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PAA 2 – 2

Question 56-63
Question 56-63

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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.

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

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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.

Audit Risk Auditor’s Response
Increased detection risk due to the fact that

Trumpet is a new client.

Ensure that the audit team is made up of suitably experienced staff.

Ensure that sufficient time is allocated to obtain an understanding of Trumpet’s business and assess the entity’s risks of material misstatement.

Increased risk of material misstatement around cut-off of inventory, purchases and payables as a result of purchased goods taking two weeks to arrive at the company’s central warehouse. Perform detailed cut-off testing of goods in transit around the year end to ensure that cut-off has been correctly applied.
Increased risk of material misstatement related to the completeness, existence and valuation of inventory under the perpetual inventory system, if all inventory is not counted at least once a year. Review the inventory count instructions and perform audit procedures to determine whether all inventory is counted at least once a year.

Assess the adequacy of internal controls around inventory records to determine whether the inventory records can be relied upon.

Increased risk of material misstatements due to sales cut-off, as a result of the sales based bonus scheme encouraging sales staff to maximize their current year bonus. Increase sales cut-off testing, and perform additional audit procedures on post year end cancellations to identify cut-off errors.
Increased risk of overvaluation of receivables, highlighted by the considerable increase in the receivables balance compared to the prior year, and concerns about the creditworthiness of some customers. Perform extended testing of post year end cash payments and review the aged receivables ledger.

Consider the adequacy of the allowance for receivables.

Risk of material misstatements relating to the valuation of land and buildings, if recent revaluations do not comply with IAS 16 Property, Plant and Equipment. Obtain an understanding of the revaluation process through discussions with management, and review the process for compliance with IAS 16.

Review the disclosures of the revaluation in the financial statements for compliance with IAS 16.

Non-compliance with local legislation concerning the disclosure of directors’ remuneration, currently included within wages and salaries. Discuss the matter with management.

Review disclosures required by local legislation in the financial statements to gain assurance over compliance.

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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.

Audit Risk Auditor’s Response
Curling Co upgraded their website during the year at a cost of $1.1m. The costs incurred should be correctly allocated between revenue and capital expenditure.

 

As the website has been upgraded, there is a possibility that the new processes and systems may not record data reliably and accurately. This may lead to a risk over completeness and accuracy of data in the underlying accounting records.

Review a breakdown of the costs and agree to invoices to assess the nature of the expenditure and if capital, agree to inclusion within the asset register or agree to the statement of profit or loss.

 

The audit team should document the revised system and undertake tests over the completeness and accuracy of data recorded from the website to the accounting records.

Curling Co has entered into a transaction to purchase a new warehouse for $3.2m and it is anticipated that the legal process will be completed by the year end.

 

Only assets which physically exist at the yearend should be included in property, plant and equipment. If the transaction has not been completed by the year end, there is a risk that assets are overstated if the company incorrectly includes the warehouse at the yearend.

Discuss with management as to whether the warehouse purchase was completed by the year end. If so, inspect legal documents of ownership, such as title deeds ensuring these are dated prior to 1 April 20X7 and are in the company name.
Significant finance has been obtained in the year, as the company has issued $5m of irredeemable preference shares. This finance needs to be accounted for correctly, with adequate disclosure made. As the preference shares are irredeemable, they should be classified as equity rather than non-current liabilities. Failing to correctly classify the shares could result in understated equity and overstated non-current liabilities. Review share issue documentation to confirm that the preference shares are irredeemable. Confirm that they have been correctly classified as equity within the accounting records and that total financing proceeds of $5m were received.

 

In addition, the disclosures for this share issue should be reviewed in detail to ensure compliance with relevant accounting standards.

The finance director has extended the useful lives of fixtures and fittings from three to four years, resulting in the depreciation charge reducing. Under IAS 16 Property, Plant and Equipment, useful lives are to be reviewed annually, and if asset lives have genuinely increased, then this change is reasonable.

 

However, there is a risk that this reduction has occurred in order to boost profits. If this is the case, then fixtures and fittings are overvalued and profit overstated.

