Audit & Assurance

All Interactive Questions of Manual-PL

Mahabub Hasan
Cell: 01914-334043
 Chapter-01 Reintroduction to audit and assurance
Interactive question 1: Benefits of assurance

During the night of 7 June 20X3 strong gales caused the brick chimney of the factory to crash through
the roof of Hancock Ltd’s assembly area. Production was severely disrupted for a period of two months.
In addition to claiming from its insurers for the cost of repairing the premises and for the equipment and
inventories destroyed in the accident, the company is also including a considerable claim under the loss
of profits provision of its policy. The directors have prepared detailed calculations of the loss of profit
and have requested the company’s auditors to review this claim and provide an assurance report which
they will submit with it to the insurers.

Requirement
What advantages would the directors expect to gain from having this report?

Answer to Interactive question 1

Advantages of report regarding loss of profits:
• Independent opinion from external source
• Enhanced credibility of compilation of claim
• Confirmation that data subjected to review and examination
• Comfort to insurers that risk of inflated claim reduced
• Could accelerate processing of claim

Interactive question 2: Review and audit compared

The directors of Connelly Ltd are concerned about the reliability and usefulness of the monthly financial
management information that they receive. As a result, the company’s auditors have been engaged to
review the system and the information it generates, and to report their conclusions.

Requirement
Contrast this assignment with the statutory audit of the company’s financial statements with regard to
the scope of the assignment and to the report issued.

Answer to Interactive question 2

Scope
This assignment Statutory audit
Agree between parties In accordance with Companies Act 1994
Restricted to instructions In accordance with audit regulations
In accordance with ISAs

Report
This assignment Statutory audit
Addressed to board Addressed to members
Format wholly discretionary On true and fair view
Private report Format prescribed
Report in public domain
Interactive question 3: Benefits of an audit
Acrylics Ltd was established in June 20X0 to produce acrylic products which are used as display units in
the retail industry. The shares are owned equally by two executive and two non-executive directors.
The company’s revenue increased steadily over the first two years of trading. The results for the first year
of trading indicated an operating profit margin of 15%, and the management accounts for the second
year of trading indicate that this has increased to 18%. The directors are currently negotiating a contract
worth CU600,000 to supply a major retailer which has over 100 outlets throughout Bangladesh. The
company will require an increased overdraft facility to fulfil the order.
The finance director of Acrylics Ltd has prepared a business plan for submission to the company’s
bankers in support of a request for a larger overdraft facility. The plan includes details of the company’s
products, management, markets, method of operation and financial information. The financial
information includes profit and cash flow forecasts for the six months ending 31 December 20X2,
together with details of the assumptions on which the forecasts are based and the accounting policies
used in compiling the profit forecast. The company’s bankers require this financial information to be
reviewed and reported on by independent accountants.
Although the company’s revenue was below the threshold for a statutory audit for its first year of
trading, the company was required by its bankers to have an audit of its financial statements for the year
ended 30 June 20X1. Your firm conducted this audit in accordance with auditing standards and issued an
unqualified report.

Requirements
3.1 Describe the benefits, in addition to continuance of its overdraft facility, to the company and its
directors and shareholders from having an audit of its annual financial statements.

3.2 Explain how and why the level of assurance provided by a report on profit and cash flow forecasts
differs from the level of assurance provided by an auditor’s report on annual financial statements.

Answer to Interactive question 3

3.1 Benefits, additional to continuance of overdraft facility, of having an audit:
• Shareholders who are not involved in the day-to-day management of the company (non- executives)
will have assurance that their interests are protected (ie, company assets are not abused).
• Financial information is likely to be more reliable, resulting in more informed decisions.
• An audit improves a company’s governance – management benefits from:
(a) assurance that they are complying with their statutory responsibilities (including the prevention and
detection of fraud, as the audit may act as a deterrent);
(b) by-products of the audit, such as the identification of weaknesses and recommendations for
improvement; and
(c) reducing risks and improving performance
• An audit imposes financial discipline which is useful for growing companies.
• It may be easier to obtain credit, as suppliers and credit rating agencies regard the additional assurance
provided by an audit important.
3.2 How and why the level of assurance provided by a report on profit and cash flow forecasts differs
from the level of assurance provided by an auditor’s report on annual financial statements.
• An audit conducted in accordance with auditing standards provides a high level of assurance which is
reasonable but not absolute.
• The delay between the reporting date and the date of the auditor’s report means that even items such
as provisions/estimates can often be substantiated.
• A review of forecasts is only likely to provide a moderate level of assurance.
• This is because financial statements are based on historical information, and forecasts are based on
assumptions which are subject to uncertainty.

Interactive question 4: Examination of cash flow forecasts

Your firm has been engaged to examine the cash flow forecasts prepared by the management of a
company whose principal activity is the installation of electrical systems for customers in the retail,
construction and industrial sectors in Bangladesh.
All contracts are fixed-price. Customers pay 95% of the contract on completion of the work and withhold
5% of the contract price for up to six months from the date of completion in case remedial work is
required. The materials and components used are bought from suppliers who require payment within 30
days of the invoice date.
As a result of a significant fall in demand for its services the company has closed two of its regional
depots and put both premises up for sale. It has also made 25% of its employees redundant.
Requirements
4.1 Identify the specific matters you would consider when examining the assumptions underlying the
receipts and payments included in the company’s cash flow forecasts.

4.2 Explain the level of assurance that will be provided in your assurance report as a result of your
examination.

Answer to Interactive question 4

4.1 The following matters should be considered when examining the reasonableness of the
assumptions underlying the receipts and payments:
Receipts
Trading receipts reflect:
• Potential loss of business following the closure of the two depots
• 95% of the contract price is received on completion and 5% received six months later
• The fact that amounts due may not ultimately be paid
Receipt from sale of premises:
• Realistic proceeds from the sale of the two depots that reflect local property values Payments
• Payments for components and raw materials reflect the 30-day credit terms
• Taxes are paid on the due dates
• Redundancy payments are in accordance with legal/contractual obligations
• Ongoing wages reflect reduced workforce following the redundancies
• Any extra costs (eg, transportation costs) involved in servicing contracts from distant depots and a fall
in overheads after the sale of the two depots are reflected
• Professional costs (eg, legal and selling agent) involved with the sale of depots are included

4.2 An examination of cash flow forecasts is likely to provide only a moderate level of assurance. This
is because forecasts are based on assumptions which are subject to uncertainty.

Chapter-02 Responsibilities

Interactive question 1: Directors’ responsibilities

You are finalizing the audit of a company. The audit highlights memorandum indicates that the company
has failed to maintain proper books and records. This is because there is no non-current asset register
and it was not possible to draw up a register, as some of the invoices were missing. The director is
furious that the audit firm says this makes it impossible to give an unqualified audit opinion. They say
that the audit firm prepared the accounts and therefore it is simply a matter of the auditors’
incompetence.
Requirement
Explain the directors’ responsibilities in relation to the books and records of the company.

Answer to Interactive question 1

The director’s responsibilities include:
• keeping proper accounting records
• disclosing with reasonable accuracy at any time the financial position of the company
• ensuring that the financial statements comply with the Companies Act 1994

Interactive question 2: Review and audit compared

The directors of Connelly Ltd are concerned about the reliability and usefulness of the monthly financial
management information that they receive.
As a result, the company’s auditors have been engaged to review the system and the information it
generates, and to report their conclusions.

Requirement
Contrast this assignment with the statutory audit of the company’s financial statements with regard to
the scope of the assignment and to the report issued.

Answer to Interactive question 2

You should take the following steps
• Review and obtain photocopies of documents which have aroused her suspicions
• Enquire into reasons for altered pages in books/documents etc
• Investigate any apparent override/circumvention of company procedure eg, cancelling a sales invoice
instead of raising a credit note
• Review previous management letters for any weaknesses facilitating misappropriations
• Consider credit controller’s motives for putting chief accountant under suspicion eg, working
relationship/job threat
• Take note of chief accountant’s standard of living; make enquiries about their lifestyle
• Consider whether past dealings with chief accountant have ever cast doubt on their integrity
• Increase analytical procedures on revenue and receivables eg, monthly revenue/receipts of major
customers/extend circularization if trade receivables collection period has increased
• Discuss with engagement partner, who may wish to discuss with client (eg, board of directors)

Interactive question 3: Reporting fraud

During the course of the audit you discover that the wages clerk has been defrauding the client through
not deleting leavers from the payroll until two months after departure, and was pocketing the money
herself.
Requirements
What should you do with regard to:
3.1 Informing the client?
3.2 The auditor’s report?

Answer to Interactive question 3

3.1 You should:

• Report to appropriate level of management
• If you believe that management or employees with significant roles in internal control are involved or
fraud results in material misstatement in financial statements, report to those charged with governance
(eg, audit committee)
• If integrity/honesty of management or those charged with governance is in doubt, seek legal advice

3.2 You should:

• If error is corrected, no need to qualify opinion
• If no correction is made and the resulting misstatement is material, then the opinion should be
appropriately modified
Interactive question 4: Related party transactions -JA-24
The training partner in your office is aware that you have covered ISA 550, Related Parties in your
Professional Stage studies. They have asked you to help them prepare for a training session they are
about to give.
Requirements
Prepare notes for a training session for junior staff on how to identify related party transactions. Your
notes should include the following:
4.1 A list of possible features which would lead you to investigate a particular transaction to determine
whether it is in fact a related party transaction.
4.2 A summary of the general audit procedures you would perform to ensure that all material related
party transactions have been identified.
Answer to Interactive question 4
Notes for a training session for junior staff on how to identify related party transactions Purpose of the
training.

