study question bank - Becker Professional Education

Transcription

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December 2014–June 2015 Edition
STUDY QUESTION BANK
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ACCA
Paper P7 | ADVANCED AUDIT AND
ASSURANCE
(INTERNATIONAL)
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ACCA
PAPER P7
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ADVANCED AUDIT AND ASSURANCE
(INTERNATIONAL)
STUDY QUESTION BANK
For Examination to June 2015
®
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STUDY QUESTION BANK – ADVANCED AUDIT AND ASSURANCE (P7)
CONTENTS
Question
Page
Answer
Marks Date worked
1
1001
20
1
1003
15
REGULATORY ENVIRONMENT
1
Audit committee (ACCA J98)
2
Money laundering (ACCA J05)
CODES OF ETHICS FOR PROFESSIONAL ACCOUNTANTS
Blake Seven (ACCA Pilot Paper 01)
Depeche (ACCA J03)
Clifden (ACCA J09)
1
2
3
1008
1010
1013
15
15
17
PL
3
4
5
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MONEY LAUNDERING
PROFESSIONAL RESPONSIBILITY AND LIABILITY
6
7
8
CD Sales (ACCA D95)
Duty of care
Juliet (ACCA J10)
QUALITY CONTROL
9
Agnesal (ACCA D01)
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PROFESSIONAL APPOINTMENTS
10
11
Valda
Dragon Group (ACCA J09)
3
4
5
1016
1018
1020
20
15
20
6
1024
25
7
7
1027
1029
15
32
9
10
12
13
1035
1040
1047
1052
34
25
30
25
14
15
16
16
17
18
1055
1057
1059
1063
1066
1070
17
20
20
20
20
20
PLANNING, MATERIALITY AND RISK
12
13
14
15
Papaya (ACCA D09)
Azure (ACCA J02)
Hydrosports (ACCA D03)
Harrier Motors (ACCA J04)
AUDIT OF FINANCIAL STATEMENTS
16
17
18
19
20
21
Sharp
IAS 24 examples
Phoenix (ACCA Pilot Paper 01)
Stilson (ACCA J01)
Vema (ACCA D03)
Eagle Energy (ACCA J04)
(iii)
ADVANCED AUDIT AND ASSURANCE (P7) – STUDY QUESTION BANK
Question
Page
Answer
Marks Date worked
19
20
21
21
1072
1075
1078
1082
25
25
25
36
23
23
24
26
1087
1090
1094
1099
20
25
25
20
GROUP AUDITS
22
23
24
25
Butch
Cuckoo Group (ACCA J94)
Beeston Industries (ACCA D86)
Grissom (ACCA J10)
26
27
28
29
Flashmark
Bellatrix (ACCA Pilot Paper 01)
Imperiol (ACCA D02)
Internal audit services
30
31
32
33
34
Theta
Libra & Leo (ACCA Pilot Paper 01)
Scheel (ACCA J02)
Kite Associates
Hegas Co (ACCA J05)
REPORTS TO MANAGEMENT
35
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AUDITOR’S REPORTS
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NON-AUDIT ASSIGNMENTS
Effective management letter
26
27
28
28
29
1101
1103
1106
1108
1110
16
15
15
15
15
30
1112
15
30
30
31
31
31
31
32
32
1114
1116
1118
1120
1122
1127
1130
1133
16
20
15
15
15
15
15
15
32
33
36
39
40
1135
1138
1143
1146
1149
15
37
27
18
25
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CURRENT ISSUES AND DEVELOPMENTS
36
37
38
39
40
41
42
43
Merging practices (ACCA D98)
International liability (ACCA D97)
Environmental issues (ACCA Pilot Paper 01)
Web-based business reporting (ACCA J01)
E-commerce (ACCA J02)
Corporate governance standards (ACCA D02)
Audit failures (ACCA J03)
ISA 240 (ACCA J04)
FURTHER PRACTICE QUESTIONS
44
45
46
47
48
(iv)
Johnston (ACCA J06) – Auditor’s reports
Bill (ACCA J11) – Case study
Butler (ACCA J11) – Going concern review
Jacob (ACCA J11) – Due diligence review
Willow (ACCA D11) – Audit completion
Question 1 AUDIT COMMITTEE
The objective of a system of corporate governance is to secure the effective, sound and efficient
operation of companies. This objective transcends any legislation or voluntary code. Good corporate
governance embraces not only making the company prosper but also doing business in a legal and
ethical manner. A key element of corporate governance is the audit committee. In many countries the
audit committee is a committee of a single board of directors and is of a voluntary nature regulated by
voluntary codes. In other countries there are committees which are of a supervisory nature and these
are regulated by statute. For example in Germany all large public companies must have a supervisory
board which contains non-executive directors who elect the board.
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Required:
Explain how an audit committee could improve the effectiveness of the external
auditor’s work.
(10 marks)
(b)
Discuss the problems of ensuring the “independence” of the members of the audit
committee where the membership is regulated by a voluntary code of practice. (5 marks)
(c)
Discuss the view that the role of the audit committee should not be left to voluntary
codes of practice but should be regulated by the law in all countries.
(5 marks)
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(a)
(20 marks)
Question 2 MONEY LAUNDERING
Explain the term “money laundering”.
(b)
Comment on the need for ethical guidance for accountants on money laundering.
(4 marks)
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(a)
(c)
(3 marks)
The Financial Action Task Force on Money Laundering (FATF) recommends preventative
measures to be taken by independent legal professionals and accountants (including sole
practitioners, partners and employed professionals within professional firms).
Required:
Describe FOUR measures that assist in preventing professional accountants from being
used for money laundering purposes.
(8 marks)
(15 marks)
Question 3 BLAKE SEVEN
(a)
Explain the importance of the role of confidentiality to the auditor-client relationship.
(5 marks)
(b)
Your firm acts as auditor and adviser to Blake Seven, a private limited company, and to its
four directors. The company is owned 50% by Brad Capella, 25% by his wife Minerva and
10% by Janus Trebbiano. Brad is the chief executive and Janus the finance director. Janus’s
sister, Rosella Trebbiano, has recently resigned from the executive board, following a
disagreement with the Capellas. Rosella has now formed her own company, Blakes Heaven,
in competition with Blake Seven.
Rosella is currently negotiating with her former co-executives the profit-related remuneration
due to her and the sale of her 15% holding of shares in Blake Seven to one or all of them.
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Rosella has contacted you to find out Brad’s current remuneration package since he refuses to
disclose this to her. She has also requested that your firm should continue to act as her
personal adviser and become auditor and adviser to Blakes Heaven.
Required:
Comment on the matters that you should consider in deciding whether or not your audit
firm can comply with Rosella’s requests.
(10 marks)
(15 marks)
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Question 4 DEPECHE
You are a manager in Depeche, a firm of Chartered Certified Accountants. You have specific
responsibility for undertaking annual reviews of existing clients and advising whether an engagement
can be properly continued. The following matters arose in connection with the audit of Duran, a listed
company, for the year to 31 December 2013:
The audit team included a manager, two supervisors, two qualified seniors and six trainees.
The final audit, which lasted approximately five weeks, was very time-pressured and the team
worked late into the night towards the end of the audit. Duran’s staff were very supportive
throughout and paid for evening meals that were brought in so that the audit team could work
with minimum disruption.
(2)
Duran’s chief finance officer, Frankie Sharkey, was so impressed with the commitment of the
audit staff that he asked that Depeche pay them all a bonus through an increase in the audit
fee. In April 2014, Depeche paid all the members of the team below manager status a bonus
amounting to a week’s salary. The bonus was processed through Depeche’s payroll, in the
same way as overtime payments, and recharged to Duran as part of audit expenses.
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(1)
(3)
One of the points initially drafted for possible inclusion in the report to the company’s audit
committee concerned the illegal dumping of drums, containing used machine oil, on nearby
wasteland. Notes of discussions between the audit manager and Frankie show that it is the
company’s unwritten policy to disregard the local environmental regulations and risk
incurring the fines, which are only small, as it would be costly to use the nearest licensed
disposal unit. The matter is not referred to in the final report.
Required:
(a)
Comment on the ethical and other professional issues raised by each of the above
matters.
(10 marks)
(b)
Discuss the appropriateness of available safeguards and advise whether or not Depeche
should continue as the auditor to Duran.
(5 marks)
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(15 marks)
Question 5 CLIFDEN
(a)
IFAC’s Code of Ethics for Professional Accountants states that a professional accountant is
required to comply with five fundamental principles, one of which is the principle of
“professional competence and due care”.
Required:
Explain what is meant by the term “professional competence and due care”, and outline
how firms of Chartered Certified Accountants can ensure that the principle is complied
with.
(4 marks)
You are a senior manager in Clifden & Co, and you are responsible for the audit of Headford
Co, a manufacturer of plastic toys which are exported all over the world. The following
matter has been brought to your attention by the audit senior, who has just completed the
planning of the forthcoming audit for the year ending 30 June 2014:
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(b)
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During a discussion with the production manager, it was revealed that there have been some
quality control problems with the toys manufactured between March and May 2014. It was
discovered that some of the plastic used in the manufacture of the company’s products had
been contaminated with a dangerous chemical which has the potential to explode if it is
exposed to high temperatures. Headford did not recall any of the products which had been
manufactured during that time from customers, as management felt that the risk of any injury
being caused was remote.
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Your firm has been invited to tender for the provision of the external audit service to Cong
Co. You are aware that Cong operates in the same industry as Headford and that the two
companies often enter into highly publicised, aggressive advertising campaigns featuring very
similar products. Cong is a much larger company than Headford and there would be the
opportunity to offer some non-audit services as well as the external audit.
Required:
Assess the ethical and professional issues raised, and recommend any actions necessary
in respect of:
(i)
(ii)
the contaminated plastic used by Headford Co; and
the invitation to audit Cong Co.
(8 marks)
(5 marks)
(17 marks)
Question 6 CD SALES
CD Sales was a growth orientated company that was dominated by its managing director, Mr A Long.
The company sold quality music systems direct to the public. A large number of sales persons were
employed on a commission only basis. The music systems were sent to the sales agents who then sold
them direct to the public using telephone sales techniques. The music systems were supplied to the
sales agents on a sale or return basis and CD Sales recognised the sale of the equipment when it was
received by the sales agents. Any returns of the music systems were treated as re-purchases in the
period concerned.
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The company enjoyed a tremendous growth record. The main reasons for this apparent expansion were
as follows:
Mr A Long falsified the sales records. He created several fictitious sales agents who were
responsible for 25% of the company’s revenue.
(ii)
At the year end, Mr Long despatched almost this entire inventory of music systems to the
sales agents and re-purchased those that they wished to return after the year end.
(iii)
Twenty per cent of the cost of sales was capitalised. This was achieved by the falsification of
purchase invoices with the co-operation of the supplier company. Suppliers furnished the
company with invoices for long term assets but supplied music systems.
(iv)
The directors of the company enjoyed a bonus plan linked to reported profits. Executives
could earn bonuses ranging from 50% to 75% of their basic salaries. The directors did not
query the unusually rapid growth of the company, and were unaware of the fraud perpetrated
by Mr A Long.
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(i)
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Mr A Long spent large sums of money in creating false records and bribing accomplices in order to
conceal the fraud from the auditors. He insisted that the auditor should sign a “confidentiality”
agreement which effectively precluded the auditors from corroborating sales with independent third
parties, and from examining the service contracts of the directors. This agreement had the effect of
preventing the auditor from discussing the affairs of the company with the sales agents.
The fraud was discovered when a disgruntled director wrote an anonymous letter to the Stock Exchange
concerning the reasons for CD Sales’ growth. The auditors were subsequently sued by a major bank
that had granted a loan to CD Sales on the basis of interim accounts. These accounts had been
reviewed by the auditor and a review report issued.
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Required:
(a)
Explain the key audit tests which would normally ensure that such a fraud as that
perpetrated by Mr A Long would be detected.
(7 marks)
(b)
Discuss the implications of the signing of the “confidentiality” agreement by the auditor.
(4 marks)
(c)
Explain how the “review report” issued by the auditor on the interim financial
statements differs in terms of its level of assurance from the auditor’s report on the
year-end financial statements.
(4 marks)
(d)
Discuss whether you feel that the auditor is guilty of professional negligence in not
detecting the fraud.
(5 marks)
(20 marks)
Question 7 DUTY OF CARE
“It is not possible for any single principle to provide a practical test for determining whether a duty of
care is owed by the maker of a statement to those who may suffer economic loss through their reliance
on it.
“Nevertheless, when accounts are defective, and have been given an unqualified auditor’s report, a
sizeable proportion of the business community considers that those who lose money because of the
auditors’ negligence should be recompensed.”
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Required:
Discuss and reach a conclusion.
(15 marks)
Question 8 JULIET CO
(a)
Auditors should accept some of the blame when a company on which they have expressed an
unmodified audit opinion subsequently fails, and they should also do more to highlight going
concern problems being faced by a company.
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Required:
Discuss this statement.
You are the manager responsible for the audit of Juliet Co, and you are planning the final
audit of the financial statements for the year ending 30 June 2014 (i.e. Juliet is a supplier of
components used in the manufacture of vehicle engines). Due to a downturn in the economy,
and in the automotive industry particularly, the company has suffered a decline in sales and
profitability over the last two years, mainly due to the loss of several key customer contracts.
Many of Juliet’s non-current assets are impaired in value, and a significant number of
receivables balances have been written off in the last six months.
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(b)
(8 marks)
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In response to the deteriorating market conditions, the management of Juliet decided to
restructure the business. The main manufacturing facility will be reduced in size by twothirds, and investment will be made in new technology to make the remaining operations
more efficient, and to enable the manufacture of a wider variety of components for use in
different types of engines and machinery. In order to fund this restructuring, the management
of Juliet approached the company’s bank with a request for a significant loan. You are aware
that without the loan, Juliet is unlikely to be able to restructure successfully, which will raise
significant doubt over its ability to continue as a going concern.
Your firm has been asked to advise on the necessary forecasts and projections that the bank
will need to see in order to make a decision regarding the finance requested. Management has
also requested that your firm attend a meeting with the bank at which the forecasts will be
discussed.
Required:
(i)
Identify and explain the matters that should be considered, and the principal
audit procedures to be performed, in respect of the additional funding being
sought.
(6 marks)
(ii)
Comment on the ethical and other implications of the request for your firm to
provide advice on the forecasts and projections, and to attend the meeting with
the bank.
(6 marks)
(20 marks)
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Question 9 AGNESAL
(a)
“Quality control policies and procedures should be implemented at both the level of the audit
firm and on individual audits.”
ISA 220 Quality Control for an Audit of Financial Information
Describe the nature and explain the purpose of quality control procedures appropriate
to the individual audit.
(7 marks)
You are the manager responsible for the quality of the audits of new clients of Signet, a firm
of Chartered Certified Accountants. You are visiting the audit team at the head office of
Agnesal Co. The audit team comprises Artur Bois (audit supervisor), Carla Davini (audit
senior) and Errol Flyte and Gavin Holst (trainees). The company provides food hygiene
services which include the evaluation of risks of contamination, carrying out bacteriological
tests and providing advice on health regulations and waste disposal.
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(b)
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Agnesal’s principal customers include food processing companies, wholesale fresh food
markets (meat, fish and dairy products)and bottling plants. The draft accounts for the year
ended 31 December 2013 show turnover $19.8 million (2012 $13.8 million) and total assets
$6.1 million (2012 $4.2 million).
You have summarised the findings of your visit and review of the audit working papers
relating to the audit of the financial statements for the year to 31 December 2013 as follows:
Against the analytical procedures section of the audit planning checklist, Carla has
written “not applicable – new client”. The audit planning checklist has not been
signed off as having been reviewed by Artur.
(2)
Artur is currently assigned to three other jobs and is working from Signet’s office.
He last visited Agnesal’s office when the final audit commenced two weeks ago. In
the meantime, Carla has completed the audit of tangible non-current assets
(including property and service equipment) which amount to $1.1 million as at 31
December 2013 (2012 $1.1 million).
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(1)
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(3)
Errol has just finished sending out the requests for confirmation of accounts
receivable balances as at 31 December 2013 when trade accounts receivable
amounted to $3.5 million (2012 $1.6 million).
(4)
Agnesal’s purchase clerk, Jules Java, keeps $2,500 cash to meet sundry expenses.
The audit program shows that counting it is “outstanding”. Carla has explained that
when Gavin was sent to count it he reported back, two hours later, that he had not
done it because it had not been convenient for Jules. Gavin had, instead, been
explaining to Errol how to extract samples using value-weighted selection.
Although Jules had later announced that he was ready to have his cash counted,
Carla decided to postpone it until later in the audit. This is not documented in the
audit working papers.
(5)
Errol has been assigned to the audit of inventory (comprising consumable supplies)
which amounts to $150,000 (2012 $90,000). Signet was not appointed as auditor
until after the year-end physical count. Errol has therefore carried out tests of
controls over purchases and issues to confirm the “roll-back” of a sample of current
quantities to quantities as at the year-end count.
(6)
Agnesal has drafted its first “Report to Society” which contains health, safety and
environmental performance data for the year to 31 December 2013. Carla has filed
it with the comment that it is “to be dealt with when all other information for
inclusion in the company’s annual report is available”.
Required:
Identify and comment on the implications of these findings for Signet’s quality control
policies and procedures.
(18 marks)
(25 marks)
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Question 10 VALDA
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As manager responsible for prospective new audit clients you have received a telephone call from an
acquaintance of a client. The caller, Richard Stone, has asked for your assistance concerning Valda Co,
a supplier of electrical alarm equipment. Business has boomed over the last two years due to reported
increasing crime rates. Turnover has nearly doubled and the company is very profitable.
Mr Stone asks you for an estimate of the cost of a “cheap and cheerful” review of the company’s
accounting systems and internal controls and of a new computer installation. The new computer is to
be supplied next month, by R S Office Equipment, subject to board approval. He suggests that you
could spend a few days looking at the systems’ flowcharts and documentation. He wants you to tell
him anything else that could be significant to the board’s decision to adopt his proposals.
Although you are keen to gain the business, you inform him that you will write after giving the matter
further consideration.
Required:
Identify and comment on the issues raised as they affect your decision to gain the
business.
(10 marks)
(b)
State what procedures you would adopt to clarify and agree the basis on which your
firm would undertake this work.
(5 marks)
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(a)
(15 marks)
Question 11 DRAGON GROUP
(a)
Explain FOUR reasons why a firm of auditors may decide NOT to seek re-election as
auditor.
(6 marks)
The Dragon Group is a large group of companies operating in the furniture retail trade. The group has
expanded rapidly in the last three years, by acquiring several subsidiaries each year. The management
of the parent company, Dragon Co, a listed company, has decided to put the audit of the group and all
subsidiaries out to tender, as the current audit firm is not seeking re-election. The financial year end of
the Dragon Group is 30 September 2014.
You are a senior manager in Unicorn & Co, a global firm of Chartered Certified Accountants, with
offices in over 150 countries across the world. Unicorn & Co has been invited to tender for the Dragon
Group audit (including the audit of all subsidiaries). You manage a department within the firm which
specialises in the audit of retail companies, and you have been assigned the task of drafting the tender
document. You recently held a meeting with Edmund Jalousie, the group finance director, in which
you discussed the current group structure, recent acquisitions, and the group’s plans for future
expansion.
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Meeting notes – Dragon Group
Group structure
The parent company owns 20 subsidiaries, all of which are wholly owned. Half of the
subsidiaries are located in the same country as the parent, and half overseas. Most of the
foreign subsidiaries report under the same financial reporting framework as Dragon Co, but
several prepare financial statements using local accounting rules.
Acquisitions during the year
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Two companies were purchased in March 2014, both located in this country:
Mermaid Co, a company which operates 20 furniture retail outlets. The audit
opinion expressed by the incumbent auditors on the financial statements for the year
ended 30 September 2013 was qualified by a disagreement over the non-disclosure
of a contingent liability. The contingent liability relates to a court case which is still
on-going.
(ii)
Minotaur Co, a large company, whose operations are distribution and warehousing.
This represents a diversification away from retail, and it is hoped that the Dragon
Group will benefit from significant economies of scale as a result of the acquisition.
Other matters
PL
(i)
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The acquisitive strategy of the group over the last few years has led to significant growth.
Group revenue has increased by 25% in the last three years, and is predicted to increase by a
further 35% in the next four years as the acquisition of more subsidiaries is planned. The
Dragon Group has raised finance for the acquisitions in the past by becoming listed on the
stock exchanges of three different countries. A new listing on a foreign stock exchange is
planned for January 2015. For this reason, management would like the group audit completed
by 31 December 2014.
Required:
(b)
Recommend and describe the principal matters to be included in your firm’s tender
document to provide the audit service to the Dragon Group.
(10 marks)
(c)
Using the specific information provided, evaluate the matters that should be considered
before accepting the audit engagement, in the event of your firm being successful in the
tender.
(7 marks)
Professional marks will be awarded in part (c) for the clarity and presentation of the
evaluation.
(2 marks)
(d)
(i)
Define “transnational audit”, and explain the relevance of the term to the audit
of the Dragon Group;
(3 marks)
(ii)
Discuss TWO features of a transnational audit that may contribute to a high
level of audit risk in such an engagement.
(4 marks)
(32 marks)
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Question 12 PAPAYA
(a)
ISA 520 Analytical Procedures requires that the auditor performs analytical procedures
during the initial risk assessment stage of the audit. These procedures, also known as
preliminary analytical review, are usually performed before the year end, as part of the
planning of the final audit.
Required:
Explain, using examples, the reasons for performing analytical procedures as
part of risk assessment; and
(ii)
Discuss the limitations of performing analytical procedures at the planning
stage of the final audit.
(6 marks)
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(i)
Explain and differentiate between the terms “overall audit strategy” and “audit plan”.
(4 marks)
(c)
You are the manager responsible for the audit of Papaya Co, a listed company, which operates
a chain of supermarkets, with a year ending 31 December 2014. There are three business
segments operated by the company – two segments are supermarket chains which operate
under internally generated brand names, and the third segment is a new financial services
division.
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(b)
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The first business segment comprises stores branded as “Papaya Mart”. This segment makes
up three-quarters of the supermarkets of the company, and are large “out of town” stores,
located on retail parks on the edge of towns and cities. These stores sell a wide variety of
items, including food and drink, clothing, household goods, and electrical appliances. In
September 2014, the first overseas Papaya Mart opened in Farland. This expansion was a
huge drain on cash resources, as it involved significant capital expenditure, as well as an
expensive advertising campaign to introduce the Papaya Mart brand in Farland.
The second business segment comprises the rest of the supermarkets, which are much smaller
stores, located in city centres, and branded as “Papaya Express”. The Express stores offer a
reduced range of products, focussing on food and drink, especially ready meals and other
convenience items.
The company also established a financial services division on 1 January 2014, which offers
loans, insurance services and credit cards to customers.
The following information was provided during a recent meeting held with the finance
director of Papaya. All of the matters outlined in the notes below are potentially material to
the financial statements.
9
Notes from meeting held 29 November 2014
On 31 August 2014, Papaya Co received notice from a government body that it is under investigation,
along with three other companies operating supermarket chains, for alleged collusion and price fixing
activities. If it is found guilty, significant financial penalties will be imposed on Papaya Co. The
company is vigorously defending its case.
To help cash flows in a year of expansion, the company raised finance by issuing debentures which are
potentially convertible into equity on maturity in 2020.
E
To manage the risk associated with overseas expansion, in October 2014, the company entered for the
first time into several forward exchange contracts which end in February 2015. The contracts were
acquired at no cost to Papaya Co and are categorised as “fair value through profit or loss” financial
instruments.
PL
The property market has slumped this year, and significant losses were made on the sale of some plots
of land which were originally acquired for development potential. The decision to sell the land was
made as it is becoming increasingly difficult for the company to receive planning permission to build
supermarkets on the land. Land is recognised at cost in the statement of financial position.
Papaya Co has 35 warehouses which store non-perishable items of inventory. Due to new regulation,
each warehouse is required to undergo a major health and safety inspection every three years. All
warehouses were inspected in January 2014, at a cost of $25,000 for each inspection.
Using the specific information provided in respect of Papaya Co:
Explain the information that you would require in order to perform analytical
procedures during the planning of the audit.
(6 marks)
SA
M
(i)
(ii)
Assess the financial statements risks to be addressed when planning the final audit for
the year ending 31 December 2014, producing your answer in the form of briefing notes
to be used at the audit planning meeting.
(16 marks)
Professional marks will be awarded in part (ii) for the format of the answer, and for the clarity
of assessment provided.
(2 marks)
(34 marks)
Question 13 AZURE
Azure sells inclusive tours (i.e. international flights, hotel accommodation and meals) to two million
customers. All hotels are independently owned and operated. The company employs 5,000 people and
uses 11 leased aircraft.
Azure has a representative office at each of 13 holiday locations. Your firm has been invited to tender
for the audit of Azure for the year ending 31 December 2014. As the prospective audit engagement
manager, you have been asked to identify the principal audit risks and other planning issues, including
audit strategy, to be presented as part of your firm’s written submission. The invitation to tender
indicates that written submissions will be used as a means of shortlisting for the presentation stage.
10
You have obtained the following information from Azure’s Annual Report 2013:
(1)
Holidays are sold through Azure’s retail travel agency, IsoTours, which has 29 outlets (2012:
31). Direct sales through call centres is the fastest growing distribution method and Internet
bookings are now offered.
(2)
The internal financial control system includes:
divisional planning and budgeting systems and regular Board reviews of actual
results compared to budget and prior year comparatives;

an internal audit function and a review of internal audit reports by the Audit
Committee.
Financial extracts ($m):
2013
942·8
27·3
109·1
29·7
138·6
(237·2)
(73·0)
2012
763·7
25·7
80·3
18·2
91·0
(200·5)
–
PL
Turnover (Note i)
Operating profit before tax
Tangible non-current assets
Trade receivables
Cash and cash equivalents
Current liabilities (Note ii)
5% Convertible debt due 2019 (Note iii)
E
(3)