Discuss with the directors the rationale for any extensions of asset lives and reduction of depreciation rates. Also, the four-year life should be compared to how often these assets are replaced, to assess the useful life of assets.
A customer of Curling Co has been encountering difficulties paying their outstanding balance of $1.2m and Curling Co has agreed to a revised credit period. If the customer is experiencing difficulties, there is an increased risk that the receivable is not recoverable and hence is overvalued. Review the revised credit terms and identify if any after date cash receipts for this customer have been made.

 

Discuss with the finance director whether he intends to make an allowance for this receivable. If not, review whether any existing allowance for uncollectable accounts is sufficient to cover the amount of this receivable.

A sales-related bonus scheme has been introduced in the year for sales staff, with a significant number of new customer accounts on favorable credit terms being opened pre year end. This has resulted in a 5% increase in revenue.

 

Sales staff seeking to maximize their current year bonus may result in new accounts being opened from poor credit risks leading to irrecoverable receivables. In addition, there is a risk of sales cut-off errors as new customers could place orders within the two-month introductory period and subsequently return these goods post year end.

Increased sales cut-off testing will be performed along with a review of any post year-end returns as they may indicate cut-off errors. In addition, increased after date cash receipts testing to be undertaken for new customer account receivables.
Curling Co has halted further sales of its new product Luge and a product recall has been initiated for any goods sold in the last four months.

If there are issues with the quality of the Luge

product, inventory may be overvalued as its

NRV may be below its cost. Additionally, products of Luge sold within the last four months are being recalled, this will result in Curling Co paying customer refunds.

The sale will need to be removed; a refund liability should be recognized along with the reinstatement of inventory, although the NRV of this inventory could be of a minimal value. Failing to account for this correctly could result in overstated revenue and understated liabilities and inventory.

Discuss with the finance director whether any write downs will be made to this product, and what, if any, modifications may be required with regards the quality.

 

Testing should be undertaken to confirm cost and NRV of the Luge products in inventory and that on a line-by-line basis the goods are valued correctly.

Review the list of sales made of product Luge prior to the recall, agree that the sale has been removed from revenue and the inventory included. If the refund has not been paid per year end, agree it is included within current liabilities.

Seats Co, a customer of Curling Co, has announced that they intend to commence legal action for a loss of information and profits as a result of the Luge product sold to them.

 

If it is probable that the company will make payment to the customer, a legal provision is required. If the payment is possible rather than probable, a contingent liability disclosure would be necessary. If Curling Co has not done this, there is a risk over the completeness of any provisions or the necessary disclosure of contingent liabilities.

Saving & Co should write to the company’s lawyers to enquire of the existence and likelihood of success of any claim from Seats Co. The results of this should be used to assess the level of provision or disclosure included in the financial statements.
The finance director has requested that the audit completes one week earlier than normal as he wishes to report results earlier. A reduction in the audit timetable will increase detection risk and place additional pressure on the team in obtaining sufficient and appropriate evidence.

 

In addition, the finance team of Curling Co will have less time to prepare the financial information leading to an increased risk of errors arising in the financial statements.

The timetable should be confirmed with the finance director. If it is to be reduced, then consideration should be given to performing an interim audit in late March or early April; this would then reduce the pressure on the final audit.

 

The team needs to maintain professional skepticism and be alert to the increased risk of errors occurring.

The company is intending to propose a final dividend once the financial statements are finalized. This amount should not be provided for in the 20X7 financial statements, as the obligation only arises once the dividend is announced, which is post year end.

 

In line with IAS 10 Events after the Reporting

Period the dividend should only be disclosed. If the dividend is included, this will result in an overstatement of liabilities and understatement of equity.

Discuss the issue with management and confirm that the dividend will not be included within liabilities in the 20X7 financial statements.

 

The financial statements need to be reviewed to ensure that adequate disclosure of the proposed dividend is included.

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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.

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

Audit Risk Auditor’s Response
Water Co (Water) undertakes continuous production and the work in progress balance at the yearend is likely to be material. As production will not cease, the exact cut-off of the work in progress will need to be assessed. If the cut-off is not correctly calculated, the inventory valuation may be under- or overstated. The auditor should discuss with management the process they will undertake to assess the cut-off point for work in progress at the year end. This process should be reviewed by the auditor while attending the year-end inventory count.

