CO

Memo From: A Manager, Tela & Co

To: Jumper & Co

Subject: Corporate Governance in the SGCC Company

Date: dd/mm/yyyy

As requested, I write to explain where your client SGCC does not appear to be following appropriate corporate governance codes and to recommend changes to ensure that the principles of good corporate governance are being followed

Chief Executive Officer (CEO) and Chairman

Mr Sheppard is both CEO and chairman of SGCC Corporate governance indicates that the person responsible for running the company (the CEO) and the person responsible for controlling the board (the chairman) should be different people This is to ensure that no one individual has unrestricted powers of decision

I recommend that Mr Sheppard is either the CEO or the chairman and that a second individual is appointed to the other post to ensure that Mr Sheppard does not have too much power in SGCC

Composition of board

The current board ratio of executive to non-executive directors is 5:2 This means that the executive

a balance of executive and executive directors so this cannot happen A minimum of three executive directors are also normally recommended, although reports such as Cadbury note this may be difficult to achieve

non-I recommend that the number of executive and non-executive directors is equal to help ensure no one group dominates the board This will mean appointing more non-executive directors to SGCC

Director appointment

At present, Mr Sheppard appoints directors to the board, giving him absolute authority over who is appointed This makes the appointment procedure and qualities directors are being appointed against difficult to determine Corporate governance suggests that appointment procedures should be

transparent so that the suitability of directors for board positions can be clearly seen

I recommend that an appointments committee is established comprising three non-executive directors to ensure there is no bias in board appointments Formal job descriptions should also be published making the appointment process more transparent

Review of board performance

It is correct that the performance of senior managers is reviewed, but this principle should also be applied to the board While Mr Sheppard may undertake some review, this is not transparent and it is not clear what targets the board either met or did not meet

I recommend that performance targets are set for each director and actual performance assessed against these on a regular basis Reasons for underperformance should also be ascertained and where

appropriate, changes made to the composition of the board

weaknesses and errors

I recommend that some more formal review of internal control is carried out, perhaps by establishing an internal audit department, as noted below The relationship with the company’s auditors must also be reviewed so that the work of the board and the auditors regarding internal control is understood by both parties

Internal audit

SGCC does not have an internal audit department Given the lack of formal review of internal control in the company, this is surprising Good corporate governance implies that the control system is monitored and that an internal audit department is established to carry out this task

I recommend that an internal audit department is established, reporting initially to the audit committee who will monitor internal control and then summarise reports for the board

Financial statements

There appears to be acceptable disclosure in the financial statements regarding the past results of the company However, the board should also provide an indication of how the company will perform in the future, by a forecast review of operations or similar statement This is partly to enable investors to assess the value of their investment in the company

I therefore recommend that the annual accounts of SGCC include some indication of the future

operations of the company

Audit committee

There is no mention in the report of an audit committee Good corporate governance implies that there

is some formal method of monitoring external auditors as well as checking that the reports from the external auditors are given appropriate attention in the company

I recommend that an audit committee is established – made up from non-executive directors The committee will receive reports from the external and internal auditors (as mentioned above) and ensure that the board takes appropriate action on these reports

I hope this information is useful Please contact me again if you require any further assistance

Sincerely

Ann C Outent

Note to candidates: An alternative and allowable answer format was to answer sections (a), (b) and (c)

of the question separately Taking this approach would also allow other valid points in part (b) such as inability to obtain a stock exchange listing

Answer 3 CORPORATE GOVERNANCE

Memo From: Chief Internal Auditor

Internal controls

The board need to maintain a sound system of internal control The internal audit department will be able to review existing controls and recommend improvements to ensure this objective

is met

Application of ISA and IFRS

The board need to have a policy for applying appropriate International Statements on

Auditing (ISA) and International Financial Reporting Standards (IFRS) to the organisation Internal audit will certainly be aware of new auditing standards and will have the technical expertise (especially where internal auditors are professionally qualified) to identify changes required by accounting standards Amendments to control systems for new auditing standards and financial accounting systems for new accounting standards can therefore be

recommended

Communication with external auditors

Under corporate governance regulations, communications with external auditors will

normally be via the audit committee, although the board must maintain an appropriate

relationship with the external auditors However, internal and external auditors can also work together to ensure that the internal control system is sufficient; possibly by external audit delegating work to internal audit, and each auditor reviewing the work of the other auditor The board will therefore receive reports from both sets of auditors which will be accurate because they have been properly checked

Communication to the board

The internal auditor can also check that appropriate information is provided to the board from

the external auditor ISA 260 Communications of audit matters with those charged with

governance provides a list of matters which should be communicated to the board and the

internal auditor can work with the external auditor to ensure that this information is provided

(b) The advantages of an audit committee include:

Public confidence

Providing increasing public confidence in the creditability and objectivity of published financial information This will be particularly important for ZX if listing arrangements go ahead While an internal audit department is not normally necessary for incorporated

companies, the provision of that department will provide additional confidence in the

accuracy of the financial statements and hopefully make ZX an attractive investment

Financial reporting

Supports the directors in fulfilling their financial reporting obligations The directors have to prepare financial statements for ZX The committee can assist by checking the financial statements to ensure that they comply with appropriate reporting requirements This is

especially important where the board do not have detailed knowledge of accounting

requirements

Communication

Enhancing the role of ZX’s external auditors by providing an appropriate channel of

communication Use of the audit committee will enable the external auditor to discuss issues with the financial statements with the internal auditor, prior to providing a final summary of key points to the board

“Friend” of the Board

The audit committee may also act as a “critical friend” to the board by monitoring the work of the board and providing helpful guidance, where corporate governance requirements do not appear to be being met The audit committee should have detailed knowledge of corporate governance as part of its monitoring function of the company and can share this with the board who may not have the time to obtain detailed information

The disadvantages of an audit committee include:

Lack of understanding of function

As the directors in ZX do not have much knowledge of corporate governance, they may see the additional involvement of the audit committee as a threat to their authority or taking away some of their responsibilities This memo has hopefully outlined the advantages of an audit committee in supporting the work of the directors, removing this as a problem

Role of non-executive directors

As the audit committee will be made up mainly from non-executive directors, the board may see this as a means of decreasing their power and possibly letting other people run the

company Again, the audit committee must be seen as fulfilling a supporting role for the main board It will utilise the special knowledge of account production and internal controls from the external auditor and business non-executives to provide appropriate review of information being given to the board

Cost

The audit committee will increase the expenditure of the company as the non-executive directors will require some remuneration due to their additional responsibilities While this cannot be avoided, the benefits of the committee in terms of providing assistance to the board and raising the profile of ZX ready for possible listing must not be forgotten

Answer 4 FRAUD AND COMPLIANCE SEMINAR

(a) Missing share certificates

The auditors must treat this matter as extremely serious Not only has a senior executive perpetrated an illegal act, he has also been guilty of deliberately attempting to mislead the auditors

The auditors must report the matter immediately to the audit committee, if there is one, or otherwise to the full board of directors (ISA 240) A criminal offence has been committed in the theft of the shares and in attempting to mislead the auditors The auditors would expect appropriate action to be taken Any further course of action depends on the action taken by the directors

If the directors do not take appropriate action, such as reporting the matter to the police, the auditors must consider the desirability of continued association with the company Failure to take action would make the directors a party to the wrongdoing involving, as it does, money for which they have a responsibility to the shareholders

In most jurisdictions the auditors do not normally have any responsibility for reporting the matter to third parties except in the public interest or where there is some direct legal duty imposed on auditors Their duty of confidentiality prevents their taking further action However, on resigning, they can take the opportunity to reveal their concerns in any

communication accompanying their resignation They may also respond appropriately to professional enquiries from auditors nominated to replace them However, they need to obtain legal advice on the form of such communication to avoid the risk of action for breach

of confidence by the company or even defamation by the finance director

If the directors do take appropriate action, the auditors must consider their position with respect to the current audit engagement The finance director is a key person with respect to representations on which the auditors would have relied Now that the credibility of that officer is in doubt, the necessary level of professional scepticism becomes much greater Such an official has the authority to override almost any control and is in a position to conceal such actions The control environment must be regarded as being wholly ineffective and inherent risk assessed as high Extended substantive procedures will now need to be

performed in all areas that could have been manipulated by the chief financial officer Providing sufficient appropriate evidence is available then there would be no effect on the auditors’ report It is possible, under the circumstances, that the auditors may be unable to reassure themselves that further misstatements are not present In this case they would need

to issue an “except for – scope limitation” qualified auditors’ report

(b) Product safety

The auditors have no duty to search for all instances of non-compliance with all applicable laws and regulations However, in addition to laws and regulations directly pertaining to financial reporting, the auditors also have a duty (ISA 250) to become familiar with any particular laws and regulations breaches of which might result in the company no longer being a going concern Moreover, in this case, they have already become aware of the

possible breach Their suspicions are aroused and they are under a duty to investigate the matter further

The finance director may be right in claiming the matter is of no consequence, but the fact of attempting to conceal the evidence from the proper authorities must arouse suspicions that the matter is serious The auditors need to obtain independent expert advice on the implications

of the matter If the company denies access to an independent expert the auditors may

consider, at the very least, issuing an “except for – scope limitation” qualified auditors’ report If the expert confirms suspicions and the effect is potentially material, at the very least the auditors would require full provision to be made, failing which an “except for –

disagreement” qualified auditors’ report would be necessary (ISA 250)