Notes:
Turnover represents gross revenue receivable from inclusive tours and travel agency
commissions. Revenues and expenses relating to inclusive tours are taken to profit or loss on
holiday departure.
(ii)
Revenue received in advance included in current liabilities amounts to $69·9 million (2012:
$61·4 million).
(iii)
Debt will be redeemed at its principal amount on 7 January 2019 unless it is converted at the
option of the debt holder any time before 31 December 2018.
(iv)
Annual commitments under non-cancellable operating leases are as follows ($m):
SA
M
(i)
Less than one year
Between one and five years
Five years or more
2013
4·3
16·7
17·4
_____
2012
2·5
17·9
12·7
_____
38·4
_____
33·1
_____
Required:
(a)
Explain the audit planning issues which should be included in the written submission as
requested by Azure.
(15 marks)
(b)
Suggest and comment on appropriate selection criteria which should be used by Azure
in its evaluation of submissions received.
(10 marks)
(25 marks)
11
Question 14 HYDRASPORTS
Hydrasports Co, a national leisure group, has sixteen centres around the country and a head office.
Facilities at each centre are of a standard design which incorporates a heated swimming pool, sauna,
air-conditioned gym and fitness studio with supervised childcare. Each centre is managed on a day-today basis, by a centre manager, in accordance with company policies. The centre manager is also
responsible for preparing and submitting monthly accounting returns to head office.
Each centre is required to have a licence from the local authority to operate. Licences are granted for
periods between two and five years and are renewable subject to satisfactory reports from local
authority inspectors. The average annual cost of a licence is $900.
E
Members pay a $100 joining fee, plus either $50 per month for “peak” membership or $30 per month
for “off-peak”, payable quarterly in advance. All fees are stated to be non-refundable.
PL
The centre at Verne was closed from July to September 2014 after a chemical spill in the sauna caused
a serious accident. Although the centre was re-opened, Hydrasports has recommended to all centre
managers that sauna facilities be suspended until further notice.
In response to complaints to the local authorities about its childcare facilities, Hydrasports has issued
centre managers with revised guidelines for minimum levels of supervision. Centre managers are
finding it difficult to meet the new guidelines and have suggested that childcare facilities should be
withdrawn.
SA
M
Staff lateness is a recurring problem and a major cause of “early bird” customer dissatisfaction with
sessions which are scheduled to start at 07.00. New employees are generally attracted to the industry in
the short-term for its non-cash benefits, including free use of the facilities – but leave when they require
increased financial rewards. Training staff to be qualified life-guards is costly and time-consuming and
retention rates are poor. Turnover of centre managers is also high, due to the constraints imposed on
them by company policy.
Three of the centres are expected to have run at a loss for the year to 31 December 2014 due to falling
membership. Hydrasports has invested heavily in a hydrotherapy pool at one of these centres, with the
aim of attracting retired members with more leisure time. The building contractor has already billed
twice as much and taken three times as long as budgeted for the work. The pool is now expected to
open in February 2015.
Cash flow difficulties in the current year have put back the planned replacement of gym equipment for
most of the centres.
Insurance premiums for liability to employees and the public have increased by nearly 45%.
Hydrasports has met the additional expense by reducing its insurance cover on its plant and equipment
from a replacement cost basis to a net realisable value basis.
Required:
(a)
12
(i)
Identify and explain the business risks which should be assessed by the
management of Hydrasports.
(8 marks)
(ii)
Explain how each of the business risks identified in (i) may be linked to
financial statement risk.
(8 marks)
(b)
Describe the principal audit work to be performed in respect of the carrying amount of
the following items in the statement of financial position of Hydrasports as at 31
December 2014:
(i)
(ii)
(c)
deferred income; and
hydrotherapy pool.
(3 marks)
(3 marks)
Suggest performance indicators that could be set to increase the centre managers’
awareness of Hydrasports’ social and environmental responsibilities and the evidence
which should be available to provide assurance on their accuracy.
(8 marks)
E
(30 marks)
Question 15 HARRIER MOTORS
PL
Harrier Motors deals in motor vehicles, sells spare parts, provides after-sales servicing and undertakes
car body repairs. During the financial year to 30 June 2014, the company expanded its operations from
five to eight sites. Each site has a car showroom, service workshop and parts storage.
In May 2014, management appointed an experienced chartered certified accountant to set up an internal
audit department.
New cars are imported, on consignment, every three months from one supplier. Harrier pays the
purchase price of the cars, plus 3%, three months after taking delivery. Harrier does not return unsold
cars, although it has a legal right to do so.
Harrier offers “trade-ins” (i.e. part-exchange) on all sales of new and used cars. New car sales carry a
three year manufacturer’s warranty and used cars carry a six-month guarantee. Many used cars are sold
for cash.
SA
M
An extensive range of spare parts is held for which perpetual inventory records are kept. Storekeepers
carry out continuous checking.
Mr Joop, the sales executive, selects a car from each consignment to use for all his business and
personal travelling until the next consignment is received. Such cars are sold at a discount as exdemonstration models.
Car servicing and body repairs are carried out in workshops by employed and sub-contracted service
engineers. Most jobs are started and finished in a day and are invoiced immediately on completion.
In May 2013 Harrier purchased a brand name, “Uni-fit”, which is now applied to the parts which it
supplies. Management has not amortised this intangible asset as it believes its useful life to be
indefinite.
Required:
(a)
Using the information provided, identify and explain the audit risks to be addressed
when planning the final audit of Harrier Motors for the year ending 30 June 2014.
(12 marks)
(b)
Identify and briefly explain the principal matters to be addressed in Harrier Motors’
instructions for the conduct of its physical inventory count as at 30 June 2014. (6 marks)
(c)
Describe the audit work to be carried out in respect of the useful life of the “Uni-fit”
brand name as at 30 June 2014.
(7 marks)
(25 marks)
13
Question 16 SHARP
You are responsible for completion of the fieldwork of the audit of Sharp, a private company
manufacturing domestic and industrial cleaning appliances. The draft accounts have been presented to
you as follows:
Statement of financial position at 30 September 2014
103
244
73
___
92
231
99
___
420
___
Capital and reserves:
Share capital
Retained earnings
Current liabilities
472
___
10
189
___
10
83
___
199
391
___
93
379
___
590
___
472
___
SA
M
Total equity and liabilities
590
___
422
___
PL
Total assets
2013
$000
50
E
Non-current assets
Current assets:
Inventory
Receivables
Cash at bank
2014
$000
170
Profit before tax was $106,000 on revenue of $1.5 million for the year ended 30 September 2014.
The audit tests have been completed. It only remains for you to evaluate the effect for the following
findings on the draft accounts. No adjustments have been made to the draft accounts other than as
indicated below.
Findings
(1)
Payments to suppliers amounting to $10,172 had been prepared and processed in the
accounting records on the last day of the financial year. Due to a clerical error they had not
been sent to the bank until several days after the year end.
(2)
An updated price list was issued in early September 2014 to take effect from 1 October 2014.
A number of invoices were issued during September using the new higher prices. Your client
became aware of this after the year-end. An allowance was made against receivables in the
draft accounts to account for credit notes which would have to be issued as a result after the
year end. The client’s estimate of the extent of the credits required was $10,000 and
allowance was made for this amount. Your audit rests show that, in the event, $17,542 in
credits was issued after the year end in respect of these pricing errors.
14
Additions to plant and machinery totalled $52,000 in the year. To verify their validity a
representative sampling test was conducted, selection being on a random basis. The value of
the sample was $13,000. A number of repair items (total value $2,500) were found to have
been incorrectly included in additions. When this was brought to the client’s attention these
items were corrected in the draft accounts.
(4)
Appliances are sold under a two year warranty. At each year end the company makes
estimates of how much should be provided for repair work to be conducted under warranties
issued but not claimed against. Client’s management accept that this is a reasonably
subjective area but feel that their estimates, based on sales volume, rates of claim and average
repair cost, are reasonable. Your workings suggest that the current provision, which stands at
$25,000, needs to be at least that much and might be as much as $5,000 understated.
However, past experience shows that the client’s estimate has always been reasonable.
Because of this, the client disagrees stating that you are taking too pessimistic a view.
(5)
You note that your client has continued to include in creditors an “uninsured risk” provision
of $20,000. Reference to the previous year’s files indicates that this provision was set up a
number of years ago to provide against “unforeseen events” but as yet no amounts have been
charged against it.
Required:
PL
E
(3)
(a)
Evaluate the significance of each finding and suggest how each should be dealt with.
(10 marks)
(b)
Summarise, the financial effect of each finding on the draft accounts, stating which, if
any, may be considered unadjusted errors.
(7 marks)
SA
M
(17 marks)
Question 17 IAS 24 EXAMPLES
In the following examples, identify related party relationships under IAS 24 and state any additional
factors to consider or information required to reach a conclusion on whether a related party relationship
exists.
Required:
(a)
Mr Smith holds a controlling interest in two companies, Voce and Stubbs. Roberts is a
wholly owned subsidiary of Voce.
(3 marks)
(b)
Mr Jones holds 75% of the voting capital of Tucker and 40% of the voting capital of
Wilton.
(5 marks)
(c)
Nancy and Paddy (who are husband and wife) are the directors and majority
shareholders of Flynn. The company makes purchases from Forsythe, a company
controlled by Paddy’s brother Danny. Danny is a director of Forsythe. Danny holds no
shares in Flynn and neither Paddy nor Nancy hold shares in Forsythe.
(7 marks)
(d)
Central is the parent company of a group which includes a 75% subsidiary, Green. The
remaining 25% of Green is owned by two of its directors, David and Donna.
(5 marks)
(20 marks)
15
Question 18 PHOENIX
You are the manager responsible for the audit of Phoenix Co, which manufactures super alloys from
imported zinc and aluminium. The company operates three similar foundries at different sites under the
direction of Troy Pitz, the chief executive. The draft accounts for the year ended 31 March 2014 show
profit before taxation of $1·7m (2013 – $1·5m). The audit senior has produced a schedule of “Points
for the Attention of the Audit Manager” as follows:
A trade investment in 60,000 $1 ordinary shares of Pegasus, one of the company’s major
shipping contractors, is included in the statement of financial position at cost of $80,000. In
May 2014, the published financial statements of Pegasus as at 30 September 2013 show only
a small surplus of net assets. A recent press report now suggests that Pegasus is insolvent and
has ceased to trade. Although dividends declared by Pegasus in respect of earlier years have
not yet been paid, Phoenix has included $15,000 of dividends receivable in its draft accounts
as at 31 March 2014.
(6 marks)
(2)
Current liabilities include a $500,000 provision for future maintenance. This represents the
estimated cost of overhauling the blast furnaces and other foundry equipment. The overhaul
is planned for August 2014 when all foundry workers take two weeks annual leave. (7 marks)
(3)
All industrial waste from the furnaces (“clinker”) is purchased by Cleanaway, a governmentapproved disposal company, under a five-year contract that is due for renewal later this year.
A recent newspaper article states that “substantial fines have been levied on Cleanaway for
illegal dumping”. Troy Pitz is the majority shareholder of Cleanaway.
(7 marks)
Required:
For each of the above points:
comment on the matters that you would consider; and
state the audit evidence that you would expect to find,
SA
M
(i)
(ii)
PL
E
(1)
in undertaking your review of the audit working papers and financial statements of Phoenix.
(20 marks)
Question 19 STILSON
You are the engagement partner for the audit of Stilson, a listed company. During the interim audit for
the year ended 31 March 2015, the audit manager noted the following in the working papers:
“There is a property rental charge of $1,250,000 paid on 30 April 2014 which relates to the first year’s
charge for the rent of a property that was previously owned by Stilson. This property was sold on
1 April 2014 to Winford for $8 million. It had a carrying value at the date of sale of $4·6 million.
Inspection of the rental agreement shows that Stilson has agreed to rent back the property for a period
of 10 years at an annual rental of $1,250,000.”
The audit manager has also noted that in his opinion both the selling price of the property and the
subsequent annual rentals seem excessively high. His preliminary estimates are that the property had a
fair market value at the date of its sale of $5 million, and a commercial annual rent for such a property
would be $800,000.
Required:
(a)
16
Explain the matters you should consider in relation to the sale and leaseback of the
property in order to determine its substance and state the accounting treatment it is
likely to require.
(6 marks)
(b)
Included in the sales revenues is an amount of $3 million relating to sales made under a
special promotion in July 2014. These goods were sold with an accompanying voucher equal
to the selling price. Five years after the sale, these vouchers will be exchanged for goods of
the customer’s choosing. Awareness of this “money back in 5 years” scheme was only
brought to light through a member of the audit staff actually buying goods from one of
Stilson’s stores at the time of the offer.
Required:
Explain why the verification of liabilities is often problematic and describe the
audit work undertaken to identify unrecorded liabilities.
(9 marks)
(ii)
Explain how liabilities may arise from the introduction of accounting
standards.
(5 marks)
E
(i)
(20 marks)
Question 20 VEMA
PL
You are the manager responsible for the audit of Vema Co, an established company. Vema offers a
national network for the distribution of wholesale goods through a fleet of heavy goods vehicles
(HGVs) and has one wholly-owned subsidiary, Weddell Co. The draft consolidated financial
statements for the year ended 31 December 2013 show revenue $125 million (2012 – $114 million),
profit before taxation of $12·4 million (2012 – $10·9 million) and total assets of $110 million (2012 –
$93 million).
The following issues arising during the final audit have been noted on a schedule of points for your
attention:
Historically, fleet vehicles have been depreciated at 331/3% on a straight-line basis as it was
Vema’s operational policy to replace them every three years. During the year, Vema decided
to change the basis of calculation to 25% reducing balance to reflect the fact that HGVs are
only replaced “as and when necessary”, usually every four to seven years. Management has
calculated the current year charge on the new basis as $2·9 million (former basis; $4·2
million) and $4·7 million of accumulated depreciation has been written back in the
restatement of opening reserves.
(8 marks)
SA
M
(a)
(b)
A payment of $592,000 selected in a substantive procedure has been traced to the following
general ledger journal in March 2013:
Debit
Administrative expenses
Credit Other liabilities
Credit Bank
$786,000
$194,000
$592,000
The accompanying narrative reads “Termination payment for Mr Z – not processed on any
payroll”. The audit senior has documented that “Mr Z, a former director of Vema, was made
redundant in September 2012 in a regional re-organisation”.
(6 marks)
(c)
The financial statements of the subsidiary company, Weddell, for the year ended 31
December 2013, are audited by another firm. Profit before taxation of $0·4 million and total
assets of $34·1 million have been included in the draft consolidated financial statements of
Vema. The notes to Weddell’s financial statements as at 31 December 2013 disclose a
contingent liability for a pending legal matter estimated at $0·2 million. In February 2014,
the courts found Weddell to be liable for costs and damages amounting to $1·1 million.
However, Weddell’s directors have refused to make a provision, for any amount, as they have
lodged an appeal against the judgement.
(6 marks)
17
Required:
For each of the above issues:
(i)
(ii)
comment on the matters that you should consider; and
state the audit evidence that you should expect to find,
in undertaking your review of the audit working papers and financial statements of Vema for the
year ended 31 December 2013.
Note: The mark allocation is shown against each of the three issues.
E
(20 marks)
Question 21 EAGLE ENERGY
PL
You are the manager responsible for the audit of Eagle Energy, an energy generation company. The
draft financial statements for the year ended 31 March 2014 show revenue of $287 million (2013 –
$262 million), profit before taxation of $7·2 million (2013 – $23 million) and total assets of $242
million (2013 – $221 million).
The following issues arising during the final audit have been noted on a schedule of points for your
attention:
During the year Eagle Energy put its technical staff through a new training program. On the
basis that this expenditure has been incurred solely for the purpose of generating future
economic benefits the chief executive is adamant that the costs, amounting to $4·3 million, be
capitalised as an intangible asset.
(7 marks)
(b)
During the year Eagle Energy assembled a laboratory on land which had been granted to it for
25 years, by the local authority, 10 years ago. Under the terms of the grant the laboratory
must be dismantled and the site decontaminated when the grant term expires in 15 years’
time. This is expected to cost $18 million at the time of dismantling and an annual provision
of $1·2 million is being made.
(7 marks)
SA
M
(a)
(c)
Eagle Energy receives significant funding from government sources and is required to report,
monthly, on its financial performance and position. Every month end a journal entry is made,
“Debit Sundry 1 account/Credit Sundry 2 account”. There is no narrative but the chief
accountant explained that the journal is approved by the chief executive to ensure that
reported debt ratios stay within government specified limits. The entries are then reversed at
the beginning of the following month. The net movement on these accounts over the year to
31 March 2014 was $0·3 million.
(6 marks)
Required:
For each of the above issues:
(i)
(ii)
comment on the matters that you should consider; and
state the audit evidence that you should expect to find,
in undertaking your review of the audit working papers and financial statements of Eagle Energy
for the year ended 31 March 2014.
Note: The mark allocation is shown against each of the three issues.
18
(20 marks)
Answer 1 AUDIT COMMITTEE
(a)
Improving the effectiveness of the external audit
E
Audit committees afford a means of strengthening the external auditor’s independence. An
audit committee is a committee of the governing body of a corporate entity which has
delegated responsibility for the external financial reporting process and the internal controls.
Over the last two decades the value of audit committees has been recognised and these
committees have been established in many countries. Their development has varied from
country to country and has often been stimulated by corporate failure. Thus it is perceived
that the audit process will be helped by audit committees as they will perhaps pre-empt
unexpected corporate failure and undetected misconduct by senior officials.
The
establishment of audit committees has been foremost in North America and the UK, closely
followed by Australia, New Zealand, South Africa, Malaysia, Singapore and Europe. The
size, composition and duties of audit committees vary from country to country.
PL
An audit committee can improve the effectiveness of the external auditor’s work by
increasing the assurance that the external auditors can derive from systems of corporate
governance and internal financial controls. The committee will be involved in ensuring that
the external auditor is independent and will participate in the selection of the auditor by
recommending certain firms who have knowledge of their industry and reviewing the source
and rationale for selecting certain firms of auditors. Additionally the terms and scope of the
external audit and corporate governance engagement will be discussed as will the
management letter and its effect on the current year’s audit.
SA
M
The committee will encourage discussions with the external auditor as to how internal
controls might be improved, and the rationale as to the use of specialist departments of the
audit firm and specialist advisors. A meeting of internal auditors, external auditors and the
audit committee will review the audit plan with a view to minimising duplication of work, the
effect of new auditing standards and providing value for money for the company. The timing
and nature of reports from the external auditors will be reviewed as to their effectiveness and
any contentious accounting issues discussed.
Generally the audit committee will make suggestions as to the problem areas which the audit
can address. The external audit partner and the chairman of the audit committee will discuss
differences of opinion and attitudes of committee members and feedback on the performance
of the auditors. The opening up of communication channels between the external auditor and
the audit committee and two-way discussions enhances the quality of the audit and adds value
to the audit process.
The audit committee will further discuss with the internal and external auditor the intended
scope of their work with a view to satisfying itself that no unjustified restrictions have been
imposed by executive management. Additionally the following duties of the audit committee
may assist in the external audit process.

dealing with difficulties in the performance of the audit such as non-availability of
client personnel;

reviewing the findings of the internal and external auditors;

reviewing the company’s financial statements and annual report prior to the
submission to the board;

reviewing public announcements that have a financial impact;

reviewing and monitoring compliance with the corporate code of conduct and legal
and statutory requirements.
1001
Audit committees are seen as valuable not only for overseeing the external reporting process
and external audit but as a means of ensuring responsible corporate governance. They are an
aid in ensuring the professional independence of auditors and the efficiency and effectiveness
of the audit and the system of corporate governance.
(b)
Independence of audit committee members where only a voluntary code is in place
E
The members of the audit committee generally comprise non-executive directors (the New
York Stock Exchange and the London Stock Exchange require audit committees to comprise
all NEDs) and although they should be independent of the company and declare any interests
in the company, the general absence of regulations in this area means that independence is
often hard to achieve (again the NYSE and LSE require audit committee members to be fully
independent). For example the NEDs often sit on committees of several companies and there
are often no regulations as regards conflicts of interest in this area. Additionally the company
pays the NEDs salaries and this fact ensures that independence is difficult to achieve under a
voluntary code.
SA
M
PL
The NEDs often sit not only on the audit committee but also on several other board
committees making strategic contributions to the running of the business. They have to
balance their role as audit committee member and the monitoring of executive directors and
management with their role as corporate strategist. They are acting in several capacities and
therefore their source of influence is somewhat diffuse and because of the complexity of the
NEDs role it is difficult to imagine that they can act independently when it comes to
exercising their corporate governance role. The internal structure of the company and the
perception of the role of the audit committee by the main board will determine the ability of
the NEDs to exercise independent judgement. NEDs may have previous executive
involvement with the company and have participation in share option schemes which is
inconsistent with the exercise of independent judgement. It is extremely difficult for an NED
to exercise independent judgement when they have any interest in the company (e.g. retired
executive director or significant shareholder), are appointed directly by executive directors
and are remunerated by the company beyond a basic salary (e.g. bonus).
(c)
Regulation of audit committees
If the audit committee is not governed by statute or required governance code, then several
issues arise. One of the problems of allowing self-regulation in the area of corporate
governance and audit committees is that if prescriptive approaches are advocated, they may
not receive the support of key industry groups and in the absence of major corporate failure or
fraud, governments may be reluctant to impose regulations on industry as it may be seen to be
a further burden to management.
Without statutory regulation, there will be inconsistency of practice and standards between
audit committees. Members of audit committees may find it difficult to criticise management.
The form of the annual report of the audit committee may not be consistent without some
form of statutory regulation. Shareholders are poorly informed about the working of the audit
committee and there would seem to be substantial benefits from making publication of the
report of the audit committee a statutory requirement. Greater transparency and disclosure
can be uncomfortable for companies but the current reliance on voluntary practices creates a
market risk which can be alienated through changes in statute and disclosure practices.
1002
However the prescriptive approach to the formation of an audit committee may result in
disproportionate significance being given to its role and may affect corporate performance
and long-term potential. Problems would also arise if a single model audit committee were
imposed on a wide range of companies of different sizes and financial profiles, and different
internal structures. Many smaller companies would not see the benefits of appointing an audit
committee and they may feel that statutory regulation is counterproductive, with the costs
outweighing any benefits: However it is important that some form of monitoring report is
made to shareholders even in the case of small publicly quoted companies.
E
If audit committees are unregulated then there is little formal requirement for adherence to
professional values of competence, independence or effective reporting to shareholders. The
identity and experience of the audit committees’ members becomes an important issue in these
circumstances. Accountancy bodies will find it difficult to set standards for NEDs on audit
committees where such persons are non-accountants and the problems of independence of NEDs
set out in part (b) above may dictate that some form of statutory regulation may be required.
Answer 2 MONEY LAUNDERING
Meaning of the term

Money laundering is the process by which criminals attempt to conceal the true
origin and ownership of the proceeds of their criminal activity (“dirty” money)
allowing them to maintain control over the proceeds and, ultimately, providing a
legitimate cover for their sources of income.