To assist junior staff in the application of IAS 24, Related Party Disclosures and ISA 550, Related Parties,
and specifically on how to identify related party transactions.
Related parties
IAS 24 defines related parties as individuals or entities (eg, companies) with more than a simple business
relationship with the client. This would be because they are directors, owners or major investors of the
client and can include family and close friends of the directors or owners.
At the start of each audit, you will be provided with an up-to-date list of known related parties. It is
important that if you come across any transactions involving these parties during the audit you should
record them on the audit file.

The directors should provide us with a complete list of these related party transactions. However, we
need to be certain that their list is complete, and by comparing the transactions you find with the list
from the directors we can obtain evidence as to its reliability.

General audit procedures

Unless we determine that the risk of non-disclosure of related party transactions is high, we gain a
significant amount of evidence needed from general audit procedures. These are listed in 4.2 below.
Additionally, they may intentionally or otherwise leave out certain transactions from the list they provide
and you therefore need to be aware of indicators of potential undisclosed related party transactions.
These are given in 4.1 below.
If you notice any such transactions, record them on the audit file. If there is a significant number of such
transactions, immediately ask the manager for specific guidance on what action to take.

4.1 List of possible features which would lead you to investigate a particular transaction to determine
whether it is a related party transaction.
• Transactions which have unusual terms of trade, eg, unusual prices, interest rates, guarantees and
repayment terms.
• Transactions which appear to lack a logical business reason for their occurrence.
• Transactions which are overly complex.
• Transactions which involve previously unidentified related parties.
• Transactions which are processed in an unusual manner.

4.2 Summary of the general audit procedures you would perform to ensure that all material related
party transactions have been identified.
• Obtain a list of current known related parties, eg, directors, other companies with common directors,
family members of directors, significant private company investments of directors, associate or joint
venture companies, key personnel and significant investors (>20%).
• Ensure that the permanent file is updated for related parties.
• If it is the first year of the audit perform company search; otherwise review statutory records to
confirm directorships, other directorships and significant investors.
• Discuss the list of related parties as disclosed by the directors as to its accuracy and completeness.
• Enquire of directors as to whether there have been any material transactions with the related party,
eg, loans, purchase or sale of assets, consultancy fees.
• List all transactions disclosed by the directors.
• Review the accounting records before and after the year end for any large or round sum amounts;
investigate and analyze with reasons.
• Analyze all loans receivable or payable, and seek confirmation of identity of lender or borrower.
• Review board minutes and enquire as to whether the company has provided any guarantees.
• Analyze the details of guarantees given and review the terms.
• Include confirmation of all related party transactions or lack of them within the letter of
representation.
• Check the accuracy of disclosure within the context of IAS 24.

Chapter-03 Professional standards

Interactive question 1: The Financial Reporting Council

What are the main functions of the Financial Reporting Council and by what bodies are those functions
carried out?

Answer to Interactive question 1

General objectives of the Council

• Determination of financial reporting and auditing professional standards, ethical standards, etc.;
• Qualitative standard development of accounting and auditing services;
• Development of accounting and auditing profession;
• Confirmation of highest standards of the financial reporting and auditing works of the scheduled
auditors;
• Enhancement of the credibility financial statements;
• Ensuring the morality, transparency of professional works of financial reporting and auditing and
cooperation in capacity building; and
• Encouraging Public Interest entities to produce high quality report of financial and non-financial
information.

Functional divisions of the Council

• Standards Setting Division;
• Financial Reporting Monitoring Division;
• Audit Practice Review Division; and
• Enforcement division.
 Chapter-04 Professional ethics

Interactive question 1: Fundamental principles

Set out the ethical fundamental principles which should be followed by members of the profession.

Answer to Interactive question 1

Members should:
• behave with integrity in all professional and business relationships
• strive for objectivity in all professional and business judgements
• not accept or perform work beyond own competence (unless obtain adequate advice and assistance)
• carry out work with due care, skill and diligence and follow expected technical and professional
standards
• respect the confidentiality of information acquired
• act professionally and comply with relevant laws and regulations

Interactive question 2: Fee income

Aitken and Waterman have been asked by a long-standing client, Lewis’s plc (a quoted company) to
perform a special assignment. This would take the total fees received by Aitken and Waterman from this
client to CU55,000. Gross practice income is CU500,000.
Requirement
Comment and reach a conclusion on the above situation.

Answer to Interactive question 2

Comments

• Total fee income received from Lewis plc > 10% of gross practice income of firm as a whole; therefore
there is a risk that perception will be that objectivity impaired
• Need to determine whether regular fees will exceed 5% threshold
Conclusion
Assignment may be accepted. Ethics partner should be consulted and those charged with governance
informed of the situation.
Interactive question 3: Threats to objectivity
Your firm is the auditor of Alpha Ltd and Beta Ltd.
(1) It provides quarterly VAT services to Alpha Ltd, which involves completing the VAT return for
submission by management from information extracted from the company’s records.
(2) It is also the auditor of Beta Ltd’s largest customer.

Requirement
What potential threats to objectivity do each of these situations pose to your firm, and what safeguards
should be in place to address them?
Answer to Interactive question 3
Alpha Ltd
Threats to objectivity and safeguards:
• Self-interest threat
• Self-review threat
• Firm may be susceptible to pressure for fear of losing work
• Lack objectivity when checking VAT
• Different staff should be used for VAT work and audit

Beta Ltd
Threats to objectivity and safeguards:
• Self-interest threat
• Advocacy threat
• Either company may be uncomfortable with arrangement and exert pressure
• Beta could exert pressure re your knowledge of customer
• Separate audit partners
• Separate audit teams

Interactive question 4: Confidentiality

You are in the middle of an audit with a tight deadline, the manager is due to visit you at the client
tomorrow and you need to be home early to meet the builders at your new flat. You are considering
taking the sales ledger and the cash book home with you to finish the trade receivables section ready for
the manager to review tomorrow.
Requirement
What must you consider before you remove any client files from their offices?

Answer to Interactive question 4

The auditor must obtain the client’s permission before removing any files from the client’s offices.
 Chapter-05 Quality management
Interactive question 1: Benefits of quality management procedures
Your manager has been asked to brief your department on the new system of quality management that
the firm has introduced. Your manager has asked you to prepare a list of the benefits of the system of
quality management in a firm, which he can use as part of his presentation.
Answer to Interactive question 1
The benefits of a system of quality management include:
• Standard of all audit work completed is high and consistent
• Registered auditors are regarded as professionals who follow standards
• Quality of the work completed can be measured against a standard
• Individuals within firms know if the work they have completed is acceptable
Interactive question 2: Quality management issues on an engagement- ND-24
You are an audit senior working for the firm Addystone Fish. You are currently carrying out the audit of
Wicker Ltd, a manufacturer of wastepaper bins. You are unhappy with Wicker’s inventory valuation
policy and have raised the issue several times with the audit manager. She has dealt with the client for a
number of years and does not see what you are making a fuss about. She has refused to meet you on
site to discuss these issues.
The former engagement partner to Wicker retired two months ago. As the audit manager had dealt with
Wicker for so many years, the other partners have decided to leave the audit of Wicker in her capable
hands.
Requirement
Comment on the situation outlined above.
Answer to Interactive question 2
Several quality management issues are raised in the scenario:
Engagement partner
An engagement partner must be appointed to each audit engagement undertaken by the firm, to take
responsibility for the engagement on behalf of the firm. Assigning the audit to an experienced audit
manager is not sufficient.
The lack of an audit engagement partner also means that several of the requirements of ISA 220, about
ensuring that arrangements in relation to independence and directing, supervising and reviewing the
audit, are not in place.
Conflicting views
In this scenario the audit manager and senior have conflicting views about the valuation of inventory.
This does not appear to have been handled well, with the manager refusing to discuss the issue with the
senior.
ISA 220 requires that the audit engagement partner takes responsibility for settling disputes in
accordance with the firm’s policy in respect of resolution of disputes required by ISQM 1. In this case,
the lack of engagement partner may have contributed to this failure to resolve the disputes. In any
event, at best, the failure to resolve the dispute is a breach of the firm’s policy under ISQM 1. At worst, it
indicates that the firm does not have a suitable policy concerning such disputes as required by ISQM 1.
Chapter-06 Accepting engagements
Interactive question 1: Disagreement with directors
You have recently had a serious disagreement with the directors of one of your major audit clients who,
as a result, have threatened to recommend another firm of auditors for appointment at the next AGM.
Requirement
What statutory rights do you have if they carry out their threat?

Answer to Interactive question 1

Rights:
• To receive notice of the resolution to appoint another auditor
• To have written representations circulated to all members, or read out at the meeting
• To attend the meeting
• To be heard at the meeting

Interactive question 2: Engagement letter

Mr Angry of Gonzo Animations Ltd has approached your audit firm to undertake the audit of his
company. When the partner held the initial meeting with Mr Angry, the client refused to sign the
engagement letter as he said that it was merely a means of the firm abdicating its responsibility for the
audit.
Requirement
Your partner has asked you to draft a letter to the client explaining the need for a letter of engagement.