If the auditors’ suspicions are confirmed and the effect is material, the auditors would

normally report the matter to the board of directors and to the audit committee, if the

company has one In this case, however, the board is implicated in the attempt to cover up the evidence, so the auditors would report solely to the audit committee

Again legal advice needs to be sought on whether the actions of the board are illegal If so, then they may consider it desirable to resign from the audit Moreover, consideration must be given to the consequences of the continued supply of unsafe goods It is likely the auditors have a case for alerting the appropriate authorities in the public interest which overrides their duty of confidentiality to the client – legal advice must be sought before doing so

(c) Understatement of royalties

This suspected fraud differs in being perpetrated by the company and not by employees against the company The auditors’ duty of confidentiality to the company prevents them from communicating their suspicions to the authors However, the company has a liability under the terms of the royalty agreements which must be provided for until extinguished by the statute of limitations or other limitation on the rights of creditors to sue for amounts due The auditors would possibly seek legal advice on whether the company’s action was illegal, such as a conspiracy to defraud the authors or false accounting to obtain a pecuniary

advantage If the directors’ actions are illegal the auditors would expect the directors to pay the amounts due in full If the directors refuse, the auditors should consider resigning

If the action is not illegal, it is certainly unethical, and the audit will be affected in two ways Firstly, if the amounts are material and the company fails to make adequate provisions within the financial statements, the auditors must issue an “except for – disagreement” qualified auditors’ report (ISA 240) Secondly, the auditors will need to revise their assessment of inherent risk at the entity level They would need to increase the tolerable level of detection risk and perform a higher level of substantive procedures than previously would have been considered necessary (ISA 240)

However, the auditor does have a duty to communicate suspicions promptly to an appropriate level of management and to see that the matter is properly investigated (ISA 240) If the auditor is not satisfied that a proper investigation is performed, it is possible that the level of management to which the suspicions are communicated is also implicated in the fraud The matter becomes more serious and must be reported to the audit committee or board of

Answer 5 STONE HOLIDAYS

(a) Internal audit function: risk of fraud and error

̈ The internal audit function in any entity is part of the overall corporate governance

function of an entity Corporate governance objectives include the management of the risks to which the entity is subject that would prevent it achieving its overall objectives such as profitability Corporate governance objectives also include the overarching need for the management of an entity to exercise a stewardship function over the entity’s assets

̈ A large part of the management of risks, and the proper exercise of stewardship,

involves the maintenance of proper controls over the business Controls over the business as a whole, and in relation to specific areas, include the effective operation

of an internal audit function

̈ Internal audit can help management manage risks in relation to fraud and error, and

exercise proper stewardship by:

(1) commenting on the process used by management to identify and classify

the specific fraud and error risks to which the entity is subject (and in some cases helping management develop and implement that process); (2) commenting on the appropriateness and effectiveness of actions taken by

management to manage the risks identified (and in some cases helping management develop appropriate actions by making recommendations); (3) periodically auditing or reviewing systems or operations to determine

whether the risks of fraud and error are being effectively managed;

(4) monitoring the incidence of fraud and error, investigating serious cases

and making recommendations for appropriate management responses

̈ In practice, the work of internal audit often focuses on the adequacy and

effectiveness of internal control procedures for the prevention, detection and reporting of fraud and error Routine internal controls (such as the controls over computer systems and the production of routine financial information) and non-routine controls (such as controls over year-end adjustments to the financial statements) are relevant

̈ It should be recognised however that many significant frauds bypass normal internal

control systems and that in the case of management fraud in particular, much higher level controls (those relating to the high level governance of the entity) need to be reviewed by internal audit in order to establish the nature of the risks, and to manage them effectively

(b) External auditors: fraud and error in an audit of financial statements

̈ External auditors are required by ISA 240 The Auditor’s Responsibility to Consider

Fraud in an Audit of Financial Statements to consider the risks of material

misstatements in the financial statements due to fraud Their audit procedures will then be based on a risk assessment Regardless of the risk assessment, auditors are required to be alert to the possibility of fraud throughout the audit and maintain an attitude of professional skepticism, notwithstanding the auditors’ past experience of the honesty and integrity of management and those charged with governance

Members of the engagement team should discuss the susceptibility of the entity’s financial statements to material misstatements due to fraud

̈ Auditors should make enquiries of management regarding management’s

assessment of fraud risk, its process for dealing with risk, and its communications with those charged with governance and employees They should enquire of those charged with governance about the oversight process

̈ Auditors should also enquire of management and those charged with governance

about any suspected or actual instance of fraud

̈ Auditors should consider fraud risk factors, unusual or unexpected relationships,

and assess the risk of misstatements due to fraud, identifying any significant risks Auditors should evaluate the design of relevant internal controls, and determine whether they have been implemented

̈ Auditors should determine an overall response to the assessed risk of material

misstatements due to fraud and develop appropriate audit procedures, including testing certain journal entries, reviewing estimates for bias, and obtaining an understanding of the business rationale of significant transactions outside the normal course of business Appropriate management representations should be obtained

̈ Auditors are only concerned with risks that might cause material error in the

financial statements External auditors might therefore pay less attention than internal auditors to small frauds (and errors), although they must always consider whether evidence of single instances of fraud (or error) are indicative of more systematic problems

̈ It is accepted that because of the hidden nature of fraud, an audit properly

conducted in accordance with ISAs might not detect a material misstatement in the financial statements arising from fraud In practice, routine errors are much easier to detect than frauds

̈ Where auditors encounter suspicions or actual instances of fraud (or error), they

must consider the effect on the financial statements, which will usually involve further investigations They should also consider the need to report to management and those charged with governance

̈ Where serious frauds (or errors) are encountered, auditors need also to consider the

effect on the going concern status of the entity, and the possible need to report externally to third parties, either in the public interest, for national security reasons,

or for regulatory reasons Many entities in the financial services sector are subject to this type of regulatory reporting and many countries have legislation relating to the reporting of money laundering activities, for example

(c) Nature of risks arising from fraud and error: Stone Holidays

̈ Stone Holidays is subject to all of the risks of error arising from the use of computer

systems If programmed controls do not operate properly, for example, the information produced may be incomplete or incorrect Inadequate controls also give rise to the risk of fraud by those who understand the system and are able to

manipulate it in order to hide the misappropriation of assets such as receipts from customers

̈ All networked systems are also subject to the risk of error because of the possibility

of the loss or corruption of data in transit They are also subject to the risk of fraud where the transmission of data is not securely encrypted

̈ All entities that employ staff who handle company assets (such as receipts from

customers) are subject to the risk that staff may make mistakes (error) or that they may misappropriate those assets (fraud) and then seek to hide the error or fraud by falsifying the records

̈ Stone Holidays is subject to problems arising from the risk of fraud perpetrated by

customers using stolen credit or debit cards or even cash Whilst credit card companies may be liable for such frauds, attempts to use stolen cards can cause considerable inconvenience

̈ There is a risk of fraud perpetrated by senior management who might seek to lower

the amount of money payable to the central fund (and the company’s tax liability)

by falsifying the company’s sales figures, particularly if a large proportion of holidays are paid for in cash

̈ There is a risk that staff may seek to maximise the commission they are paid by

entering false transactions into the computer system that are then reversed after the commission has been paid

Answer 6 MANLY

(a) Removal from office

The financial statements being reported on represent a statement of accountability by

management and directors to those on whose behalf they exercise their function, that is the shareholders, in the case of an incorporated business The ability of management to control the appointment of auditors threatens to undermine the independence of the audit They can effectively evade an unsatisfactory auditor’s report by dismissing the auditor Even where the right to appoint (and remove) auditors is in the hands of shareholders or members,

management are often able to influence the exercise of that function

There are a number of safeguards available to auditors to minimise the extent of the problem

̈ Not accepting appointment where there is reason to suspect management might seek

to dismiss the auditor to evade an unsatisfactory report

̈ Communicating with predecessor auditors to ascertain if such reasons lie behind the

proposed change of auditor

̈ Adhering strictly to professional independence rules to ensure an ability to

withstand management threats of removal from office in an attempt to dissuade auditors from modifying their report

̈ Taking full advantage of whatever statutory protection exists against removal from

office such as a right to communicate with shareholders where a change in appointment is proposed by management

̈ Adhering to professional rules relating to providing advice to non-audit clients,

which might put undue pressure on their auditor Without discussing all of the issues with the current auditors, the other firm in this question appears to be acting

in breach of this rule

It is now a requirement under many listing jurisdictions for listed companies to have an independent audit committee The role of the committee is to oversee the integrity of the financial reporting controls and procedures implemented by management, to protect the interests of shareholders and other stakeholders

For example, under the OECD Principles, the audit committee should be responsible (or at least recommend – as required by the UK Combined Code) for the appointment, re-

appointment and sacking of the external auditors

This therefore clarifies that the external auditors are responsible to the shareholders and not directly to the executive management of an entity

All material audit findings should be discussed with the audit committee, as well as the executive directors If the audit committee accept the auditor’s findings and the need to qualify, then it is unlikely that they would also recommend sacking the auditor

