PAA 2 – 2

56. ISA 210 Agreeing the Terms of Audit Engagements requires auditors to agree the terms of an engagement with those charged with governance and formalise these in an engagement letter.

 Required:

(a) Identify and explain TWO factors which would indicate that an engagement letter for an existing audit client should be revised.

(b) List SIX matters which should be included within an audit engagement letter.

57. Trumpet Communications Co (Trumpet) is a large mobile phone company which operates a network of stores in countries across Europe. The company’s year-end is 30 June 20X4. You are the audit senior of Music & Co. Trumpet is a new client and you are currently planning the audit with the audit manager. You have been provided with the following planning notes from the audit partner following his meeting with the finance director. Trumpet purchases goods from a supplier in South Asia and these goods are shipped to the company’s central warehouse. The goods are usually in transit for two weeks and the company correctly records the goods when received. Trumpet does not undertake a year-end inventory count, but carries out monthly continuous (perpetual) inventory counts and any errors identified are adjusted in the inventory system for that month. During the year the company introduced a bonus based on sales for its sales persons. The bonus target was based on increasing the number of customers signing up for 24-month phone line contracts. This has been successful and revenue has increased by 15%, especially in the last few months of the year. The level of receivables is considerably higher than last year and there are concerns about the creditworthiness of some customers. Trumpet has a policy of revaluing its land and buildings and this year has updated the valuations of all land buildings. During the year the directors have each been paid a significant bonus, and they have included this within wages and salaries. Separate disclosure of the bonus is required by local legislation.

Required:

(a) Describe FIVE audit risks, and explain the auditor’s response to each risk, in planning the audit of Trumpet Communications Co.

58.

(a) Define audit risk and the components of audit risk.

You are an audit supervisor of Savings & Co and you are planning the audit of Curling Co, a listed company, for the year ending 31 March 20X7. The company manufactures computer components and forecast profit before tax is $33.6m and total assets are $79.3m. Curling Co distributes its products through wholesalers as well as via its own website. The website was upgraded during the year at a cost of $1.1m. Additionally, the company entered into a transaction in February to purchase a new warehouse which will cost $3.2m. Curling Co’s legal advisers are working to ensure that the legal process will be completed by the year end. The company issued $5m of irredeemable preference shares to finance the warehouse purchase.

During the year the finance director has increased the useful economic lives of fixtures and fittings from three to four years as he felt this was a more appropriate period. The finance director has informed the audit engagement partner that a revised credit period has been agreed with one of its wholesale customers, as they have been experiencing difficulties with repaying the balance of $1.2m owing to Curling Co. In January 20X7, Curling Co introduced a new bonus based on sales targets for its sales staff. This has resulted in a significant number of new wholesale customer accounts being opened by sales staff. The new customers have been given favorable credit terms as an introductory offer, provided goods are purchased within a two month period. As a result, revenue has increased by 5% on the prior year.

The company has launched several new products this year and all but one of these new launches have been successful. Feedback on product Luge, launched four months ago, has been mixed, and the company has just received notice from one of their customers, Seats Co, of intended legal action. They are alleging the product sold to them was faulty, resulting in a significant loss of information and an ongoing detrimental impact on profits. As a precaution, sales of the Luge product have been halted and a product recall has been initiated for any Luge products sold in the last four months.

The finance director is keen to announce the company’s financial results to the stock market earlier than last year and in order to facilitate this, he has asked if the audit could be completed in a shorter timescale. In addition, the company is intending to propose a final dividend once the financial statements are finalized.

Curling Co’s finance director has informed the audit engagement partner that one of the company’s non-executive directors (NEDs) has just resigned, and he has enquired if the partners at Saving & Co can help Curling Co in recruiting a new NED. Specifically he has requested the engagement quality control reviewer, who was until last year the audit engagement partner on Curling Co, assist the company in this recruitment. Saving & Co also provides taxation services for Curling Co in the form of tax return preparation along with some tax planning advice. The finance director has recommended to the audit committee of Curling Co that this year’s audit fee should be based on the company’s profit before tax. At today’s date, 20% of last year’s audit fee is still outstanding and was due to be paid three months ago.