 

In addition, consideration should be given as to whether an independent expert is required to value the work in progress. If so, this will need to be arranged with consent from management and in time for the year-end count.

Water has ordered $720,000 of plant and machinery, two-thirds of which may not have been received by the year end. Only assets which physically exist at the yearend should be included in property, plant and equipment. If items not yet delivered have been capitalized, PPE will be overstated.

 

Consideration will also need to be given to depreciation and when this should commence. If depreciation is not appropriately charged when the asset is available for use, this may result in assets and profit being over- or understated.

Discuss with management as to whether the remaining plant and machinery ordered have arrived; if so, physically verify a sample of these assets to ensure existence and ensure only appropriate assets are recorded in the non-current asset register at the year end. Determine if the asset received is in use at the yearend by physical observation and, if so, if depreciation has commenced at an appropriate point.
A patent has been purchased for $1.3 million, and this enables Water to manufacture specialized elevator equipment for the next five years. In accordance with IAS 38 Intangible Assets, this should be included as an intangible asset and amortized over its five-year life. If management has not correctly accounted for the patent, intangible assets and profits could be overstated. The audit team will need to agree the purchase price to supporting documentation and to confirm that the useful life is five years. The amortisation charge should be recalculated in order to ensure the accuracy of the charge and that the intangible is correctly valued at the year end.
The company has borrowed $1.2 million from the bank via a 5-year loan. This loan needs to be correctly split between current and noncurrent liabilities in order to ensure correct disclosure. During the audit, the team would need to confirm that the $1.2 million loan finance was received. In addition, the split between current and non-current liabilities and the disclosures for this loan should be reviewed in detail to ensure compliance with relevant accounting standards. Details of security should be agreed to the bank confirmation letter.
Also, as the level of debt has increased, there should be additional finance costs. There is a risk that this has been omitted from the statement of profit or loss leading to understated finance costs and overstated profit. The finance costs should be recalculated and any increase agreed to the loan documentation for confirmation of interest rates. Interest payments should be agreed to the cash book and bank statements to confirm the amount was paid and is not therefore a year-end payable.
During the year Water outsourced its payroll processing to an external service organization. A detection risk arises as to whether sufficient and appropriate evidence is available at Water to confirm the completeness and accuracy of controls over payroll. If not, another auditor may be required to undertake testing at the service organization. Discuss with management the extent of records maintained at Water and any monitoring of controls undertaken by management over the payroll charge. Consideration should be given to contacting the service organization’s auditor to confirm the level of controls in place.
The payroll processing transferred to Mint Payrolls Co from 1 January. If any errors occurred during the transfer process, these could result in the payroll charge and related employment tax liabilities being under/overstated. Discuss with management the transfer process undertaken and any controls put in place to ensure the completeness and accuracy of the data.

 

Where possible, undertake tests of controls to confirm the effectiveness of the transfer controls. In addition, perform substantive testing on the transfer of information from the old to the new system.

The land and buildings are to be revalued at the yearend; it is likely that the revaluation surplus/deficit will be material.

 

The revaluation needs to be carried out and recorded in accordance with IAS 16 Property, Plant and Equipment, otherwise non-current assets may be incorrectly valued.

Discuss with management the process adopted for undertaking the valuation, including whether the whole class of assets was revalued and if the valuation was undertaken by an expert. This process should be reviewed for compliance with IAS 16.
Receivables for the year to date are considerably higher than the prior year. If this continues to the year end, there is a risk that some receivables may be overvalued as they are not recoverable. Discuss with management the reasons for the increase in receivables and management’s process for identifying potential irrecoverable debt. Test controls surrounding management’s credit control processes.

 

Extended post year end cash receipts testing and a review of the aged receivables ledger are to be performed to assess valuation. Also consider the adequacy of any allowance for receivables.

Water is planning to make approximately 65 employees redundant after the year end. The timing of this announcement has not been confirmed; if it is announced to the staff before the year end, then under IAS 37 Provisions, Contingent Liabilities and Contingent Assets a redundancy provision will be required at the year end. Failure to provide will result in an understatement of provisions and expenses. Discuss with management the status of the redundancy announcement; if before the year end, review supporting documentation to confirm the timing. In addition, review the basis of and recalculate the redundancy provision.