(b) Provision of other services

(i) Rules of Professional Conduct

̈ An auditor should not provide accountancy services to listed or public interest

company audit clients except of a purely mechanical nature such as drafting the statutory financial statements

̈ Where accountancy services are provided to other company audit clients, the client

should accept full responsibility for the records, the assistance should not extend to management decision making and a full audit must also be undertaken

̈ In the provision of other services, care must be exercised that the service is limited

to providing advice and not the exercise of management functions This applies particularly in providing executive recruitment services The service should be limited to identifying a short-list and not to making the final selection

̈ Other services should not include the making of specialist valuations, which are to

be incorporated in the audited financial statements

̈ The provision of non-audit services should not constitute recurring work which

brings total fees received from that audit client to more than 15% of the firm’s gross fee revenues or 10% if the client is a listed or public interest company The reasons for this are evident from the engagement partner’s reluctance to qualify the opinion for fear of angering the management and losing the audit

̈ Although not over the limit, fees from the provision of non-audit services are,

nevertheless, high The engagement partner’s concern is unprofessional and it would be hoped that professional accountants would be more objective

̈ Nevertheless, it illustrates concerns that would arise in the minds of users of

(ii) Prohibition of non-audit service provision

The Rules of Professional Conduct state that, in principle, there is no objection to providing non-audit services to audit clients However, it is also claimed that the provision of such services impairs auditor independence The alleged scenario is as follows:

̈ As auditors, the firm is appointed by and is responsible to the members of the

company

̈ In providing other services, the firm is appointed by and is responsible to the

management, although an audit committee would advise on the appointment

̈ Because of the advantages of dealing with just one firm of accountants, the

management tends to prefer to use the audit firm to provide these other services

̈ If the firm loses the audit, they are likely to lose revenues from the provision of

other services This is clearly the case here and the audit partner’s judgement is strongly influenced by the potential loss of revenue

̈ The auditors recognise the ability of the management to influence auditor

appointment Where auditors receive revenues from providing non-audit services,

as in the case of Manly, it is alleged that management may exploit this fact in order

to put pressure on the auditors

̈ Other services often attract higher fees than audit services Firms may seek to

secure audit appointments primarily as a means of obtaining contracts for the provision of more rewarding other services

̈ For these reasons, it is argued, firms should be forbidden to provide non-audit

services to audit clients, or at the very least, such services are appointed by the audit committee

The profession, on the other hand, argues that quarantining audit from the provision of audit services denies companies the right to select their professional advisers It also imposes costs in that the audit, necessarily, will become more expensive as will the provision of non-audit services as the firm providing the services will not have the benefit of knowledge of the company gained through the audit

non-As professionals, it is argued, accountants will not allow their judgement to be influenced by such considerations and the situation illustrated in the question is an unlikely one Moreover, there is bound to be overlap between audit and non-audit services such as advice on internal control and related matters contained in the management letter

(c) Rotation

Rotation is the term given to limiting the number of years an individual or a firm is associated with the audit of a particular client

As from 2004, the ACCA professional ethics require that that the engagement partner should

be rotated every 5 years and other audit partners every 7 years The benefit of understanding

of the clients’ business is outweighed by the possible loss of professional scepticism In this case the audit partner has known Manly’s chief financial officer for too long to be able to entertain ideas that he may not be trustworthy In addition she is in breach of the ACCA rules

At a further level it is argued that audit firms should only serve a fixed term of office,

although not part of the requirements of the ACCA The benefits of securing non-audit work from clients are substantially reduced if the term of office as auditor is limited to say seven years Similarly, efforts to maintain good relations with management possibly to the extent of condoning questionable financial statements would no longer serve a useful purpose

The argument against rotation of audit firms is that it imposes additional costs and risks It is the first year as auditor that is most costly and also the year the auditor is at greatest risk of failing to detect misstatement through unfamiliarity with the client Rotation of audit firms is statutorily required in some countries

Answer 7 INTERNAL AUDITOR

(a) Request to alter accounts

̈ The first Fundamental Principle of the ACCA’s “Rules of Professional Conduct”

states that members should behave with integrity in all professional relationships, and that integrity implies honesty, fair dealing and truthfulness

̈ It is therefore unethical for members of the ACCA to falsify financial records To

do so might also constitute a criminal offence and if the public interest or national security is involved, there may even be a responsibility to report the matter to third parties, although there is no indication in the question that this is the case In practice however, the dividing line between what is acceptable and what is not is often a difficult one to draw

̈ The internal auditor should first conduct a thorough review of the internal records to

establish whether or not the company has in fact complied with the bank’s requirements If the company has not done so, the question arises as to whether any legitimate changes can be made in order to meet the requirements

̈ The question indicates that the profit figures are significantly affected by the

calculation of the bad debt and depreciation figures It is not uncommon for changes

to such calculations to be made, although the justification for such changes must be

in order to present the financial position more fairly, and not simply to achieve targets

̈ Changes in these calculations do not generally amount to changes in accounting

policy and do not therefore require separate disclosure in financial statements as required by accounting standards (IAS 8 “Accounting Policies, Changes in Accounting Estimates and Errors”), unless perhaps the amounts are material, in which case they might constitute exceptional items (IAS 1 “Presentation of Financial Statements”) Only if a change in calculations is justified by reference to a re-assessment of assets lives perhaps, or because the bad debt provision has been calculated over-prudently in the past, will it be acceptable to make the changes

̈ It may be legitimate to move bad debts and certain elements of depreciation from

cost of sales to overheads, thus improving gross margins This would not amount to

a change in accounting policy but it would be important for the change to be disclosed if the effect were to mean that the bank’s conditions were met, and they would not have been met were the changes not made

̈ It is essential that the documentation that goes to the bank clearly discloses the

changes, as they are likely to be material to the bank

̈ The situation might arise where the changes are made and the internal auditor

agrees, subject to proper disclosure being made, or signs relevant documentation, but at a later stage discovers that the bank has not been properly informed about the changes In these circumstances, there is no duty to report the matter to the bank, and the auditor would be in breach of his duty of confidentiality to his employer if

he did so

̈ However, I would seriously consider whether to continue in employment with such

a company I would express my concerns, in writing, at the highest possible level, at all stages during the proceedings

(b) Implications for the audit, the auditor’s report and the relationship between the firm

and client

(i) Implications for the audit of the financial statements

̈ The reasons for the changes in the accounting policy in relation to leases is likely to

be important, because the amounts involved are likely to be material and disclosure

in the financial statements is required by IAS 8 The external auditor should satisfy himself that the reason for the change is justified in terms of the financial statements giving a true and fair view

̈ The external auditor should establish the reasons for the change in the calculation of

provisions in the same way as the internal auditor in (a) above Whilst a matter may

be material to the bank in the context of the lending decision, it may not be material

to the audit of the financial statements

̈ If the external auditor believes that these changes are unjustified and symptomatic

of a wider problem, he should investigate any other areas in which inappropriate changes may have been made, and form an opinion on the view given by the financial statements as a whole, not just in part

(ii) Potential effect on the auditor’s report

̈ The fact that the chief financial accountant is on holiday and that the internal auditor

is unavailable is suspicious in itself If the auditor cannot obtain adequate information and explanations from the company then he is required to say so in the auditor’s report, which will be qualified The external auditor should warn senior management of the client of this possibility, at the earliest possible opportunity, preferably in writing

̈ Furthermore, if there is significant doubt about the company’s ability to continue as

a going concern, then a modified (but unqualified) audit report may be required under ISA 570 “Going Concern” (provided that the matter is properly disclosed), or

a qualified report if the matter is not properly disclosed

(iii) Implications for the continuing relationship between the audit firm and the client

̈ If the auditor considers that the client lacks integrity, or does not have a proper

regard for accounting standards and disclosure requirements, the firm should consider whether it is appropriate to continue the relationship with the client It may

be preferable to discontinue the relationship

Answer 8 CLIENT CONFIDENTIALITY

(a) Disclosure of information relating to clients to third parties

̈ Auditors are permitted or required to disclose information about their clients to third

parties without their knowledge or consent in very limited circumstances

̈ Generally, auditors can be required to, or are permitted to, disclose information to

certain regulatory bodies, including certain specialist units within police forces under legislation Such legislation in many countries includes financial services legislation, legislation concerning banks and insurance companies, legislation concerning money laundering and legislation concerning the investigation of serious fraud or tax evasion

̈ Auditors are also permitted or required to disclose information where they are

personally involved in litigation, including litigation that involves the recovery of fees from clients, or where they are subject to disciplinary proceedings brought by ACCA or similar professional bodies

̈ Auditors are also permitted to disclose information where they consider it to be in

the “public interest” or in the interests of national security Factors to take into account include the seriousness of the matter, the likelihood of repetition and the extent to which the public is involved This right is rarely used in practice

(b) Response to requests

̈ It is not unusual in practice for various bodies to request information from auditors

“informally” because it relieves them of the obligation to obtain the necessary statutory authorities which may be time consuming or difficult

̈ Auditors must not disclose information without the consent of the client or unless

the necessary statutory documentation is provided by the person(s) requesting the information