Answer to Interactive question 2

Mr Angry
Engagement letters
We are required by International Standards on Auditing to send you a formal engagement letter before
conducting the audit. All firms of auditors should abide by this procedure.
The letter is there as much to protect the client, as it is the auditor, and we would suggest that legal
advice is taken prior to you accepting the terms.

Purpose of engagement letter

The purpose of the letter is to:
• define clearly the extent of our responsibilities, and your responsibilities
• minimize the possibility of any misunderstanding between ourselves and Gonzo Animations Ltd
• provide written confirmation of our acceptance of appointment, the scope of the audit and the form of
the report
We believe that it is important for both parties to clearly understand their roles within the external audit
function.

Contents of engagement letter

The contents of the letter are set out below, together, where necessary, with the justification of the
inclusion of the section.
• Our respective relevant statutory and professional responsibilities (to avoid misunderstanding).
• An explanation of the scope of the audit (so that we inform you of what we will do).

This covers a number of issues.

– The audit will be carried out in accordance with the International Standards on Auditing issued by the
Financial Reporting Council.
– We need to obtain an understanding of the accounting system in order to assess its adequacy as a
basis for the preparation of the financial statements.
– We need to obtain relevant and reliable evidence sufficient to enable us to draw reasonable
conclusions therefrom.
– The nature and extent of our procedures will vary according to the assessment of the accounting
system and, where we wish to place reliance upon it, the system of internal control.
– We will endeavor to plan the audit so that we have a reasonable expectation of detecting material
misstatements in the financial statements or accounting records resulting from fraud, error or non-
compliance with law or regulations but that the examination ought not to be relied upon to disclose all
frauds, errors or instances of non-compliance which may exist (as some may be immaterial).
– Due to the test nature and other inherent limitations of an audit, together with the inherent limitations
of any system of internal control, there is an unavoidable risk that even some material misstatement may
remain undiscovered.
– An explanation that management representations may be required in writing during the audit (this will
only be in the case of audit areas where we have to rely on your representations).
– The fact that we may send a letter of comment, adding value to the audit, by outlining ways in which
we discussed the business may be improved.
• Other matters such as:
– our billing arrangements
– any arrangements in the future concerning the involvement of:
-other auditors and experts
-internal auditors
-previous auditors
– management’s responsibility to detect and prevent fraud
– your complaints procedures
– a proposed timetable for the engagement (which will vary each year).
I hope this clarifies the need for the letter. Except for the timetable, we will only send out such letters in
future where absolutely necessary.
Yours sincerely
Accountant

Chapter-07 Planning
Interactive question 1: The need to plan
State the reasons why auditors need to plan audits.

Answer to Interactive question 1

Purpose of planning:
• To enable the audit to be performed in an effective and timely manner
• To ensure that:
– appropriate attention is directed to important areas of the audit
– potential problems are identified
– work is completed expeditiously
• Assists in:
– proper assignment of work to the team
– coordination of work done by others
• Facilitates review

Interactive question 2: Benefits and limitations of analytical procedures

Analytical procedures must be carried out at the planning stage of an audit to help identify risk are as
requiring extra work.
Requirement
Set out the benefits and limitations of using analytical procedures to identify risk areas during audit
planning.

Answer to Interactive question 2

Benefits:
• Identifies items for attention that detailed tests may miss
• Uses information outside accounting records, for example, budgets
• Allows comparison of data from different sources

Limitations:
• A good knowledge of the business is required to understand results
• Consistency of results may conceal a material error
• There may be a tendency to carry out procedures mechanically, without appropriate professional
skepticism
• Requires an experienced member of staff to be done properly
• Reliable data may not be available
 Chapter-08 Understanding the entity and its environment
Interactive question 1: Sources of information
From what sources of information can auditors obtain a knowledge of the entity they are about to audit
and the industry in which that entity operates?

Answer to Interactive question 1

Sources of information:
• Previous experience with entity and its industry
– Last year’s file/audit team
– Permanent file
– Tax file
– Correspondence file
• Visits to entity’s premises and plant facilities
• Discussion with people within entity
• Discussion with other auditors and with legal/other advisers who have provided services to the entity
or within the industry (eg, industry specialists)
• Publications related to the industry legislation and regulations that significantly affect the entity, eg,
industry surveys
• Industry publications such as trade journals
• Documents produced by the entity/entity website
• Companies House (RJSC) searches

Interactive question 2: What matters?

Auditors should use their knowledge of the business to assess the risks arising from fraud, error and non-
compliance with laws and regulations.
Requirement
What matters should they consider in making this assessment?
Answer to Interactive question 2
Non-compliance
• Previous experience
• Incidents which call into question integrity or competence of management or other staff, eg:
– Investigations
– Payment of fines/penalties
• Unusual transactions/payments
• Payments for/of
– Unspecified services/loans
– Excessive commission
• Unauthorised/improperly recorded transactions
• Accounting system which fails to provide adequate audit trail/sufficient evidence
• Adverse media comment
Fraud/error (ISA 240 Appendix 3)
• Discrepancies in the accounting records, eg:
– Incomplete recording of transactions
– Significant last-minute adjustments
• Conflicting or missing evidence, eg:
– Missing documents
– Unexplained items on reconciliations
• Problematic or unusual relationships between the auditor and management, eg:
– Denial of access to records or delays in producing information
– Complaints about the conduct of the audit
• Other, eg:
– Accounting policies at variance with industry norms
– Frequent, unnecessary changes in accounting estimates

Chapter-09 Risk assessment

Interactive question 1: Assessing the risks of material misstatement
Your firm has recently been appointed auditor of Trendy Products Ltd, a wholesaler of clothing and
fashion accessories geared to the younger market. You are responsible for planning the audit, and have
obtained the following background information.
The company imports most of its goods from manufacturers in the Far East. The suppliers issue invoices
in dollars, payable within 30 days. The finance director uses a mixture of forward exchange contracts and
spot purchases of dollars to pay these suppliers.
Most of the company’s customers are small retailers. However, the company has increased its sales by
50% in the last quarter due to a new contract to supply a large retailer. In order to secure this new
business, credit terms had to be relaxed from the standard 30 days to 60 days for this customer.
As a result of this expansion the company is finding it difficult to stay within its overdraft limit and is
currently negotiating with the bank to increase the facility.
The company recently upgraded its PC-based modular purchases, sales and nominal ledger systems to an
integrated system. The accounting package was supplied by a software company which had recently
commenced trading.
The software supplier assisted the company with the changeover from the old system to the new. As a
result, management decided that there was no need to involve the previous auditor or to have a parallel
run.
Mrs Evans is solely responsible for the input of data, but due to the changeover she is several weeks
behind with her work. She hopes to be up to date by the time of the audit as she intends to work
overtime to clear the backlog.
The company has introduced an incentive scheme under which the directors are entitled to a bonus on
achieving a certain level of profit. The bonus will be paid 30 days after the audited accounts are
available.
Requirement
Identify the factors that impact on audit risk in respect of the above matters, and state what effect these
would have on audit procedures.
Note: You should set out your answer in a two-column format using the headings ‘Risk factor’ and ‘Effect
on audit procedures’

Answer to Interactive question 1

Risk factor Effect on audit procedures
This is a new audit appointment. Accounting systems and internal controls need to
New appointment increases detection risk due to be ascertained.
lack of cumulative/prior knowledge from previous Current period audit work should have regard to
audits. the opening balances and comparatives. ISA 510
and ISA 710 will assist the auditor.
Trendy Products Ltd operates in the fashion Evaluate inventory count instructions for
industry. procedure to identify obsolete items.
The nature of the industry contributes to high Review post year-end order book to establish
inherent risk, as clothes and accessories do not adequacy of allowances to reduce inventory to
stay in fashion and year end allowances to reduce NRV.
inventory to NRV may be inadequate.
Most purchases are imported and paid for in Any gains and losses on dollar transactions/year-
dollars. end balances should be taken to the statement of
Inherent risk is increased by exposure to dollar profit or loss and monetary items should be
fluctuations. translated at the year-end rate.
Economic dependence on a principal customer. Having expanded to accommodate this customer,
Pressure from the new customer may increase ensure the going concern assumption remains
inherent risk. appropriate if the new contract is terminated.
The company is currently renegotiating its The auditor should review management
overdraft. assessment of going concern.
Deterioration of cash flows increases going The effect on liquidity ratios, debtor days etc,
concern risk, which will be made worse if the should be calculated and actions to remedy the
overdraft is withdrawn. cash flow problems discussed with directors.
The bank may seek to place reliance on the Particular attention should be given to bank
audited accounts before negotiations are overdraft/creditor cut-off; most likely areas of
finalized. misstatement and significant areas where
This increases risk as management have a motive judgement is involved, eg, provisions; and impact
to manipulate the accounts. of potential audit adjustments on key ratios.
The software company being used has only The level of audit testing of the new system is
recently commenced trading. likely to be higher than for an accounting package
Inherent risk may be increased by the with a good track record.
inexperience of the software company.
There is a potential risk that data transfer was The lack of proper accounting records may need
 inaccurate or incomplete. referring to in the auditor’s report.
If any significant problems with the changeover
are encountered then, in the absence of a parallel
run, proper accounting records may not have
been kept.
Human error is more likely if overtime working is Cut-off should be carefully reviewed as errors are
excessive, therefore inherent risk is increased. more likely if data processing is not up to date at
the year end.
There is a backlog of data input.
Human error is more likely if overtime working is
excessive, therefore inherent risk is increased.
The introduction of the incentive scheme may Extended checks and/or increased sample sizes to
cause management to overstate the profit. look for potential understatement of liabilities
and expenses, and overstatement of assets and
income.