The term is widely defined to include:
SA
M
(a)
PL
Tutorial note: The answer which follows is indicative of the range of points which might be made.
Other relevant material will be given suitable credit.



possessing; or
in any way dealing with; or
concealing
the proceeds of any crime (“criminal property”).

It also includes:



an attempt or conspiracy or incitement to commit such an offence; or
aiding, abetting, counselling or procuring the commission of such an
offence.
Further, it includes failure by an individual in a regulated sector (in the UK) to
inform the financial intelligence unit (FIU), as soon as practicable, of knowledge or
suspicion that another person is engaged in money laundering.
Tutorial note: The FIU serves as a national centre for receiving (and, as permitted,
requesting), analysing and disseminating suspicious transaction reports (STRs).
1003
Need for ethical guidance
Accountants (firms and individuals) working in a country that criminalises money
laundering are required to comply with anti-money laundering legislation and
failure to do so can lead to severe penalties. Guidance is needed because:





legal requirements are onerous;
money laundering is widely defined; and
accountants may otherwise be used, unwittingly, to launder criminal
funds.
Accountants need ethical guidance on matters where there is conflict between legal
responsibilities and professional responsibilities. In particular, professional
accountants are bound by a duty of confidentiality to their clients. Guidance is
needed to explain:
E


how statutory provisions give protection against criminal action for
members in respect of their confidentiality requirements;

when client confidentiality over-ride provisions are available.
PL
(b)
Further guidance is needed to explain the interaction between accountants
responsibilities to report money laundering offences and other reporting
responsibilities, for example:
reporting to regulators;
auditors’ reports on financial statements (ISA 700);
reports to those charged with governance (ISA 260);
reporting misconduct by members of the same body.
SA
M





Professional accountants are required to communicate with each other when there is
a change in professional appointment (i.e. “professional etiquette”). Additional
ethical guidance is needed on how to respond to a “clearance” letter where a report
of suspicion has been made (or is being contemplated) in respect of the client in
question.
Tutorial note: Although the term “professional clearance” is widely used,
remember that there is no “clearance” that the incumbent accountant can give or
withhold.

1004
Ethical guidance is needed to make accountants working in countries that do not
criminalise money laundering aware of how anti-money laundering legislation may
nevertheless affect them. Such accountants may commit an offence if, for example,
they conduct limited assignments or have meetings in a country having anti-money
laundering legislation (e.g. UK Ireland, Singapore, Australia and the United States).
(c)
Measures
The following measures are designed to assist in preventing professional accountants from
being used for money laundering purposes:


developing programmes against money laundering and terrorist financing;
compliance officer;
employee training programme;
customer due diligence (CDD);
establishing/enhancing record keeping systems for:

all transactions; and

the verification of clients’ identities;
reporting of suspicious transactions;
refusing to have relationships with “shell banks”.
Tutorial note: Only FOUR are required.

PL
Developing programs
E





Internal policies, procedures and controls should be established and recorded
including:



SA
M
Compliance officer
compliance management arrangements (including appointment of a
compliance officer);
an on-going employee training programme;
an audit function to test the system

Appointing a compliance officer having a suitable level of seniority and experience
(e.g. one of the principals of an accountancy firm).

Making alternative arrangements (e.g. appointing a deputy) when the compliance
officer is going to be unavailable for a period of time (as reports have to be made as
soon as is reasonably practicable).

The compliance officer being made responsible for:



receiving and assessing money laundering reports from colleagues;
making reports to the FIU; and
ensuring that individuals are adequately trained.
Employee training programme

Providing an employee training programme on:



relevant legislation (e.g. the main money laundering offences);
ethical guidance (e.g. ACCA’s Guidance for Accountants); and
the firm’s procedures to forestall and prevent money laundering.

Establishing a culture of complying with money laundering requirements.

Documenting the provision of training (to demonstrate compliance).
1005

Training methods may effectively include:

attending conferences, seminars and training courses run by external
organisations; and

participating in computer based training courses.
Customer due diligence (CDD)
Firms should not keep anonymous accounts or accounts in obviously fictitious
names.

Firms should verify the identity of their customers, when:
establishing business relations;
carrying out occasional transactions (e.g. above a designated threshold);
there is a suspicion of money laundering or terrorist financing; or
there is doubt about the reliability or adequacy of previously obtained
customer identification data.
PL




E

CDD measures should include:

Identifying the customer and verifying that customer’s identity using reliable,
independent source documents, data or information.
Tutorial note: Similarly identify and verify the beneficial owner.
Obtaining information on the purpose and intended nature of the business
relationship.
SA
M


Conducting on-going due diligence on business relationships by scrutinising
transactions to ensure that they are consistent with the firm’s knowledge of :



the customer;
their business and risk profile;
the source of funds.
Tutorial note: These requirements should apply to all new customers and existing customers
on the basis of materiality and risk.
Record keeping

Maintaining all client identification records together with a record of all
transactions, in a full audit trail form.

Maintaining records of transactions (whether domestic or international) in a readily
retrievable form for a period of at least five years (to facilitate swift compliance
with information requests from the competent authorities).
Tutorial note: Such records must be sufficient to permit reconstruction of
individual transactions (including the amounts and types of currency involved, if
any) so as to provide, if necessary, evidence for prosecution of criminal activity.

1006
Retaining client verification records throughout the period of the relationship and
for five years after termination of the relationship.

Making available identification data and transaction records to domestic competent
authorities upon appropriate authority.

Paying special attention to all complex, unusual large transactions, and all unusual
patterns of transactions, which have no apparent economic or visible lawful purpose
(in accordance with ISA 240 The Auditor’s Responsibilities Relating to Fraud in an
Audit of Financial Statements).
Client identification



E
For an individual – inspecting official documents, with a photograph, establishing
the client’s full name and permanent address, for example:
a driving licence or passport, supported by;
a recent utility bill.
For the entity – obtaining from the Registrar of Companies:



certificate of incorporation;
company’s registered address; and
a list of shareholders and directors.
PL


Checking the names of new clients against lists of known terrorists and other
sanctions information.

For trusts – ascertaining:
the nature and purpose of the trust;
the original source of funding; and
the identities of the trustees/controllers, principal settlers and beneficiaries.
SA
M



Suspicion reporting

Prompt reporting of suspicions to the (FIU) in a suspicious transaction report (STR).

There should be no de minimis concessions. Reporting should be irrespective of:


the amount involved; or
whether tax matters are involved.
Tutorial note: Attempted transactions should also be reported.

Enhancing confidentiality of the source of reports by:



disclosing the compliance officer only once; and
not naming the personnel making reports to the compliance officer.
Disclosing further information only if:


legally required to do so; or
otherwise justified, in the public interest.
1007
Shell banks
Tutorial note: A “shell bank” is a bank incorporated in a jurisdiction in which it has no
physical presence and which is unaffiliated with a regulated financial group.

Firms should guard against relationships with parties that permit their accounts to be
used by shell banks
Answer 3 BLAKE SEVEN
(a)
Importance of role of confidentiality to auditor-client relationship
E
That auditors should monitor and maintain the confidentiality and security of information is
one of the mandatory competence requirements for membership of newly qualified Chartered
Certified Accountants. It applies to all professional accountants.
In particular:
confidential information is only disclosed to those entitled to receive it;

information obtained in the course of professional work is not used for purposes
other than the client’s benefit;

any decision to over-ride the duty of confidentiality (e.g. if required by a court
order) is taken after due consideration and discussion with professional colleagues;

the duty of confidentiality continues even after an auditor-client engagement ceases;

an accountant who moves into new employment must distinguish previously gained
experience from confidential information acquired from their former employment;
SA
M
PL


prospective accountants must treat any information given by existing accountants in
the strictest confidence.
Confidentiality is a fundamental principle of IESBA’s “Code of Ethics for Professional
Accountants”. It is also an implied contractual term.
In order to fulfil their duties, auditors require full disclosure of all information they consider
necessary. A duty of confidentiality is therefore essential to ensuring that the scope of the
audit is not limited as a result of information being withheld in the belief that the auditor will
pass that information on to a third party who is not entitled to receive such information.
Confidentiality is also essential to client’s seeking advice in that the auditor will need to know
all the facts in order to give appropriate advice.
(b)
Matters to consider
Rosella has made three requests:
(1)
(2)
(3)
1008
disclosure of a former co-executive’s level of remuneration;
continuing to act as personal adviser;
accepting an appointment as audit and adviser to Blake Heaven.
(1)
Disclosure of remuneration package
In an audit appointment, the auditor owes a duty of confidentiality to the client (i.e. the
company not individual shareholders or executives). There is no legal or professional right or
duty to disclose client information on an ad hoc basis merely because it is available to the
auditor.
It would be a breach of the audit firm’s duty of confidentiality to Blake Seven (in acting as
auditor) and Brad (in acting as adviser) to disclose the information requested when clearly
there is no process of law or “public interest” involved.
E
The audit firm could only disclose the information to Rosella with Brad’s consent. This is
highly unlikely since Brad has refused to do so. Also, attempting to obtain permission from
Brad is likely to result in a breach of the duty of confidence that the audit firm owes to
Rosella (in their current role as adviser).
PL
In general, the audit firm’s working papers are its own property and any request for them (e.g.
if Rosella requested a schedule of emoluments, etc) should be refused.
The latest audited financial statements (which are available to Rosella in her capacity as a
shareholder) may disclose Brad’s remuneration for the previous year (e.g. as chairman and/or
highest paid executive). Rosella will need to wait for this information to be publicly
available.
As a member of the company (i.e. shareholder), Rosella would also be entitled to inspect any
relevant documents required to be held at Blake Seven’s registered office (e.g. if Brad has a
service contract with the company).
Continuing as personal adviser
SA
M
(2)
A conflict between the interests of Blake Seven (and its continuing directors) and Rosella
Trebbiano (in a personal capacity) is likely to arise (e.g. over the valuation of Rosella’s
shareholding).
It would be inappropriate for one adviser to act for both parties in certain matters, such as
negotiating a share price (in the event of subsequent disagreement) without appropriate
safeguards.
Valuing Rosella’s shareholding and negotiating her profit-related remuneration may appear to
threaten the objectivity of the audit of Blake Seven. Rosella may try to exert influence to
overstate profits (e.g. over Janus, as her brother and finance director, as well as the auditor).
However, the interests of these clients may not be materially prejudiced in all matters if:


adequate disclosure is possible (i.e. of all relevant matters to all parties); and
appropriate safeguards are implemented (e.g. advising one or all clients to seek
additional independent advice).
In particular it may be possible to advise Rosella on personal tax matters.
(3)
Appointment as auditor
A conflict between the interests of Rosella’s new company, Blakes Heaven, and Blake Seven
is likely to arise as the former has been set up in competition with the latter.
1009
There is nothing improper in having both companies as audit clients if there are appropriate
safeguards (e.g. different reporting partners and teams of staff for each audit engagement).
However, even with safeguards, the directors of Blake Seven (the Capellas in particular) may
perceive that the involvement of the company’s auditors with a competitor (in the capacity of
auditor and adviser) could materially prejudice their interests. Also, that the new company
has been set up with so similar a name suggests that Rosella may be quite aggressive in
targeting Blake Seven’s business.
E
In view of the adversarial relationship between Rosella and Blake Seven it would be prudent
to include in their respective engagement letters a clause reserving the right to act for other
clients subject to confidential information being kept secure.
The provision of other services (as adviser) could threaten the objectivity of the audit
assignment. In particular, it would be inappropriate for the personal adviser to be the
reporting partner or otherwise involved in the audit.
PL
Conclusion
The request to disclose Brad’s remuneration must be declined. However, Rosella may be directed to
alternative sources of information that may be of use (though not strictly current).
The firm may continue to act as Rosella’s personal adviser subject to appropriate conditions and
safeguards being put in place in respect of matters that may materially prejudice either client. For
example:


the agreement of Blake Seven (and the remaining directors);
Rosella being advised to seek additional independent advice.
SA
M
However, given the apparent acrimony between Rosella and her former associates, it seems unlikely
that Blake Seven would agree to such an arrangement.
The audit appointment could only be accepted with appropriate safeguards (e.g. reporting partner and
audit staff not involved in the audit of Blake Seven or the provision of other services). However, even
with safeguards, if Rosella’s appointments are accepted, Blake Seven may decide not to re-appoint the
firm in future.
Answer 4 DEPECHE
(a)
Ethical and professional issues

The review, on an on-going basis, of existing clients is a safeguard. For example,
Duran is a listed company which should not be retained if recurring fees from it
exceed 15% of Depeche’s gross practice income over a two year period. A preissuance (hot) review would be a standard safeguard as Duran is a listed company.

In making a decision to retain a client, Depeche must consider:


1010
its independence and ability to serve Duran properly; and
the integrity of Duran’s management.
Hospitality

Depeche’s objectivity may be threatened, or appear to be threatened, by acceptance
of goods, services or hospitality from Duran, unless the value of any benefit is
clearly insignificant.

The audit staff have already accepted the hospitality. Their objectivity should not
have been impaired provided that the meals were appropriate to the normal
courtesies of social life.

However, undue hospitality is likely to be regarded as a corrupt practice, which
could be indicative of fraudulent activities having taken place.

As the staff needed to work late to meet the deadlines, an alternative to Duran
buying in the refreshments would have been for the audit team to make their own
arrangement and for Duran to have been re-charged the expense.
(2)
Financial reward

Professional accountants in public practice should be and appear to be free of any
interest which might be regarded, whatever its actual effect, as being incompatible
with integrity, objectivity and independence.

The bonus was not accepted in respect of the audit manager’s involvement.
Therefore there is no obvious threat to his objectivity.

The bonus may be perceived to be a reward (or “bribe”) for having not detected or
reported on a matter and acceptance of it may cast aspersions on the audit team’s
integrity.

The bonus has been processed by Depeche in such a way as to account for tax,
social security contributions, etc and recovered through the recharge of expenses
associated with the audit. It represents an increase in the audit fee and the gross
cost to Duran should be included in the amount disclosed in the note to the financial
statements as auditors’ remuneration.

The bonus should be excluded from the fee when considering the “recurring
element” in relation to the % level of gross practice fee income.

Has this situation arisen in respect of previous Duran audits? Was the subject of
such bonuses mentioned before the audit fieldwork was completed? If the audit
team had any expectation that a bonus might be awarded to them it is likely that
there will be a perception that their objectivity could have been impaired.

Has the situation created an expectation that such bonuses could be a feature of this
audit? Acceptance of the bonuses may have created problems for Depeche’s
practice management as it may be more difficult to allocate audit staff to other
assignments if they have a preference for the Duran audit.

That the bonus was not accepted at the manager level suggests that this was
considered to be a threat to objectivity. The same approach should have been taken
for all members of the audit team. The bonus should not have been paid.
SA
M
PL
E
(1)
Tutorial note: Usually examination questions should not be answered with further
questions. But note the technique used here of raising the question (as a thought)
and then providing an appropriate response.
1011
(3)
Client/auditor integrity

Frankie Sharkey’s apparent disregard for environmental legislation should have
been taken into account when making a risk assessment of Duran’s control
environment. It may cast doubt on his integrity.

The audit of Duran should have been carried out with due regard to:
ISA 260 Communications With Those Charged With Governance.
E

For example, if the illegal dumping became apparent during the audit but was not
known at the planning stage, consideration should have been given to:

the frequency of the illegal act, how long it has been going on and what
measures, if any, had been taken to conceal it from the auditors;

the potential financial consequences (e.g. fines, penalties, enforced
discontinuation of operations and litigation);

whether the potential consequences require disclosure;

whether risk assessments made at the planning stage need now to be
revised;

the validity of management representations.
Matters to be communicated to those charged with corporate governance (i.e. the
audit committee) include:
SA
M

ISA 250 Consideration of Laws and Regulations in an Audit of Financial
Statements; and
PL



the potential effect on the financial statements of any significant risks and
exposures, such as pending litigation, that are required to be disclosed in
the financial statements (this could arise from the illegal dumping); and

other matters warranting the attention of those charged with governance,
such as questions regarding management integrity.
Tutorial note: Although the fines are “only small”, the boycotting of Duran’s
products or other adverse publicity could have a detrimental effect on the
company’s operations.
1012

It is of potential concern that the matters have not been included in the final report
unless the engagement partner knows, for example, that the matter has already been
brought to the audit committee’s attention (e.g. in an internal auditor’s report).

Does the draft report constitute an audit working paper? If it is retained on file it
should clearly explain why it was not incorporated into the final report (and whose
decision it was to exclude; the manager’s or partner’s). If there is no apparent
justification for its exclusion, the integrity of the audit manager and/or engagement
partner may be questioned.
(b)
Available safeguards
Tutorial note: Available safeguards will be appropriate if they eliminate the threats or
reduce them to an acceptable level.
The firm’s guidance on receiving hospitality should be reviewed and amended as
necessary. It may be that “on-going” hospitality is refused, if construable as
excessive.

Review of the engagement partner’s decision to accept the bonus on behalf of the
staff. For example, whether the firms’ quality assurance policies and procedures
required him to consult with other partners.

Audit staff and the client should be advised that the bonus was a “one-off” and not
to be repeated.

Senior staff (the two qualified seniors and two supervisors) should not be assigned
to the audit for the year to 31 December 2014.

Involving a second partner to review the conduct of the audit and advise staff
involved of any concerns they have about their independence from Duran and the
integrity of Duran’s management.

If the engagement partner has been involved in the audit for a number of years (say
seven), it may be time to rotate the assignment.

Discuss issues of independence with Duran’s audit committee and obtain written
confirmation that they are aware of the potential threats posed by public interest,
fees, hospitality, etc and that they are satisfied that the firm’s safeguards are
adequate.
SA
M
PL
E

Advice whether or not the audit of Duran should continue
The Duran audit should be retained only if a partner of Depeche unconnected with Duran
independently reviews the safeguards available and considers them to be adequate.
Alternatively: If the safeguards available are not adequate to maintain independence,
Depeche should withdraw from the audit.
Answer 5 CLIFDEN
(a)
Professional competence and due care
“Professional competence and due care” is one of the fundamental ethical principles
explained as part of the Code’s conceptual framework. It can be broken down into two parts.
Professional competence
This is the concept that a professional accountant must firstly achieve, and subsequently
maintain, professional knowledge and skill at the level required to ensure that clients and
employers receive competent professional service.
Attaining professional knowledge is achieved through a mixture of formal professional
qualifications, informal “on the job” training, and gaining experience of a range of
professional work.
1013
Maintaining professional knowledge is achieved through continuing professional
development. Professional accountants must ensure that they are aware of changes in
technical fields such as tax, auditing and financial reporting regulations where relevant to the
services they offer to clients. Professional accountants should also be aware of general
business developments, such as the use of information technology and e-commerce.
Due care
Compliance with the principle
PL
Attaining and maintaining professional knowledge
E
This is about acting diligently in accordance with applicable technical and professional
standards when providing professional services. This means applying knowledge to a specific
situation with careful consideration, minimising the chance of mistakes being made. It may
also include wider issues such as making sure that there is enough time to complete work with
due care, and ensuring that staff fully understand the objectives of the work they are being
asked to perform.
Firms can offer training on specific technical matters, such as changes to tax rules or new
auditing guidelines, which could be provided by senior members of the firm or by external
consultants.
Due care
Adherence to quality control guidelines will help ensure that due care has been exercised.
Particularly the briefing, supervision and review of work by more senior members of the firm
should act as a preventative and detective control to pick up any errors made in the work.
SA
M
In addition, formal and informal staff appraisals will enable members of staff to raise issues
with more senior members of staff (e.g. if they felt under too much time pressure to properly
perform their work).
Reviews carried out as part of the normal audit cycle (i.e. hot and cold reviews) can also help
to identify where the firm may need to organise more training for staff.
(b)
Ethical and professional issues
(i)
Contaminated plastic
It appears that Headford has manufactured items which potentially could cause serious injury
or even death to a consumer. Management has decided not to recall any products, which
indicates a lack of integrity. Even though the risk of this happening has been assessed by
management as low, it would still be ethically appropriate to announce the problem, allowing
customers to return potentially harmful products. As the contaminated products were made in
the last few months of the year, it is likely that some items are still held by the company as
finished goods inventory, in which case the company is putting its own staff and assets in
danger. The assertion by management that the risk of injury is “remote” should be treated
with scepticism.
Firstly, Clifden & Co should encourage the management of Headford to make the problem
with the products public. There will obviously be reluctance to do this due to the bad
publicity which would follow, especially in the competitive industry in which the company
operates. However, the auditors should try to explain to management the reasons why they
should disclose, and hopefully convince management that this would be the ethically correct
way to proceed.
1014
Tutorial note: Do not get distracted into discussing the ethical and moral issues faced by the
company. Only the auditing aspects, as noted below, should be considered.
If management still refuse to make a disclosure, Clifden & Co should consider their duty of
confidentiality. Both IFAC and ACCA recognise that information discovered while
performing a professional engagement must not be disclosed without proper and specific
authority to do so, or unless there is a legal or professional right or duty to disclose. Clifden
& Co may wish to disclose the problem with the products in order to protect consumers from
potential harm, but the firm must be very careful to consider whether it has a right or duty to
disclose.
E
ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements may
provide relevant guidance in this situation. It is likely that children’s toys have to be tested in
accordance with industry regulations for health and safety. If this is the case, and the use of
contaminated ingredients constitutes a non-compliance with law and regulations, the auditor
may have a statutory right or duty to report the situation to the appropriate authority.
PL
In the absence of any industry regulation, Clifden & Co should consider if there is a necessary
disclosure in the public interest. This is a difficult and subjective decision, as there is little
guidance on what is meant by “public interest”, and it would be hard to decide who exactly
the recipient of any disclosure should be. In deciding whether to disclose in the public
interest, the auditors should consider the reasons for the client’s unwillingness to disclose, the
seriousness of the matter (i.e. the likelihood of harm being caused, and the relevant laws and
regulations).
SA
M
Before making any disclosure, Clifden & Co should obtain information and evidence
regarding the contamination (e.g. how the contamination was discovered (did a toy actually
explode?)) and whether anyone has been injured. If this is the case there could be legal
claims already in progress against the company.
As a last resort, Clifden & Co could consider resigning from the audit. The firm could then
circularise a “statement of circumstances” which would describe the reason for the
resignation, including details of the faulty products and the lack of management integrity.
In addition Clifden & Co should establish whether the supplier of the plastic raw material has
been contacted, the number of products sold which are contaminated and the number still held
as inventory (if any). There could be a counter-claim against the supplier in which case the
likelihood of the claim’s success should be evaluated.
Finally, the situation also affects the audit procedures that are currently being planned. Any
contaminated inventory still held by Headford should be written off, and a provision may be
necessary for refunds of returned products, if the matter becomes known. The financial
statements may need to contain disclosures relating to contingent liabilities, or provisions may
need to be recognised in respect of damages claimed by customers in the event of any injuries
occurring and legal action being taken against Headford. The audit should be planned to
devote sufficient time to these matters.
Careful consideration should be made relating to the year-end inventory count. Assuming
that some finished goods containing the contaminated ingredient are still held by the
company, audit staff may be in danger of injury when they attend the inventory count.
Headford must take action to make the items safe or to keep them in safe conditions (i.e. at
low temperatures) in order to prevent any injuries to its own staff and members of the audit
team.
1015
(ii)
Invitation to audit Cong
This gives rise to a potential conflict of interest between the interests of different clients.
There is nothing ethically wrong in having clients operating in the same industry; in fact it is
normal for firms of auditors to specialise in the provision of services to companies in a
particular industry or market sector, some of whom are likely to be competitors. However,
acting for two competing companies can give rise to ethical threats, particularly objectivity
and confidentiality. It could be perceived that impartial, objective services and advice cannot
be offered to a company where the audit firm also audits a competitor, and the client
companies may be concerned that commercially sensitive information may become known to
its competitor if the same audit firm is used by both companies.
E
The main safeguard in this situation is disclosure of the potential conflict to all parties
concerned. Therefore, the audit of Cong should only be accepted if both companies have
been informed of the services provided by Clifden & Co which could be perceived to create a
conflict of interest, and if both companies give their consent to act.