̈ Unless the auditor has reason to believe that there is a statutory duty not to inform

the client that an approach has been made, the client should first be approached to see if consent can be obtained, and to see if the client is aware of the investigations,

as should normally be the case The auditor should ensure that the client is aware of the fact that voluntary disclosure may work in the client’s favour in the long run, but

if the client refuses, the auditor should inform the client if the auditor has a statutory duty of disclosure

̈ Auditors should consider taking legal advice in all of the cases described

̈ Where auditors are made aware of potential actions against the client that may have

an effect on the financial statements, they must consider the effect on the audit report If the client is aware of the investigation, auditors will be able to seek audit evidence to support any necessary provisions or disclosures in the financial statements

̈ The auditors should consider whether the suspected fraud relating to the managing

director relates to the company and affects the financial statements

̈ Auditors will be in a very difficult situation if they become aware of an action that

may materially affect the financial statements, but where the client is not, and where

auditors are under a statutory duty not to inform the client This situation will not be

improved by the resignation of auditors as they may be obliged to make a statement

on resignation This puts auditors in a very difficult position and legal advice is essential in such circumstances

̈ Tax authorities normally have powers to ask clients to disclose information

voluntarily Such voluntary disclosure is often looked on favourably by the tax authorities and the courts Tax authorities normally also have statutory powers to demand information from both clients and auditors The same is generally true of environmental and health and safety inspectors

̈ The power of the police to demand information is sometimes less clear and auditors

and clients should take care to ensure that the appropriate authorities are in place Those sections of the police investigating serious frauds usually have more powers than the general police It is unlikely that trade union representatives have any statutory powers to demand information

Answer 9 MELTON MANUFACTURING

(a) Investigations and practical and ethical matters to be considered

̈ Eligibility – the firm should be recognised to provide audit services (eg a firm of

Chartered Certified Accountants) and the reporting partner should hold a recognised qualification (eg be a member of the Association of Chartered Certified

Accountants and hold a practising certificate) The firm should have adequate professional indemnity insurance (PII) cover

̈ The reason for the change in auditor – whether it is just that the directors believe

they do not receive a cost effective service from the existing auditor There may be problems with the level of the audit fee or the existing auditor may want to modify his auditor’s report (which the directors are trying to prevent)

̈ Previous years’ audited accounts If the auditor’s report is modified, it indicates that

the audit has a higher than normal risk From these accounts it may be possible to assess:

̌ whether the company appears to be having going concern problems (eg by

calculating appropriate ratios, eg debt/equity ratio);

̌ if there could be weaknesses in the system of internal control (because the

company is small or has a dominant proprietor)

With a manufacturing company there are likely to be more problems with the valuation of inventory, but there would be less risks over sales and purchases as they are likely to be on credit There could be problems with obsolete plant and equipment

̈ The size of the audit client and the fee compared with other clients The Guide to

Professional Ethics says that an auditor’s independence may be compromised if the fee from a single client exceeds 15% of the total practice income (10% for listed and other public interest companies)

̈ This does not appear to be a public company, but for a public company the auditor

should not normally both prepare and audit the financial statements For other companies, if the auditor both prepares and audits the financial statements, it is desirable that these are carried out by different staff

̈ Independence issues – in particular, shares should not be held in the client company

(Any shareholdings should be disposed before being appointed as auditor.) Close family and business relationship with any directors of the company would also impair objectivity

̈ Fees – should be sufficient to provide an acceptable return An inadequate fee

could result in insufficient audit work being carried out and thus increase the audit risk

̈ Prior experience of the manufacturing industry and auditing companies in this

industry Without such experience the auditor may not have the skills necessary to audit inventory, impairment of plant and equipment, etc Thus, the invitation to accept the audit appointment would need to be declined

̈ Whether staff with special skills (eg of computer-aided manufacturing design) or

external specialists may be required to carry out certain aspects of the audit

̈ Whether Melton Manufacturing will give permission to communicate in writing

with the retiring auditor If the prospective client refuses, the nomination should be refused

̈ With permission, the retiring auditor will be contacted and asked if there are any

professional reasons why the appointment should not be accepted

̈ If the company has not paid the retiring auditor’s fees, the appointment can be

accepted However, if it suggests that Melton is a “bad payer” it can obviously be declined

(b) Letter of engagement

̈ The main reason why it is important that an auditor should send a letter of

engagement to the client is that it explains the duties of the auditor: and the contract, which exists between the auditor and the client If no letter of engagement is sent, disputes and misunderstandings may arise about the auditor’s duties

̈ The letter of engagement explains that the auditor’s duties are governed by the

relevant legislation and cannot be limited by the company Also, the auditor reports

to the shareholders (and not the directors) whether the financial statements show a true and fair view

̈ Further, it explains the directors’ responsibilities, particularly that they are

responsible for preparing the financial statements (although the auditor can prepare the financial statements for the directors, if requested) and for ensuring there are proper systems of internal control to prevent or detect errors, irregularities and fraud

̈ The auditors are only responsible for giving an opinion on the financial statements

They are not responsible for detecting small errors and fraud, but their audit

procedures should have a reasonable expectation of detecting material errors and fraud

̈ Finally, the engagement letter explains that the fee is based on the time spent by

partners and staff in carrying out the audit

̈ It is important that the auditor obtains the directors’ agreement of the letter of

engagement and that a revised letter is sent when there are significant changes to the terms of the existing letter

̈ The letter is written on the auditor’s headed paper and is addressed to the directors

of Melton Manufacturing

̈ It states the directors’ responsibilities for keeping proper accounting records and for

preparing financial statements which show a true and fair view The directors must make available to the auditor all the records he may reasonably require, and provide answers to the auditor’s questions

̈ The auditor has a duty to report on whether the financial statements show a true and

fair view and comply with any relevant legislation

̈ Normally, the auditor would report if the financial statements do not comply in any

material respect with accounting standards (IFRSs)

̈ The audit is conducted in accordance with Auditing Standards (ISAs)

̈ Oral or written representations may be asked from the directors concerning various

matters in the financial statements

̈ The directors are responsible for preventing and detecting irregularities and fraud

The audit procedures would be designed so there is a reasonable expectation of detecting material misstatements in the financial statements: However, the audit should not be relied upon for detecting all irregularities and fraud that may exist

̈ As auditor, we may provide additional services For example:

̌ Preparing financial statements;

̌ Lodging returns with the Registrar of Companies;

̌ Investigating irregularities and fraud;

̌ Providing taxation services

̈ Fees are based on the time spent by partners and staff and on the levels of skill and

responsibility involved

The letter ends by saying that it remains effective until it is replaced, and it asks the directors

to agree the terms of the letter in writing

Answer 10 BONDI

(a) Arguments against acceptance of nomination

̈ Rapid growth is often accompanied by inadequate accounting systems and weak

internal controls Of itself this is not sufficient reason to decline an audit but it increases inherent risk

̈ Rapid growth through aggressive take-overs implies a management philosophy that

is willing to accept risks and this is likely to apply to controls as well Again this increases inherent risk

̈ Failure to take action against employee fraud brought to their notice by the auditors

is more serious This fosters a visible culture of unethical behaviour that is likely to permeate the company and to be shared by all employees This will result in a weak control environment

̈ Introduction of a new computer system must be undertaken very carefully In

addition, an unnecessarily complicated system is one of the warning signs of fraud Such a computer system may be difficult to audit

̈ Aggression against audit staff is a well known device for concealment of top

management fraud There are many documented examples of audit failure through fear of the audit staff to query management explanations

̈ The impending public listing means that the company is under pressure to show an

improving performance but also means that the work of the auditor will come under increasing scrutiny There are always significant risks in accepting an audit under such terms

Arguments for accepting nomination

As a larger firm your firm is likely to have the capability of influencing the directors of Bondi and persuading them of the benefits of a more ethical style of business This will benefit the company’s shareholders If your firm rejects the audit they are likely to appoint a less

reputable firm This will not be in the shareholders’ interest and may discredit the profession

(b) Matters relevant to obtaining knowledge for development of the audit plan

Employee frauds

̈ More information is needed about the alleged employee frauds In particular the

specific control weaknesses that were exploited and whether any changes have since been made to the accounting and internal control systems

̈ The current positions held by the guilty employees and whether they have access to

assets and accounting records Also, whether they are adequately supervised especially if a lack of segregation of duties is apparent

Computer system

̈ Particular attention should be given to the control environment relating to computer

systems and to the evaluation of general (IT) and application controls

̈ Tests of controls could include the use of test data or other computer assisted audit

techniques

Contracts with manufacturers

̈ Examine the terms of contracts and the strategies adopted by the company for

securing maximum benefit from them

̈ An industry specialist may provide evidence regarding the problems encountered by

manufacturers and dealers in confirming compliance with these contracts

̈ As the incentive schemes may have accounting implications (eg 0% finance) the

commercial substance as well as the legal form of the transactions with the manufactures must be understood and the impact on the financial statements assessed

(c) Misstatement

̈ As this appears to be a fraud against the government through falsification of

accounting records, the evidence that the falsification of the records is deliberate and not an accidental consequence of a poorly designed computer system, must be documented

̈ The matter must be discussed with management Management must be asked to:

− correct the fictitious records;

− make full provision for all taxes including any penalties for which they are

potentially liable; and

− make a full disclosure to the taxation authorities

̈ If management refuse, the audit opinion should be qualified if the amount of taxes

not provided for, if material (However, the auditor’s report should not, for example, accuse the directors of impropriety.)