Chapter-10 Audit approach

Interactive question 1: Reliance on controls

List the factors that you would consider in deciding at the planning stage of the audit whether to seek to
rely on internal controls as part of the audit.

Answer to Interactive question 1

The factors are:
• the approach that has been taken in previous years
• whether a substantive approach would be more effective
• the results of walk-through tests on the systems (that is, do the systems operate as the auditor
has been led to believe, if so, it may be possible to rely on internal controls)
• the results of preliminary evaluations of the effectiveness of the controls
• improvements made to the system of control (perhaps as a result of a management letter in
prior years)

Interactive question 2: Reliance on internal controls

In the course of planning an audit several internal controls in the company’s systems have been
identified. List the conditions that each control must satisfy if it is to be relied upon in reducing the
extent of substantive procedures to be performed.

Answer to Interactive question 2

The conditions are as follows:
• whether the controls have operated throughout the year
• whether the control has been evidenced and tested
• whether reliance on the control assists audit objectives, that is, whether it is relevant to the validity of
a financial statement assertion, such as that revenue is complete
• whether it is cost-effective to test controls
• whether the results of tests of controls are satisfactory
Interactive question 3: Bix plc
You are the senior auditor in charge of the audit of Bix plc, a manufacturing company. You have been
talking with the payroll supervisor who has commented on the strength of the company’s payroll internal
control system. She has assumed that this internal control system guarantees the completeness,
accuracy and validity of the payroll accounting records.
Requirements
3.1 State whether you agree with the supervisor’s assumption that an internal control system can
guarantee the completeness, accuracy and validity of the records, supporting your answer by using
examples from a payroll system.
3.2 The supervisor has also asked you to explain some internal control terminology which she does not
understand.
Explain the meaning of the following terms, using payroll examples different from those you have given
above.
(1) Segregation of duties
(2) Approval and control of documents

Answer to Interactive question 3

3.1 Supervisor’s assumption Objectives and limitations Completeness
To ensure that all workers who should be paid are included on the payroll:
• Payroll expense could be reconciled to production output records.
• Management could review exception reports of employees having personnel records but not included
on the payroll.
However,
Cost/Benefit
The expense of setting up computerized personnel records may outweigh the benefit to the company.
(Risk is of over payment as employees entitled to pay are likely to bring non-payment to management’s
attention promptly.)
Changes in conditions
A reduction in the ratio of production to support staff may limit the usefulness of production output
records as a basis of comparison.
Accuracy
To prevent errors in payroll deductions:
• Calculations of TAX, can be checked prior to processing.
• Non-statutory deductions (eg, pension contributions, union subscriptions) should require prior
authorization in writing.
However,
Human error/misunderstanding
Errors in deductions may not be detected, due to fatigue, distraction, misjudgment or misinterpretation.

Non-routine transactions
Systematic checking procedures may be directed at routine deductions (eg, TAX) rather than non-routine
transactions (eg, give as you earn, maintenance payments).
Validity
To ensure that employees are only paid for work done:
• Hours worked per time sheets (or clock cards) can be approved by a departmental manager (or
supervisor).
• The duties of payroll preparation and payment should be segregated.
However,
Abuse of override
Authorization could be given for a new employee to be added to the payroll without the proper checks
being carried out by the authorizer.
Collusion
The person responsible for paying wages could collude with the person responsible for accounting for
wages to perpetrate and conceal a theft of wages.

3.2 Internal control terminology

Segregation of duties
Meaning
Segregation of duties is a factor reflected in the control environment (the overall attitude, awareness and
actions of management regarding internal controls in the entity).
If one person has responsibility for the recording and processing of a complete transaction, they may
also have the power to falsify the records or to misappropriate money or assets without being
discovered.
Separation of these responsibilities will reduce the risk of intentional or unintentional errors occurring.
The functions that should normally be separated include authorization, execution, custody and
recording.
Examples
• Calculations of TAX and deductions should be reviewed and authorized by the payroll supervisor who
is not actually involved in performing the calculations.
• Unclaimed wages should be kept by someone (eg, the cashier) other than the person responsible for
recording payroll entries, otherwise there could be a temptation to falsify the figures and pocket some of
the wages.

Approval and control of documents

Meaning
Approval and control of documents is a specific control procedure (aimed at preventing or detecting and
correcting errors).
Approval is concerned with ensuring that transactions are properly authorized prior to execution.
Control of documents is aimed at ensuring that all, and only valid transactions, are promptly recorded.

Examples
• Overtime pay should be approved by a manager or director prior to payroll preparation, to ensure that
employees are paid at authorized rates.
• Clock cards should be batched and control totals established (eg, number of cards, total hours worked,
hash total of employee number) prior to submission to payroll department, to prevent (or detect for
early investigation) any omissions (or unauthorized insertions).
• The numerical sequence of forms for new joiners should be checked periodically to detect omissions
(or unauthorized insertions).
Interactive question 4: Substantive testing
King Ltd is a new audit client of your firm.
The finance director has attended a seminar on ‘Understanding how your auditors work’, and has come
away convinced that you will be able to rely on the internal controls within the company to reduce the
overall amount of work done.
Requirement
Identify the circumstances in which this approach may not be possible, leading you to undertake full
substantive testing.

Answer to Interactive question 4

Circumstances include:
• the auditor’s initial assessment is that controls are not strong
• there is a lack of evidence that controls are in operation
• the controls are tested and results show that the controls are not strong
• it is not cost-effective to test controls
Interactive question 5: Hydra Ltd
Your firm acts as auditor to Hydra Ltd, which manufactures and bottles non-alcoholic drinks in
Bangladesh under licence from a Swiss company.
Hydra Ltd has two products only: ‘Eau Vital’, a sparkling cold drink made from fruit juices, herbal extracts
and mineral water, and ‘Glowvine’, which is to be served hot, made from grape juices, herbs and spices.
Royalties are payable to the Swiss company, which is not related to Hydra Ltd, at the rate of 20p per
bottle of Eau Vital or Glowvine sold. Royalties are included in cost of sales, and Hydra Ltd expects to
make an average mark-up on total cost of 150% for Eau Vital and 120% for Glowvine.
To reflect environmental concerns the customer is charged a deposit of 10p, which is reimbursed on
return of the bottle. This scheme was introduced during the year. The theme of concern for the
environment is echoed in Hydra Ltd’s advertising, which emphasizes the natural ingredients.
The final audit is scheduled to commence in two weeks’ time. You have recently received a copy of Hydra
Ltd’s management accounts, which reflect the position for the current year.
2016 2017
‘000 ‘000
Revenue 3,280 1,876
Gross profit 1,940 1,042
Profit from operations 1,345 807
Requirements
5.1 Prepare a schedule that indicates the analytical procedures which would form part of your year- end
substantive procedures. Where relevant, suggest possible reasons for the changes between 20X6 and
20X5.
5.2 Explain what impact the new scheme involving deposits on bottles will have on the audit of liabilities
at the year end.
Answer to Interactive question 5
5.1 Analytical procedures and reasons for change:
Analytical procedures Possible reasons for change
Analyze revenue per product type by month A difference in the rate of increase would indicate
a switch from one product to the other. Seasonal
variations are expected as Glowvine is largely a
winter product and Eau Vital a summer product.
Analyse gross profit per product type by month GP margin has increased from 55.5% to 59.1%.
The higher margin indicates a move from
Glowvine to Eau Vital.
Analyse cost of goods sold per product type by Cost of goods sold only increased by 60.6%, while
month revenue increased by almost 75%. Again, a
possible reason could be the switch from one
product to the other. It does seem a
disproportionately small increase, especially as
royalties are included in cost of goods sold and
remain constant per bottle sold, regardless of
product. However, recycling of glass bottle
returns could account for the slower rate of
increase.
Analyse distribution and administrative costs into: These have increased by 153%, contributing to
the fall in net profit margin from 43% to 41%. The
increase in these costs could have been caused
by:
Administrative cost (especially deposit scheme) Implementation of the deposit scheme (unlikely
to account for the whole increase as not
operational for the whole year)
Advertising costs Increased advertising costs to promote the
deposit scheme and ‘environment friendly’
nature of the products (this could also increase in
revenue)
Transport costs Increased transport costs in proportion to the
75% increase in revenue
 Labor costs Increased labor costs, again in proportion to the
rise in revenue
Analysis of nature, valuation and consistency of The disproportionately smaller increase in cost of
treatment of closing inventories. Compare with goods sold could be caused by an error in the
inventories held at end of previous years. The counting or valuation of closing inventories,
disproportionately smaller increase in cost of causing them to be overstated and thus cost of
goods sold could be caused by an error in the goods sold reduced.
counting or valuation of closing inventories,
causing them to be overstated and thus cost of
goods sold reduced.
5.2 Impact of deposit scheme on audit of liabilities
Liabilities at the 20X6 year-end will have increased, as this is the first year in which the scheme has been
implemented. This should be evident in analytical procedures on sundry payables.
The amount may be material as the number of bottles sold and not returned per annum could be high.
It is necessary to ascertain and evaluate the client’s procedure for recording:
(1) the number of bottles (or cases) sold
(2) the number of bottles returned
(3) the number outstanding
As this is the first year of the scheme there will be no opening liability to provide added assurance.
Consideration should be given to the length of time the client intends to keep the provision in place. It
may be that, each year, the previous year’s provision can be written back.
Because of the uncertainty in calculating the liability required and the fact that the final figure may rest
on an estimate of the number of bottles likely to be returned, the auditor’s main concern will be that
liabilities are not understated.
The auditor therefore needs to be satisfied that returns are recorded with reasonable accuracy.
Records of returns will be received from retailers (mainly supermarkets and off-licences) and the auditor
will need to be satisfied that the client can reasonably rely on these records.
Since the retailers will be requesting a refund of money paid by them with the returns, there is a risk that
the number of returns may be overstated.
In summary, the principal impact on the audit of liabilities will be:
(1) an additional year end liability in 20X6
(2) uncertainty in the calculation of the liability, and therefore
(3) the risk that this liability may be understated