PL
If the audit of both companies goes ahead, then the following extra safeguards should be
considered:
The use of separate engagement teams
Issuing clear guidelines to the teams on issues of security and confidentiality
The use of confidentiality agreements by audit team members
Regular review of the safeguards by an independent partner.
In addition, as Cong is a large company, an evaluation as to whether Clifden & Co has
sufficient resources to carry out both audits using totally separate teams should take place.
SA
M
It is quite likely that one or both of the companies do not give consent, in which case Clifden
& Co will have to decide which company to act for. As Cong is a larger company, it is
probable that a higher audit fee would be charged. In addition the provision of non-audit
services can be lucrative, indicating that it may be commercially advantageous to take on
Cong as a client, and to resign from the audit of Headford.
Answer 6 CD SALES
(a)
Key audit tests that would normally detect such fraud
The company’s growth record had been achieved by the falsification of records for sales and
cost of sales. The following procedures would normally detect a fraud such as that
perpetrated by Mr Long.

Direct confirmation of certain matters with the sales agents. The auditor would
request the following information from the agent:




amount of balance owing to CD Sales;
amount of the inventory on hand at the period end;
amount of sales and returns during the period;
copy of the agent’s contract/agreement with CD Sales.
This information would be agreed to the company’s records. Any agents who did
not reply would be subject to alternative audit procedures such as verification of
existence with trade directories, etc and close scrutiny of the outstanding amounts to
third party documentation (if any). Further, the auditor may pay a visit to the
agents’ premises simply to ensure physical existence of the agents.
1016
Direct confirmation of inventory held on sale or return by physical verification. A
sample of sales agents would be taken and the auditor would visit the premises and
count the inventory.

Review the procedure for the authorisation of sales agents. Fictitious agents may be
detected where there is a lack of appropriate evidence of existence or authority for
the approval of the agents.

Sales and purchase cut-off tests should be performed at the year end. These tests
should detect any sale and repurchase agreement such as the one practised by Mr
Long. Further returns of goods after the year end should be scrutinised by the
auditor.

A physical check of long term assets should detect the fictitious assets. The auditor
should take a sample of invoices for non-current asset purchases, agree them to the
fixed asset register (if any) and physically verify their existence. Similarly the
auditor could carry out a physical inventory count (on a sample basis) and agree the
resultant test counts to purchase invoices. Any exceptions (e.g. invoices for noncurrent assets that do not exist or inventory on hand with no corresponding
invoices) should be invested by the auditor.

The auditor should scrutinise the directors’ service contracts. This procedure would
bring to the attention of the auditor any high bonuses which the directors may be
earning. Thus, the control environment within which the internal controls are
operating could be affected by the fact that the directors may be looking to
maximise profits in order to maximise their income. This fact would increase the
audit risk in the company.

The auditor should try and ascertain if there are any “related parties”. This may
help the evaluation of the possibility of collusion between the company and third
parties.
SA
M
PL
E


(b)
The auditor should perform and carry out analytical procedures and compare the
results with companies in the same sector and prior years’ results of the company.
It is likely that such a test would show any exceptionally high profit margins and
unusual returns on capital employed.
Implications of the “confidentiality” agreement
The confidentiality agreement imposed restrictions on the ability of the auditors to
corroborate certain transactions with third parties and to scrutinise the directors’ service
contracts. Many companies are concerned that confidential information may be leaked to
third parties/competitors, especially where the audit firm serves competing companies.
Legislation usually gives auditors the power to inspect the accounting records of the company
and to obtain such information and explanations as they deem necessary. Agreements such as
this would contravene such rights.
Further, constraints of this type are preventing the auditor from complying with generally
accepted auditing standards. The scope of the auditor’s work has been limited and it is
unlikely that sufficient audit evidence will be obtained to support the audit opinion. As a
result the auditor should inform the client that the auditor’s report will have to be qualified
due to the limitation in the scope of the audit.
1017
If such a qualification is not included in the auditor’s report, then the auditor may be deemed
to have been negligent and possibly may be deemed to have acted unlawfully in signing such
an agreement.
(c)
Negligence
The auditor’s function is not to prevent fraud and error. When planning the audit, the auditor
should assess the risk that fraud or error may cause material misstatements in the financial
statements.
E
As a result of the risk assessment, the auditors should design audit procedures so as to have a
reasonable expectation of detecting such material misstatements. If the risk assessment or the
audit procedures indicate that there is a possibility of fraud, then the auditor should undertake
additional procedures in order to dispel or otherwise this possibility.
PL
The subsequent discovery of fraud does not necessarily indicate that the auditors have failed
to adhere to the basic procedures of an audit. The auditors are entitled to accept
representations as truthful, and records and documents as genuine. The auditor must perform
the audit, however, with a degree of professional scepticism. Accounting and internal control
systems may be ineffective against fraud involving collusion or where management overrides
controls (e.g. by suppressing or falsifying information relating to transactions). In the case of
the audit of CD Sales it is difficult to determine whether the auditor is guilty of negligence.
There are several points to be taken into account. Firstly, Mr Long has perpetrated a
sophisticated fraud by recruiting third party accomplices. It is difficult for the auditor to
detect such a fraud where collusion and bribery takes place.
SA
M
If the auditor was satisfied that there was no fraud apparent from his audit procedures and his
suspicions were not aroused then he may not be found to be negligent. Mr Long had spent a
significant amount of money to conceal the fraud and the auditor could easily have been
deceived by the level of sophistication of it. However, the auditor signed a “confidentiality
agreement” with the client which precluded him from verifying certain transactions with third
parties and from examining the directors’ service contracts. This restriction in the scope of
his work would mean that he could not carry out certain audit procedures which could have
detected the fraud.
Also, the results of the analytical procedures and the cut-off tests ought to have indicated that
there was a need for explanations for the high profitability and the treatment of returns from
sales agents.
It is likely in the light of the above that the auditor would find it difficult to defend an action
brought by a third party, mainly because of the signing of the confidentiality agreement.
Answer 7 DUTY OF CARE
Tutorial note: It is not necessary to be able to recall all of the cases mentioned, although Caparo and
Bannerman are classics in auditor case law. You must, however, be able to be able to build a suitable
answer based around the facts and outcome of the cases.
Establishing a duty of care is the first issue to address if an action for negligence is to succeed. So
much so that the landmark Caparo case (1990) came to court on this preliminary issue alone.
There is no doubt that a duty of care is owed where a contractual relationship exists, for example,
between the auditor and the company (as an artificial person and the shareholders as a body). However,
it has fallen to the courts to develop the law and provide tests (e.g. special relationship, foreseeability,
just & reasonable) to establish whether a claim, against persons with whom no contractual relationship
exists, can succeed.
1018

Special relationship – The case of Hedley Byrne (1964) established the principle, that where
the auditor knows (or should have known) about a third party’s intended reliance on their
report, a special relationship – proximity – exists. This need for proximity was re-affirmed in
Caparo (1990).

Foreseeability – This concept (which was originally brought to the fore by the Scottish cases
of JEB Fastners (1982) and Twomax (1983)) effectively took the auditor’s duty of care
beyond the special relationship established by Hedley Byrne, twenty years earlier.
E
Basically, where the auditor can reasonably foresee that persons (known or unknown) relying
on an inaccurate statement would suffer loss, the auditor should be liable. This effectively
raised the possibility that an auditor might owe a duty of care to an unknown third party
whose reliance on the financial statements, in making an investment or some other decision,
results in a financial loss.
PL
As noted above, the Caparo case then limited the concept of foreseeability in relation to
proximity, as it was held under Caparo that the auditor only owed a duty of care to
shareholders as a group and not to any one individual shareholder (or any other party) who
decided to make further investment (that subsequently resulted in a financial loss) in the
company.
However, the 2005 case of Bannerman added clarification to the concept of foreseeability in
that it was held that as the auditors were specifically aware of the reliance of a third party (a
bank) on the audited financial statements – this was part of a lending agreement between the
company and the bank that the auditors were aware of and therefore knew the identity of the
third party – the auditors could not escape their duty of care to that third party.
SA
M
The only way that the auditors could escape any duty of care to third parties, was for their
auditor’s report to include a disclaimer of a duty of care to any third party (other than
shareholders as a group). For there to be a duty of care, specific agreement had to be reached
between the auditor and the third party (e.g. through a legally binding contract). Interestingly,
whilst this “Bannerman clause” has been included in UK auditor’s reports, many jurisdictions
(e.g. the US SEC) ban the use of such disclaimer clauses.

Just and reasonable – In order that foreseeability does not create unlimited liability, a
negating principle has also emerged – that it must be just and reasonable to impose a duty of
care. The Lloyd Cheyham (1987) case recognised that a wholly unjustified responsibility was
being placed on the auditor because investors must exercise some care in protecting
themselves.
Recent cases have not established any one general principle to provide a practical test to derive what is
and is not a duty of care. In fact, successive cases appear to apply all the concepts, with greater or less
emphasis, to arrive at unique solutions based on the specific circumstances of each case.
However, the fact that the issue is a complex one does not mean that it should not be addressed. An
auditor’s duty of care means that there is a duty to use care in reports and in the work resulting in those
reports (e.g. the auditor forms opinions on the directors’ historic stewardship for shareholders to
exercise their statutory powers in general meeting). The unqualified auditor’s report is not a guarantee
of future results to induce potential investors or individual shareholders to involuntarily accept financial
risk.
1019
Business failure is the most common cause of financial loss with investors and creditors, in particular,
losing money. In the recent banking crisis, several banks collapsed because of poor investment and
lending decisions, compounded by poor risk management – many UK bank shareholders saw their
investment value decline by 80% or more. Despite calls by many affected parties of “where were the
auditors”, subsequent investigations and inquiries by various governments concluded that auditors (in
general) had carried out their duties in accordance with legislation and regulations – it was just that the
legislation and regulations needed to be strengthened.
E
In addition, the extent to which any loss can be attributed to the auditor may be nominal. If an auditor
qualifies his opinion on going concern grounds and, as a result, millions are wiped off the value of
shares – financial loss would appear to be attributable to the auditor even though his report has not been
negligently prepared.
Conclusion
PL
As a professional expert on accounts, the auditor is seen to be in a position to “do something”, when
things go wrong. In those (rare) situations, when loss is directly attributable to an auditor’s negligence,
that loss should be recompensed. If the auditor does not have the statutory backing to fulfil the
responsibilities expected by the business community (e.g. to report fraud) then liability should perhaps
fall on Government. However, it would be unreasonable to expect taxpayers to compensate investors
who choose to accept risk for potentially high rewards.
Those who lose money will always seek to be recompensed, whatever the circumstances. The auditor
should be held wholly accountable, if he is negligent, but only to those whose interests he alone can
serve.
Answer 8 JULIET CO
Should auditors be blamed when a company fails?
SA
M
(a)
The recent economic crisis has led to a number of high profile company collapses. This
usually results in an examination of the role of the company’s auditors, and a discussion of
whether the audit firm should have spotted the going concern problems, and warned
stakeholders of the issues.
Looking at the first part of the statement, this asks whether auditors should accept some of the
blame when their client firm fails. This suggests that the auditor is in some way at fault, and
has helped to contribute in some way to the failure of a business. It is the responsibility of
management to ensure proper risk assessment and risk management is conducted in a
business. Although in some jurisdictions the auditor performs an assessment of risk
management procedures, this is not the fault of the auditor if such procedures are inadequate
and contribute to the collapse of a company.
Tutorial note: Credit will be awarded here for discussion specific to jurisdictions where the
auditor attests to risk management procedures, and also for discussions on the recent
proposals that audit firms should specifically comment on this in their report.
However, it is fair to say that auditors have a responsibility to gain an in-depth understanding
of their client’s business, including the environment in which it is operating. This means that
the auditor should at the very least be aware of going concern problems, and are in a position
to alert management to problems that they may have overlooked. But it remains the
responsibility of management to deal with such problems.
1020
One of the features of the recent economic crisis, which has resulted in the failure of many
companies, is the speed at which the crisis deepened. The auditor, when assessing going
concern status, does not have a crystal ball, and cannot be expected to foresee situations in the
future which may affect the survival of their client’s business. Especially in a speedy
economic downturn it is unfair to criticise the auditor’s view of going concern status at a year
end.
E
The issue may be one of misunderstanding – the so-called expectation gap. The general
public perceive the role of the auditor to be much wider than just providing an opinion on the
financial statements. The expectation is that auditors provide advice on business strategy, and
so should take some of the responsibility when the business fails. This indicates that the
public do not understand the importance of the independent status of the auditor, and that the
auditor must not take on the role of management.
PL
There may of course be situations in which an audit firm has not acted appropriately, for
example, in not challenging the management on matters having a significant impact on the
financial statements, or failing to detect frauds which have a material impact on the financial
statements. In such cases the auditor may indeed be partly to blame if the company
subsequently collapses.
SA
M
The second part of the statement asks whether the auditor should do more to warn
stakeholders about going concern issues. It could be argued that it is the responsibility of
management to make such warnings, and in fact, financial reporting standards require a lot of
disclosure about concentrations of risk. In particular IFRS 7 Financial Instruments:
Disclosures requires detailed notes to the accounts describing and providing details on
concentrations of certain risks. So, a lack of disclosure may not be the critical issue. The
problem is more likely to be that readers of financial statements do not have the financial
awareness to understand these disclosures. The auditors cannot be blamed if users of
financial statements are not sufficiently financially literate to be able to understand such
disclosures.
Auditors highlight significant going concern problems by including an emphasis of matter
paragraph in the auditor’s report. This means that problems should be clearly highlighted for
users of the accounts. Perhaps more could be done to make any such disclosures as
transparent as possible, which would aid users’ understanding of going concern problems. In
addition, shareholders’ meetings could be used more often as a vehicle for the auditor to raise
concerns with shareholders. Auditors, however, may be reluctant to voice concerns in such a
forum, and may be put under pressure from management not to speak out.
To conclude, it would seem unfair to make auditors take some of the blame for the failure of a
company, when it is explicitly the role of management to safeguard the company and manage
its risk exposure. However, auditors could be more proactive in highlighting going concern
problems through the various channels available to them (e.g. in the auditor’s report and
through contact with shareholders at general meetings of the company).
(b)
(i)
Additional funding
ISA 570 Going Concern states that an inability to obtain financing for essential new product
development or other essential investments is an indicator which may cast doubt on an
entity’s ability to continue as a going concern.
1021
The receipt of the loan is of huge significance for the financial statements and for the audit, as
if it is not received, the company may not continue in operational existence. This will then
affect the fundamental basis of preparation of the financial statements using the going concern
concept. The auditor must ensure that sufficient, appropriate evidence is sought regarding the
finance.
E
If there is any doubt over the receipt of the loan and therefore the going concern status of
Juliet, the financial statements should contain a note to explain the significant uncertainty
over the future of the company. The auditor’s report should contain an emphasis of matter
paragraph (in accordance with ISA 706 Emphasis of Matter Paragraphs and Other Matter
Paragraphs in the Independent Auditor’s Report), which discusses the uncertainty and refers
to the note in the financial statements. If the note is not provided then a qualification of the
audit opinion will be necessary due to lack of disclosure leading to a disagreement over the
preparation of the financial statements.
PL
However, the bank may be reluctant to provide confirmation that the loan will be advanced to
Juliet. This could be due to the bank itself facing going concern threats, forcing it to severely
restrict the amount and type of lending offered. Or, the bank may have a policy not to
confirm to their customers or to auditors that lending facilities will be made available.
The fact that the company’s assets are impaired in value may reduce the likelihood of the loan
being advanced, as there is little for Juliet to offer as security for the amount advanced.
In the event of the bank not offering the loan to Juliet, alternative providers of finance could
be approached. So it is not automatically the case that a refusal from the bank to offer the
loan means that Juliet is unable to successfully restructure.
SA
M
Even if the loan is received, Juliet may face significant threats to its going concern status, due
to cancelled customer contracts and bad debts. The audit firm must be extremely thorough in
its going concern review, and not just assume that the receipt of the loan would guarantee the
future of the company.
Procedures:
1022

Obtain and review the forecasts and projections prepared by management and
consider if the assumptions used are in line with business understanding.

Obtain a written representation confirming that the assumptions used in the
forecasts and projections are considered achievable in light of the economic
recession and state of the automotive industry.

Obtain and review the terms of the loan that has been requested to see if Juliet can
make the repayments required.

Consider the sufficiency of the loan requested to cover the costs of the intended
restructuring.

Review the repayment history of any current loans and overdrafts with the bank, to
form an opinion as to whether Juliet has any history of defaulting on payments.
(Any previous defaults or breach of loan conditions makes it less likely that the new
loan would be advanced.)

Discuss the loan request with the company’s bankers and attempt to receive
confirmation of their intention to provide the finance, and the terms of the finance.

Discuss the situation with management and those charged with governance, to
ascertain if any alternative providers of finance have been considered, and if not, if
any alternative strategies for the company have been discussed.

Obtain a written representation from management stating management’s opinion as
to whether the necessary finance is likely to be obtained.
(ii)
Ethical and other implications
E
In Juliet’s case, the cash flow forecast will be used by the bank as part of its lending decision,
so the forecast is crucial to the future existence of the company. Advising on the cash flow
forecast is effectively a non-audit service that has been requested.
PL
ISA 570 states that one of the procedures that should be performed when there is doubt over
going concern status is analysis and discussion of cash flow, profit and other relevant
forecasts with management. Further, when analysis of cash flow is a significant factor in
considering the outcome of events, the auditor should consider the reliability of the
company’s information system for generating the cash flow information, and also whether
there is adequate support for the assumptions underlying the figures.
The issue is that a self-review threat to independence and objectivity is likely to arise where
the audit firm provides assistance to management in the preparation of the forecasts, but
would then need to analyse and discuss the forecast for the reasons outlined above.
There could also be an advocacy and a management threat due to the audit firm advising on a
matter significant to the company’s operational existence, and promoting the company’s
position to the potential provider of finance.
SA
M
The audit firm should consider carefully whether safeguards could be put in place to reduce
the threats described above to an acceptable level. The forecasts could be reviewed by a
separate team which would reduce the self-review threat, and management should provide
written confirmation that they alone are responsible for the forecasts, which reduces the
management threat. If such safeguards were considered satisfactory, then the audit firm can
proceed with the work as requested by Juliet.
However, the firm may decide that it is unlikely that safeguards could be used to reduce these
threats to an acceptable level because the non-audit service requested is so significant to the
financial statements and the very existence of the company. In this case the review of
forecasts should not be performed by the audit firm.
At the meeting with the bank, the audit firm must be careful to avoid assuming responsibility
for the company’s proposals and for the forecasts presented, or being regarded as negotiating
on behalf of the entity, or advocating the appropriateness of the proposals. The situation
could easily create an advocacy threat to objectivity.
In addition, from a legal perspective, the audit firm must be careful not to create the
impression that they are responsible for the forecasts, or are in any way guaranteeing the
future existence of the company. In legal terms, attending the meeting and promoting the
interests of the client could create legal “proximity”, which increases the risk of legal action
against the auditor in the event of Juliet defaulting on the loan.
1023
Answer 9 AGNESAL
(a)
QC procedures
Quality controls are the policies and procedures adopted by a firm to provide reasonable
assurance that all audits done by a firm are being carried out in accordance with the objective
and general principles governing an audit (ISA 220).
Individual audit level
Work delegated to assistants should be directed, supervised and reviewed to ensure
the audit is conducted in compliance with ISAs.

Assistants should be professionally competent to perform the work delegated to
them with due care.

Direction (i.e. informing assistants about their responsibilities and the nature, timing
and extent of audit procedures they are to perform) may be communicated through:




PL
E

briefing meetings and on-the-job oral instruction;
the overall audit plan and audit programs;
audit manuals and checklists; and
time budgets.
Supervisory responsibilities include monitoring the progress of the audit to ensure
that assistants are competent, understand their tasks and are carrying them out as
directed. Supervisors must also address accounting and auditing issues arising
during the audit (e.g. by modifying the overall audit plan and audit program).