 

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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.

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(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.

Audit Risk Auditor’s Response
The external audit team may place reliance on the controls testing work undertaken by the IA department. If reliance is placed on irrelevant or poorly performed testing, then the external audit team may form an incorrect conclusion on the strength of the internal controls at Foamy Co.

 

This could result in them performing insufficient levels of substantive testing, thereby increasing detection risk.

The external audit team should meet with IA staff, read their reports and review their files relating to store visits to ascertain the nature of the work undertaken.

 

Before using the work of IA, the audit team will need to evaluate and perform audit procedures on the entirety of the work which they plan to use, in order to determine its adequacy for the purposes of the audit. In addition, the team will need to re‐perform some of the testing carried out by IA to assess its adequacy.

Forecast ratios from the finance director show that the gross margin is expected to increase from 56% to 60% and the operating margin is expected to decrease from 21% to 18%. This movement in gross margin is significant and inconsistent with the fall in operating margin. There is a risk that costs may have been omitted or included in operating expenses rather than cost of sales.

 

Misclassification of expenses would result in understatement of cost of sales and overstatement of operating expenses.

The classification of costs between cost of sales and operating expenses should be reviewed in comparison to the prior year and any inconsistencies investigated.
Foamy Co’s inventory valuation policy is selling price less average profit margin, as this is industry practice. Inventory should be valued at the lower of cost and net realizable value (NRV). IAS 2 Inventories allows this as a cost calculation method as long as it is a close approximation to cost. If this is not the case, then inventory could be under or overvalued. Testing should be undertaken to confirm cost and NRV of inventory and that on a line‐by‐line basis the goods are valued correctly.

 

In addition, valuation testing should focus on comparing the cost of inventory to the selling price less margin for a sample of items to confirm whether this method is actually a close approximation to cost.

The company utilizes a perpetual inventory system at its warehouse rather than a full year‐end count. Under such a system, all inventory must be counted at least once a year with adjustments made to the inventory records on a timely basis. Inventory could be under or overstated if the perpetual inventory counts are not all completed, such that some inventory lines are not counted in the year. The timetable of the perpetual inventory counts should be reviewed and the controls over the counts and adjustments to records should be tested.
During the interim audit, it was noted that there were significant exceptions with the inventory records being higher than the inventory in the warehouse. As the year‐end quantities will be based on the records, this is likely to result in overstated inventory. The level of adjustments made to inventory should be considered to assess their significance. This should be discussed with management as soon as possible as it may not be possible to place reliance on the inventory records at the year end, which could result in the requirement for a full year‐end inventory count.
A number of assets which had not been fully depreciated were identified as being obsolete.

 

This is an indication that the company’s depreciation policy of non‐current assets may not be appropriate, as depreciation in the past appears to have been understated. If an asset is obsolete, it should be written off to the statement of profit or loss. Therefore depreciation may be understated and profit and assets overstated.

Discuss the depreciation policy for noncurrent assets with the finance director and assess its reasonableness. Enquire of the finance director if the obsolete assets have been written off. If so, review the adjustment for completeness.
Foamy Co is planning to include a current asset of $0.7m, which relates to advertising costs incurred and adverts shown on TV before the year end.

 

The costs were incurred and adverts shown in the year ending 20X9 and there is no basis for including them as a current asset at the year end. The costs should be recognized in operating expenses in the current year financial statements. If these costs are not expensed, current assets and profits will be overstated.

Discuss with management the rationale for including the advertising as a current asset. Request evidence to support the assessment of probable future cash flows, and review for reasonableness.

 

Review supporting documentation for the advertisements to confirm that all were shown before the 20X9 year end. Request that management remove the current asset and record the amount as an expense in the statement of profit or loss.

During the year, Foamy Co outsourced its payroll function to an external service organization.

 

A detection risk arises as to whether sufficient and appropriate evidence is available at Foamy     Co to confirm the completeness and accuracy of controls over the payroll cycle and liabilities at the year end.

Discuss with management the extent of records maintained at Foamy     Co for the period since January 20X9 and any monitoring of controls which has been undertaken by management over payroll.