Interactive question 6: Using the work of internal audit

You are currently involved in planning the audit of Midget Ltd. At the beginning of the year that you are
auditing, the company set up an internal audit department, and this is the first visit since you were
aware of its existence. From your initial discussions with the managing director, you have established
that Mrs Gnome, the internal auditor, has undertaken a number of assignments across the company, and
fed back to the board on her findings.
Requirement
What factors should you take into account when considering whether you can rely on the work
undertaken by Mrs Gnome and her staff?

Answer to Interactive question 6

You should take into account the following factors:
• The objectivity of the department, including its freedom from conflicting responsibilities and the level
of management it reports to. In this case, you know that Mrs Gnome reports directly to the board of
directors, so the department has an important status in the company. You would also consider whether
there is any limitation on the assignments carried out, and to what extent recommendations are acted
upon by management.
• The competence of the people carrying out the work. In this case it would be necessary to inquire
about the competence of Mrs Gnome; for example, is she a qualified accountant? It would also be
necessary to identify the other members of the internal audit team (if there are any) and assess their
competence as well.
• The application of a systematic and disciplined approach. The external auditors should review the work
carried out by the internal auditors to check that it was documented in the first place, and to assess
whether it was planned and whether there is evidence of its being supervised and reviewed.
• Communication with external audit. You would need to enquire what arrangements have been put in
place to enable internal audit to communicate freely and effectively with external audit.
Interactive question 7: Extensions plc
Extensions plc is a retailer of fashion accessories. It has revenue of CU54 million and 150 shops
throughout the Bangladesh. It also has six regional warehouses from which the shops are supplied with
goods.
The company has an internal audit department which is based at the company’s head office in Dhaka.
Internal auditors make regular visits to the shops and warehouses.
This is the first year that your firm has acted as auditor for Extensions plc. The partner in charge of the
audit has expressed his opinion that the internal audit department might be able to assist the external
audit team in carrying out its work.
Requirements
7.1 State, with reasons, the information that you would require to make an assessment of the likely
effectiveness and the relevance of the internal audit function.
7.2 Describe four typical procedures that might be carried out by the internal auditors during their visits
to the shops and warehouses, and on which you might wish to rely.
7.3 Assuming that you intend to rely on the work of the internal audit department of Extensions plc,
describe briefly the effect this will have on your audit of the company’s financial statements.
Answer to Interactive question 7
7.1 Information for assessment and reasons:
Information Reasons
The organisational status and reporting The degree of objectivity is increased when
responsibilities of the internal auditor and any internal audit:
constraints and restrictions thereon. is free to plan and carry out its work and
communicate fully with the external auditor has
 access to the highest level of management
Areas of responsibility assigned by management Not all areas in which internal audit may operate
to internal audit, such as review of: will be relevant to the external auditor. (Relevant)
Accounting systems and internal controls (Not relevant)
Implementation of corporate plans
Routine tasks carried out by internal audit In these respects, staff are not functioning as
staff such as authorisation of petty cash internal audit (simply as an internal control).
reimbursements

Internal auditor’s formal terms of reference Internal auditor’s role will be most relevant
where it has a bearing on the financial statements
and involves a specialization.
Internal audit documentation such as an It is more likely that due professional care is being
audit manual and audit plans exercised where the work of internal
audit is properly planned, controlled, recorded
and reviewed.
Professional membership and practical Unless internal audit is technically competent it is
experience (including computer auditing skills) of inappropriate to place reliance on it.
internal audit staff
Internal audit reports generated and How the company responds to internal audit
feedback thereon findings may be regarded as a measure of the
department’s effectiveness.
Number of staff, computer facilities and any The effectiveness of internal audit (and hence
other resources available to internal audit the reliance placed thereon) will be limited if
the department is under-resourced.

7.2 Typical procedures (four only)

Inspection of tangible non-current assets
Assets seen at the warehouses (eg, delivery vehicle fleet) should be noted and subsequently agreed to
the fixed asset register maintained at head office (HO). Assets recorded in the register (eg, shop fixtures
and fittings) should be selected for inspection prior to visits to ensure their existence.

Attendance at inventory counts

Periodic counts (eg, monthly) should be attended:
• on a rotational basis
• at warehouses and larger shops
to ensure adherence to the company’s procedures. Test counts should be made to confirm the accuracy
and completeness of the inventory counts.

Cash
Cash counts should be carried out on cash register takings (and petty cash floats) whenever shops (and
warehouses) are visited on a ‘surprise’ basis.
Goods dispatch
Internal control procedures should be observed to be in operation, for example, to ensure that all
dispatches are documented and destined for the company’s retail outlets.
Employee verification
Payroll procedures are likely to be carried out at HO, warehouses and shops informing HO on a weekly
basis of hours worked by employees, illness and holiday etc. However, new employees, especially in the
shops (and probably also in the warehouses) will be recruited locally and their details notified to HO.
Internal audit will be able to select a sample of employees from HO records and ensure on their visits to
shops and warehouses that these represent Bonafide employees.

7.3 Effect on audit

Systems documentation
The accuracy of systems documentation which has been prepared by internal audit need only be
confirmed using ‘walk-through tests’. This saves time (if the systems documentation is correct) since only
copies will be required for the audit file.
Tests of controls
The level of independent testing (ie, by the external auditor) can be reduced where controls have been
satisfactorily tested by internal audit, especially if error rates are found to be similar. In particular,
attendance at stocktaking at the year-end may be limited to those locations with the highest
stockholdings.
Substantive procedures
Internal audit’s evidence (eg, concerning the existence of tangible non-current assets) will reduce sample
sizes for year-end verification work. Substantive procedures may also be reduced where the internal
audit checks reconciliations (eg, bank reconciliations).

Interactive question 8: Using the work of other auditors

You are the group auditor of Golden Holdings plc, a listed company, which has components in the UK and
overseas, many of which are audited by other firms. All components are involved in the manufacture or
distribution of metal goods and have the same accounting period as Golden Holdings plc.

Requirement
Outline why you would wish to review the work of the auditors of components not audited by your firm
and detail the work you would carry out in that review.

Answer to Interactive question 8

Reasons for reviewing the work of other auditors

The main consideration which concerns the audit of all group accounts is that the parent company’s
auditors are responsible to the members of that company for the audit opinion on the whole of the
group financial statements.
It may be stated (in the notes to the financial statements) that the financial statements of certain
components have been audited by other firms, but this does not absolve the parent company auditors
from any of their responsibilities.
The auditors of a parent company have to report to its members on the truth and fairness of the view
given by the financial statements of the company and its components dealt with in the group financial
statements. The auditors should have powers to obtain such information and explanations as they
reasonably require from the components and their auditors, or from the parent company in the case of
overseas components, in order that they can discharge their responsibilities as parent company auditors.
The auditing standard ISA 600 clarifies how the group engagement team can carry out a review of the
audits of components in order to satisfy themselves that, with the inclusion of figures not audited by
themselves, the group financial statements give a true and fair view.
The scope, standard and independence of the work carried out by the auditors of components (the
component auditors) are the most important matters which need to be examined by the group
engagement team before relying on financial statements not audited by them. The group engagement
team need to be satisfied that all material areas of the financial statements of components have been
audited satisfactorily and, in a manner, compatible with that of the group engagement team’s
requirements.