The work of assistants must be reviewed to assess whether:
SA
M







Documentation which needs to be reviewed on a timely basis includes:





1024
it is in accordance with the audit program;
it is adequately documented;
significant matters have been resolved;
objectives have been achieved;
conclusions are appropriate (i.e. consistent with results).
the overall audit plan (including risk assessments);
the audit program (and modifications thereto);
results from tests of control/substantive procedures and conclusions drawn;
financial statements, proposed audit adjustments and the proposed audit
opinion.
An independent review (i.e. by personnel not otherwise involved in the audit), to
assess the quality of audit work (before issuing an auditor’s report) should be
undertaken for listed and other public interest or high risk audit clients.
(b)
Implications of findings for QC policies and procedures
Tutorial note: “Planning an answer” means, as a minimum, deciding how marks are likely
to be allocated and structuring the answer accordingly. In general, the more a question is
broken down into parts, the less time needs to be spent on “formal” writing out of an answer
plan. In this Q there are 18 marks for addressing 6 matters (i.e. just 3 marks of answer for
each). However, there are also “pervasive” issues which can be brought out as overall
conclusions on QC policies and procedures at the level of the audit firm. It is a higher skill to
recognise causes and effects or other links between the findings.
(1)
Analytical procedures
E
Applying analytical procedures at the planning stage, to assist in understanding the business
and in identifying areas of potential risk, is an auditing standard and therefore mandatory.
Analytical procedures should have been performed (e.g. comparing the draft accounts to 31
December 2013 with prior year financial statements).
PL
Audit staff may have insufficient knowledge of the highly specialised service industry in
which this new client operates to assess risks. In particular, Agnesal may be exposed to risks
resulting in unrecorded liabilities (both actual and contingent) if claims are made against the
company in respect of outbreaks of contamination (e.g. CJD, BSE, foot and mouth, listeria,
etc).
The audit has been inadequately planned and audit work has commenced before the audit plan
has been reviewed by the audit supervisor. The audit may not be carried out effectively and
efficiently.
(2)
Supervisor’s assignments
SA
M
The senior has performed work on tangible non-current assets which is a less material (18%
of total assets) audit area than trade receivables (57% of total assets) which has been assigned
to an audit trainee. Tangible non-current assets also appear to be a lower risk audit areas than
trade receivables because the carrying amount of tangible non-current assets is comparable
with the prior year ($1.1m at both year ends), whereas trade receivables have more than
doubled (from $1.6m to $3.5m). This corroborates the implications of (1).
The audit is being inadequately supervised as work has been delegated inappropriately. It
appears that the firm does not have sufficient audit staff with relevant competencies to meet
its supervisory needs.
(3)
Direct confirmation
It is usual for direct confirmation of accounts receivable to be obtained where accounts
receivable are material and it is reasonable to expect customers to respond. However, it is
already more than 2 months after the end of the reporting period and, although trade
receivables are clearly material (57% of total assets), an alternative approach may be more
efficient (and cost effective). For example, monitoring of after-date cash will provide
evidence about the collectability of accounts receivable (as well as corroborate their
existence).
This may be a further consequence of the audit having been inadequately planned.
Alternatively, monitoring of the audit may be inadequate. For example, if the audit trainee
did not understand the alternative approach but mechanically followed circularisation
procedures.
1025
Depending on the reporting deadline, there may still be time to perform a circularisation.
However, consideration should be given to circularising the most recent month end balances
(i.e. November) rather than the year end balances (which customers may be unable or
reluctant to confirm retrospectively).
(4)
Cash count
Although $2,500 is very immaterial, the client’s management may well expect the auditor to
count it, albeit routinely, to confirm that it has not been misappropriated.
E
Monitoring of the trainee may have been inadequate. For example, Gavin may not have
understood the need to count the cash immediately the request was made of the client.
However, the behaviour of Gavin also needs to be investigated in that he failed to report back
to the audit senior on a timely basis and allowed himself to be unsupervised.
The trainees do not appear to have been given appropriate direction. Gavin may not be
sufficiently competent to be explaining sample selection methods to another trainee.
(5)
Inventory
PL
Although it is not practical to document every matter, details should have been recorded to
support Carla’s decision to change the timing of a planned procedure. (Carla’s decision
appears justified as it is inappropriate to perform a cash count when the client is “ready” for
it). Also, if some irregularity is discovered by the client at a later date (e.g. if Jules is found to
be “borrowing” the cash), documentation must support why this was not detected sooner by
the auditor.
SA
M
Inventory is almost as immaterial as the cash in (4) from an auditing perspective, being less
than 2.5% of total assets (2012 2.1%). Although it therefore seems appropriate that a trainee
should be auditing it, the audit approach appears highly inefficient. Such in-depth testing (of
controls and details) on an immaterial area provides further evidence that the audit has been
inadequately planned.
Again, it may be due to a lack of monitoring of a mechanical approach being adopted by a
trainee.
This also demonstrates a lack of knowledge and understanding about Agnesal’s business – the
company has no stock-in-trade, only consumables used in the supply of services.
(6)
“Report to Society”
The audit senior appears to have assumed that this is “other information” to be included in a
document containing audited financial statements (the annual report). “To be dealt with”
presumably means “to be read” with a view to identifying significant misstatements or
inconsistencies. However, Agnesal may be intending to publish it as an entirely separate
report and require an assurance service (other than audit) such as an independent verification
statement on performance standards.
As the preceding analysis casts doubts on Signet’s ability to deliver a quality audit to
Agnesal, it seems highly unlikely that Signet has the resources and expertise necessary to
provide such assurance services.
1026
Answer 10 VALDA
(a)
Issues raised
Identity of caller
Mr Stone may be a major shareholder in Valda or otherwise control the voting. He may be an
officer (e.g. the managing or finance director). His interest(s) in the companies concerned
should be ascertained to establish:
his authority to commission the proposed review;
his interest in the outcome of the decision to purchase; and
whether this is a related party transaction.
Richard Stone could own RS Office Equipment.
Valda’s auditors
E



Future business
PL
The company’s auditors might expect to be approached to undertake this assignment. If
approached, they may have declined due to lack of resources or even expertise. If not
approached, the reasons must be established. The auditors should be notified of the special
work requested as a matter of professional courtesy. A new computer installation will
concern the auditors and they would expect to be involved.
There may be an opportunity to gain the audit of Valda or additional non-recurring work. In
particular, the company’s rapid expansion may result in the current auditors being outgrown.
SA
M
Timescale
As for all professional work, it should be carried out with a proper regard for the technical
and professional standards expected. It is unlikely that the level of care and skill expected can
be met within a restricted timescale. “A few days” is unlikely to be feasible for the work
proposed and conclusions cannot be drawn until the fieldwork is completed. If the purchase
cannot be deferred beyond next month it may not be possible to accept the work.
Access to information
Restricted access to information and explanations, which limits the scope of the proposed
review, may prevent conclusions being drawn. It may be necessary to discuss sensitive issues
including proposed business expansion, technical obsolescence of products, product
development, etc. Also, the current auditors’ permission should be sought to review their
management letter.
Reporting
Presumably the findings of the review will be reported, possibly to Mr Stone rather than the
board. Any opinions must be commensurate with the scope of the review performed. In
particular, the report will not recommend the board’s decision.
1027
Nature of review
The company’s flowcharts and documents may not be up to date. The “reviews” could
require some element of verification (e.g. using walk-through checks). Alternatively, it may
be assumed that the flowcharts and documents are reliable and accurate. In this case,
management’s responsibility for the information provided must be made absolutely clear in
any report.
Decision to purchase
cost and availability of software support;
alternative methods of financing the acquisition;
capacity to meet future needs if growth continues at current rate;
Mr Stone’s commission or other interest, if any; and
the potential impact on the conduct and cost of the annual audit.
Fees
PL





E
The decision to purchase, or not, will be taken by the board. Matters significant to the
board’s decision, which may not be included in Mr Stone’s proposals, could be:
The assignment cannot be accepted if fees are contingent on the outcome. Fees will be based
on time spent and the level of skill of staff involved.
Resources available
SA
M
The assignment will require at least one member of staff with relevant systems and computer
knowledge and experience. Some knowledge of the industry will be useful. Such a person
may not be available, at such short notice, without disturbing the services provided to existing
clients. For this reason alone, the assignment could be declined.
(b)
Procedures
Telephone Valda and enquire as to the status of Mr Stone.

If appropriate, telephone the existing client (with whom Mr Stone is acquainted)
and ascertain their relationship. Decline nomination if a conflict of interest could
arise.

Undertake company searches of Valda and RS Office Equipment to establish:



Call or write to Mr Stone:


1028
current auditors;
Mr Stone’s interests as director/shareholder.
declining work if there are obvious barriers at this stage; or
arranging a meeting at Valda’s premises.

Meet at Valda’s premises to discuss the unresolved issues concerning acceptance of
the assignment.

Advise Mr Stone of the need to notify and liaise with Valda’s auditors.

Obtain the systems flowcharts/documentation and consider whether the level of
detail provided is consistent with the review required.

Agree a provisional timetable to accommodate the needs of Mr Stone, the review
work, board decision and supplier’s delivery/installation.

Agree the basis on which fees will be charged and the account rendered paid.

Write to the existing auditors:



advising them of the assignment being undertaken;
requesting a copy of the latest management letter, if relevant.
Draft an appropriate letter of engagement.
E
Tutorial note: This answer effectively assumes that Mr Stone has the authority to act for
Valda (e.g. because he is a director). Alternative assumptions would be acceptable providing
they were not unduly restrictive.
Answer 11 DRAGON GROUP
Reasons why an audit firm may decide not to seek re-election
PL
(a)
Tutorial note: Briefly list all of the reasons, then deal with the four that will provide the best
opportunity to gain maximum marks.
Disagreement with the client
SA
M
The audit firm may have disagreed with the client for a number of reasons, for example, over
accounting treatments used in the financial statements. A disagreement over a significant
matter is likely to cause a breakdown in the professional relationship between auditor and
client, meaning that the audit firm could lose faith in the competence of management. The
auditor would be reluctant to seek re-election if the disagreement were not resolved.
Lack of integrity of client
The audit firm may feel that management is not acting with integrity, for example, the
financial statements may be subject to creative accounting, or dubious business ethics
decisions could be made by management, such as the exploitation of child labour. The
auditor would be likely not to seek re-election (or to resign) in this case to avoid being
associated with the client’s poor decisions.
Fee level
The audit firm could be unable to demand a high enough audit fee from the client to cover the
costs of the audit. In this situation the audit firm may choose not to offer itself for re-election,
to avoid continuing with a loss making audit engagement, and consequently to use resources
in a more commercially advantageous way.
Fee payments
The audit firm could have outstanding fees which may not be fully recovered due to a client’s
poor cash flow position. Or, the client could be slow paying, causing the audit firm to chase
for payment and possibly affecting the relationship between the two businesses. In such cases
the audit firm may make the commercial decision not to act for the client any longer.
1029
Resources
The audit firm may find that it lacks the resources to continue to provide the audit service to a
client. This could happen if the client company grows rapidly, financially or operationally,
meaning that a larger audit team is necessary. The audit firm may simply lack the necessary
skilled staff to expand the audit team.
Competence
E
The audit firm could feel that it is no longer competent to perform an audit service. This
could happen for example if a client company diversified into a new and specialised business
operation of which the audit firm had little or no experience. The audit firm would not be
able to provide a high quality audit without building up or buying in the necessary knowledge
and skills, and so may decide not to be considered for re-election.
Overseas expansion
Independence
PL
A client could acquire one or several material overseas subsidiaries. If the audit firm does not
have an associate office in the overseas location, the firm may feel that the risk and resources
involved in relying on the work of other auditors is too great, and so decide not to act for the
client any longer.
SA
M
There are many ethical guidelines in relation to independence which must be adhered to by
auditors, and in the event of a potential breach of the guidelines, the audit firm may decide not
to seek re-election. For example, an audit firm may need to increase the audit fee if a client
company grows in size. This could have the effect of increasing the fee received from the
client above the allowed thresholds. As there would be no ethical safeguard strong enough to
preserve the perception of independence, in this case the audit firm would not be able to
continue to provide the audit service.
Tutorial note: Other examples may be used to explain why the issue of independence could
cause an audit firm not to seek re-election (e.g. audit firm takes on a financial interest in the
client, close personal relationships develop between the firm and the client).
Conflicts of interest
An audit firm may become involved in a situation where a conflict of interest arises between
an existing audit client and another client of the firm. For example, an audit firm could take
on a new audit client which is a competitor of an existing audit client. Although with the use
of appropriate safeguards this situation could be successfully managed, the audit firm may
decide that stepping down as auditor of the existing firm is the best course of action.
(b)
Matters to be included in tender document
Brief outline of Unicorn & Co
This should include a short history of the firm, a description of its organisational structure, the
different services offered by the firm (such as audit, tax, corporate finance, etc), and the
locations in which the firm operates. The document should also state whether it is a member
of any international audit firm network. The geographical locations in which Unicorn & Co
operates will be important given the multi-national structure of the Dragon Group.
1030
Specialisms of the firm
Unicorn & Co should describe the areas in which the firm has particular experience of
relevance to the Dragon Group. It would be advantageous to stress that the firm has an audit
department dedicated to the audit of clients in the retail industry, as this emphasises the
experience that the firm has relevant to the specific operations of the group.
Identification of the needs of the Dragon Group
Outline of the proposed audit approach
E
The tender document should outline the requirements of the client, in this case, that each
subsidiary is required to have an individual audit on its financial statements, and that the
consolidated financial statements also need to be audited. Unicorn & Co may choose to
include here a brief clarification of the purpose and legal requirements of an audit. The
potential provision of non-audit services should be discussed, either here, or in a separate
section of the tender document (see below).
PL
This is likely to be the most detailed part of the tender document. Here the firm will describe
how the audit would be conducted, ensuring that the needs of the Dragon Group (as discussed
above) have been met. Typically contained in this section would be a description of the audit
methodology used by the firm, and an outline of the audit cycle including the key deliverables
at each phase of work. For example:
How the firm intends to gain business understanding at group and subsidiary level.

Methods used to assess risk and to plan the audits.

Procedures used to assess the control environment and accounting systems.
SA
M


Techniques used to gather evidence (e.g. the use of audit software).

How the firm would structure the audit of the consolidation of the group financial
statements and how they would liaise with subsidiary audit teams.
The firm should clarify its adherence to International Standards on Auditing, ethical
guidelines and any other relevant laws and regulations operating in the various jurisdictions
relevant to the Dragon Group. The various financial reporting frameworks used within the
group should be clarified.
Quality control
Unicorn & Co should emphasise the importance of quality control and therefore should
explain the procedures that are used within the firm to monitor the quality of the audit
services provided. This should include a description of firm-wide quality control policies,
and the procedures applied to individual audits. The firm may wish to clarify its adherence to
International Standards on Quality Control.
Communication with management
The firm should outline the various reports and other communication that will be made to
management as part of the audit process. The purpose and main content of the reports, and
the timing of them, should be outlined. Unicorn & Co may provide some “added value” biproducts of the audit process. For example, the business risks identified as part of the audit
planning may be fed back to management in a written report.
1031
Timing
Unicorn & Co should outline a proposed timetable. For example, the audits of the
subsidiaries’ financial statements should be conducted before the audit of the consolidated
financial statements. The firm may wish to include an approximate date by which the group
audit opinion would be completed, which should fit in, if possible, with the requirements of
the group. If Unicorn & Co feel that the deadline requested by the client is unrealistic, a more
appropriate deadline should be suggested, with the reasons for this clearly explained.
Key staff and resources
E
The document should name the key members of staff to be assigned to the audit, in particular
the proposed engagement partner. In addition, the firm should clarify the approximate
number of staff to be used in the audit team and the relevant experience of the key members
of the audit team. If the firm considers that external specialists could be needed, then this
should be explained in this section of the document.
PL
Fees
The proposed fee for the audit of the group should be stated, and the calculation of the fee
should be explained (i.e. broken down by grade of staff and hourly/daily rates per grade). In
addition, invoicing and payment terms should be described (e.g. if the audit fee is payable in
instalments, the stages when each instalment will fall due).
Extra services
SA
M
Unicorn & Co should ensure that any non-audit services that it may be able to offer to the
Dragon Group are described. For example, subject to ethical safeguards, the firm may be able
to offer corporate finance services in relation to the stock exchange listing that the group is
seeking, although the provision of this non-audit service would need to be carefully
considered in relation to independence issues.
(c)
Evaluation of matters to be considered
Size and location of the group companies
The Dragon Group is a large multi-national group of companies. It is extremely important
that Unicorn & Co assesses the availability of resources that can be allocated to the audit
team. The assignment would comprise the audit of the financial statements of all 20 current
subsidiaries, the audit of the parent company’s and the group’s financial statements. This is a
significant engagement which will demand a great deal of time.
The location of half of the group’s subsidiaries in other countries means that the overseas
offices of Unicorn & Co would be called upon to perform some or all of the audits of those
subsidiaries. In this case the resource base of the relevant overseas offices should be
considered to ensure there is enough staff with appropriate skills and experience available to
perform the necessary audit work.
Unicorn & Co must consider if they have offices in all of the countries in which the Dragon
Group has a subsidiary.
Depending on the materiality of the overseas subsidiaries to the group financial statements, it
is likely that some overseas visits would be required to evaluate the work of the overseas
audit teams. Unicorn & Co should consider who will conduct the visits (presumably a senior
member of the audit team), and whether that person has the necessary skills and experience in
evaluating the work of overseas audit teams.
1032
Planned expansion of the group
In light of the comments above, Unicorn & Co should consider that the planned further
significant expansion of the group will mean more audit staff will be needed in future years,
and if any subsidiaries are acquired in other countries, the audit is likely to be performed by
overseas offices. The firm should therefore consider not only its current resource base in the
local and overseas offices, but whether additional staff will be available in the future if the
group’s expansion goes ahead as planned.
Relevant skills and experience
E
Unicorn & Co has an audit department specialising in the audit of retail companies, so it
should not be a problem to find audit staff with relevant experience in this country.
Timing
PL
On consolidation, the financial statements of the subsidiaries will be restated in line with
group accounting policies and financial reporting framework, and will also be retranslated
into local presentational currency. All of this work will be performed by the management of
the Dragon Group. Unicorn & Co must evaluate the availability of staff experienced in the
audit of a consolidation including foreign subsidiaries.
SA
M
The audit of each subsidiary’s financial statements should be carried out prior to the audit of
the consolidated financial statements. Unicorn & Co should consider the expectation of the
Dragon Group in relation to the reporting deadline, and ensure that enough time is allowed for
the completion of all audits. The deadline proposed by management of 31 December is only
three months after the year end, which may be unrealistic given the size of the group and the
multi-national location of the subsidiaries. The first year auditing a new client is likely to
take longer, as the audit team will need to familiarise themselves with the business, the
accounting systems and controls, etc.
Mermaid Co – prior year qualification
If Unicorn & Co accepts the engagement, the firm will take on the audit of Mermaid, whose
financial statements in the prior year were in breach of financial reporting standards. This
adds an element of risk to the engagement. Unicorn & Co should gather as much information
as possible about the contingent liability, and the reason why the management of Mermaid did
not amend the financial statements last year end. This could hint at a lack of integrity on the
part of the management of the company.
The firm should also consider whether this matter could be significant to the consolidated
financial statements, by assessing the materiality of the contingent liability at group level.
Further discussions should be held with the management of the Dragon Group in order to
understand their thoughts on the contingency and whether it should be disclosed in the
individual financial statements of Mermaid, and at group level. Contacting the incumbent
auditors (after seeking relevant permission from the Dragon Group) would also be an
important procedure to gather information about the qualification.
Minotaur Co – different business activity
The acquisition of Minotaur represents a new business activity for the group. The retail
business audit department may not currently have much, if any, experience of auditing a
distribution company. This should be easily overcome, either by bringing in staff from a
different department more experienced in clients with distribution operations, or by ensuring
adequate training for staff in the retail business audit department.
1033
Highly regulated/reliance on financial statements and auditor’s report
The Group is listed on several stock exchanges and is therefore subject to a high degree of
regulation. This adds an element of risk to the engagement, as the management will be under
pressure to publish favourable results. This risk is increased by the fact that a new listing is
being sought, meaning that the financial statements and auditor’s report of the group will be
subject to close scrutiny by the stock exchange regulators.
Previous auditors of Dragon Group
E
There may be extra work required by the auditors due to the listings (e.g. reconciliations of
financial data) or additional narrative reports on which the auditors have to express an opinion
under the rulings of the stock exchange. The firm must consider the availability of staff
skilled in regulatory and reporting listing rules to perform such work.
PL
Unicorn & Co should consider why the previous audit firm is not seeking re-appointment, and
whether the reason would affect their acceptance decision. After seeking permission from the
Dragon Group, contact should be made with the previous auditors to obtain confirmation of
the reason for them vacating office (amongst other matters).
In conclusion, this large scale, multi-national group carries a fairly high level of risk. Unicorn
& Co must be extremely careful to only commit to the group audit if it has the necessary
resources, can manage the client’s expectations for reporting deadlines, is convinced of the
integrity of management, and is confident to take on a potentially high-profile client.
SA
M
Tutorial note: Credit will be awarded in this requirement for discussion of ethical matters
which would be considered prior to accepting the appointment as auditor of the Dragon
Group. However as the scenario does not contain any reference to specific ethical matters,
marks will be limited to a maximum of 2 for a general discussion of ethical matters on
acceptance.
(d)
Transnational audit
(i)
Definition and relevance
Definition: A transnational audit means an audit of financial statements which are or may be
relied upon outside the audited entity’s home jurisdiction for the purpose of significant
lending, investment or regulatory decisions.
Relevance: The Dragon Group is listed on the stock exchange of several countries, (and is
planning to raise more finance by a further listing). This means that the group is subject to
the regulations of all stock exchanges on which it is listed, and so is bound by listing rules
outside of its home jurisdiction. The group also contains many foreign subsidiaries, meaning
that it operates in a global business and financial environment.
(ii)
Features
Application of auditing standards
Although many countries of the world have adopted International Standards on Auditing
(ISAs), not all have done so, choosing instead to use locally developed auditing regulations.
In addition, some countries use modified versions of ISAs. This means that in a transnational
audit, some components of the group financial statements will have been audited using a
different auditing framework, resulting in inconsistent audit processes within the group, and
potentially reducing the quality of the audit as a whole.
1034
Regulation and oversight of auditors
Similar to the previous comments on the use of ISAs, across the world there are many
different ways in which the activities of auditors are regulated and monitored. In some
countries the audit profession is self-regulatory, whereas in other countries a more legislative
approach is used. This also can affect the quality of audit work in a transnational situation.
Financial reporting framework
E
Some countries use International Financial Reporting Standards, whereas some use locally
developed accounting standards. Within a transnational group it is likely that adjustments,
reconciliations or restatements may be required in order to comply with the requirements of
the jurisdictions relevant to the group financial statements (i.e. the jurisdiction of the parent
company in most cases). Such reconciliations can be complex and require a high level of
technical expertise of the preparer and the auditor.
Corporate governance requirements and consequent control risk
PL
In some countries there are very prescriptive corporate governance requirements, which the
auditor must consider as part of the audit process. In this case the auditor may need to carry
out extra work over and above local requirements in order to ensure group wide compliance
with the requirements of the jurisdictions relevant to the financial statements. However, in
some countries there is very little corporate governance regulation at all and controls are
likely to be weaker than in other components of the group. Control risk is therefore likely to
differ between the various subsidiaries making up the group.
Tutorial note: Two only required.
SA
M
Answer 12 PAPAYA
(a)
(i)
Reasons
It is mandatory to perform analytical procedures as part of risk assessment. Analytical
procedures can help the auditor to develop an understanding of the entity, and highlight
matters of which the auditor was previously unaware. Procedures are therefore invaluable in
terms of developing knowledge about the operations and performance of the entity. For
example, this may be particularly important in the case of a new audit client, when analytical
procedures such as a comparison of margins made by the entity with those made by its
competitors will provide the auditor with some degree of knowledge about the relative
performance of the entity in its business environment.
In addition, performing analytical procedures at the planning stage may indicate aspects of the
financial statements which appear to carry a high risk of material misstatement. This would
happen when unexpected trends and unusual relationships between pieces of financial data
were revealed by the analytical procedures. For example, procedures may reveal that revenue
has increased by 20% compared to the previous year, but that the budgeted increase was only
5% and the industry average increase was only 8%. These results could indicate the possible
overstatement of revenue, and thus the auditor has been alerted to a possible material
misstatement in the financial statements.
For these reasons, performing analytical procedures can help the auditor to identify and to
prioritise potential areas of risk, and to develop an appropriate audit strategy to minimise
detection risk.
1035
(ii)
Limitations
Analytical procedures are usually performed before the financial year end, and will therefore
be based on draft projected figures up to the year end, or interim financial information,
budgets and management accounts. This may make the analysis problematical for the
following reasons:
The information will not cover the entire accounting period. Extrapolating figures
to cover a 12 month period is not always easy to do, especially for a seasonal
business where income and expenses do not accrue evenly throughout the year.
Care must be taken when performing the procedures to take account of this, and it
should not be assumed that income and expense figures should simply be grossed
up on a monthly basis to enable annual comparisons.

