ACCA P7

Advanced Audit and Assurance

Question Based Revision

QBR Submission Form

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|ACCA P7 QBR 2

Answer One

(a)

Briefing Notes

To: Audit partner

From: Audit manager

Subject: Principal Audit Risks – Island Co

Introduction

These briefing notes evaluate the audit risks to be considered at the planning stage of Island Co; principal audit

procedures to be performed over the warranty provision and opening balances, and discussion of why related

party transactions can be difficult for auditors.

Revenue Recognition – timing

Island Co appears to receive payment from its customers in advance of performing any obligation, as the stage

one invoice is raised when an order is confirmed i.e. before any work has actually taken place.

There is potential for breach of IAS 18 Revenue, which states that revenue should only be recognised once the

seller has the right to receive it, in other words the seller has performed its contractual obligations.

This creates the potential for revenue to be recognised too early, in advance of any performance of contractual

obligation. When a payment is received in advance of performance, a liability should be recognised equal to the

amount received, representing the obligation under the contract.

Therefore a significant risk is that revenue is overstated and liabilities understated.

Disputed receivable

The amount owed from Jacks Mine Co is highly material as it represents 50.9% of profit before tax, 2.3% of

revenue, and 3% of total assets.

The receivable if a financial asset and any impairment should be dealt with in accordance with IFRS 9 Financial

instruments. The dispute with the customer indicates the receivable is impaired and should be written down.

The risk is that the receivable is overstated if no impairment of the disputed receivable is recognised.

Sawyer: Provision for legal claim

The chief executive officer’s (CEO) opinion that the claim will not result in any financial consequence for Island Co

is without substance. Damages could be awarded against Island Co if it is found that the machinery is faulty.

The recurring high level of warranty provision implies that machinery faults are fairly common and therefore the

accident could be the result of a defective machine being supplied to Sawyer Co.

The risk is that no provision is created for the potential damages under IAS 37 Provisions, Contingent Liabilities

and Contingent Assets, if the likelihood of paying damages is considered probable resulting in understatement of

liabilities.

Alternatively, if the likelihood of damages being paid to Sawyer Co is considered possible then a contingent

liability should be disclosed in the notes to the financial statements. The note would describe the nature and

possible financial effect of the contingent liability.

|ACCA P7 QBR 3

A further risk is that any legal fees associated with the claim have not been accrued within the financial

statements.

Sawyer: Provision for refund of stage one payment

If the stage one payments have already been made, then Sawyer Co may claim a refund, in which case a provision

should be made to repay the amount. There is a risk that a provision has not been made for the refund of any

payments made to date.

Risk of manipulation

The fact that the legal claim is effectively being ignored may cast doubt on the overall integrity of senior

management, and on the integrity of the financial statements.

Representations from management should be approached with professional scepticism during the audit.

Kate Shannon exerts control over Island Co via a majority shareholding, and by holding the position of CEO. This

greatly increases the risk that the financial statements could be deliberately misstated, i.e. overvaluation of

assets, undervaluation of liabilities, and thus overstatement of profits.

The risk is severe at this yearend as Kate Shannon is hoping to sell some Island Co shares post year end. As the

price that she receives for these shares will be to a large extent influenced by the statement of financial position

of the company she has a definite interest in manipulating the financial statements for her own personal benefit.

For example:

not recognising a provision or contingent liability for the legal claim from Sawyer Co

not providing for the potentially irrecoverable receivable from Jacks Mines Co

not increasing the warranty provision

recognising revenue earlier than permitted by IAS 18 Revenue.

Going concern

Sawyer Co is one of only five major customers, and losing this customer could have future going concern

implications for Island Co if a new source of revenue cannot be found to replace the lost income stream from

Sawyer Co.

If the legal claim becomes public knowledge, and if Island Co is found to have supplied faulty machinery, then it

will be difficult to attract new customers.

A case of this nature could bring bad publicity to Island Co, a potential going concern issue if it results in any of

the five key customers terminating orders with Island Co.

There is a risk of inadequate disclosure of going concern uncertainties in the notes to the financial statements. If it

is considered the company is not a going concern, there is a risk that the financial statements are prepared on an

inappropriate basis if the going concern basis has been used instead of the break-up basis.

Inventories

Work in progress is material to the financial statements, representing 8.9% of total assets.

The inventory count was held two weeks prior to the year end. There is a risk that the roll forward has not been

performed accurately resulting in inaccurate quantities of inventory reported at the year end and corresponding

misstatement of inventory.