Work to be carried out by group engagement team in reviewing the component auditors’ work
(a) Before commencing the audit, the group engagement team needs to provide instructions to the
component auditor in the form of an engagement letter which should include the following matters
relating to planning the audit work:
• confirmation that the component auditor will cooperate with the group engagement team
• timetable for completing the audit
• dates of planned visits
• key contacts
• work to be performed by the component auditor
• ethical requirements
• component materiality levels
• details of related parties
• work to be performed on intra-group transactions
• guidance on statutory reporting responsibilities
• specific instructions for a subsequent events review where required
(b) Carry out a detailed review of the component auditors’ working papers on each component whose
results materially affect the view given by the group financial statements. This review will enable the
group engagement team to ascertain whether (inter alia):
• An up-to-date permanent file exists with details of the nature of the component’s business, its staff
organization, its accounting records, previous year’s financial statements and copies of important legal
documents.
• The systems examination has been properly completed, documented and reported on to management
after discussion.
• Tests of controls and substantive procedures have been properly and appropriately carried out, and
audit programs properly completed and signed.
• All other working papers are comprehensive and explicit.
• The overall review of the financial statements has been adequately carried out, and adequate use of
analytical procedures has been undertaken throughout the audit.
• The financial statements agree in all respects with the accounting records and comply with all relevant
legal requirements and accounting standards.
• Minutes of board and general meetings have been scrutinized and important matters noted.
• The audit work has been carried out in accordance with approved auditing standards.
• The financial statements agree in all respects with the accounting records and comply with all relevant
legal and professional requirements.
• The audit work has been properly reviewed within the firm of auditors and any laid down quality
management policies and procedures adhered to.
• Any points requiring discussion with the parent company’s management have been noted and brought
to the group engagement team’s’ attention (including any matters which might warrant a qualification in
the auditor’s report on the component company’s financial statements).
• Adequate audit evidence has been obtained to form a basis for the audit opinion on both the
components’ financial statements and those of the group.
If the group engagement team are not satisfied as a result of the above review, they should arrange for
further audit work to be carried out either by the component auditors on their behalf, or jointly with
them. The component auditors are fully responsible for their own work; any additional tests are those
required for the purpose of the audit of the group financial statements.

Interactive question 9: Estimated allowances

Explain how the auditor would approach the audit of an allowance for receivables.

Answer to Interactive question 9

Audit approach
• Review the requirements of the appropriate financial reporting framework for allowances for
receivables.
• Discuss with management how the allowance has been calculated.
• Obtain a breakdown of the allowance, agree balances to the receivable’s ledger and reperform
calculations.
• Compare actual receivables written off in prior periods with previous estimates.
• Ascertain who is responsible for reviewing and approving the allowance.
• Obtain an aged listing of receivables as at the reporting date and identify overdue amounts and review
correspondence relating to these accounts and arrive at an independent estimate of the allowance
required.
• Compare this with management’s estimate.
• Review cash received from customers after the reporting date up to the date of the auditor’s report to
identify whether any receivables balances that appeared to be doubtful have subsequently been settled.

Chapter-11 Audits of different types of entity

Interactive question 1: Links Famine Relief
You have recently been appointed to audit Links Famine Relief, a small registered charity which receives
donations from individuals to provide food in worldwide famine areas.
The charity is run by a voluntary management committee, which has monthly meetings, and it employs
the following full-time staff:
(1) A director, Ms Roberts, who suggests fund raising activities and payments for relief of famine, and
implements the policies adopted by the management committee; and
(2) A secretary (and bookkeeper), Ms Beech, who deals with correspondence and keeps the accounting
records. Links Famine Relief is required by its constitution to have an annual external audit of its financial
statements.
You are planning the audit of income of the charity for the year ended 5 April 20X7 and are considering
the controls which should be exercised over income.
The previous year’s accounts, to 5 April 20X6 (which have been audited by another firm) show the
following income.
Tk TK
Gifts under non-taxing arrangements 15,335
Tax reclaimed on gifts under non-taxing arrangements 4,325
19,660
Postal donations 63,452
Autumn Fair 2,671
Other income
Legacies 7,538
Bank deposit account interest 2,774
10,312
96,095

Notes
1 Income from gifts under non-taxing arrangements is stated net. Each person who pays by gift aid has
filled in a special tax form, which is kept by the secretary, Ms Beech.
2 All gifts under non-taxing arrangements are paid by banker’s order – they are credited directly to the
charity’s bank account from the donor’s bank. Donors make their payments by gift aid either monthly or
annually.
3 The tax reclaimed on these gifts is 28.2% (22/78) of the net value of the gifts, and relates to income
received during the year – as the tax is received after the year end, an appropriate amount recoverable is
included in the balance sheet. The treasurer, who is a voluntary (unpaid) member of the management
committee, completes the form for reclaiming the income tax, using the special tax forms (in Note 1
above) and checks to the full-time secretary’s records that each donor has made the full payment in the
year required by the arrangement.
4 Donations received through the post are dealt with by Ms Beech. These donations are either cheques
or cash (bank notes and coins). Ms Beech prepares a daily list of donations received, which lists the
cheques received and total cash (divided between the different enominations of bank note and coin).
The total on this form is recorded in the cash book.
She then prepares a paying-in slip and banks these donations daily. When there is a special fund-raising
campaign, Ms Beech receives help in dealing with these donations from voluntary members of the
management committee.
5 The Autumn Fair takes place every year on a Saturday in October. Members of the management
committee and other supporters of the charity give items to sell (for example food, garden plants,
clothing). A charge is made for entrance to the fair and coffee and biscuits are available at a small charge.
At the end of the fair, Ms Beech collects the takings from each of the stalls, and she banks them the
following Monday.
6 Legacies are received irregularly, and are usually sent directly to the director of the charity who gives
them to Ms Beech for banking. They are stated separately on the daily banking’s list (in note (4) above).
7 Bank deposit account interest is paid gross of income tax by the bank, as the Links Famine Relief is a
charity.
Requirement
List and briefly describe the work you would carry out on the audit of income of the charity, the controls
you would expect to see in operation and the problems you may experience for the following sources of
income, as detailed in the statement of profit or loss above:
(1) Gifts under non-taxing arrangements
(2) Tax reclaimed on gifts made under non-taxing arrangements
(3) Donations received through the post
(4) Autumn Fair

Answer to Interactive question 1

The audit consideration in relation to the various sources of income of the Links Famine Relief charity
would be as follows:
(1) Gifts made under non-taxing arrangements
This type of income should not present any particular audit problem as the donations are made by
banker’s order direct to the charity’s bank account and so it would be difficult for such income to be
‘intercepted’ and misappropriated.
Specific tests required would be as follows:
(a) Check a sample of receipts from the bank statements to the cash book to ensure that the income has
been properly recorded.
(b) Check a sample of the receipts to the special tax forms to ensure that the full amount due has been
received. Any discrepancies revealed by either of the above tests should be followed up with Ms Beech.
(2) Tax reclaimed on gifts made under non-taxing arrangements
Once again, this income should not pose any particular audit problems. The auditors should check the
claim form submitted to the tax authorities.
(3) Donations received through the post
There is a serious problem here as the nature of this income is not predictable and also because of the
lack of internal check with Ms Beech being almost entirely responsible for the receipt of these monies,
the recording of the income and the banking of the cash and cheques received. The auditors may
ultimately have to express a qualified opinion relating to the uncertainty surrounding the completeness
of income of this type.
Notwithstanding the above reservations, specific audit tests required would be as follows:
(a) Check the details on the daily listings of donations received to the cash book, bank statements and
paying-in slips, ensuring that the details agree in all respects and that there is no evidence of any delay in
the banking of this income.
(b) Check the donations received by reference to any correspondence which may have been received
with the cheques or cash.
(c) Consider whether the level of income appears reasonable in comparison with previous years and in
the light of any special appeals that the charity is known to have made during the course of the year.
(d) Carry out, with permission of the management committee, surprise checks to vouch the
completeness and accuracy of the procedures relating to this source of income.
(4) Autumn Fair
Once again there is a potential problem here because of the level of responsibility vested in one person,
namely Ms Beech.
Specific work required would be as follows:
(a) Attend the event to observe the proper application of laid down procedures and count the cash at
the end of the day.
(b) Check any records maintained by individual stall holders to the summary prepared by Ms Beech.
(c) Check the vouchers supporting any expenditure deducted from the proceeds in order to arrive at the
net bankings.
(d) Agree the summary prepared by Ms Beech to the entry in the cash book and on the bank statement.

Chapter-12 Audit completion

Interactive Question-01 Opening balances
Your firm has just been appointed auditors of Cross Ltd after the previous auditors were removed
following a dispute with the directors. This dispute related to certain costs capitalized by the directors,
which the auditors believed should have been written off. (Last year’s auditor’s report was qualified
because of the disagreement.)
Requirement
State the procedures you would carry out regarding the opening balances.