Year-end close down procedures will not have occurred. For example, many
entities will only account for items such as asset impairments or revisions to
estimated figures such as provisions at the financial year end. Thus comparisons to
figures derived from prior year published accounts may not be valid.

Information may be produced differently during the year, controls may be weaker,
and the internal management accounts may not be produced in compliance with the
same reporting framework as the year-end financial statements. Measurement,
recognition and presentation of financial information may be very different, so care
should be taken when extracting figures from management accounts to be used in
comparisons with published financial information.

Some entities, especially smaller companies, may not have a complete or formal
reporting system during the year, making analytical procedures before the year end
accounts have been produced difficult. It may be possible to perform some limited
analysis on the information that is available before the year end, but the use of this
analysis will be limited due to its incomplete nature. This means that it may be
impossible to base expectations on the data, as it is incomplete at the time of the
preliminary analytical review.
SA
M
PL
E

(b)
Strategy and plan
The definitions of “overall audit strategy” and “audit plan” are found in ISA 300 Planning an
Audit of Financial Statements.
The overall audit strategy sets the scope, timing and direction of the audit. Scope involves
determining the characteristics of the audit client, such as its locations, and the relevant
financial reporting framework, as these factors will help to establish the scale of the
assignment. Timing refers to establishing deadlines for completion of work and key dates for
expected communications. Establishing the overall audit strategy also includes the
consideration of preliminary materiality, and initial identification of high risk areas in the
financial statements. All of these matters contribute to the assessment of the nature, timing
and extent of resources necessary to perform the engagement. The overall audit strategy
should then lead to the development of the audit plan.
The audit plan is more detailed than the audit strategy and includes a description of the risk
assessment procedures, and the further planned audit procedures necessary at the assertion
level for gathering evidence on the material transactions and balances in the financial
statements. The general purpose of developing the audit plan is to design audit procedures
which will reduce audit risk to an acceptably low level.
1036
The difference between the audit strategy and the audit plan is therefore that the strategy is
the initial planning to ensure there will be adequate resources allocated to the audit
assignment in response to an initial evaluation of the entity’s characteristics, whereas the audit
plan is a detailed programme of audit procedures.
The strategy will therefore usually be developed before the plan; however, the two activities
should be seen as inter-related, as changes in one may result in changes to the other. Both the
strategy and the plan should be fully documented as this represents the record of proper
planning of the audit assignment.
(i)
Information required
E
(c)
PL
Financial information is needed in order to calculate operating and net margins and to
compare to prior period(s). If possible, separate information from the statement of
comprehensive income, and asset and liability information should be obtained for each
segment of the business.
It is important that the information is disaggregated as Papaya operates in different business
segments and different geographical locations. Information would be needed at a minimum
level of disaggregation as follows:




Financial information for the Papaya Mart chain of supermarkets;
Financial information for the operations in Farland;
Financial information for the Papaya Express chain of supermarkets;
Financial information for the new financial services division.
SA
M
The information should be separated out as above to enable analytical procedures to be
performed on each separate component of the business, as each component is likely to
achieve different margins and returns on capital. Calculating ratios and making comparisons
for the company as a whole would be relatively meaningless. For example, the margins made
by the two different supermarket chains are likely to be different, as the Papaya Express
stores are in city centres where overheads are likely to be much higher than in the out of town
locations used by the Papaya Mart stores. The two types of supermarket also sell a different
range of goods, which will also make the overall margins different.
Analytical procedures should be performed on the operations in Farland as a separate exercise
if possible. This division is likely to have a different cost base, and revenue may be based on
a different pricing structure due to the overseas locations of the stores. There may also be
distortions to the figures caused by retranslation into the currency of Papaya.
The financial services division will have a completely different profit structure, cost base and
return on investment than the retail divisions and so must be analysed separately. It is likely
to be much less capital intensive, which will mean that returns on investment and asset
utilisation ratios will be very different to the retail divisions.
1037
Information about any significant non-recurring items of income and expense for each
division should also be requested as these would cause fluctuations in profit and make
comparisons difficult if not taken into account. For example, the heavy advertising costs of
the new overseas operations will reduce the margin of that division of supermarkets compared
to the local stores. Budgeted information should also be requested. This will be important for
the two new divisions – the foreign stores, and the financial services division. As these are
start-up activities during the year, there will be no possible comparisons to prior year
information. Therefore the main analytical procedures to be performed will be comparisons
of actual to budgeted performance. The auditor should bear in mind the reliability of the
budgeted information when performing these procedures.
E
The auditor should also request any information about new accounting policies or estimation
techniques which have been used this year. New accounting treatments may distort
comparisons, so full understanding of the impact of any new policies is important when
evaluating the results of analytical procedures. For example, the new forward exchange
contracts entered into during the year will have caused the introduction of a new accounting
policy which may cause fluctuations in profit.
(ii)
PL
It is also useful to make comparisons to similar companies in the same industry. There should
be financial information which is readily available for Papaya’s competitors in the
supermarket retail sector, and also for financial services companies. This is a useful source of
information, as the auditor will be able to gauge the relative performance of Papaya, and
assess if margins and returns are similar to industry comparisons or averages. Care should be
taken however, when comparing the new divisions to industry competitors, as there may be
one-off start-up costs included in the statement of comprehensive income for this year, which
will reduce profitability.
Briefing notes to be used at audit planning meeting
SA
M
Subject: Financial statement risks identified at planning meeting
Introduction
At a recent planning meeting held with the finance director of Papaya, several issues were
discussed which could lead to financial statement risks. All of these issues relate to matters
which are potentially material to the financial statements.
Alleged collusion and price fixing
It appears that several companies are under investigation for breaching regulations, and
Papaya could face potentially material financial penalties if found guilty. The situation needs
to be assessed by reference to IAS 37 Provisions, Contingent Liabilities and Contingent
Assets. The risk is that the financial statements do not reflect the situation as either a
provision or a contingent liability, depending on the evaluation of the potential outcome of
the case. If it is considered that the company faces a probable cash outflow, then a provision
and associated expense should be recognised. If the outflow is considered possible, then a
note to the financial statements should describe the contingent liability and show an estimate
of the potential financial effect. Therefore the financial statement risk is both understated
liabilities and overstated profit, if the cash outflow is considered probable but no provision is
made. Alternatively, the risk is incomplete disclosure if the outflow is considered possible
and no note is provided.
1038
Convertible debentures
Forward exchange contracts
E
According to IAS 32 Financial Instruments: Presentation convertible debt instruments should
be presented in the statement of financial position split into two separate components. This is
because the company does not know if it has an obligation to pay cash on the redemption of
the debt in 2020, or whether the debt will be settled by an equity distribution. Therefore, on
the receipt of cash proceeds, the credit entry is split between debt and equity. The debt is
valued by discounting the potential cash outflows to present value, with the credit entry to
equity a residual balancing figure. The financial statement risk is firstly that split accounting
has not been applied, so the whole of the credit has been recognised as either debt or equity,
and therefore incorrectly recognised in the statement of financial position. This would then
have a further consequence for the statement of comprehensive income, as any finance charge
calculated on the basis of an incorrect debt component would then also be incorrectly
measured.
SA
M
PL
These contracts are derivative financial instruments. As such, they must be recognised in the
statement of financial position at the year end, as a financial asset or a financial liability,
depending on whether the terms of the derivative contract are favourable or unfavourable at
the reporting date. The financial statement risk is that the derivatives have not been
recognised at all, particularly because the contracts were acquired at no cost, so there is no
accounting entry when the contract is taken out. A second risk relates to the valuation of the
derivative asset or liability. This could be complex to calculate, and if not performed by an
experienced specialist, could cause the over or understatement of the financial instrument
recognised, and an associated incorrect entry recognised in profit. Finally, IFRS 7 Financial
Instruments: Disclosures imposes potentially onerous disclosure requirements in relation to
derivative instruments. The risk is that disclosures made in the notes to the financial
statements are incomplete.
Land held for development potential
There are indicators that the land could be impaired at the year end. Some land was sold at a
loss during the year, and it seems that planning permission for the development of the sites is
becoming harder to obtain, meaning that the value of the land has fallen. Following IAS 36
Impairment of Assets, an impairment review must be carried out if there are indicators of
impairment to an asset. It is likely that land will be overstated in the statement of financial
position, and expenses understated, unless an impairment review is conducted and any
resulting loss fully recognised. In addition, the losses made on the disposal of land during the
year should be separately disclosed in the statement of comprehensive income or a note to the
financial statements per IAS 1 Presentation of Financial Statements, so there is a risk of
inadequate disclosure if this is not done.
Inspection of warehouses
A new regulatory requirement has resulted in an inspection of all of the warehouses operated
by Papaya. Under IAS 16 Property, Plant and Equipment, costs of a major inspection should
be capitalised and then depreciated over the period to the next inspection. The risk is that the
cost has been expensed, in other words, treated as an operating expense. This would result in
understated profit and understated non-current assets.
1039
Other financial statement risks (not arising from notes made at the planning meeting) include
the following:
Disclosure of operating segments
Internally generated brand names
E
IFRS 8 Operating Segments requires listed companies to disclose in a note to the financial
statements information about the performance of the various different operating segments of
the business. Papaya has two potential new disclosures this year end. The first is the new
financial services division, which is likely to be a separate reportable segment under IFRS 8.
The second new disclosure relates to the overseas expansion of the company, as IFRS 8
requires disclosure of limited geographical analysis of revenue and non-current assets. The
financial statement risk is the non-disclosure of information relating to these new operating
and geographical segments.
Conclusion
PL
Papaya Mart and Papaya Express are internally generated brand names. IAS 38 Intangible
Assets prohibits the recognition of internally generated brands. The risk arises from
significant expenditure on the launch of the brand in Farland. If any of the associated expense
has been capitalised as a brand name, this would mean that non-current assets are overstated,
and profit for the year would be overstated.
SA
M
There are several financial statement risks identified at the planning meeting, resulting from
the company operating in a regulated industry, changed market conditions, and new business
activities for the company. Now that the risks have been identified, an appropriate audit
strategy will be devised to minimise the risk of material misstatement in relation to these
matters.
Tutorial note: Credit will be awarded for other financial statement risks identified from the
question scenario, such as potential over-valuation of inventories, classification of land as
held for sale, incorrect timing of recognition of revenue from financial services products, and
potential impairment of loans made to financial services customers.
Answer 13 AZURE
(a)
Audit planning issues
Tutorial note: “Planning an answer” means, as a minimum, deciding how marks are likely
to be allocated and structuring the answer accordingly. In general, the more a question is
broken down into parts, the less time needs to be spent on “formal” writing out of an answer
plan. In this Q there are clearly three specific matters to be addressed. However, there are
further explicit planning issues (“audit risks” and “audit strategy” referred to in the second
paragraph) as well as those implicit to planning (e.g. materiality and logistics).
Risks

1040
Inherent risk is increased at the entity level as the company operates in
geographically diverse locations. Also, the “holiday” industry is very competitive
and the collapse of major tour operators is not uncommon.

Inherent risk is increased at the account balance and class of transactions level
because, for example:

there are indicators of off-balance sheet financing (i.e. operating lease
commitments on aircraft);

certain accounting policies may be imprudent (e.g. the point of revenue
recognition is holiday departure).
Revenue and profit may be overstated for holidays which commence before the year
end, but the costs of providing those holidays are incurred after the year end. For
example, an increasing number of early retirees take long vacations commencing
December (say) over the winter months (January, February).

That cash and cash equivalents exceed non-current assets reflects Azure’s exposure
to liquidity risk. The company needs to maintain a high level of liquid funds to
meet its current liabilities (and operating lease commitments).

Azure’s implementation of policies and procedures (e.g. in its internal financial
control system) suggest a risk-conscious management. The control environment is
likely to be assessed as strong which is crucial if reliance is sought to be placed on
internal controls.

The main financial risks likely to be faced by Azure are those associated with
foreign exchange and fuel costs (also possibly interest rates).
Audit strategy
PL
E

Tutorial note: Although presented here as a “general” point, this could be regarded as a
conclusion and so appear at the end of a planned answer.
SA
M
A risk-based approach (either audit risk or business risk model) should be adopted given:

the emphasis on risk needed for the submission (and the existence of apparent risks);

the likely need to rely on internal financial controls including the internal audit
function (e.g. for multiple locations);

that it would be inappropriate to adopt certain “standard” tests of detail (e.g. to
confirm trade receivables by direct confirmation);

the scope for analytical procedures in providing substantive evidence.
Analytical procedures on quarterly/monthly (“regular” per Q) actual, budgeted and prior year
results may be used to effectively audit Azure’s financial statements. For example, to review
the reasonableness of actual seasonality in turnover by a comparison of budgeted and prior
year amounts by location.
Also, by “proofs in total”, to confirm the reasonableness of:



travel agency commissions
depreciation (not aircraft, as leased)
interest receivable on cash deposits.
Tutorial note: See also (3) below.
1041
Materiality
Based on the 2013 accounts, preliminary materiality can be assessed to be approximately:

$5m which lies in the ranges 1/2% – 1% turnover and 1% – 2% total assets.

alternatively $2·7m which lies in the ranges 1% – 2% total assets and 5% – 10% PBT.
WORKINGS
 4·7m – 9·4m
 2·8m – 5·5m
 1·4m – 2·7m
E
1/2% – 1% turnover
1% – 2% total assets (at least 109·1 + 29·7 + 138·6 = 277·4)
5% – 10% PBT
Logistics
PL
Tutorial note: The assessment of materiality at the planning stage is its quantification. A
statement that “preliminary materiality is $x” is worth a mark (just) providing it is in a
suitable range (say $2·5m – $5·5m). However, with an explanation of how it has been
derived, it is worth 2 or 3 marks. Also, a materiality threshold outside of the suggested
suitable range would also be awarded marks if justified.

The audit of Azure will require visits to a number of locations at the same time (e.g.
the year-end). For example, to verify the existence and condition of certain assets
(e.g. aircraft).

To visit all 13 holiday locations (and 29 outlets) would not only be costly, but
unnecessary. A combination of:
visits to the offices of the most significant holiday locations (on a
rotational basis); and

the review of “branch returns” (from offices not visited),
SA
M

should provide sufficient audit evidence regarding the offices’ transactions and balances.
(1)
Sales & distribution

Call centres are being increasingly used in the travel sector as a means of gaining
competitive advantage through:



1042
reduced costs (as compared with high street retail agents);
increased quality of customer service and satisfaction; and
convenience and speed.

Most of the problems experienced in call centres relate to poor staff retention, high
absenteeism and poor employee relations, which increase costs. Audit procedures
on the payroll should include, inter alia, the analysis of labour turnover.

Azure should have policies to manage the potential risks to health and safety which
arise in call centres (e.g. relating to eye-strain, headaches, voice loss, tinnitus and
Repetitive Strain Injury “RSI”).
Azure’s developing e-commerce business may be outsourced to a third party or
managed in-house. In either case, orders and payments (“Internet bookings”) need
to be taken over a secure website which should have an authentic Site stamp (e.g.
“WebTrust”, “Thawte”) for immediate customer recognition and assurance.

Increasing distribution through these emerging channels may reduce customers’
demand for the traditional “travel shop” resulting in closures of the retail travel
agents. If the number of retail agents has fallen again in 2014 (having fallen from
31 in 2012 to 29 in 2013) this trend should be reflected in the analytical procedures
on the costs and revenues associated with these outlets.

Azure’s business strategy clearly includes investment in suitable technologies which
will help maintain/improve the company’s market position (and returns to investors)
– supporting the appropriateness of the going concern assumption as the basis for
the preparation of the financial statements.

The changes in distribution methods are a source of actual and contingent liabilities.
If retail travel agents are closing, liabilities for staff redundancy costs and onerous
contracts (e.g. leases on premises) may arise. Contingent liabilities may arise in
respect of health and safety issues (e.g. through non-compliance with regulations or
injury claims by employees).

During the transition from retail to direct sales methods, there may be a duplication
of costs (e.g. customers still want glossy brochures even though they can look at
their contents on the Internet) with a consequent reduction in net margins.
(2)
Internal financial control system

The audit of Azure should be more efficient if reliance can be placed on a strong
control environment (which will significantly complement specific internal
controls). The control environment is likely to be assessed as strong if budgetary
controls and the internal audit function are shown to be effective.
SA
M
PL
E



Factors to be considered in assessing the effectiveness of budgetary controls will
include:

the frequency and timeliness of the review of budgets against actual
(monthly, quarterly?);

the action taken, if any, when actual is not as budgeted (e.g. spiralling
costs or slump in revenue at a location).
Factors to be considered when assessing the suitability of budgeted information for
analytical procedures include:

the degree of disaggregation (e.g. would expect revenue and costs to be
analysed between holiday location/hotel);

the availability of financial and non-financial data (e.g. non-financial
might be expected to include air passengers, passenger-kilometres, room
occupancies, booking cancellations, etc);

its relevance and reliability (e.g. if it is prepared with care).
1043
(3)
The precise scope of the internal audit function will need to be ascertained in
planning an effective approach to the external audit of Azure. Other factors to be
considered in making a preliminary assessment of the relevance and reliability of
internal audit include:

its organisational status (appears to be high as it reports to the Audit
Committee);

the technical competence of the team (professional qualifications, etc);

its exercise of due professional care (as evidenced by procedures
performed and documentation thereof);

the action, if any, that is taken by the Audit Committee on the internal
audit function’s findings and recommendations.
E


PL
The opportunity to use analytical procedures in a cost-effective audit of Azure can be
demonstrated by the comparison of 2013 figures against 2012. For example:
The 23·5% increase in turnover is attributed to the growth in direct sales. However,
that the expansion is less than the increased investment in non-current assets (nearly
36%), may indicate that:

retail revenue are falling;

some of the investment (e.g. in Internet technology) has not yet reached its
full revenue-generating potential – in which case revenues in 2014 may be
expected to show a further increase.
Although turnover increased by nearly 25%, operating PBT increased by only
6·2%. Some of the increase in operating costs could be relatively short-term (e.g.
staff training and other expenses incurred in the setting up of new distribution
methods). Alternatively, this could reflect longer term inefficiencies.

Operating PBT represents just 2·9% of turnover (2012 – 3·4%). Azure’s margins
may be being squeezed by higher distribution costs (especially if duplicated) and
increased competition.

The $28·8m increase (35·9%) in tangible non-current assets may have been
financed by the issue of convertible debt.
SA
M

Tutorial note: It is unlikely that any meaningful comparison of asset turnover can be made
given that significant leased assets are “off balance sheet”.
1044

The $11·5m increase (63%) in trade receivables is barely material (1·2% of
turnover). A crude estimate of receivable days is 11·5 (2012 – 8·7). Trade
receivables do appear to be a risk area of the audit. Direct confirmation
(“circularisation”) of individual customer balances is clearly inappropriate (2m
11.5
 63,000 owing money at the year-end).
customers ×
365

Cash has increased by 52% ($47·6m) as a result of having issued the convertible
debt. The high level of cash reflects Azure’s exposure to liquidity risk. In
particular current liabilities have increased by $36·7m (18·3%).


a fall in the level of advance bookings (e.g. as more customers wait for
“last minute” bargains);

Azure having relaxed its policy on the timing and/or amount of holiday
deposits and advance payments (e.g. to attract bookings);

delays or other problems being encountered in collecting deposits on
Internet bookings.
The debt appears to have financed an increase in tangible non-current assets and
increased Azure’s liquidity in the short to medium-term. If the debt is converted
before its redemption date, Azure will have increased its equity base and obtained
finance for the longer term (e.g. to meet increasing lease commitments of more than
five years).
Appropriate selection criteria
Tutorial notes
PL
(b)
The 13·8% increase in advances is less than the increase in turnover. This could be
due to:
E

This part is perhaps easier than (a) in that it does not require the same depth of analysis of
the scenario. Candidates who strictly allocate their time to each part are likely to score more
highly on this question overall than those who allow themselves to over-run on part (a) and
produce “sketchy” answers to (b).
SA
M
The marking scheme indicates that full marks could be obtained by identifying and briefly
commenting on 10 criteria or identifying and providing a more detailed commentary on just
four criteria – or anything in between. This answer is indicative of the comments that could
be made, it is not prescriptive.
Audit firm
“Background information” provided by the audit firms invited to tender is likely to include:





organisation structure (e.g. into specialised departments for audit, tax, etc);
its size (e.g. in terms of staffing levels);
locations of offices (including overseas locations relevant to Azure);
affiliated firms (if any);
its relevant client portfolio (as an indicator of the firm’s relevant experience and
reputation in the travel/holiday/leisure industry).
Azure may be particularly interested in the reputation of the audit firm (i.e. how highly it is
regarded). For example, Azure may be seeking to improve its “standing”/image (e.g. with its
bankers or other finance providers) by association with a distinguished audit firm name.
First impressions

Whether the submission deadline for responses was met (on a timely basis or at the
last minute) – as evidence of speed of delivery (e.g. in meeting the auditor’s
reporting deadlines).