Consideration should be given to contacting the service organization’s auditor to confirm the level of controls in place. A type 1 or type 2 report could be requested.

The payroll function was transferred to the service organization from 1 January 20X9, which is five months prior to the yearend.

 

If any errors occurred during the transfer process, these could result in wages and salaries being under/overstated.

Discuss with management the transfer process undertaken and any controls which were put in place to ensure the completeness and accuracy of the data. Where possible, undertake tests of controls to confirm the effectiveness of the transfer controls. In addition, perform substantive testing on the transfer of information from the old to the new system.
A $3m loan was obtained in March 20X9. This finance needs to be accounted for correctly, with adequate disclosure made. The loan needs to be allocated between non‐current and current liabilities. Failure to classify the loan correctly could result in misclassified liabilities. Re‐perform the company’s calculations to confirm that the split of the loan note is correct between non‐current and current liabilities and that total financing proceeds of $3m were received.

 

In addition, the disclosures for this loan note should be reviewed in detail to ensure compliance with relevant accounting standards.

Foamy Co is planning to make approximately 60 employees redundant after the year end.

 

The timing of this announcement has not been confirmed; if it is announced to the staff before the year end, then under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a redundancy provision will be required at the yearend as a constructive obligation will have been created. Failure to provide or to provide an appropriate amount will result in an understatement of provisions and expenses.

Discuss with management the status of the redundancy announcement; if before the year end, review supporting documentation to confirm the timing. In addition, review the basis of and recalculate the redundancy provision.

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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.

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(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.

Audit Risk Auditor’s Response
Star Fruit Co values its inventory at the lower of cost and net realizable value. Cost includes both production and general overheads. IAS 2 Inventories requires that costs included in valuing goods and services should only be those incurred in bringing inventory to its present location and condition. Although production overheads meet these criteria, general overheads do not.

 

If these are included in inventory cost, then this will result in over‐valued inventory.

Discuss with management the nature of the overheads included in inventory valuation. If general overheads are included, request management remove them from the valuation to be included in the draft financial statements.

 

Review supporting documentation to verify those overheads deemed to be of a production nature are valid

The company is planning to undertake the full year‐end inventory counts after the year end and then adjust for movements from the year end. If the adjustments are not completed accurately, then the year‐end inventory could be under or overstated. The auditor should attend the inventory count held after the year end and note details of goods received and dispatched post year end, in order to agree to the reconciliation. During the final audit, the year‐end inventory adjustments schedule should be reviewed in detail and agreed to supporting documentation obtained during the inventory count for all adjusting items.
A patent has been purchased for $1.1m and this grants Star Fruit Co the exclusive right for three years to customize their portable music players to gain a competitive advantage in their industry. Management has expensed the full amount paid to the current year statement of profit or loss.

 

In accordance with IAS 38 Intangible Assets, this should have been included as an intangible asset and amortized over its three‐year life.

 

As the sum has been fully expensed and not treated in accordance with IAS 38, intangible assets and profits are understated.

The audit team will need to agree the purchase price to supporting documentation and confirm the useful life is three years as per the contract.

 

Discuss with management the reason for fully expensing the $1.1m paid, and request they correct the treatment.

 

The correcting journal should be reviewed and the amortisation charge recalculated in order to ensure the accuracy of the charge and that the intangible is correctly valued.

During the year Star Fruit Co has raised new finance through issuing $1.2m of shares at a premium.

 

This needs to be accounted for correctly, with adequate disclosure made and the equity finance needs to be allocated correctly between share capital and share premium.

 

If this is not done, then the accounts may be misstated due to a lack of disclosure or share capital and share premium may be misstated.

The audit team should confirm that proceeds of $1.2m were received and that the split of share capital and share premium is correct and appropriately recorded.

 

In addition, the disclosures for this finance should be reviewed in detail to ensure compliance with relevant accounting standards and local legislation.

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.

 

There is a risk that the full impact of the fraud has not been quantified and any additional fraudulent transactions would need to be written off in the statement of profit or loss.

 

If these have not been uncovered, the financial statements could be misstated.

 

In addition, individual receivable balances may be under/overstated as customer receipts have been misallocated to other receivable balances.