̈ The auditor’s duty of confidentiality prevents the auditor from raising the matter

with the taxation authorities Therefore, it may be most appropriate to resign from the audit if management refuse to put a stop to the malpractice Any written

“statement of circumstances” required on ceasing to hold office could allude to the matter but would need to be carefully worded, probably with legal advice, to avoid accusing the directors of fraud and exposing the firm to a charge of defamation

Answer 11 PLANNING DOCUMENTATION

(a) “Overall strategy” v “Audit plan”

These documents are prepared and updated during the planning process, which is an ongoing process throughout the audit

The audit strategy sets the scope, timing and direction of the audit, and helps guide the

development of the more detailed audit plan For example:

̈ Determining the scope of the audit engagement, covers the financial reporting

framework used, industry-specific law and regulation requirements, governance requirements, locations of the components of the entity (may have different requirements), terms of engagement, client assistance

̈ Ascertaining the reporting objectives deals with the timing of the audit and

communications required, deadlines for interim and final reporting; key dates for expected communications with management and those charged with governance

̈ Establishing the direction of the audit deals with, for example, determination of

appropriate materiality levels, preliminary identification of areas where there may

be higher risks of material misstatement, preliminary identification of material components and account balances, evaluation of whether the auditor may plan to obtain evidence regarding the effectiveness of internal control, identification of recent, industry, financial reporting or other relevant developments impacting upon the entity

The process of establishing the audit strategy helps the auditor to ascertain the nature, timing and extent of resources necessary to perform the engagement

The detailed approach for the nature, timing and extent of the audit procedures is set out in the audit plan

The plan is more specific and concerns the principal audit areas, eg tangible assets, inventory, revenue cycle (ie sales, receivables and cash receipts), subsequent events and going concern

An audit program typically contains:

̈ Audit objectives eg “To ensure inventory is materially correctly stated”;

̈ Audit procedures eg attendance at physical inventory count;

̈ Timing of tests of control (usually “interim audit” procedures) and substantive

procedures (usually at the “final audit”)

The audit program has to be much more detailed than the overall strategy in order to serve as

a set of instructions

(b) Standardized audit programs

Tutorial note: The Q refers only to the use of standardized AUDIT PROGRAMS and not

“working papers” in general Thus references to the use of standard letters and

documentation other than programs are not relevant to answering the question set

Advantages

̈ Their use can lead to more efficient planning in identifying the audit objectives and

adopting an approach based on these objectives Greater assurance as to the completeness of the audit approach is obtained than if it were started from scratch Planning can be undertaken by less senior staff

̈ Standardised programmes facilitate delegation to junior staff and help to instruct in

basic audit techniques They help to ensure that all assignments are planned and conducted to a consistent quality

̈ A standardised approach makes the review of audit working papers easier

Programmes may include sections to be completed, thereby reducing the need for separate supporting working papers

Disadvantages

̈ Standardisation may lead to an overly mechanical approach This may stifle

initiative because an alternative, more efficient approach may not be considered

̈ No account is taken of the particular circumstances of the individual enterprise

This decrease in the use of professional judgement for a particular assignment might result in over-auditing low risk or immaterial areas

̈ There is a risk that sufficient, relevant and reliable audit evidence may not be

obtained For example, where alternatives to tests not applicable to a particular client, are not considered

Conclusion

̈ Standard audit programmes may be useful on certain assignments to improve audit

efficiency but they cannot replace the need for professional judgement

(c) Information in working papers relating to attendance at physical inventory count

̈ Viewco’s physical count arrangements and instructions should be obtained before

attending the count:

̌ to assess the adequacy of the client’s planned procedures; and

̌ to ascertain whether client’s staff are carrying out their instructions

properly

̈ Pre-selected (eg high value) items chosen to ensure that an adequate proportion of

the final inventory value is tested (to conclude satisfactorily on the population)

̈ Results of test counts (ie serial/component references and quantities) provide

evidence as to the completeness and accuracy (or otherwise) of the count records (ie rough count sheets) Test counts also enable the auditor to assess whether the client’s count procedures and controls are working properly

̈ The sequence of rough count sheets issued and used will detect any additional items

being included subsequent to attending the count

̈ Inventories identified as damaged, obsolete or slow-moving must be detailed to

assess the adequacy of allowances/provisions for items with net realisable value less than cost

̈ Items owned by third parties must be recorded to ensure exclusion from the final

inventory valuation sheets

̈ Last goods movement document references for 31 December 2008 (ie goods

received note, stores requisition, despatch note/sales invoice) are needed to check the accuracy of the year-end cut-off

̈ Movements, if any, during physical inventory counting to ensure items are not

omitted or double-counted in error

Other points

̈ A floor plan (sketch) of central warehouse should ensure complete coverage (by

management and auditor) of the physical inventory count

̈ Details (eg serial numbers) of finished goods held by third parties are required to

confirm the validity of their inclusion in the final inventory value

̈ The degree of assembly of incomplete TVs and VRs must be noted to assess

appropriateness of stage of completion used in valuing WIP

̈ Instances where the client’s procedures have not been satisfactorily carried out (eg

damaged items not set aside) will be required for the report to management with recommendations for improvements (eg in standing instructions for physical counts)

Answer 12 BESTWOOD TRADING

(a) Audit working papers

The permanent audit file contains information which is relevant to many years’ audits Its contents can include:

̈ the letter of engagement;

̈ the legal and organisational structure of the company, memorandum and articles of

the company;

̈ a history of the company, a description of its business, products, markets,

production facilities, workforce, major suppliers, major customers;

̈ details of statute/regulations under which the business operates, regulatory reports,

related parties and past transactions;

̈ details of directors and senior staff, non-executive directors, major shareholders,

financing arrangements;

̈ copies of previous years’ financial statements with key ratio analysis/trends (eg over

five years) and commentary on the figures, performance measures

̈ details of the company’s business control system, internal audit, risk procedures,

control environment, accounting systems, control procedures, flowcharts, completed control and evaluation questionnaires, Business Risk Assessments;

̈ details of the company’s locations, relevance to audit and visits made (perhaps on a

rotational basis and rotational testing of controls)

̈ copies of significant documents, including long-term contracts, finance leases

minutes of significant board meetings;

̈ past management letters and responses, summary of past matters for attention of

partner and actions taken, past qualified audit reports;

The current audit fire contains documents which are relevant to the current year’s audit This information includes:

̈ understanding the entity and its environment updated from prior year and showing

the impact for this year;

̈ evidence of planning (strategy and plan) of the audit including the audit planning

memorandum and briefing of key audit team members;

̈ copies of board minutes, significant management reports, management accounts, the

trial balance and draft financial statements There should be a reconciliation of any difference in profit between the draft financial statements and the management accounts;

̈ consideration of business and audit risk for each area of the audit This could

include notes on high risk areas of the audit, decisions on sampling approach, materiality etc;

̈ consideration of fraud indicators;

̈ copies of flowcharts and completed ICQs or ICEs if they are not included in the

permanent audit file;

Tutorial note: It may be preferable to include flowcharts and ICEs or ICQs in the

current audit file when there are changes to the systems in the year

̈ records of the audit work done (effectiveness of controls, transaction work,

substantive work and analytical review), problems encountered and conclusions reached (see below);

̈ by whom the schedules have been prepared and reviewed (as evidenced by their

initials) and when (ie date);

̈ evaluation, review and closedown procedures, going concern, subsequent events,

IFRS checklists

̈ a section for the manager’s and partner’s attention which lists significant problems

encountered in the audit This will include a summary of unadjusted errors This section will direct the partner to these important areas, and to decide whether the financial statements need amending or a qualified auditors’ report should be given;

̈ details of discussions with management and audit committee;

̈ partner completion, approval and sign off

Recording audit work in working papers is usually divided into sections which have a

reference letter or number For instance, the letter “R” could be used for Sales and

Receivables work Thus, for any audit carried out by the firm, any member of staff wanting

to look at audit work on Sales or Receivables can go to the section with the letter “R”

Within each section, there will be a sub-division whereby verification of receivables will be in pages Rl to 099 and audit work on the sales system will be on pages R100 to R199 (ie tests on statement of financial position items will be on pages 1-99 and tests on accounting systems will be on pages 100-199 – these numbers will be preceded by a letter which signifies the area

of the audit, with “R” being for sales and receivables)

The front page of the “R” section of the audit file will show the value of receivables in the statement of financial position, and references on the make-up of receivables will be to the pages where details of verification of these items is included in the working papers For instance, the total value of receivables will be broken down into:

̈ verifying the gross value of trade receivables (eg on page R2 of the audit file);

̈ checking the bad and doubtful debt provision (eg on page R5);

̈ audit of sundry receivables and prepayments (eg on page R10)

By using this standardized procedure for referencing audit files, all members of the firm’s audit staff, including managers and partners can review each section of the audit in a

systematic manner This should enable them to come to an appropriate conclusion on the audit work done and the form of auditors’ report which should be attached to the financial statements