The quality of the submission (e.g. whether it is complete, well-presented, factually
correct, etc) – as evidence of the likely quality of audit work.
1045
Understanding the business
Azure will expect the submissions to demonstrate the experience of each of the audit firms in
the travel/holiday/leisure industry (e.g. as evidenced by its relevant client portfolio). An
appreciation of significant economic and legal issues in any of the countries in which Azure
offers holidays would also be relevant.
Azure may rank, in particular, the audit firms’ understanding of Azure’s business (how it
works) and its objectives (future aspirations) – which must be evident in the submissions.
The audit team
E
Factors to consider when Azure is assessing the calibre of each of the proposed audit teams
may include:
its size (staffing levels) and mix (between grades of staff);

its organisation (e.g. between sub-ordinates/managers and audit/tax etc) and
coordination (e.g. with clear communication channels and lines of reporting);

the relevant experience of key individuals (audit engagement partner and
managers);

the level of partner input;

access to relevant specialists both within the firm and external consultants (e.g. in
IT).
PL

SA
M
Services
The services of greatest interest to Azure are likely to be international tax and IT (in addition
to audit). However, legal matters (e.g. relating to contracts and franchises or licences) may
also be relevant. Azure is most likely to be looking for a firm with the capability to deliver
the range and quality of services relevant to their immediate and future needs (for the benefits
of “one stop shopping” such as economies of scale).
Azure may be seeking an audit firm with a proactive approach and the ability to add value to
its business. For example, there may be tax or other benefits to be obtained by changing the
status and/or registration of representative offices (e.g. from overseas branches to local
companies or vice versa).
Audit approach
In having requested, as part of the submission, “principal audit risks … other planning issues
… audit strategy”, Azure will expect the firms to have demonstrated, for example:



a high level of planning
an understanding of audit issues (and how these issues will be reported to Azure)
an audit methodology offering a cost effective approach.
Tax
Submissions will be expected to show an understanding of tax issues (e.g. in relation to
overseas operations) and pro-activity in providing practical, cost-effective solutions.
1046
Chemistry
Although personal rapport and the audit firm’s enthusiasm for a working relationship with
Azure will be more apparent at the presentation stage, Azure will make some assessment
about “chemistry” before then. Azure will be asking “Do they understand our business
issues?” and if, for example, Azure met with any of the firms before the submission “Does the
submission show that they listened to us?”.
Fees
Azure will expect competitive fees/value for money/constructive business advice.

A fee breakdown (e.g. split between grades of staff and/or audit and tax compliance
work) will probably have been requested to facilitate comparison between the firms.

Azure may be suspicious of (have reservations about) an audit fee proposed by a
tenderer if it is significantly lower (“lowballing”?) or higher than others.
E

Other criteria
PL
Whilst there is no suggestion that Azure is seeking “malleable” (i.e. acquiescent) auditors,
Azure is unlikely to invite to the presentation stage any firm whose submission shows a lack
of empathy for the organisation’s business objectives, risk management policies, etc.
Tutorial note: Whilst “nepotism” may be a factor considered in the selection of auditors or
advisors, it is not one that should be used in the “evaluation of submissions received”.
Answer 14 HYDRASPORTS
(a)(i)
Business risks
(ii)
Financial statement risk
SA
M
Tutorial note: As part (ii) is clearly related in the requirement to part (i), it is appropriate that a
“tabular” approach be adopted.

The standard design of facilities increases
operational risk as any difficulties
encountered in one facility will be
compounded by the number of other
facilities (potentially all) which are similarly
affected. This is illustrated by the closure of
the saunas.

The carrying amount of the associated noncurrent assets (i.e. equipment, fixtures and
fittings) is likely to be overstated as they are
likely to be impaired if they are not in use.

Management circumvention or override of
control procedures laid down by head office
may result in system weaknesses. If errors
arising are not detected and corrected the risk
of misstatement in the financial statements is
increased.
Tutorial note: Standard design may also reduce
risk as it results in a higher quality “product”.

Centralised control through company policy
is resulting in inefficient and ineffective
operations as managers cannot respond on a
timely basis to local needs.

Business reporting risk is likely to be

increased by centre managers preparing
monthly accounting returns. Operational risk
may be increased if centre managers cannot
fulfil their day-to-day responsibilities (e.g.
relating to customer satisfaction, human

resources, health and safety).
Information processing risk is increased as
accounting information flowing into the
financial statements may not be properly
captured, input, processed or output by the
centre managers.
Inherent risk, of errors arising, in monthly
“branch” returns is high.
1047

(ii)
Advanced payments contribute to business
reporting and financial (cash flow) risk.
Cash received must be available to meet the
costs of providing future services.
Hydrasports cannot operate a centre if a
licence is suspended, withdrawn or not
renewed (e.g. through failing a local
authority inspection or failing to apply for
renewal).

Revenue may be overstated if an accurate
cut-off is not achieved. In particular, there is
an estimate risk in determining the amount of
deferred income at the end of the reporting
period.

An error of principle may also arise if
Hydrasports’ revenue recognition policy
does not comply with IAS 18 Revenue.

An error of principle arises if licences are not
capitalised as intangible assets (but instead
written off as expenses when incurred).

Intangible assets (licences) should be
reviewed for impairment at the end of each
reporting period (e.g. for centres which are
closed).
PL

Business risks
E
(i)
Closure may result in customers finding
alternative facilities with permanent loss of
fee revenue.

“Early bird” customers’ dissatisfaction
similarly increases operational risk.

Failure risk (i.e. that Hydrasports will not
continue to operate as a going concern) is
increased.

This creates disclosure risk if the disclosures
relating to going concern as the basis of
accounting do not meet the requirements of
IAS 1 Presentation of Financial Statements.

Serious accidents may prompt investigation
by local authority – resulting in penalties,
fines and/or withdrawal of licence to operate.

If licences are withdrawn, the intangible
asset (amounts prepaid) should be written off
to the extent that monies are not refundable.

The likelihood of contingent (if not actual)
liabilities increases disclosure risk.
SA
M


Although fees are non-refundable,
suspension of a facility (e.g. sauna) may
result in customers asking for partial refund.
In particular Hydrasports may have an
obligation to refund fees paid in advance
when centres are closed (e.g. the Verne
centre from July–September 2014).

Provisions may be understated at 31
December 2013 if Hydrasports has a legal
obligation to refund fees where it has failed
to provide services.

Permanent loss of customers requiring
childcare facilities increases operating risk.
Compliance risk is increased if the new
guidelines are not met.

Disclosure risk is (again) increased if
fines/penalties arising are material and not
disclosed.

Similarly, inability to retain lifeguards
increases operational risk that pools cannot
open (due to health and safety regulations).
Compliance risk is increased by the
possibility that pools may be operated
without a lifeguard being on duty.
1048
(i)
Business risks
(ii)

High staff turnover indicates increased
operational risk (poor human resource
management, inefficiency in working
practices, reduced capacity, etc).

Limitations on centre managers’ levels of

authority may not be commensurate with
their responsibilities. Empowerment risk
arises if managers are not properly led (and if
they, in turn, do not properly lead their
centre staff).

More centres may become loss-making if the
reasons for falling membership are not
addressed.

Loss-making centres should be tested for
impairment as cash-generating units.

The hydrotherapy pool cannot operate until
construction is completed and completion
may be threatened by cash flow difficulties.

The value of the asset in construction should
be written down if it is impaired (even
though it has not yet been brought into use).

Cash flow difficulties increase
liquidity/financial risk.

See above reference to going concern and
disclosure risk.

Obsolete gym equipment increases
operational risk as customer satisfaction
decreases and health and safety risks are
increased.

Depreciation may be overstated if
Hydrasports continues to calculate
depreciation on fully-depreciated assets.

Disclosures for capital commitments (e.g. to
replace equipment) in the financial
statements may be inappropriate if
Hydrasports does not have funds to finance
such commitments.
Staff costs may be overstated as the risk that
payments may be made to leavers is
increased.
E
Any lack of integrity may increase the risk of
management and/or employee fraud, illegal
acts and unauthorised use of company assets.
In particular the assertion of existence of
assets may be at risk (resulting in
overstatement).
SA
M
PL


The reduction in insurance cover reduces the
recoverable amount of assets in the event of
loss through fire (for example). Inability to
replace lost/damaged assets increases
operational risk (see obsolete gym equipment
above).

See above reference to going concern and
disclosure risk.

Operational risk is increased if the
substantial increase in liability insurance
premiums is a reflection of an increase in the
level of claims being made.

Disclosure risk is increased in relation to
contingent assets (for reimbursement under
insurance policies).
(b)
Principal audit work
Deferred income

Agreeing Hydrasports’ analysis of joining fee and peak/off-peak membership fees
on a sample basis.
Tutorial note: Initial joining fees should not be deferred but recognised when received.

Reconciling membership income to fees paid. If customers can renew their
membership without payment there should be no deferral of income (unless the debt
for unpaid fees is also recognised).
1049

Assessing the collectability of unpaid fees (if any) by reviewing after date receipts
and correspondence with members.

Recomputing the deferred income element of fees received in the three months
before the end of the reporting period.

Comparison of year-end balance with prior year and investigation of variance.
Hydrotherapy pool
Verifying the initial cost of this constructed asset will include an examination of:



the contract with the builder
contractors billings; and
stage payments.
E

Hydrasports is likely to be advised by its own expert (a quantity surveyor) on how
the contract is progressing. Audit work will include a review of the expert’s
assessment of stage of completion as at the end of the reporting period, estimated
costs to completion, etc.

Physical inspection of the construction at the year end to confirm work to date and
assess the reasonableness of stage of completion.

Borrowing costs associated with this substantial (“heavy”) investment should be
agreed to finance terms and payments. The calculation of any amount capitalised
should be recomputed to confirm accuracy.

The basis of capitalisation, if any, should be agreed to comply with IAS 23
Borrowing Costs (e.g. interest accruing during any suspension of building work
should not be capitalised).
SA
M
PL


As the construction has already cost twice as much as budgeted, its value in use
(when brought into use) may be less than cost. Management’s assessment of
possible impairment (of the hydrotherapy pool and the centre) should be critically
appraised.
Tutorial note: The asset should not yet be subject to depreciation as it has still to be brought
into use.
(c)
Performance indicators – social/environmental responsibility
Member satisfaction




Number of people on membership waiting lists (if any).
Number of referrals/recommendations to club membership by existing members.
Proportion of renewed memberships.
Actual members: 100% capacity membership (sub-analysed between “peak” and
“off-peak”).
Membership dissatisfaction


1050
Proportion of members requesting refunds per month/quarter.
Proportion of memberships “lapsing” (i.e. not renewed).
Staff





Average number of staff employed per month.
Number of starters/leavers per month.
Staff turnover/average duration of employment.
Number of training courses for lifeguards per annum.
Average hourly (weekly) wage: average national hourly (weekly) wage (or national
minimum).
Predictability
Number of late openings (say more than 5, 15 and 30 minutes after advertised
opening times).

Number of days closed per month/year of each facility (i.e. pool, crèche, sauna,
gym) and centre.
E

PL
Safety

Incidents reports documenting the date, time and nature of each incident, the extent
of damage and/or personal injury, and action taken.

Number of accident free days.
Other society
Local community involvement (e.g. facilities offered to schools and clubs at
discount rates during “off-peak” times).

Range of facilities offered specifically to pensioners, mothers and babies, disabled
patrons, etc.

Participation in the wider community (e.g. providing facilities to support sponsored
charity events).
SA
M

Environment

Number of instances of non-compliance with legislation/regulations (e.g. on
chemical spills).

Energy efficiency (e.g. in maintaining pool at a given temperature throughout the
year).

Incentives for environmental friendliness such as discouraging use of
cars/promoting use of bicycles (e.g. by providing secure lock-ups for cycles and
restricted car parking facilities).
Evidence
Tutorial note: As there is a wide range of measures of operational performance which
candidates could suggest, there is always a wide range of possible sources of audit evidence.
As the same evidence may contribute to providing assurance on more than one measure they
are not tabulated here, to avoid duplication. However, candidates may justifiably adopt a
tabular layout.
1051
Membership registers clearly distinguishing between new and renewed members,
also showing lapsed memberships.

Pool/gym timetables – showing sessions set aside for “over 60s”, “ladies only”,
schools, clubs, special events, etc.

Staff training courses and costs.

Staff timesheets – showing arrival/departure times and adherence to staff rotas.

Documents supporting additions to/deletions from payroll standing data (e.g. new
joiner/leaver notifications).

Engineer’s inspection reports – confirming gym equipment, etc is in good working
order. Also, engineer and safety check manuals and the maintenance program.

Levels of expenditure on repairs and maintenance.

Energy saving equipment/measures (e.g. insulated pool covering).

Safety drill reports (e.g. alarm tests, pool evacuations).

Accident report register – showing date, nature of incident, personal injury
sustained (if any), action taken (e.g. emergency services called in).

Any penalties/fines imposed by the local authorities and the reasons for them.

Copies of reports of local authority investigations.

The frequency and nature of insurance claims (e.g. to settle claims of injury to
members and/or staff).
SA
M
PL
E

Answer 15 HARRIER MOTORS
(a)
Audit risks
Inherent – financial statements level
1052

Major business expansion increases going concern risk due to increased dependence
on financing and the risk of overtrading. This must be taken account of when
planning the audit so that, on completion of the fieldwork, sufficient audit work has
been obtained to support management’s assertion that the going concern basis is
appropriate.

Multi-locations increase inherent risk. For example, the movement of assets
between locations creates a risk of double-counting and/or omission. Inter-location
trading (e.g. of parts inventory) may be transferred at a mark-up which must not be
recognised until realised.

It is in the nature of the car trade business that sales are transacted for cash. If
controls over the recording of cash income are inadequate this would cast doubts on
the truth and fairness of the financial statements as a whole. For example, cash may
be spent on capital and/or revenue items and not recorded as business
assets/expenditure.
Inherent – assertion level
The legal form of the consignment inventory is that Harrier Motors does not own it
and should therefore not recognise it in the statement of financial position. However,
Harrier does not return new cars and therefore the substance of the transactions with
the supplier is that they are purchases. That Harrier effectively has the rights of
ownership and should recognise unsold cars in inventory is supported by the fact that
the sales executive can use any car in each consignment. A physical inspection of
new car inventory will therefore be required at the year end.

For vehicles more than three months old, 3% purchase price is not a cost of
acquiring inventory but a finance cost which should be expensed (time-apportioned
if necessary to give accurate cut-off between accounting periods).

Liabilities (actual and contingent) arising under the three-year warranties and sixmonth guarantees will require some provision (to the extent that they are expected
to materialise) and disclosure, in accordance with IAS 37 Provisions, Contingent
Liabilities and Contingent Assets.

Inventory valuation will depend on whether cars are new, used/trade-in, or ex-demo
models. The year-end physical inventory count must ensure that each vehicle is
appropriately categorised to ensure that it is correctly valued.

In particular, used cars accepted in part-exchange (on the sale of a new car), will be
assigned a trade-in value which is the difference between the listed selling price on
the new car and the cash consideration. Trade-in value may exceed the net
realisable value of used cars (which must be serviced in order that they are
guaranteed before they can be offered for resale).

As a member of key management personnel, the sales executive is a related party.
Even though there is no consideration for the loan of the assets (new cars) IAS 24
Related Party Disclosures applies. There is a cost to Harrier which is the
diminution in value between sales price of a new car and ex-demo price. In some
jurisdictions this will be a benefit in kind assessable on the sales executive which
should be disclosed as part of his remuneration package.

WIP is unlikely to be material at the year end (as for the most part it is invoiced as
finished work on the same day that it is undertaken). However, attention will need
to be given to the cut-off between parts inventory (at cost) and completed WIP (at
selling price).

The term “indefinite” does not mean “infinite” but rather that the planned future
expenditure on the brand name is in excess of that required to maintain the
intangible assets at its current level of performance (IAS 38 Intangible Assets). This
expenditure must therefore be verified to substantiate non-amortisation of the “Unifit” brand name.

As there is a rebuttable presumption that the useful life of an intangible asset does
not exceed 20 years, Harrier’s management must also subject the brand name to an
annual impairment test.
SA
M
PL
E

Control risk

The existence of an internal audit function may reduce the assessment of control
risk on future audits. However, as the department is only now in the process of
being established it is unlikely that much, if any, reliance can be placed on it in
respect of the current year.
1053
To the extent that additional staff are recruited to the internal audit department
before the year end, there is an opportunity for co-operation in verifying inventory
and non-current tangible assets at the end of the reporting period.

Tests of control should be planned on continuous stock-checking to determine the
extent of reliance to be placed on this internal control. In particular, Harrier’s
storekeepers should be carrying out test counts to a program which ensure that all
inventories are counted at least once in each financial year. Discrepancies between
book records and physical counts must be corrected by persons independent of the
storekeeping function.
E
Principal matters – instructions for physical inventory counting
Harrier’s year-end instructions should be approved by the newly-appointed head of
internal audit. Any matters raised by the external auditor concerning last year’s
count (e.g. in a management letter) should be addressed.

High value inventory (new cars) are held at three locations more than in the prior
year and external audit staff might be expected to attend all three. Internal audit is
not yet sufficiently developed to carry out tests of compliance on controls over
inventory movements on a “cyclical” basis. The newly appointed head (plus any
additional staff recruited before the year end) should therefore plan to attend counts
in consultation with the external auditors.

Attendance at the counts is primarily a test for existence. As new cars contribute
most to the valuation of inventory, they will most likely be 100% examined at all
locations visited.

Perpetual inventory records and continuous stock-checking provide a system of
control over inventory quantities which, if effective, eliminates the necessity of a
full physical count at the year end. If tests of controls in this area are strong Harrier
will be performing test checks on a sample basis.
PL

SA
M
(b)

1054

The risk of material error arising due to cut-off will be reduced if new car
consignments are not scheduled to be received close to the year end. The likelihood
of material error arising from work in progress is also low as servicing and body
repairs are generally performed and invoiced on the same day.

The greatest risks of material error arise if sales after the year end are brought into
the current year sales – particular attention should be given to any cars which are
seen to exist but are excluded from the count.

Physical movement of new cars should be kept to a minimum (so perhaps no test
driving on the day of the count).

In selecting used cars for test checking it will be important to note their physical
condition and any indications that they are slow-moving (e.g. if they are not easily
accessible for a test drive).

Consignment inventory which is more than three, six, nine, etc months old should
be identified for later consideration of net realisable value. Mr Joop’s car should be
included in the count and any of his ex-demo models which are still in inventory.
(c)
Audit work – useful life
Tutorial note: “Indefinite” does not mean “infinite”. Useful life reflects the level of future
maintenance expenditure required to maintain the asset at its standard of performance
assessed at the time of estimating its useful life.
Agree the carrying amount (cost) to prior year working papers.

Review the history of the “Uni-fit” brand name. In particular, how many years it
was in existence before it was purchased.

Substantiate the level of marketing/advertising expenditure incurred on the brand
name during the current year (by agreeing advertising to invoices, etc).

Compare the accounting policy, of indefinite useful life, with that adopted for
similar brand names in the industry.

Review of planned future expenditure (i.e. advertising budgets) to maintain the
brand name at the level of performance at which it was purchased.

The results of management’s impairment test (i.e. comparison of recoverable
amount (per IAS 36) with carrying amount (i.e. cost)).
Answer 16 SHARP
Significance of findings
(1)
Payments to suppliers $10,172

If this was deliberate “window-dressing” an adjustment might be appropriate. The
amount is material, being 14% of cash at bank.
SA
M
(a)
PL
E


However, the payments were processed and cleared the bank soon after the year
end. Though cash and payables may be understated there is no effect on net current
assets. If an adjustment was made the reduction in liquidity ratios would be
negligible.

The clerical error should be noted in the draft management letter to avoid repetition.
As the error could be considered as not being significant, an adjustment appears not
to be necessary.
(2)
Credit notes not recognised $7,542

Receivables, net current assets, revenue and profit before tax are overstated by
$7,542. The error represents 7% of profit before tax and is therefore considered
material.

Stricter controls over the introduction of price increases should be recommended in
the draft management letter.

An adjustment for further allowance is proposed.
(3)
Additions to plant and machinery $52,000

Though the errors detected amounting to $2,500 were not material (to total assets,
net assets and profit), it is possible that a material error may exist in the $39,000 not
tested. A simple extrapolation suggests a potential error of $7,500 (1.2 % of total
assets, 3.75% net assets and 7% of profit).
1055
If a material error is found to have occurred it would usually be appropriate to
reconsider the depreciation charge for the year. However, the depreciation error
would need to be greater than $5,300 (5%  $106,000) to be considered material. It
is also highly unlikely that any adjustment would be made based on performance
materiality (e.g. if performance materiality was set at 50% of planning materiality,
this would mean the depreciation error would need to be at least $2,650,
representing a depreciation rate of 35% on plant and equipment – a rate of 10%
could be considered the norm).

The systems weakness in the classification of expenditure should be noted in the
draft management letter.
(4)
Warranty provision $25,000

Detailed tests suggest a maximum potential understatement of $5,000 which is 5%
of profit before tax and 17% of net current assets and may be considered material.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that in
providing for a contingency a prudent estimate of the amount involved should be
included in the accounts. Since the estimate requires a certain degree of judgement
an adjustment would only be appropriate if it can be certain that management’s
estimate is not sufficiently prudent.

On balance, accepting that the estimate is not highly subjective and that professional
scepticism has been appropriately applied, it appears that the client’s estimate
should be accepted.
(5)
“Uninsured risk” provision $20,000

This should only be carried forward if the provision meets the requirements of
IAS37 (past event, present obligation, unavoidable, future economic outflow).
SA
M
PL
E


(b)
Financial effect on the draft accounts
Profit or loss
DR
CR
$000
$000
Profit per draft accounts
106
(1)
(2)
(3)
(4)
(5)
1056
As no amounts have ever been charged against it, and there is no indication of an
applicable event, the $20,000 should be written back to profit or loss. The write
back should be disclosed separately since it represents 19% of profit and is clearly
material.
DR
DR
DR
DR
DR
Cash
CR Payables
Revenue
CR Receivables
Statement of financial position
DR
CR
$000
$000
10
10
8
8
Repairs
7
CR Non-current assets
7
Warranty claims
CR Payables
5
Payables
CR Profit or loss
5
20
20
Overall effect on profit and total assets less current liabilities $Nil.
Of these, item 1 (payments to suppliers) and item 4 (warranty provision) would be classified
as unadjusted errors. The payment to suppliers was a simple clerical error and the warranty
provision is acceptable as a reasonable estimate. The overall impact on the financial
statements of these items, separately and cumulatively is not material.
E
Item 3 (repairs) should be discussed further with management. If management accepts the
extrapolation, the financial statements should be adjusted. If not, further audit tests to clarify
the potential error must be carried out. If no further errors are found, the initial error of
$2,500 may be left as an unadjusted error. Given the nature of warranty claims, the
cumulative impact of unadjusted errors would remain immaterial.
Tutorial notes: Alternative answers to (b) are possible. However, the schedule should show
potential adjustments in order to take an overview.
Answer 17 IAS 24 EXAMPLES
PL
Introduction
IAS 24 Related Party Disclosures applies to the following related parties:
entities that directly or indirectly, through one or more intermediaries, are controlled by, or
are under common control with, the reporting entity;

associated companies (where there is “significant influence”, usually 20% voting control);

individuals owning directly or indirectly an interest in the voting power of the reporting entity
that gives them significant influence over the entity, and their close family members;
SA
M


key management personnel and their close families; and

entities where significant influence can be exercised, directly or indirectly, through the use of
voting power by any person included in (iii) or (iv) above. This includes entities owned by
directors or shareholders of the reporting entity and entities that have key management in
common with the reporting entity.
(a)
Smith
Smith
control
Voce
control
Stubbs
control
Roberts
1057
Voce, Stubbs and Roberts all have a related party relationship with Smith as they are all
directly or indirectly controlled by Smith.
Roberts and Voce are related parties of each other due to a parent/subsidiary relationship.
A related party relationship also exists between Roberts, Voce and Stubbs as they are all
subject to common control from the same source.
These relationships fall under the first category above.
Jones
Jones
40%  influence
Tucker
PL
75%  control
E
(b)
Wilton
Tucker and Garvey are related parties of each other as Jones controls Tucker under the first
category above.
Hence, Garvey and Wilton are related parties under the second category above.
Tucker and Wilton are not related parties as they are not subject to common control. Jones
only has significant influence over Wilton which is not the same as control.
Nancy and Paddy
SA
M
(c)
Nancy & Paddy
(Directors)
Danny
(Director)
Brothers
control
Flynn
Purchases
control
Forsythe
Nancy and Paddy are related parties with Flynn as they are directors.
Danny is a related party with Forsythe as he is a director.
If Danny and Paddy are close family members, further related party relationships are
presumed to exist as follows:



Nancy and Paddy would be related parties with Forsythe.
Danny would be a related party with Flynn.
Flynn and Forsythe would be related parties of each other as they are controlled by
close family members.
Danny and Paddy will constitute close family members if one may be expected to influence,
or be influenced by, the other in their dealings with the reporting entity.
1058
Further information is required on the transactions between Flynn and Forsythe but, if
purchases are significant, a related party relationship appears likely.
These relationships fall under the fifth heading above.
(d)
Central
75%
David & Donna
(Directors)
PL
25%
E
Central
Green
Central and Green are related parties due to a parent/subsidiary relationship.
David and Donna are related parties with Green as they are directors.
David and Donna would be related parties of Central if they are also directors of Central.
SA
M
David and Donna would be related parties of Central if they constitute key management of it
(but are not directors).
David and Donna will be key management if they are in senior positions (in the group) or if
they have authority and responsibility for planning directing or controlling the major activities
of Central.
The same applies in reverse to the directors and key management of Central.
Answer 18 PHOENIX
Tutorial note:
“Matters” will often encompass considerations of “risk”, “materiality” and “accounting treatment”
(i.e. the omission of recognition and/or disclosure as well as benchmark and alternative treatments).
(1)
Trade investment
(i)
Matters
Assuming that Pegasus is insolvent (e.g. a receiver or liquidator has been appointed) this is an
adjusting event (IAS 10 Events After the Reporting Period).
As the recoverable amount is likely to be $nil, an $80,000 impairment loss should be
recognised in profit or loss for the year to 31 March 2014 (IAS 36).
As the likelihood of any distribution of the declared dividends is remote, the $15,000
dividends receivable should be written off.
1059
The total expense of $95,000 represents 5·6% of draft profit before tax and is therefore
material. As is it not expected to recur, separate disclosure (IAS 1) may be appropriate to
explaining Phoenix’s performance for the year.
Before deciding whether or not an “except for” modified opinion would be reported if
adjustments are not made, materiality should also be assessed in relation to the statement of
financial position.
The event after the reporting period may also be described in the directors’ report with a
cross-reference to the investments’ note.