Answer to Interactive question 1

Regarding all opening balances:
• check prior year closing balances have been correctly brought forward;
• where appropriate, restated;
• consider impact of current year work on opening balances (eg, irrecoverable debts write off in current
year compared to opening allowance); or
• review management’s working papers, accounting and internal control systems for prior year.
For capitalized costs:
• Agree amounts capitalized to supporting documentation (to confirm amount)
• Discuss with previous auditors the reason for the qualification
• Decide whether opening balances need amendment

Interactive question 2: Gamston Burgers plc- JA-24

You are the auditor of Gamston Burgers plc, whose principal activities are haulage and warehousing
services and the repair of lorries.
During the current year the company has suffered a significant fall in revenue and gross profit, which has
led to a trading loss. The company is also experiencing cash flow problems.
You have been informed by the managing director that the fall in revenue is due to:
• the loss, half way through the year, of a long-standing customer to a competitor
• a decline in trade in the lorry repair business
Due to the reduction in the repairs business the company has decided to close the workshop and sell the
inventory of equipment and spares.
During the year the company replaced a number of vehicles, funding them by a combination of leasing
and an increased overdraft facility. The facility is to be reviewed early next year after the audited
accounts are available.
The draft accounts show a loss for the current year but the forecasts indicate a return to profitability in
20X6, as the managing director is optimistic about generating additional revenue from new contracts.
Requirements
2.1 Explain why an auditor attaches so much importance to considering an entity’s ability to continue as
a going concern.
2.2 Describe the audit work you would undertake in order to ascertain whether Gamston Burgers plc is a
going concern.
2.3 Explain the effect on your auditor’s report on the financial statements of Gamston Burgers plc if you:
(1) agree with the director’s assertion; and
(2) conclude that trading conditions will not improve.
Answer to Interactive question 2
2.1 Importance of going concern
(1) The ‘Going concern basis of accounting’ is an accounting concept. It is presumed to apply to any
financial statements, unless contrary disclosure is given.
(2) The amount at which assets and liabilities are included in the statement of financial position may be
significantly different where the company is not a going concern. For example: – Assets will be valued on
a break-up basis. – Additional provisions (eg, for closure costs) may be required.
(3) The classification of items will differ where financial statements reflect a break-up basis. For example,
non-current assets/liabilities reclassified as current.
(4) The risk of failure is a real threat to many businesses and the failure of the auditor to give any
warning may result in litigation/adverse publicity.
2.2 Audit work regarding going concern
To ascertain whether Gamston Burgers plc can meet its debts as they fall due:
(1) Obtain a written statement (management representation) from the managing director confirming
their considered view that the company is a going concern.
(2) Review management’s profit and cash flow forecasts for the next financial year to ascertain, inter alia,
the company’s working capital requirements.
(3) Confirm the appropriateness of relevant assumptions (eg, average trade receivables collection
period) by comparison with ratios obtained from analytical procedures.
(4) Request a statement of borrowing facilities to be included in the bank confirmation letter.
(5) Review the day-to-day utilisation of the bank overdraft facility and its proximity to the current limit.
(6) Obtain a loan confirmation from the leasing company and confirm that all instalments to date have
been met.
(7) Discuss with the credit controller (or financial accountant) the current pressures under which
the company is being placed by larger customers who may be seeking extended credit terms.
(8) Undertake sensitivity analysis on client’s forecasts to variable factors both within the managing
director’s control and outside it.
(9) Review the level of trade and other payables (including VAT and TAX and whether any
penalties are being incurred) after the reporting date and the extent to which they are financing short-
term needs.
To ascertain whether Gamston Burgers plc can otherwise continue in business (ie, return to profitable
trading):
(1) Obtain a copy of tenders submitted/correspondence to date concerning any new contracts currently
being negotiated and monitor all subsequent developments.
(2) Review drivers’ logs, reports on warehouse utilization etc, and discuss with management how current
spare capacity will be utilised by new contracts obtained.
(3) Review the terms of the contract with the long-standing customer which was lost and the grounds on
which it was lost to a competitor.
(4) Verify reasonableness of estimates arising from closure of workshop (eg, concerning costs of external
servicing of the transport vehicle fleet).
(5) Obtain written confirmation from the company’s legal adviser as to whether or not there are any
pending legal claims (eg, in respect of inventory losses from warehouses, late deliveries, damage to
goods in transit etc).
2.3 Agree with director’s assertion
If doubt surrounding the going concern status of the company is minimal, disclosure in the financial
statements would not be required in order to give a true and fair view. The auditor’s opinion would
therefore be unqualified. The report would still, however, need to contain a section headed ‘Conclusions
relating to Going Concern’ in which the auditor would state that they are required to report by exception
in relation to going concern, and have nothing to report in relation to this.
If the branch is so material that its inability to trade could affect the going concern status of the company
(unlikely), the matter should be disclosed in the financial statements. If adequate disclosure is made in
the financial statements, the auditor should express an unqualified opinion but modify their report by
adding a paragraph headed ‘Material Uncertainty Related to Going Concern’ that:
• highlights the existence of a material uncertainty relating to the event or condition that may cast
significant doubt on the company’s ability to continue as a going concern
• draws attention to the note in the financial statements that discloses these matters Disagree with
director’s assertion
The form of auditor’s report will depend upon the materiality of the branch and extent to which the
uncertainty has been disclosed in the financial statements.
As the director appears confident about the future of this branch, it is unlikely that adequate (if any)
disclosure has been made. The auditor’s opinion would therefore be qualified on the grounds of material
misstatement due to the inadequate disclosure of the uncertainty.
Interactive question 3: Subsequent events review
You are the auditor of Weekly Ltd, which derives half its revenue from sales to one large national
company. During your audit you notice that the sales ledger balance of this customer has nearly doubled
during the year, although sales to it have increased only marginally.
Requirement
Note down the main elements of your subsequent events review programme relating to this receivable
balance.
Answer to Interactive question 3
Main elements:
• Monitor post year end customer receipts (to confirm recoverability)
• Review of customer correspondence (to ascertain problem, eg, dispute)
• Calculation of trade receivables collection period, by month, after year end (to determine whether
situation is deteriorating further)
• Consider likely effectiveness of any reservation of title clause/other security (to assess possible extent
of recovery if customer liquidated)
• Review latest available audited accounts of customer (for indications of GC problems)
• Review level of post year-end sales and orders (to determine whether situation is continuing
unchecked)

Chapter 13 Reporting
Interactive question 1: Mouse and Ratty Ltd
You are currently undertaking an assurance engagement for Mouse and Ratty Ltd, a large firm of PR
consultants in Leeds.
During the course of the work, you have found a number of issues on which you need to report.
These can be summarized as follows:
(1) You have found a total of CU18,000 of unauthorized expenditure on IT equipment. Any IT
expenditure in excess of CU150 has to be authorized by a director.
(2) The IT expenditure for the year is 65% in excess of budget. There does not appear to have been an
investment project which was not budgeted for. There seems to be little reason for the rise.
(3) Large sums for travelling expenses are not being authorized when in excess of nightly limits set. Four
executives spent a total of CU25,000 in excess of nightly limits throughout the year.
(4) When examining work in progress, it became clear that there were sums which have been there for
more than six months without being billed. These total CU56,000. There appears to be no explanation
for this.
(5) When overtime forms are submitted, any amounts of more than three hours per month need to be
authorized. This is rarely done. The company paid out CU180,000 in unauthorized overtime.
(6) There are no controls over non-chargeable time. The proportion of non-chargeable time for
individual executives varies from 5% to 34%.

Requirement
Identify the following:
(1) The internal control deficiencies arising from the above
(2) The risks to which each identified deficiency exposes the company
(3) Actions that the company should take to mitigate those risks
Answer to Interactive question 1
(1) Deficiency (2) Risks arising (3) Action to mitigate
There has been a breakdown of That IT expenditure is Purchasing department to be
controls over expenditure. uncontrolled and investment is warned that no IT expenditure
not always clearly for the should be incurred without
benefit of the company. authorization; otherwise,
disciplinary action could result.
Excessive amounts are being IT expenditure is not planned IT expenditure must only be
spent on IT, adversely affecting properly, which means that undertaken under the budget,
profit. investment may not be as unless authorized by two
beneficial as it should be. directors. Also, if additional
investment is required the
budget should be flexed.
Travelling expenses in some Loss of profits due to excessive Travelling expenses should not
cases are excessive, with expenditure. be reimbursed when limits are
CU25,000 being spent in excess exceeded, unless the prior
of set limits. consent of two directors has
been received. The executives
involved need to be informed of
the problem.
Work-in-progress is not always Items involved are not Monthly billing meetings should
being billed on a timely basis. being billed. This has an be held at director level and
This is to the extent that adverse effect on cash within teams, where they
CU56,000 has been held for flow, and eventual recovery should be told that any amounts
more than six months. may be difficult. more than two months’ old
must be billed.
The authorization controls on Excessive costs, adversely Overtime over one hour per
overtime are not being affecting profits. week should be authorized prior
exercised. This has resulted in to the work being undertaken,
the company paying CU180,000 and should then be authorized
 of excess overtime. Some may once the time sheet is
be genuine, but controls will submitted.
reduce this amount.
There is no control over non- With some staff, an excessive Individual staff to be set targets
chargeable time. This leads to a amount of the time that they for non-chargeable time,
variable amount of non- are spending at work is not depending on their other
chargeable time by executives. being charged to clients, thus responsibilities. Adherence to
This varies from 5% to 34%. having an adverse effect on their targets must be
revenue, and hence profits. monitored.
Interactive question 2: Auditor’s report
You are the auditor of Purity Ltd, a manufacturer of water filters for domestic use. The company
headquarters are in Wapping but it also has 10 regional branches to organize the sales effort in each
geographical area.
Head office issued instructions for all inventories to be counted at the year end. However, due to an
administrative error, the new branch in Newcastle did not receive any instructions and no physical
inventory count took place. The inventories were material, estimated at CU50,000 and included in the
financial statements. No alternative procedures could be applied.
Requirements
2.1 How will your auditor’s opinion be modified?
report?