Discuss with the finance director what procedures they have adopted to fully identify and quantify the impact of the teeming and lading fraud. In addition, discuss with the finance director, what controls have been put in place to identify any similar frauds.

 

Review the receivables listing to identify any unusual postings to individual receivable balances as this could be further evidence of fraudulent transactions.

 

In addition, the team should maintain their professional skepticism and be alert to the risk of further fraud and errors.

During the year Star Fruit Co outsourced its receivables ledger processing to an external service organization.

 

A detection risk arises as to whether sufficient and appropriate evidence is available at Star Fruit Co to confirm the completeness and accuracy of controls over the sales and receivables cycle and balances at the year end.

Discuss with management the extent of records maintained at Star Fruit Co for the period since February 20X8 and any monitoring of controls undertaken by management over sales and receivables.

 

Consideration should be given to contacting the service organization’s auditor to confirm the level of controls in place.

The receivables ledger processing transferred to the service organization from 1 February 20X8.

 

If any errors occurred during the transfer process, these could result in sales and receivables being under/overstated.

Discuss with management the transfer process undertaken and any controls put in place to ensure the completeness and accuracy of the data.

 

Where possible, undertake tests of controls to confirm the effectiveness of the transfer controls. In addition, perform substantive testing on the transfer of information from the old to the new system.

No supplier statement or payables ledger control account reconciliations have been performed in the period from December 20X7 to the year end.

 

This a key control which is being overridden and as such there is an increased risk of errors within trade payables and the year‐end payables balance may be under or overstated.

The audit team should increase their testing on trade payables at the year end, including performing supplier statement reconciliations, with a particular focus on completeness of trade payables.

 

Request management prepare a yearend payables ledger control account reconciliation. The audit team should undertake a detailed review of this reconciliation with a focus on any unusual reconciling items.

A current asset of $360,000 has been included within the statement of profit or loss and assets. It represents an anticipated pay out from liquidators handling the bankruptcy of a customer who owed Star Fruit Co $0.9m. The sum of $0.9m was written off in the prior year accounts. However, the company has not received a formal notification from the liquidators confirming the payment and this would therefore represent a possible contingent asset.

 

To comply with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, this should not be recognized until the receipt is virtually certain. With no firm response to date, the inclusion of this sum overstates profit and current assets.

Discuss with management whether any notification of payment has been received from the liquidators and review the related correspondence.

 

If virtually certain, the treatment adopted is correct.

 

If payment has been received, agree to post‐year end cash book.

 

If receipt is not virtually certain, management should be requested to remove it from profit and receivables.

 

If the receipt is probable, the auditor should request management include a contingent asset disclosure note.

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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.

Audit Risk Auditor’s Response
Cancer Construction Co is a new client for Star & Co.

 

As the team is not familiar with the accounting policies, transactions and balances of the company, there will be an increased detection risk on the audit.

Star & Co should ensure they have a suitably experienced team. In addition, adequate time should be allocated for team members to obtain an understanding of the company and the risks of material misstatement including a detailed team briefing to cover the key areas of risk.
Cancer Construction Co is likely to have a material level of work in progress at the year end, being construction work in progress as well as ongoing maintenance services, as Cancer  Construction Co has annual contracts for many of the buildings constructed.

 

The level of work in progress will need to be assessed at the year end. Assessing the percentage completion for partially constructed buildings is likely to be quite subjective, and the team should consider if they have the required expertise to undertake this. If the percentage completion is not correctly calculated, the inventory valuation may be under or overstated.

The auditor should discuss with management the process they will undertake to assess the percentage completion for work in progress at the year end. This process should be reviewed by the auditor while attending the year‐end inventory counts.

 

In addition, consideration should be given as to whether an independent expert is required to value the work in progress or if a management expert has been used. If the work of an expert is to be used, then the audit team will need to assess the competence, capabilities and objectivity of the expert.

The August 20X7 management accounts contain $2.1 million of completed properties; this balance was $1.4 million in September 20X6.

 

IAS 2 Inventories requires that inventory should be stated at the lower of cost and NRV.

 

The increase in inventory may be due to an increased level of pre year‐end orders. Alternatively, it may be that Cancer Construction Co is struggling to sell completed properties.

 

This may indicate that they are overvalued.