Required:

(b) Describe EIGHT audit risks, and explain the auditor’s response to each risk, in planning the audit of Curling Co.

Note. Prepare your answer using two columns headed Audit risk and Auditor’s response respectively.

59. You are an audit supervisor of Label & Co and are currently planning the audit of your client, Water Co (Water) which manufactures elevators. Its year end is 31 July 20X6 and the forecast profit before tax is $15.2 million.

The company undertakes continuous production in its factory, therefore at the year-end it is anticipated that work in progress will be approximately $950,000. In order to improve the manufacturing process, Water placed an order in April for $720,000 of new plant and machinery; one-third of this order was received in May with the remainder expected to be delivered by the supplier in late July or early August.

At the beginning of the year, Water purchased a patent for $1.3 million which gives them the exclusive right to manufacture specialized elevator equipment for 5 years. In order to finance this purchase, Water borrowed $1.2 million from the bank which is repayable over 5 years. In January 20X6 Water outsourced its payroll processing to an external service organization, Mint Payrolls Co (Mint). Mint handles all elements of the payroll cycle and sends monthly reports to Water detailing the payroll costs. Water ran its own payroll until 31 December 20X5, at which point the records were transferred over to Mint.

The company has a policy of revaluing land and buildings and the finance director has announced that all land and buildings will be revalued at the year end. During a review of the management accounts for the month of May 20X6, you have noticed that receivables have increased significantly on the previous year end and against May 20X5.

The finance director has informed you that the company is planning to make approximately 65 employees redundant after the year end. No decision has been made as to when this will be announced, but it is likely to be prior to the yearend.

Required:

(a) Define audit risk and the components of audit risk.

(b)Describe SIX audit risks, and explain the auditor’s response to each risk, in planning the audit of Aquamarine Co.

60. You are an audit supervisor of Dildo & Co and are planning the audit of Foamy Co for the year ending 31 May 20X9. The company is a food retailer with a large network of stores across the country and four warehouses. The company has been a client of your firm for several years and the forecast profit before tax is $28.9m. The audit manager has attended a planning meeting with the finance director and has provided you with the following notes of the meeting.

Planning meeting notes

Foamy Co has an internal audit (IA) department which undertakes controls testing across the network of stores. Each store is visited at least once every 18 months. The audit manager has discussed with the finance director that the external audit team may rely on the controls testing which is undertaken by IA. During the meeting, the finance director provided some forecast financial information. Revenue for the year is expected to increase by 3% as compared to 20X8; the gross margin is expected to increase from 56% to 60%; and the operating margin is predicted to decrease from 21% to 18%. Foamy Co values inventory in line with industry practice, which is to use selling price less average profit margin. The directors consider this to be a close approximation to cost.

The company does not undertake a full year‐end inventory count and instead undertakes monthly perpetual inventory counts, each of which covers one‐twelfth of all lines in stores and the warehouses. As part of the interim audit which was completed in January, an audit junior attended a perpetual inventory count at one of the warehouses and noted that there were a large number of exceptions where the inventory records showed a higher quantity than the physical inventory which was present in the warehouse. When discussing these exceptions with the financial controller, the audit junior was informed that this had been a recurring issue. During the year, IA performed a review of the non‐current assets physically present in around one‐third of the company’s stores. A number of assets which had not been fully depreciated were identified as obsolete by this review.

The company launched a significant TV advertising campaign in January 20X9 in order to increase revenue. The directors have indicated that at the yearend a current asset of $0.7m will be recognized, as they believe that the advertisements will help to boost future sales in the next 12 months. The last advertisement will be shown on TV in early May 20X9. Foamy Co decided to outsource its payroll function to an external service organization. This service organization handles all elements of the payroll cycle and sends monthly reports to Foamy Co which detail wages and salaries and statutory obligations. Foamy Co maintained its own payroll records until 31 December 20X8, at which point the records were transferred to the service organization.