Answer to Interactive question 2

2.1 The opinion will be qualified on the grounds of an inability to obtain sufficient appropriate
audit evidence, because:
(1) Matter is material but not so pervasive.
(2) Scope of the audit has been limited.

Interactive question 3: Modifie auditor’s report

An auditor is considering possible modification of their auditor’s report on the financial statements of
three separate companies.
(1) Watkins Ltd is being sued by a customer for material damages. Legal opinion is divided as to the
outcome of the case, and all relevant information has been included in the notes.
(2) Pope Ltd suffered a flood at its head office and a significant number of accounting records have been
destroyed.
(3) Tilden Ltd has included an allowance for receivables of CU100,000 in the financial statements.
Obviously, the allowance cannot be estimated with complete accuracy but the reporting partner believes
it should be materially higher.
Requirement
Recommend, giving reasons, whether the opinion should be modified in each case.

Answer to Interactive question 3

Recommended opinion Reasons
 Unmodified opinion but modified auditor’s report Significant uncertainty, properly disclosed, does
by an emphasis of matter paragraph regarding not require a modification
the legal case if considered significant
Modified opinion – probably disclaimer Loss of records results in limitation of scope
‘Significant number’ implies that auditors will
probably be unable to form an opinion
Modified opinion – ‘except for’ Audit partner disagrees with size of allowance
necessary Problem limited to one area – unlikely
to require adverse opinion
Chapter 14 Other assurance engagements

Interactive question 1: Engagement letter for review of financial statements

To the appropriate representative of management or those charged with governance of ABC Company:
You have requested that we review the general-purpose financial statements of ABC Company, which
comprise the statement of financial position as at December 31, 20X1, and the statement of
comprehensive income, statement of changes in equity and cash flow statement for the year then
ended, and a summary of significant accounting policies and other explanatory information. We are
pleased to confirm our acceptance and our understanding of this review engagement by means of this
letter.
We will perform the following services:
(1) We will review the statement of financial position of ABC Company as of December 31 20X1, and the
related statements of income and cash flows for the year then ended, in accordance with the
International Standards in Review Engagements (ISRE) 2400 (or refer to relevant national standards or
practices applicable to reviews). We will not perform an audit of such financial statements and,
accordingly, we will not express an audit opinion on them.
Accordingly, we expect to report on the financial statements as follows:
(2) Based on our review, nothing has come to our attention that causes us to believe that the
accompanying financial statements do not give a true and fair view (or are not presented fairly, in all
material respects) in accordance with International Financial Reporting Standards.
(3) Responsibility for the financial statements, including adequate disclosure, is that of the management
of the company. This includes the maintenance of adequate accounting records and internal controls and
the selection and application of accounting policies. As part of our review process, we will request
written representations from management concerning assertions made in connection with the review.
(4) Our engagement cannot be relied upon to disclose whether fraud or errors, or illegal acts exist.
However, we will inform you of any material matters that come to our attention.
(5) Please sign and return the attached copy of this letter to indicate that it is in accordance with your
understanding of the arrangements for our review of the financial statements. XYZ LLP
Acknowledged on behalf of ABC Company by (Signed)
(Name and Title) (Date)
Requirement
Explain the purpose of each of the numbered paragraphs.
Answer to Interactive question 1

The purpose of each numbered paragraph:

(1) Establishes the purpose of the letter.
(2) Describes the nature of the services to be performed and professional standards that will be
followed. The paragraph also emphasises that this is not an audit assignment, and that the nature of the
opinion will differ from an audit opinion. This is included to minimise the risk of misunderstandings.
(3) A review gives limited assurance and the opinion will be expressed using a negative form of words. It
is important that the directors understand this before the assignment starts, again to eliminate
misunderstandings regarding the level of assurance that will be provided.
(4) This paragraph sets out the responsibilities of management in respect of the subject matter of the
review.
(5) One of the roles of the engagement letter is to limit the liability being taken on by the practitioner.
Here the practitioner is trying to protect himself from being held liable if fraud and errors exist.
(6) It is important that the terms are formally agreed by the two parties so the practitioner requires
signed confirmation from the directors that they are in agreement.

Interactive question 2: Herbalink Ltd

Herbalink Ltd (Herbalink) is a client of your firm that operates a chain of shops in Cardiff selling ethically
produced herbal cosmetics and toiletries. Since opening its first store five years ago, the company has
expanded and now has 10 outlets in the south Wales area. The directors wish to continue the company’s
expansion by opening additional stores in major UK cities and by introducing a mail order service.
In order to finance these expansion plans the directors of Herbalink have been discussing an increase in
their borrowing with the company’s bank. In support of the funding request the directors have prepared
profit and cash flow forecasts for the three years ending 31 December 2016, based on assumptions they
have made about the future success of the business.
Herbalink’s bankers require this information to be examined and reported on by independent
accountants, and the directors have asked your firm to undertake this assignment.
Two potential properties have been found for the new outlets, both of which are leasehold premises
that will require considerable refurbishment to bring them up to the standard of existing stores.
The mail order service, for which postage will be charged, will be run from the main Cardiff branch which
incorporates the central delivery warehouse of the company. The packaging for delivered items will be
specially designed to protect the products in transit and to reflect the company’s logo and ethical trading
credentials.
The ingredients for preparing the herbal products are purchased centrally on credit terms. All ingredients
are sourced from UK producers and all packaging is made from recycled materials. Employees at
Herbalink are paid at rates above the industry average and are also paid bonuses linked to profits made
by the company as a whole.

Requirements
2.1 From the information provided above, identify the key receipts and payments that you would expect
to be included in the cash flow forecasts prepared by the directors of Herbalink. For each receipt and
payment, identify the specific matters you would consider when reviewing the reasonableness of the
assumptions in forecasting that receipt or payment.
2.2 Explain the role of written representations in the examination of and reporting on forecast
information.
2.3 Describe the differences between the conclusion expressed in an assurance report on forecast
information and the opinion expressed in an auditor’s report on financial statements. Give reasons for
these differences.
Answer to Interactive question 2
2.1 Specific matters to consider:
Receipts
Sales receipts: these should include sales from the new outlets and mail order service, which should be
staged to reflect the timing of the opening of the new shops and the commencement of the mail order
service. In other respects, the inflow should reflect the pattern of prior years. Consideration should be
given as to whether amounts are prudent given prevailing economic conditions and whether the
introduction of the mail order service has an impact on shop takings.
Bank loan: the amount should correspond to what was agreed with the bank, as evidenced by
correspondence, and should be sufficient to cover the expansion costs. The timing of the inflow
should precede the start of new business activities.
Payments
Refurbishment costs: these should be based on suppliers’ quotations and the outflow should precede
the start of new business. Payments for ingredients and packaging: these should reflect the level of
forecast revenue and payments should reflect the suppliers’ terms of trading.
Mail order operational costs: these should be based on staffing and packaging based on forecast
revenue.
Premises costs: to include extra costs, eg, rent and utility costs relating to the new outlets. The rent
should reflect the terms of the lease agreements such as up-front costs, rental periods and rent reviews.
Wages and salaries: these should include the costs of additional staff at the new outlets as well as the
mail order operation. Rates of pay can be compared with the industry average and bonuses should
reflect profits.
Sundry payments: to include advertising, training and recruitment costs relating to the new business.
Outflows should precede the commencement of new business. Professional fees will include payments
to legal advisors and the reporting accountant.
Loan repayments and finance costs: loan instalments should reflect the repayment terms negotiated
with the bank and finance costs should reflect market rates and the level of borrowings. All outflows
should be recorded on the anticipated due dates.
Tax payments: TAX, VAT and corporation tax should be consistent with the relevant figures in the profit
forecast and should be paid on the due dates.
Dividend payments: these should be in line with prior years’ policies or take into account any anticipated
changes in policy which should be confirmed by the directors.
General
Sensitivity analysis should be undertaken on key variables, eg, customer receipts, finance costs and raw
ingredients.
2.2 Role of written representations:
When conducting an engagement to examine forecast information, written representations are obtained
from management regarding:
• the intended use of the forecast information
• the completeness of significant management assumptions
• management’s responsibility for the forecast information
The representations provide evidence that management accepts its responsibilities regarding the
assumptions and will reduce the risk of any misunderstandings regarding respective responsibilities (ie,
narrow the expectations gap). The representation regarding the intended use of the forecasts may
protect the reporting accountant from claims for damages from unforeseen third parties.

2.3 Differences between assurance and auditor’s reports:

Assurance report
The conclusion of the assurance report on the forecast information will include a statement of negative
assurance (ie, limited or moderate assurance) in the form of ‘nothing has come to our attention which
causes us to believe that the assumptions do not provide a reasonable basis for the forecast’. It will also
include an opinion on whether the forecast information is properly prepared on the basis of the
assumptions and is presented in accordance with the relevant financial reporting framework.
Auditor’s report
The opinion in the auditor’s report on financial statements will provide reasonable assurance that the
financial statements:
• give a true and fair view
• have been properly prepared in accordance with IFRSs
Reasons
Financial statements are mainly based on historical information whereas forecast information is based
on assumptions about future events. The historical information can be verified to a greater degree than
forecasts, which will always be subject to uncertainty.