Detailed cost and net realizable value (NRV) testing to be performed at the year end and the aged inventory report to be reviewed to assess whether inventory requires to be written down.
At the yearend there will be inventory counts undertaken at all 11 of the building sites in progress.

 

It is unlikely that the auditor will be able to attend all of these inventory counts, increasing detection risk, and therefore they need to ensure that they obtain sufficient evidence over the inventory counting controls, and completeness and existence of inventory for any sites not visited.

The auditor should assess for which of the building sites they will attend the counts. This will be those with the most material inventory or which according to management have the most significant risk of misstatement.

 

For those not visited, the auditor will need to review the level of exceptions noted during the count and discuss with management any issues, which arose during the count.

Cancer Construction Co offers its customers a building warranty of five years, which covers any construction defects. A warranty provision will be required under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Calculating warranty provisions requires judgment as it is an uncertain amount.

 

The finance director anticipates this provision will be lower than last year as the company has improved its building practices and the quality of its finished properties. However, there is a risk that this provision could be understated, especially in light of the overdraft covenant relating to a minimum level of net assets and is being used as a mechanism to manipulate profit and asset levels.

Discuss with management the basis of the provision calculation, and compare this to the level of post yearend claims, if any, made by customers.

 

In particular, discuss the rationale behind reducing the level of provision this year. Compare the prior year provision with the actual level of claims in the year, to assess the reasonableness of the Judgments made by management.

Customers who wish to purchase a property are required to place an order and a 5% non‐refundable deposit prior to the completion of the building.

 

These deposits should not be recognized as revenue in the statement of profit or loss until the performance obligations as per the contracts have been satisfied.

 

This is likely to be when the building is finished and the sale process is complete. Instead, they should be recognized as deferred income within current liabilities.

 

Management may have incorrectly treated the deferred income as revenue, resulting in overstated revenue and understated liabilities.

Discuss with management the treatment of deposits received in advance, to ensure it is appropriate.

 

During the final audit, undertake increased testing over the cut‐off of revenue and completeness of deferred income.

An allowance for receivables has historically been maintained, but it is anticipated that this will be reduced.

 

There is a risk that receivables will be overvalued; some balances may not be recoverable and so will be overstated if not provided for.

 

In addition, reducing the allowance for receivables will increase asset values and would improve the covenant compliance, which increases the manipulation risk further.

Review and test the controls surrounding how the finance director identifies old or potentially irrecoverable receivables balances and credit control to ensure that they are operating effectively.

 

Discuss with the director the rationale for reducing the allowance for receivables.

 

Extended post year‐end cash receipts testing and a review of the aged receivables ledger to be performed to assess valuation and the need for an allowance for receivables.

Cancer Construction Co has a material overdraft which has minimum profit and net assets covenants attached to it. If these covenants were to be breached, the overdraft balance would become instantly repayable.

 

If the company does not have sufficient cash to meet this repayment, then there could be going concern implications.

 

In addition, there is a risk of manipulation of profit and net assets to ensure that covenants are met.

Review the covenant calculations prepared by the company at the year end and identify whether any defaults have occurred; if so, determine the effect on the company.

 

The team should maintain their professional skepticism and be alert to the risk that profit and/or net assets have been overstated to ensure compliance with the covenants.

Preliminary analytical review of the August management accounts shows a payables payment period of 56 for August 20X7, compared to 87 days for September 20X6. It is anticipated that the year‐end payables payment period will be even lower.

 

The forecast profit is higher than last year, indicating an increase in trade, also the company’s cash position has continued to deteriorate and therefore, it is unusual for payables payment period to have decreased.

 

There is an increased risk of errors within trade payables and the year‐end payables may be understated.

The audit team should increase their testing on trade payables at the year end, with a particular focus on completeness of payables. A payables circularization or review of supplier statement reconciliations should be undertaken.

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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.

13 / 13

(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.

Audit Risk Auditor’s Response
Fantasy Sparkle Co purchases their goods from suppliers in Africa and the goods are in transit for up to three weeks.

 

At the year‐end, there is a risk that the cut‐off of inventory, purchases and payables may not be accurate and may be under/overstated.