If no standardized procedure is used the partner would find it time-consuming to find a particular matter in the audit file By standardizing audit files, the audit work should be carried out in a more systematic manner which should ensure a high quality audit is carried out

Particularly important sections in audit files include:

̈ conclusions reached in each area of the audit and notes of any significant problems

detected;

̈ matters for consideration by the partner and the summary of unadjusted errors

(which should include significant uncertainties)

(iii) Types of checklists

̈ Internal control evaluation questionnaires (ICE) and internal control questionnaires

(ICQ) for evaluating controls in accounting systems

̈ Physical inventory count checklists which are used to record work done and to

ensure all aspects are covered

̈ Companies Act and International Financial Reporting Standards checklists to ensure

the financial statements comply with relevant statutory and professional requirements

̈ Audit completion checklists (senior, manager and partner) to help the auditor ensure

all material audit work has been performed and matters considered

Checklists are important, as they are a means of ensuring that all aspects of the audit work are carried out A standard ICE on the sales system would be better than one prepared for each audit, as the standard ICE will be “tried and tested” so there will be a lower risk of a matter being omitted than if the checklist was prepared by the auditor at each audit

Types of specimen letters

̈ The engagement letter which the auditor should send to the client (and get agreed by

the client) before the audit is accepted The contents of this letter should be reviewed and a new one issued and agreed when there are significant changes in the auditor’s responsibilities

̈ Management letters which are letters sent by the auditor to the company recording

weaknesses found in the audit

̈ Management representation letter which is a letter drafted by the auditor, but on the

company’s letter heading and signed by the directors It is used to enable the directors to confirm to the auditor certain matters where the auditor cannot obtain adequate evidence from other sources

̈ Bank letter, where the bank states the balances on the company’s bank accounts and

other matters

̈ Direct confirmation letters from trade debtors The circularisation letter asks trade

debtors of the company to confirm (or otherwise) the balance on the sales ledger

(b) Reasons why auditors have working papers

̈ As a record of work performed on the audit, and to ensure a consistent, logical and

reasoned approach to audit work by following an audit plan and recording work performed as the audit progresses

̈ To provide evidence to external regulatory bodies (eg the ACCA, FRC) that the

audit has been carried out in accordance with ISA and applicable audit regulations This evidence will also be required for internal quality control reviews

̈ To assist the manager in reviewing the audit work, and the partner in coming to an

audit opinion The audit working papers will provide evidence to the partner of work done From the working papers it may become apparent that insufficient work has been carried out in certain areas and more work is required

̈ To provide evidence of work done if there is a threat of or action taken against the

auditor for negligence The audit working papers should provide evidence that appropriate audit procedures have been carried out and conclusions reached, In the case of a material doubtful debt, should show the evidence the auditor has obtained and the matters he has considered in deciding whether the company’s estimate of the bad debt provision is reasonable

Generally, all audit work should be recorded in the audit working papers Work performed on some immaterial items may not be included However, as is noted in part (c) below, it is desirable that all audit work is recorded, as an item which may appear to be immaterial may subsequently become material

For instance, an item which is checked in a test of controls may not in itself be material, but

an error detected in a test will probably be material in terms of the conclusion reached on the population (using statistics) To a certain extent, audit working papers are a summary of work done So a check performed in a test of control may be signified by an audit tick against the item, and the tick will be explained at the bottom of the schedule If some audit work is thought to be unimportant (and thus there is the possibility of it not being recorded) the auditor should consider whether it is necessary to carry out that work

It is important to record audit work as, if legal action is taken against the audit firm, it may be necessary for the firm to demonstrate that items have been checked and support the

conclusions reached

(c) Late banking of cash receipts

If the late banking of receipts of $7,000 was a fraud at 31 October 2007, this is 4.4% of profit before tax, so it is unlikely to be material When the fraud was found in May 2008, it

amounted to 11.25% of profit before tax which is probably material If the auditor did not report the late banking to the company which he found at 31 October 2007, then he could be held (partially) responsible for the loss between 31 October 2007 and when it was found in May 2008 The loss during this period is $11,000, or 6.9% of profit before tax, which may be material

It appears the auditor is not negligent The only matters which might be unsatisfactory in the auditor’s work are:

̈ it appears he has not determined whether a fraud was being carried out at 31

October 2007; and

̈ the company should have been informed immediately at the time the discrepancy

was found, rather than leaving it to the management letter

However, both of these criticisms of the auditor appear to be relatively minor It may not be possible at today’s date to determine whether there was fraud at 31 October 2007, as the

$7,000 of late banking could have been held by the cashier (although this seems unlikely) In conclusion, the auditor is probably not liable for negligence in this situation The company has been warned of the risk of a fraud but appears to have taken no action until May 2008

(ii) Not mentioned in the management letter

In this situation, the auditor may have some liability for negligence The late banking of deposits should have been reported to the company both verbally and in the auditor’s

management letter Also, the auditor should have been “put upon enquiry” by the delay and investigated the matter further as at 31 October 2007 (or at the date he checked the bank reconciliation) Thus, the auditor has some liability for negligence for not reporting the matter to the company’s management and not carrying out further procedures

The auditor could argue the possible fraud at 31 October 2007 was immaterial as it is 4.4% of profit before tax, but by taking no action on the matter it has increased to 11.25% of profit before tax, which is material The auditor should not be held wholly responsible for the extra loss of $11,000 (between 31 October 2007 and May 2008) as it is probable that the

company’s control procedures were inadequate As the cashier was “recording cash received and preparing the bank reconciliation” as well as “having custody of the cash received” there was an inadequate division of duties, so another person in the company should either have prepared the bank reconciliation or checked it It is apparent that either this check was not being performed or it was not performed competently As the auditor was aware of the late banking of $7,000 of cash receipts and he should have been aware of the weakness in control over the cashier, the auditor should have reported these problems to the company, even though the fraud was immaterial at the time of the audit

Thus, in this situation, the auditor has some liability for the fraud continuing but this is

mitigated by the fact that there was a clear weakness in the division of duties with the cashier, and the company should have established an effective system of internal check over the cashier’s work This was either not being performed or not being performed competently Thus, the company must accept some liability for the fraud developing If the case came to court, reference will probably be made to the audit working papers as one factor in

determining the extent of the auditor’s liability for negligence

Answer 13 WORKING PAPERS

(a) Audit programs

Tutorial note: In the context of the Q set, the term “audit program” should not be confused

with “audit software” (ie a CAAT)

Design and use

Audit programs are lists of audit procedures to be performed by audit staff in order to obtain sufficient appropriate audit evidence The individual procedures are determined after

obtaining an understanding of the entity and its environment and determining the audit

strategy to be followed The procedures reflect the understanding of the control system and will incorporate the mix of tests of control and substantive procedures based on the planned audit approach for each material financial statement assertion

The program also serves as a means of monitoring and co-ordinating the progress of the audit The program should be designed with columns alongside each procedure for staff members to enter their initials and date on completing the performance of each procedure and to note the reference of the working paper detailing the results of the tests performed and the conclusions drawn

Standardized or tailored

Tutorial note: The Q specifically asked for “merits”, therefore disadvantages, as well as or

instead of advantages, are not called for

It used to be common for audit firms to pre-print standardized audit programs; usually one set for larger entities and another set for smaller entities The advantages of this approach

include:

̈ A consistent approach to all audits

̈ Reduced risk of procedures being omitted

̈ Reviewers could quickly check the progress of the audit being familiar with the

contents of the program

Although most firms continue to provide model audit programs, these are designed to be tailored to the specific circumstances of each engagement The benefits of this approach are:

̈ The design of procedures and the names of the documents and records detailed in

the program match the actual accounting system of the entity

̈ The balance between tests of control and substantive procedures can be varied to

match the preliminary assessment of inherent and control risk separately for each major financial statement assertion

̈ It provides engagement staff with greater control over the audit based on their

knowledge of the entity and of the specific audit risks This, in turn, results in a better understanding of the purpose of each procedure since the staff member performing the procedure will have been involved in designing the program being followed

(b) Audit trail

Recording details of evidence examined and leaving a trail that could enable the evidence procedure to be replicated serves several purposes

̈ It facilitates the progress of the audit on a day by day basis where a procedure is

performed over several days or by different staff members By maintaining detailed records, procedures completed, partially completed and as yet unperformed can be readily identified

̈ For example, a variety of tests may be carried out on a sample of purchase invoices

Each of the sample of invoices is listed, as a row, on a working paper with columns for the separate tests to be performed on each invoice Progress is indicated by recording the results of the test in the appropriate cell

̈ As in any control procedure, requiring staff to evidence the work performed

provides assurance that the task is likely to be properly performed If staff members know that their work could be checked, they are likely to perform it more

conscientiously One of the risks of auditing, especially where staff are required to work to a time budget, is that of premature sign-off – claiming to have performed tests that were not properly completed

̈ The temptation for audit staff to skimp the proper performance of each procedure is

also reduced by requiring them to leave a visible trail on entity records In the above example, the invoices selected for sampling would be initialled by the staff member and where procedures require it, other documents examined and entries in the records would also be ‘ticked’ by the staff member