A copy of the press report.

The audited accounts of Pegasus for the year ended 30 September 2013 showing
whether there are assets with market values in excess of carrying amounts.

The receiver’s (or liquidator’s) statement of affairs indicating whether any
distribution is possible.

If a meeting of the shareholders of Pegasus has been held to consider the company’s
state of affairs, a copy of the minutes (may be obtained by Phoenix).

Discussion with client who, if anyone, has replaced Pegasus as one of their major
shipping contractors. Also, whether any consignments have been held up while
negotiating for an alternative shipping contractor.

Written management representation confirming that there have been no events after
the reporting period other than Pegasus’s insolvency.
PL
Future maintenance
E
Audit evidence
SA
M
(2)
(ii)
(i)
Matters
The provision represents 29% of draft profit before tax and is therefore material.
The accounting treatment of maintenance costs should be consistent with prior years (IAS 1).
However, IAS 37 does not permit the recognition of a provision that does not meet the
recognition criteria for liabilities.
Overhaul expenditure to restore or maintain the future economic benefits expected from the
plant and equipment should normally be recognised as an expense when it is incurred (IAS
16). However, blast furnaces are of a type of plant and equipment that require relining after a
specified period. The components (blast furnace interiors) which require replacement are
separate assets that should be depreciated over the replacement cycle. To the extent that the
$500k includes the cost of replacing separate assets, it represents future capital cost.
Prudence does not permit the creation of hidden reserves and excessive provisions. This
“provision” does not meet the IAS 37 definition:



there is no uncertainty about the timing (August);
there may be relatively little uncertainty about the amounts involved;
there is no liability as at 31 March 2014.
If the provision is not “unmade”, as being unnecessary, the audit opinion should be qualified
“except for” on grounds of non-compliance with IAS 37.
1060
Draft profit before tax ($1·7m) shows a 13% increase on the previous year. If adjustments are
made for points (1) and (2), profit will be increased by at least $400,000 (i.e. (1) $95k
decrease plus (2) $500k increase). Profit before tax of $2·1m would be a 40% increase on the
prior year.
The management of Phoenix may have decided that $1·7m is what is to be reported.
Management may have made the future maintenance provision (which may have been
permitted in previous years) as a way of “setting aside” a reserve. For example, in
anticipation of increased costs expected to arise in respect of waste disposal in (3).
Tutorial note:
Audit evidence

Client’s schedule showing make-up of provision.

Discussion with senior management their reasons for having made the provision and
whether any costs have been contracted for.

External tenders or quotes for sub-contracted work (and/or internal costings).

Prior year working papers (and/or the permanent audit file) showing the cost and
frequency of overhauls in previous periods (whether all sites done at once or on a
cyclical basis).
Cleanaway
PL
(ii)
SA
M
(3)
E
It is a “higher skill” to be able to demonstrate an ability to stand back from the individual
items and take an overall view in this part of the question, considering the overall impact on
the draft PBT.
(i)
Matters
The matter is likely to be material as ALL Phoenix’s industrial waste is disposed of by
Cleanaway.
Whether Phoenix has been implicated in Cleanaway’s illegal dumping (e.g. by Phoenix’s
clinker having been dumped or by Troy Pitz’s relationship with the two companies).
Whether the integrity of Troy Pitz has been questioned (either by the media or other key
personnel in Phoenix) and, if so, the implications for the audit. For example, any assessment
of control risk as less than high should be reassessed in the light of his role in the control
environment.
Possible consequences for Phoenix of the contract not being renewed:

a legal alternative will need to be found for disposal of clinker, for example:



another approved provider of waste disposal services;
a suitable landfill site (taxes may be substantial), otherwise;
there may be doubts about going concern.
1061
Possible consequences for Phoenix of the contract being renewed:

a substantial increase in costs of disposal, for example, because:


terms were last agreed 5 years ago;
Cleanaway will need to pass on the costs of penalties to its customers;

loss of customers’ goodwill through associations with Cleanaway;

risk of investigation by a government agency into the company’s environmental
practices.
E
Even if doubts about the going concern assumption are resolved, whether or not the contract
is renewed in the future amounts to a “significant uncertainty”. An emphasis of matter
paragraph in the auditor’s report is likely to be appropriate. The matter must therefore be
adequately disclosed (e.g. in the notes to the financial statements).
PL
Cleanaway is a related party. Troy Pitz has authority and responsibility for Phoenix’s
operational activities (as chief executive) and a controlling interest in Cleanaway. The
financial statements of Phoenix should disclose (IAS 24):

the nature of the related party relationship;

an indication of the services received including:




amount (or proportion) of costs;
pricing policy (per contract);
amount outstanding (trade payable balance);
credit terms, etc.
Audit evidence

The terms of the contract, in particular whether:
SA
M
(ii)
1062

early termination could be an option for Phoenix (in the light of
Cleanaway’s illegal activities);

any clauses are relevant to its renewal (e.g. restricting price increases).

Newspaper articles, including any editorial comment or letters from Cleanaway or
Troy Pitz.

Discussions with senior management (Troy Pitz and others) whether a suitable
alternative service provider exists.

Concerning related parties and related party transactions:

prior year working papers and financial statements;

review of Phoenix’s procedures (e.g. keeping of registers and requiring
board approval of certain transactions);

inquiries of directors, key management and the company secretary;

an extract of principal shareholders from the share register;

minutes of shareholder and board meetings;

relevant statutory books and records (e.g. register of directors’ interests);

relevant returns supplied to regulatory agencies (e.g. income tax returns);

extracts from all significant contracts;

third party replies (e.g. bank reports for audit purposes and loan
confirmations identifying guarantees).
A post-year-end review, up to the date of signing the auditor’s report, must support the
validity or otherwise of the going concern assumption. In particular:
board minutes should indicate what action, if any, management propose to take to
mitigate the adverse publicity surrounding Cleanaway;

order books may reveal the loss of major customers (e.g. if delays experienced
consequent on the demise of Pegasus);

successful negotiations with existing or new shipping contractors, to take on the
work of Pegasus, should result in signed contracts;

discussions with management, to ascertain their plans to secure Phoenix’s future,
may be confirmed by written management representations (assuming there is neither
corroborative nor conflicting alternative evidence).
E

Tutorial note:
Answer 19 STILSON
(a)
Matters to consider
“Substance over form”
PL
Taking an overall view on something like the going concern assumption is another example of
the higher skill of “standing back” from the individual items.
SA
M
The IASB’s Conceptual Framework for Financial Reporting requires that transactions should
be accounted for based on their substance (i.e. commercial reality) rather than their “legal”
form. The auditor should be aware of circumstances that may indicate that the substance of a
transaction differs from its legal form.
Indicators of these circumstances are:


the linking of one transaction with another; and
the sale of an asset at a price that differs from its fair value (either above or below).
In this case both of these factors are present and the auditor should be alerted to problems of
substance. The sale of the property is linked to the agreement to rent it back for a period of
ten years, and the sale price is $3 million higher than its fair value.
Tutorial note: Even where an asset is sold for its fair value and leased back, the auditor has
to be careful. For example, if a leasehold property with a ten-year remaining life was “sold”
and subsequently leased back for a period of ten years, then this is not a sale at all, it is a
secured loan.
Likely accounting treatment required
The correct treatment in the financial statements would be that the property should continue
to remain on the vendor company’s statement of financial position and the “sale proceeds”
should be treated as a loan. The associated “rental” payments should be treated partly as a
finance cost and the remainder would be repayments of the loan.
In this example, as the property is a freehold, it must be treated as sold. This is because the
majority of the risk and reward associated with property now rests with the purchaser.
1063
Value of sale
No company would take a commercial decision to buy a property for $8 million when its fair
value is $5 million. The excess of $3 million is, in substance, a loan. The implications of this
are that the “linked” rental payments for the next ten years will have been “inflated”. The
substance of the annual rentals is that they contain three elements:



“arm’s length” rent;
finance costs; and
the repayment of the $3 million “loan”.
(b)
Unrecorded liabilities
(i)
Why problematic
PL
E
The auditor will have to determine what the fair value of the property was at the date of sale.
The auditor may have knowledge of the price of similar properties, or an independent
surveyor may be consulted for a valuation. Similarly the auditor should use his experience to
determine what a commercial rate for the rent of the property should be. From this
information it is a relatively simple task to apportion the “excess” rentals between finance
costs and repayments of the loan. The audit work will necessarily involve discussing the
above principles and subsequent accounting treatment with the management of Stilson.
By their very nature it is difficult to identify a liability if there is no documentation on it in an
entity’s accounting or administrative records. This may occur because the management:


do not realise that a liability exists (more often); or
do not wish to recognise it and have deliberately concealed it (occasionally).
SA
M
The detection of unrecorded liabilities is a task that pervades all audit areas including sales,
purchases, capital acquisitions and financing; and all stages of the audit, interim, final and
post audit review. The techniques used to determine unrecorded liabilities are varied and
depend upon which type of liability the auditor is trying to detect.
Because of the detailed knowledge of the company’s affairs possessed by the directors,
inquiries of management, both orally and in writing, are vital. The auditor should specifically
describe the type of liability/contingency that management may have been unaware of or
overlooked. Reference to the absence of unrecorded liabilities should also be included in the
representation letter. (Of course, these types of enquiry will not discover any liabilities that
management has deliberately concealed.)
1064
(i)
Audit work

Cut-off tests after inventory counts are a common method to detect any unrecorded
trade payables. A cut-off error (in respect of an unrecorded liability) exists where
an item of inventory has been purchased and included in the total of the closing
inventory, but the corresponding trade payable has been omitted from current
liabilities. The auditor should test that unpaid purchase invoices for goods included
in the year-end inventory figure, or for goods that have already been sold, are also
shown as trade payables.

Routine expense payables, accruals and provisions can often be determined by
normal audit practice such as reviewing the following period’s invoice file, or by
obtaining the previous period’s working paper schedule of accruals and testing to
see if similar accruals exist at the current year end. Commonly accruals will be
required for wages and salaries, interest payments, utility expenses etc.
Tutorial note: The above types of liability are unlikely to have a material effect on the
financial statements even if they are not detected. Potential material unrecorded liabilities
can occur in the following areas.
A review of the cash payments after the year-end may reveal payments in respect of
liabilities that existed (but were not recorded) at the end of the reporting period.
Other types of liability that may be material and difficult to detect would include;
product warranties, design defects on mass-produced goods (e.g. motor cars),
discounted loans notes receivable (bills of exchange) and third party guarantees on
borrowings.

Contingent liabilities represent a serious risk. The most common of these is
pending legal matters. Board minutes should be reviewed for details of these and
other contingencies. Communication with the company’s lawyers should be made,
observing correct protocols. An examination of the invoices for legal expenses may
also shed light on contingencies.

Provision for income taxes. The risk areas here would be taxation in dispute with
the tax authorities and the provision for deferred taxation, which is a complex
calculation. The auditor should inspect correspondence files with the tax authorities
and discuss the matter with the company’s tax consultants. The auditor may need
the help of a tax expert, possibly from their own practice. The assumptions and
calculations relating to the provision for deferred tax should be checked for
reasonableness.
PL
E

SA
M
Tutorial note: The above techniques and examples of possible unrecorded liabilities might
be described as “traditional” areas. In addition to these there is now a greater number of
potential unrecorded liabilities due to the introduction in recent years of several complex
accounting standards.
(ii)
How liabilities may arise

IAS 32, IAS 39 and IFRS 9 dealing with financial instruments require certain types
of hybrid financial instruments (e.g. convertible loans) to be classified according to
their substance (i.e. part debt and part equity). Prior to this some companies had
classified these as equity. The auditor must scrutinise the details and terms of the
issue documents for financial instruments to determine the appropriate treatment of
them in the statement of financial position. Another potentially very risky area,
both for the company and the auditor, is the possibility of unrecorded liabilities in
relation to derivative contracts. Many of these derivative contacts do not have a
“cost” in historic cost accounting terms, and therefore are difficult for the auditor to
detect by vouching and verification techniques.

The application of the concept of substance in IAS 17 Accounting for Leases (and in
The Framework) generally means that some schemes that may have been entered
into by management to keep various forms of financing or liabilities “off balance
sheet” no longer achieve their objective. The auditor should try to ensure that the
substance of any such scheme is recorded and this will often lead to the recognition
of more liabilities.
Common examples of these schemes are: sale and leaseback and sale and
repurchase agreements (these are really secured loans, not sales), consignment
stock, and the requirement to consolidate “controlled” non-subsidiaries. A finance
lease that has been treated as an operating lease would be a similar example of an
unrecorded liability (and asset).
1065
IAS 37 Provisions, Contingent Liabilities and Contingent Assets now prohibits
certain types of provisions from being made, but more important, it requires the
immediate recognition (in full) of certain types of liability that may either not be
provided for at all, or are being provided for gradually (rather than immediately in
full). A common example of this type of unrecorded liability would be a provision
for environmental damage.

IAS 10 Events After the Reporting Period generally discusses circumstances
occurring after the end of the reporting period which may indicate that a subsequent
event or subsequent information gives rise to an adjustment of the previous period’s
financial statements. Some of these adjustments could relate to what would
otherwise be unrecognised liabilities.
Answer 20 VEMA
Change in depreciation method
(i)
Matters

The depreciation charge for the year has been reduced by $1·3m ($4·2m – $2·9m)
as a result of the change, therefore reported profit before tax has been increased by
10·5% ($1·3m ÷ $12·4m  0·105) and is therefore material.
PL
(a)
E

Tutorial note: Alternative calculation, $1·3m ÷ $(12·4m – 1·3m) 11·7%

The write back to reserves (prior period adjustment) is 4·3% ($4·7m ÷ $110m 
0·043) of total assets and therefore material.
SA
M
Tutorial note: It is not appropriate to gauge the materiality of this item against PBT as it
represents an adjustment to the statement of financial position and has no bearing on current
period profit or loss.

The carrying value of tangible non-current assets has been uplifted by $6·0m
($1·3m + $4·7m) which is 5·5% of total assets and, again, material.

Management is responsible for reviewing the useful life of tangible non-current
assets periodically and, if significantly different, adjusting the depreciation charges
for the current and future periods (IAS 16 Property, Plant and Equipment).
Tutorial example: Two-year old vehicles at the beginning of the period, which management
now estimate to have a remaining useful life of a further two years from the end of the current
period (i.e. five years in total):
– opening balance = 1/3 of cost (2/3 having already been depreciated)
– current period charge = 1/3 opening balance (writing off balance over next three years).
1066

Management is also responsible for reviewing the depreciation method periodically
and changing it, if necessary, to reflect the change in expected pattern in economic
benefits. This is accounted for as a change in accounting estimate (i.e. adjusted
through current and future periods’ depreciation charge).

Management’s restatement of opening reserves is the treatment for a change in
accounting policy or the correction of an error (IAS 8 Accounting Policies, Changes
in Accounting Estimates and Errors). This is incorrect. The change in depreciation
method is a change in accounting estimate, which, by nature, is an approximation.
Tutorial note: The measurement basis “depreciated cost” has not changed.
The audit opinion should be qualified “except for” non-compliance with IASs 8 and
16 unless the write back to opening reserves is removed and the current year charge
is recalculated on the remaining useful lives (and not as currently calculated,
retrospectively, as though the new method had always been applied).
(ii)
Audit evidence

Agreement of opening balances of cost, accumulated depreciation and carrying
value to prior year working papers and financial statements.

Client’s schedules showing remaining useful lives with current year depreciation
calculated at 25% of brought forward reduced balance (25% cost on additions in the
period).
E

PL
Tutorial note: If Vema’s management was not prepared to provide these calculations, the
auditor would need to estimate what the correct depreciation charge for the current year
should be, to quantify the extent of their disagreement.
A “proof in total” calculation of what the depreciation charge for the year under the
new basis should be (i.e. 25% × (opening carrying amount + Additions – carrying
amount of disposals)).

Test checking a sample of remaining useful lives per client’s schedules to the fixed
asset register.

Review of Vema’s fleet vehicle replacement policy (e.g. as documented in an
operational manual for fleet managers).
SA
M

(b)

Review of age of fleet assets disposed of during the year – to check for consistency
with assertion that this is now every 4 to 7 years.

Scrutiny of profits/losses on disposals of vehicles – should expect to have
consistently reported profits if they are currently depreciated too quickly.
Termination payment
(i)
Matters

$786,000 represents 6·3% of profit before tax and is therefore material. (However,
it is not material to the statement of financial position; only 0·7% of total assets.)
Tutorial note: It is more meaningful to assess the effects of the gross amount on the financial
statements rather than the net payment to the former director.

Mr Z was made redundant in the previous accounting period (to 31 December 2012)
and the after-date payment, in March 2013, was therefore a subsequent event.

If the audit for the year ended 31 December 2012 was not finished when the
termination payment was made, it should have already been accounted for (i.e. the
liability recognised) in accordance with IAS 10 Events After the Reporting Period.

If the liability should have been known about, but was omitted from the prior year
financial statement, the error should be corrected by a restatement of opening
reserves.
1067

It is not unusual that such a “sensitive” transaction be accounted for using a journal
entry, rather than processed through a payroll, especially as Mr Z should have been
removed from the payroll last year.
Tutorial note: This avoids drawing staff’s attention to the payment.
The “golden handshake” has been “lost” in administrative expenses. Although it
may not be considered sufficiently material to warrant separate presentation in the
statement of comprehensive it appears sufficiently material to be presented
separately in the notes (IAS 1 Presentation of Financial Statements).

As a regional director Mr Z would have been a related party (key management
personnel), making the payment to him a related party transaction. The amount
should therefore be disclosed in the notes to the financial statements (IAS 24
Related Party Disclosures).

Whether the $194,000 included in “Other liabilities” represents the accurate
deduction of tax/social security contributions or a balance due to Mr Z.
(ii)
Audit evidence

Documentation in last year’s working papers concerning provisions made for
redundancies arising from the regional re-organisation.

The bank payment $592,000 in March 2013.

Settlement during the year to 31 December 2013 of $194,000. For example,
inclusion of this amount in payments of tax deducted at source/”pay as you earn”
and a notification of receipt from the relevant taxation authority.

Mr Z’s employment contract and director’s service contract, in which the terms of
the termination payment were set out.

Any correspondence with Mr Z. For example, a letter accompanying the payment
of $592,000 stating that it is in full and final settlement of the termination of his
employment.

Written management representation that there are no payments to current or former
directors relating to the current or prior period which have not been included in the
financial statements.
SA
M
PL
E

Tutorial note: A management representation supporting the assertion of completeness of
transactions and events.
(c)
1068
Legal liability
(i)
Matter

Although Weddell contributes a mere 3·2% of Vema’s profit before taxation, it
comprises 31% of total assets. The subsidiary is therefore material to the
consolidated financial statements.

The amount of the contingent liability disclosed is immaterial to Vema being 1·6%
of Vema’s profit before taxation and less than 0·2% of total assets.
Tutorial note: Although it is 50% of Weddell’s profit before taxation it may not be
considered material even in Weddell’s financial statements as it represents only 0·6% of the
company’s total assets. Materiality in relation to PBT is distorted because the company is
reporting a near break-even position.
The amount of the legal liability for costs and damages not provided for is material
to Vema, being 8·9% of Vema’s profit before taxation (and 1% of total assets). (It
is 3·2% of Weddell’s total assets and would turn its reported profit into a loss.)

The court’s verdict in February was an adjusting event – providing additional
evidence regarding the amount and likelihood of settlement of a liability. It should
therefore be adjusted for (i.e. the liability recognised).

The lodgement of an appeal is also an event after the reporting period – however it
is non-adjusting – arising from a condition (the court hearing) that did not exist at
the end of the reporting period.

As Weddell is a subsidiary it is, by definition, controlled by Vema and the
management of Weddell can be told to adjust the subsidiary’s financial statements.

If no adjustment is made in Weddell’s financial statements the auditor’s report
thereon should be qualified “except for” on grounds of disagreement about the
amount and nature of a liability (being actual rather than contingent).
PL
E

Tutorial note: Although this is not the responsibility of the group auditor – the component
auditor’s opinion is one source of evidence available to the group auditor.
If the amount is not adjusted in Weddell’s financial statements, an adjustment
should be made by Vema’s management on consolidation (otherwise the audit
opinion on the consolidated financial statements would need to be qualified “except
for” non-compliance with IAS 37 Provisions, Contingent Liabilities and Contingent
Assets).
SA
M

(ii)
Audit evidence

The official notification of the court’s ruling.

A copy of the appeal lodged with the court.

Legal advice regarding the possible success of the appeal.

Copy correspondence with legal advisers including a copy of the external
confirmation letter obtained by Weddell’s auditor.

Consolidation/reporting pack from Weddell and their local auditor’s report thereon
(if applicable).

The local firm’s auditor’s report on the financial statements of Weddell, when
available.
Tutorial note: This should be before the auditor’s report on Vema’s consolidated financial
statements is signed.
1069
SA
M
PL
E
1154
E
PL
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