The audit team should undertake detailed cut‐off testing of purchases of goods at the year‐end and the sample of GRNs from before and after the yearend relating to goods from suppliers in Africa should be increased to ensure that cut‐off is complete and accurate.
Fantasy    Sparkle Co has incurred expenditure of $1.3 million in developing a new range of cleaning products. Obtain a breakdown of the expenditure and verify that it relates to the development of the new products.

 

Undertake testing to determine whether the costs relate to the research or development stage.

This expenditure is classed as research and development under IAS 38 Intangible Assets.

 

IAS 38 requires research costs to be expensed to profit or loss and development costs to be capitalised as an intangible asset.

 

If the company has incorrectly classified research costs as development expenditure, there is a risk the intangible asset could be overstated and expenses understated.

 

In addition, as the senior management bonus is based on year‐end asset values, this increases this risk further as management may have a reason to overstate assets at the year‐end.

Discuss the accounting treatment with the finance director and ensure it is in accordance with IAS 38.
In September 20X5, the company invested $0.9 million in a complex piece of plant and machinery. The costs include purchase price, installation and training costs.

 

As per IAS 16 Property, Plant and Equipment, the cost of an asset incudes its purchase price and directly attributable costs only. Training costs are not permitted. Plant and machinery and profits are overstated.

Obtain a breakdown of the $0.9 million expenditure and undertake testing to confirm the level of training costs which have been included within non‐current assets.

 

Discuss the accounting treatment with the finance director and the level of any necessary adjustment to ensure treatment is in accordance with IAS 16.

The bonus scheme for senior management and directors of Fantasy    Sparkle Co has been changed and is now based on the value of year‐end total assets.

 

There is a risk that management might be motivated to overstate the value of assets through the judgments taken or through the use of releasing provisions or capitalization policy.

Throughout the audit, the team will need to be alert to this risk and maintain professional skepticism. Detailed review and testing on judgmental decisions, including treatment of provisions, and compare treatment against prior years. Any manual journal adjustments affecting assets should be tested in detail.

 

In addition, a written representation should be obtained from management confirming the basis of any significant judgments.

The finance director of Fantasy    Sparkle Co believes that an allowance for receivables is excessive and unnecessary and therefore has not provided for it at the year‐end and has credited the opening balance to profit or loss.

 

There is a risk that receivables will be overvalued; some balances may be irrecoverable and so will be overstated if not written down.

 

In addition, releasing the allowance for receivables will increase asset values and hence the senior management bonus which increases the risk further.

Extended post year‐end cash receipts testing and a review of the aged receivables ledger to be performed to assess valuation and the need for an allowance for receivables.

 

Review and test the controls surrounding how Fantasy    Sparkle Co identifies receivables balances which may require an allowance to ensure that they are operating effectively in the current year.

 

Discuss with the finance director the rationale for not maintaining an allowance for receivables and releasing the opening balance.

A new general ledger system was introduced in May 20X6 and the old and new systems were run in parallel until August 20X6.

 

There is a risk of the balances in May being misstated and loss of data if they have not been transferred from the old system completely and accurately. If this is not done, this could result in the auditor not identifying a significant control risk.

The auditor should undertake detailed testing to confirm that all of the balances at the transfer date have been correctly recorded in the new general ledger system.

 

The auditor should document and test the new system. They should review any management reports run comparing the old and new system during the parallel run to identify any issues with the processing of accounting information.

A number of reconciliations, including the bank reconciliation, were not performed at the year‐end, however, they were undertaken in June and August.

 

Control account reconciliations provide comfort that accounting records are being maintained completely and accurately. This is an example of a control procedure being overridden by management and raises concerns over the overall emphasis placed on internal control.

 

There is a risk that balances including bank balances are under or overstated.

Discuss this issue with the finance director and request that the July control account reconciliations are undertaken. All reconciling items should be tested in detail and agreed to supporting documentation.
The payables ledger of Fantasy    Sparkle Co was closed down on 8 August, rather than at the year‐end 31 July.

 

There is a risk that the cut‐off may be incorrect with purchases and payables over or understated.

The audit team should undertake testing of transactions posted to the payables ledger between 1 and 8 August to identify whether any transactions relating to the 20X7 yearend have been included or any 20X6 balances removed.

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