̈ Marking documents and records provides evidence, to management of the entity,

that a thorough audit has been performed It also serves to alert entity staff that their work is subject to audit and adds to the incentives to perform their work carefully

̈ Not least is the need to demonstrate proper performance of the audit in the event of

a claim for negligence Reliance on sample evidence means that it may be necessary for the audit firm to prove that a properly designed and selected sample was examined and that failure to detect an error or misstatement was not due to negligence in the performance of the audit

Although the level of detail recorded is a matter of judgement, it is usually desirable to include:

̈ Results of all tests performed

̈ Details of individual items selected for sampling including an indication of how the

sample was selected

̈ A tick or some other mark on entity records and documents vouched, traced or

̈ A typical work schedule detailing the audit trail would cover:

̌ the test objective;

̌ accounting policy;

̌ materiality and risk

̌ sampling approach and sample sizes;

̌ matters arising;

̌ action taken; and

̌ conclusion

Answer 14 PHONES ANYWHERE

(a) Risks associated with the audit

There appear to be considerable risks associated with undertaking the audit In particular; Phones Anywhere appears to have a very high inherent business risk

̈ The low coverage of the country will be a disincentive to new subscribers Initially,

subscribers will only be those who operate in the town with a population of 1,000,000 The service will not be available when the subscribers are outside that town There will be serious doubts about going concern if the company does not have the financial resources for future developments (to towns with a population of 250,000 in the next year and its planned developments to the year 2011)

̈ The company’s plans for extending the network do not appear to be realistic, as

many mobile phones are used on motorways and trunk roads Motorways will not

be covered until the year 2011, and coverage of other roads is not mentioned These plans are likely to be a serious disincentive to new subscribers joining the system, when competitors cover most of the country The risk of business failure appears to

be high

̈ The central computer is pivotal to the organization, as it relays the calls and

calculates the bills for subscribers Will this computer and its software be reliable? The consequences of a breakdown of the computer will be very serious Ideally, there should be more than one computer running the system, and the system should

be able to continue if one of the computers fails

̈ What is the capacity of the main computer? With the planned expansion, it is

probable that it will run out of capacity in the near future Is it possible to expand the capacity of the computer? Has the cost of upgrading the computer been included in future forecasts? Will the current software be able to process a large increase in subscribers, or will it have to be re-written (at substantial cost)?

̈ Is it reasonable to amortise the cost of the relay stations and main computer over six

years? Six years may be realistic for the “buildings” part of capital expenditure, but

it may be too long for electronic components including the main computer and transmitters

̈ Is the discount paid to retailers for the purchase of the phones recoverable? It is

capitalised and amortised over four years Do subscribers remain connected to a single operator for as long as four years (if many change in less than four years, this amortisation period is too long), and are subscribers likely to change their phones within four years (to update to a more advanced model)?

̈ Paying the executive directors a bonus based on the number of subscribers of the

system could encourage them to obtain as many subscribers as possible (by offering discounted prices) rather than charging a realistic price which will ensure the long term future of the company However, the executive directors should be concerned with the long-term future of the company, as this will ensure they continue to be paid (rather than have to find a new job when the company fails)

̈ In view of the planned high borrowings, and future trading losses, there is a very

serious risk the company may not be a going concern This increases the risk of the audit firm being sued for negligence Also, Phones Anywhere will put severe pressure on the audit firm to give an unmodified auditor’s report This pressure will increase because the audit firm is small and Phones Anywhere is a relatively large and rapidly growing company

̈ As an alternative to the company not being a going concern, there is the risk that

other investors may purchase more shares in the company (to provide additional equity finance) or purchase the company outright from the existing directors (or the administrator/liquidator) If this occurs, recent financial statements will be subject

to close scrutiny The standard of audit work will have to be high, and the problems mentioned above (eg complex computer systems and depreciation rates which may

be inaccurate) could lead to undetected material errors in the financial statements Thus, there is a high risk that legal action for negligence could be taken against the audit firm following a take-over or purchase of shares

̈ Flotation of the company on the Stock Exchange is a further risk Immediately

prior to the flotation, audit work carried out will be subject to close scrutiny The increase in audit risk must be reduced by an increase in audit work (to reduce detection risk) – increasing the cost of the audit and reducing its profitability Also, when the company becomes quoted on the Stock Exchange, it is probable the audit firm will be replaced as being “too small” The majority of companies quoted on recognised Stock Exchange are audited by one of the “big 5” firms

̈ This is a high technology industry The technology or customer requirements may

change, which could make parts of the equipment obsolete Alternatively, it could

be expensive to modify the equipment or software to meet the demands of subscribers Is the company currently providing a similar range of facilities to other mobile phone companies If its service is not as comprehensive as other mobile phone companies, it may not be successful in breaking into the market

̈ This appears to be a very competitive industry Are the competitors profitable, or

are they making losses to keep prices low to prevent other companies entering the market? Establishing Phones Anywhere as a major company in the market will probably require large expenditure on advertising and offering new subscribers a service at a lower price than competitors Both of these factors will tend to make Phones Anywhere unprofitable (as note (j) in the question suggests)

̈ The reputation of the three major shareholders and the executive directors should be

assessed If they have been directors of companies which have failed, or been involved in financial or other wrongdoings, this will increase the inherent risk The reputation of the financial director and the quality of the accounting records should also be considered

(b) Professional and ethical matters

̈ The size of the audit fee The Association of Chartered Certified Accountants’

(ACCA) rules of professional conduct say the fees for audit and other recurring work paid by one client should not normally exceed I5% of the gross practice income (and 10% for listed and other public interest companies) If the planned audit fee is over 15% of the current practice income, the audit should not be accepted

̈ However, the rate of expansion of Phones Anywhere will probably be much greater

than the increase in practice income, so the 15% rule may become a problem in the next few years When Phones Anywhere becomes a listed company in the year

2011, the audit fee from Phones Anywhere must be less than 10% of the fees of the practice

̈ It seems probable that this limit of 10% will be exceeded In practice, it is

undesirable for the audit fee to approach 15% of the practice income, as reliance on such a large audit fee could be seen to affect the firm’s independence

̈ The audit firm may be able to audit Phones Anywhere at its current size However,

when the system covers all towns with a population of over 250,000, on occasions audit work will probably have to cover all areas of the country, and it is most unlikely that the audit firm will have sufficient staff to perform this work

̈ Whether the firm is technically competent to perform the audit, and whether the size

of the firm being audited is too large for the experience of the practice Mobile telephone companies are very complex and have specialised accounting procedures; both in terms of the accounting system and the ways matters are treated in the financial statements (eg the advance payment of $200 given towards the purchase of phones purchased by new subscribers)

̈ The firm will probably not have experience in auditing the computerised accounting

system which controls calls and generates bills for subscribers This requires specialised computer auditing techniques

̈ The firm may also be unfamiliar with many of the accounting treatments for

current assets and may not be able to determine whether the lives given to current assets are reasonable

non-̈ This lack of experience will probably mean that the audit will be too high a risk for

the audit firm (ie the firm’s relative inexperience will mean that a satisfactory audit cannot be carried out, so there will be a high risk of material misstatements in the financial statements, which increases the risk of litigation being brought against the firm)

̈ The audit firm must have adequate professional indemnity insurance (PII) cover

This is unlikely in view of the size of Phones Anywhere, so there will be an increased cost of obtaining more PII cover The insurance company may refuse to increase the PII cover if it perceives this to be a high risk audit which is exacerbated

by the small size of the firm

Other matters

̈ The audit partners must have no family or personal relationships with the directors

of Phones Anywhere These relationships also apply to any staff involved in the audit Ideally, none of the firm’s staff should have relationships with the directors

of Phones Anywhere

̈ No one in the audit firm should own shares or any investments in Phones

Anywhere

̈ No one in the audit firm should be a beneficiary or trustee of a trust which holds

shares in Phones Anywhere The ACCA’s rules of professional conduct do allow employees of the audit firm to be a beneficiary of shares in an audit client, but that employee must not be employed on the audit of that client

̈ For trustees, the trust should hold less than 10% of the shares of the company, and

the value of the shares should be less than 10% of the total assets of the trust

̈ Employees and partners of the audit firm must not vote on the appointment, removal

or remuneration of a firm which is an audit client

̈ The audit firm should not make a loan to or accept a loan from an audit client

(exceptions to this rule apply where the audit client is a bank or other financial institution which does not appear to apply in this case)

̈ The audit fee has been considered earlier in this section However, the audit fee

should be sufficient for the firm to perform the audit to a satisfactory standard

̈ Thus, it would not be acceptable to offer a very low fee (often called “lowballing”)

in order to obtain the audit, as this would impose pressure on the time allowed to carry out the audit This could lead to inadequate audit work being carried out which would increase the risk that material misstatements in the financial statements may not be detected

Other matters covered by the ACCA’s rules of Professional Conduct

̈ When the audit firm is asked to accept the audit appointment, the client’s

permission to communicate with the existing auditor must be sought If this permission is refused, the firm should decline to accept appointment as auditor

̈ The audit firm should write to the existing auditor requesting all the information

which ought to be made available to decide whether or not to accept the audit appointment

̈ The audit firm should consider the reply from the existing auditor If the existing

auditor makes adverse comments, further consideration should be given whether or not to accept the audit appointment