Foamy Co is planning to expand the company by opening three new stores during July 20X9 and in order to finance this, in March 20X9 the company obtained a $3m bank loan. This is repayable in arrears over five years in quarterly instalments. In preparation for the expansion, the company is looking to streamline operations in the warehouses and is planning to make approximately 60 employees redundant after the year end. No decision has been made as to when this will be announced, but it is likely to be in May 20X9.

Required:

(a) Define and explain materiality and performance materiality.

(b) Describe EIGHT audit risks and explain the auditor’s response to each risk in planning the audit of Foamy Co.

Note: Prepare your answer using two columns headed Audit risk and Auditor’s response respectively.

61. You are an audit senior of Berry Fruit & Co and are planning the audit of Star Fruit Co for the year ending 31 March 20X8. The company is a manufacturer of portable music players and your audit manager has already had a planning meeting with the finance director. Forecast revenue is $68.6m and profit before tax is $4.2m.

She has provided you with the following notes of the meeting:

Planning meeting notes

Inventory is valued at the lower of cost and net realizable value. Cost is made up of the purchase price of raw materials and costs of conversion, including labour, production and general overheads. Inventory is held in three warehouses across the country.

The company plans to conduct full inventory counts at the warehouses on 2, 3 and 4 April, and any necessary adjustments will be made to reflect post year‐end movements of inventory. The internal audit team will attend the counts.

During the year, Star Fruit Co paid $1.1m to purchase a patent which allows the company the exclusive right for three years to customize their portable music players to gain a competitive advantage in their industry. The $1.1m has been expensed in the current year statement of profit or loss. In order to finance this purchase, Star Fruit Co raised $1.2m through issuing shares at a premium.

In November 20X7, it was discovered that a significant teeming and lading fraud had been carried out by four members of the receivables ledger department who had colluded. They had stolen funds from wholesale customer receipts and then to cover this, they allocated later customer receipts against the older receivables. These employees were all reported to the police and subsequently dismissed. As a result of the vacancies in the receivables ledger department, Star Fruit Co decided to outsource its receivables ledger processing to an external service organization. This service organization handles all elements of the receivables ledger cycle, including sales invoicing and chasing of receivables balances and sends monthly reports to Star Fruit Co detailing the sales and receivable amounts.

Star Fruit Co ran its own receivables ledger until 31 January 20X8, at which point the records were transferred to the service organization.

In December 20X7, the financial accountant of Star Fruit Co was dismissed. He had been employed by the company for nine years, and he has threatened to sue the company for unfair dismissal. As a result of this dismissal, and until his replacement commences work in April, the financial accountant’s responsibilities have been adequately allocated to other members of the finance department. However, for this period no supplier statement reconciliations or payables ledger control account reconciliations have been performed.

In January 20X7, a receivable balance of $0.9m was written off by Star Fruit Co as it was deemed irrecoverable as the customer had declared itself bankrupt. In February 20X8, the liquidators handling the bankruptcy of the company publicly announced that it was likely that most of its creditors would receive a pay‐out of 40% of the balance owed. As a result, Star Fruit Co has included a current asset of $360,000 within the statement of financial position and other income in the statement of profit or loss.

Required:

(a) Describe Berry Fruit & Co’s responsibilities in relation to the prevention and detection of fraud and error.

(b) Describe EIGHT audit risks and explain the auditor’s response to each risk in planning the audit of Star Fruit Co.

Note: Prepare your answer using two columns headed Audit risk and Auditor’s response respectively.