̈ If the existing auditor does not reply to the letter, a further letter should be sent

giving notice (eg seven days) that if no reply is received in that time, it is understood that there are no professional or other reasons preventing the firm from accepting the audit appointment

̈ Before finally accepting the audit, a letter of engagement should be prepared and the

(c) Conclusion

From the discussion above, the firm should not offer itself nor accept the appointment as auditor of Phones Anywhere The main reasons for this decision are:

̈ Phones Anywhere appears to be too large a company for the firm to audit, and it is

likely to grow faster than the audit firm The audit fee will probably exceed the ACCA’s limit of 15% of the practice income, and if this is not exceeded now, it is likely to be exceeded in the next few years

̈ Phones Anywhere is a specialised company with complex computer systems It is

possible the firm will not have the skills to perform this work

̈ The accounting conventions for Phones Anywhere may be unfamiliar to a small

firm, particularly the treatment of the $200 given to new subscribers to purchase the phones and the lives of the non-current assets If the firm doe not have the skills to consider whether these treatments are satisfactory this could lead material

misstatements in the financial statements being undetected

̈ Phones Anywhere appears to be undercapitalised Currently, leverage is 20% but

this will increase substantially with expansion of the network and losses in early years of trading Thus, there is a serious risk that Phones Anywhere will fail or be taken over, which could result in the firm being sued for negligence

̈ The large size of Phones Anywhere and the small size of the audit firm could

compromise the firm’s independence Third parties (including shareholders) will perceive that the firm is not independent (on the relative size criteria), and Phones Anywhere could bring severe pressure on the firm which would be hard to resist (ie they will ask for an unmodified auditor’s report to be given when either a qualified opinion should be given or an emphasis of matter paragraph included)

̈ The potential listing of the company on the Stock Exchange increases the audit risk,

as there will be greater scrutiny of the financial statements prior to listing, which could highlight problems in the financial statements

̈ Finally, because of the large size of Phones Anywhere and the large audit fee,

Phones Anywhere may attempt to “squeeze” the audit fee Accepting a reduced audit fee (rather than losing altogether such a large audit fee) could result in a reduction in the time to perform the audit and thus increase the risk of not detecting material misstatements in the financial statements

Answer 15 BRIDGFORD PRODUCTS

(a) Importance of planning

ISA 300 Planning an Audit of Financial Statements requires that “The auditor should plan the

audit work so that the audit will be performed in an effective manner” It goes on to say that

“planning means developing a general strategy and a detailed approach for the expected nature, timing and extent of the audit”

As this is a continuing audit, the general strategy will probably be similar to last year’s audit However it will be modified by problems experienced in last year’s audit and significant events which have taken place in the company since last year’s audit The timing of the audit work is important, as time will be wasted if it is planned to carry out audit work when the appropriate information is not available from the company

The timing of the audit work will influence the make-up of the audit staff during the audit (ie the balance between junior and experienced audit staff) It will be necessary to agree a timetable with the company of when information will be available and this will determine when the audit work is carried out Also, the following dates will be important:

̈ the inventory count

̈ when the full financial statements are available for audit

̈ when the financial statements are agreed and signed by the directors and the auditor

̈ the date of the annual general meeting when the financial statements are approved

by the shareholders

The extent of the audit work in each area will have to be considered This will be based on a number of factors, including the materiality of the item and the audit risk based on experience

in previous years’ audits

A budget will be prepared which suggests the time which should be spent on each aspect of the audit and the completion dates of each part of the audit

During the audit, progress will be compared with the audit plan Any adverse (and

favourable) variances against the plan will be investigated, and the plan amended if it is considered appropriate

Planning an audit is important One would not build a house without a plan, so one should not carry out an audit without a plan The requirement to plan an audit ensures senior audit staff have considered the work which is required to complete the audit, and the timing of that work so that it fits in with the dates information is available from the company and the planned completion date when the financial statements are approved by the directors and the auditor

By having a plan, the auditor should take a more considered approach to the audit which will improve the quality of the audit, and thus both minimise the time spent on the audit and the overall audit risk When the audit is carried out, the progress can be monitored against the plan, and action taken when the audit starts to take more time than expected, both in terms of staff time and in reaching deadlines

(b) Matters to be considered and further action

(i) Sales and profits

The company’s sales for 10 months are $130 million, which given an annualised sales of

$156 million, is a 41.8% increase over the previous years The annualised profit before tax is

$4.8 million, compared with $8 million last year, which is a fall of 40% It appears the company is increasing sales at the expense of profits

If profits are falling, the actual profit for the 10 months to 30 November 2008 may be even less than the $4 million shown by the monthly accounts The fall in profit indicates problems which may not be fully reflected in the monthly accounts

(ii) New computerised inventory system

Audit work will have to be carried out on the new computerised inventory control system Computer audit specialists within the audit firm will probably have to be used It may be appropriate to carry out this work before the year end, so that any problems with the system can be highlighted and either overcome or allowed for at the year end

The company says it will not be carrying out an inventory count at the year end, so as auditor

I will have to place considerable reliance on the accuracy of the inventory quantities reported

by the inventory control system I will have to determine from the company how frequently they count the inventory, the proportion of the inventory counted at each inventory count, and the checks they make to the inventory quantities on the computerised system

If there are a large number of differences between the physical inventory quantities and those

on the computer, inventory counts should be carried out more frequently and on a larger proportion of the inventory than if differences are infrequent This information will have to

be determined before the year end, as, if differences are frequent, it may be necessary to carry out a full inventory count at the year end Otherwise, there is a high risk the auditor’s report will have to be modified

(iii) Product reliability

Reliability problems with the company’s products could result in the following:

̈ Certain inventory being unsaleable, and thus worth less than cost (or even being

worth only scrap value);

̈ Legal claims against the company;

̈ Customers not paying for the products

Tutorial note: These last two points are mentioned in the question

Further details will have to be obtained about legal claims against the company and customers refusing to pay their outstanding balances Information can be obtained for this by inspecting correspondence with customers and discussing the matter with the company’s staff, including the company secretary, sales director and the credit controller

The audit risks with these problems include:

̈ The difficulty in estimating the costs (ie the costs of defending legal claims and

damages which may have to be paid, and the cost of the bad debts)

̈ The risk that there may be more claims and bad debts, which relate to the year under

review, but may not become apparent until after the auditor’s report is signed

̈ The value of the faulty inventory held at the year end The selling price of

inventory sold between the year end and the audit will have to be checked to ensure

it is valued at the lower of cost and net realisable value There may be problems determining the value of year-end inventory which is still held at the time of the audit

(iv) Extended credit

The large increase in receivables age will have resulted in a large increase in receivables, from $14.7 million at 31 January 2008 to an estimated $53.3 million at 31 January 2009 The increase of $38.6 million will probably have come from increased borrowings

Thus, the increase in the credit period and sales to new customers will result in the following audit risks:

̈ New customers tend to have a higher risk than existing ones, thus increasing the risk

̈ Increasing the credit period tends to attract customers who are a poor credit risk

This is for two reasons:

(1) the longer credit limit will reduce the customer’s cash flow problems; and (2) it attracts customers who already have cash flow problems, as these

customers are unable to pay other vendors within the shorter credit period (eg the one month credit period previously allowed by Bridgford)

̈ A potential bad debt, or dispute about a faulty product, may not become apparent until

after the credit period is being exceeded Thus, it will probably take at least three months before the doubtful receivable becomes apparent, rather than the one month with the previous credit period So, doubtful receivables from sales immediately prior

to the year end may not become apparent until after the auditor’s report has been signed

In addition, the actual age of receivables is 1.1 months in excess of the current credit limit (of three months) compared with 0.6 months over the credit limit in the previous year This

indicates there may be problems with collection of receivables from customers and thus an increase in bad debts

With the large increase in receivables, the company is probably experiencing liquidity

problems Are the company’s borrowing facilities adequate, and is there a risk the company may not be a going concern?

(v) Staff dismissals

The reasons for the dismissal of the chief financial officer and purchasing manager will have

to be ascertained Were they carrying out a fraud (separately or together)? or were they

contravening financial procedures? If this was happening, what are the financial

consequences? Is it possible for this type of fraud to recur? Could our audit firm be liable for not detecting these events?

If the dismissed employees are claiming unfair dismissal and compensation from the

company, the likely outcome from these claims would have to be investigated and an

appropriate provision included in the financial statements This could be a high risk area of the audit

In addition, I will have to consider the consequences of the company being without a

purchasing manager from IS August until the new purchasing manager was appointed There

is the risk that controls during this period will have been weaker than normal, thus increasing the risk of a fraud

The new purchasing manager will take time to become effective in his post, which could

increase the risk of fraud Also, the wrong products may be purchased, or products may be purchased at an inflated price This could mean that some products in inventory at the year end may be worth less than cost

The effect of there being no chief financial officer between 15 August and the year end may mean that financial records and controls may not be as effective as in previous years The chief accountant will probably be much busier than when there was a chief financial officer which could mean that, with less time to prepare the financial statements, the annual accounts are less accurate and less complete If the chief financial officer prepared the annual draft financial statements in previous years, does the chief accountant have the skills and

experience to prepare this years financial statements?