62. You are an audit supervisor of Stars & Co, planning the final audit of a new client, Cancer Construction Co, for the year ending 30 September 20X7. The company specializes in property construction and providing ongoing annual maintenance services for properties previously constructed. Forecast profit before tax is $13.8m and total assets are expected to be $22.3m, both of which are higher than for the year ended 30 September 20X6.

You are required to produce the audit strategy document. The audit manager has met with Cancer Construction Co’s finance director and has provided you with the following notes, a copy of the August management accounts and the prior year financial statements.

Meeting notes

The prior year financial statements recognize work in progress of $1.8m, which comprised property construction in progress as well as ongoing maintenance services for finished properties. The August 20X7 management accounts recognize $2.1m inventory of completed properties compared to a balance of $1.4m in September 20X6. A full year‐end inventory count will be undertaken on 30 September at all of the 11 building sites where construction is in progress. There is not sufficient audit team resource to attend all inventory counts.

In line with industry practice, Cancer Construction Co offers its customers a five‐year building warranty, which covers any construction defects. Customers are not required to pay any additional fees to obtain the warranty. The finance director anticipates this provision will be lower than last year as the company has improved its building practices and therefore the quality of the finished properties.

Customers who wish to purchase a property are required to place an order and pay a 5% nonrefundable deposit prior to the completion of the building. When the building is complete, customers pay a further 92.5%, with the final 2.5% due to be paid six months later. The finance director has informed you that although an allowance for receivables has historically been maintained, it is anticipated that this can be significantly reduced.

Information from management accounts

Cancer Construction Co’s prior year financial statements and August 20X7 management accounts contain a material overdraft balance. The finance director has confirmed that there are minimum profit and net assets covenants attached to the overdraft.

A review of the management accounts shows the payables period was 56 days for August 20X7, compared to 87 days for September 20X6. The finance director anticipates that the September 20X7 payables days will be even lower than those in August 20X7.

Required:

(a) Using all the information provided describe SEVEN audit risks, and explain the auditor’s response to each risk, in planning the audit of Cancer Construction Co.

Note: Prepare your answer using two columns headed Audit risk and Auditor’s response respectively.

63. You are an audit supervisor of Chase & Co and are planning the audit of your client, Fantasy Sparkle Co which manufactures cleaning products. Its year‐end was 31 July 20X6 and the draft profit before tax is $33.6 million.

You are supervising a large audit team for the first time and will have specific responsibility for supervising and reviewing the work of the audit assistants in your team.

Fantasy Sparkle Co purchases most of its raw materials from suppliers in Africa and these goods are shipped directly to the company’s warehouse and the goods are usually in transit for up to three weeks. The company has incurred $1.3 million of expenditure on developing a new range of cleaning products which are due to be launched into the market place in November 20X6. In September 20X5, Fantasy Sparkle Co also invested $0.9 million in a complex piece of plant and machinery as part of the development process. The full amount has been capitalized and this cost includes the purchase price, installation costs and training costs.

This year, the bonus scheme for senior management and directors has been changed so that rather than focusing on profits, it is instead based on the value of year‐end total assets. In previous years an allowance for receivables, made up of specific balances, which equaled almost 1% of trade receivables was maintained. However, the finance director feels that this is excessive and unnecessary and has therefore not included it for 20X6 and has credited the opening balance to the profit or loss account.

A new general ledger system was introduced in May 20X6; the finance director has stated that the data was transferred and the old and new systems were run in parallel until the end of August 20X6. As a result of the additional workload on the finance team, a number of control account reconciliations were not completed as at 31 July 20X6, including the bank reconciliation. The finance director is comfortable with this as these reconciliations were completed successfully for both June and August 20X6. In addition, the year‐end close down of the payables ledger was undertaken on 8 August 20X6.

Required:

(a) Explain the benefits of audit planning.

(b) Describe SIX audit risks, and explain the auditor’s response to each risk, in planning the audit of Fantasy Sparkle Co.

Note: Prepare your answer using two columns headed Audit risk and Auditor’s response respectively.