A key risk is the estimation of the stage of completion of work in progress. This is subjective, and could be used to

manipulate the financial statements.

|ACCA P7 QBR 4

Inventory could be overvalued if the machines are assessed to be more complete than they actually are at the

year end.

Absorption of labour costs and overheads into each machine is a complex calculation and must be done

consistently with previous years.

Overseas supplier

The payable of $1.5mn represents 1.6% of total assets and is material.

Trade payables should be retranslated using the year end exchange rate per IAS 21 The Effects of Changes in

Foreign Exchange Rates.

If the retranslation is not performed at the year end, the trade payable could be significantly over or under

valued, depending on the movement of the dollar to euro exchange rate between the purchase date and the year

end.

Warranty provision

The warranty provision is material at 2.6% of total assets.

The provision has increased by only $100,000, an increase of 4.2%, compared to a revenue increase of 21.4%.

The percentage change in revenue would be expected to be in line with the percentage change in the warranty

provision, unless significant improvements had been made to the quality of machines installed for customers

during the year.

This appears unlikely given the legal claim by Sawyer Co, and the machines installed at Jacks Mine Co operating

inefficiently.

There is a risk of under-provision which is of special concern given that it is the CEO and majority shareholder who

estimates the warranty provision.

Related party disclosures

Kate Shannon controls Island Co and also controls Pacific Co. Transactions between the two companies should be

disclosed per IAS 24 Related Party Disclosures.

There is risk that not all transactions have been disclosed, or that a transaction has been disclosed at an

inappropriate value.

Details of the lease contract between the two companies should be disclosed within a note to the financial

statements as well as any amounts owed from Island Co to Pacific Co at the year end.

Tight deadline

Kate Shannon wants the audit to be completed as soon as possible, which brings forward the deadline for

completion of the audit.

The audit team may not have time to complete all necessary procedures, or there may not be time for adequate

reviews to be carried out on the work performed.

Detection risk, and thus audit risk is increased, and the overall quality of the audit could be jeopardised.

New audit client

This is the first year audit and therefore the audit team will have no cumulative audit knowledge and experience.

Audit procedures may take longer than originally planned, yet there is little time to extend procedures where

necessary.

|ACCA P7 QBR 5

Sale of shares

Kate Shannon may also exert considerable influence on the members of the audit team to ensure that the

financial statements show the best possible position of Island Co in view of her share sale.

It is crucial that the audit team members adhere strictly to ethical guidelines.

Given the level of risk involved with this engagement, an engagement quality control review should be arranged.

A suitable independent reviewer should be identified, and time planned and budgeted for at the end of the

assignment.

Conclusion

From the range of issues discussed in these briefing notes, it can be seen that the audit of Island Co will be a

relatively high risk engagement. Appropriate responses must be designed to address these risks and documented

in the audit plan.

[Professional marks: 1 mark for clarity of answer. 1 mark for subheadings providing structure to the briefing

notes]

(b) (i) Procedures: Warranty provision

Review and test the process used by management to develop the estimate

Review contracts or orders for the terms of the warranty to gain an understanding of the obligation of

Island Co.

Review correspondence with customers during the year to gain an understanding of claims already in

progress at the year end.

Perform analytical procedures to compare the level of warranty provision year on year, and compare

actual to budgeted provisions. If possible disaggregate the data, for example, compare provision for

specific types of machinery or customer by customer. Discuss fluctuations with Kate Shannon.

Re-calculate the warranty provision to confirm arithmetical accuracy.

Agree the percentage applied in the calculation to the stated accounting policy of Island Co.

Review board minutes for discussion of on-going warranty claims, and for approval of the amount

provided.

Use management accounts to ascertain a normal level of warranty rectification costs during the year.

Discuss with Kate Shannon the assumptions she used to determine the percentage used in her

calculations.

Compare prior year provision with actual expenditure on warranty claims in the accounting period.

Review subsequent events which confirm the estimate made

Agree cash expended on rectification work in the post reporting period to the cash book.

Agree cash expended on rectification work post year end to suppliers’ invoices, or to internal cost ledgers

if work carried out by employees of Island Co.

Read customer correspondence received post year end for any claims received since the year end.

Procedures: Opening balances

Review the most recent financial statements, if any, and the prior year auditor’s report, if any, for

information relevant to opening balances, including disclosures.

Agree the opening balances to the prior year’s financial statement closing balances to confirm whether

they have been correctly brought forward to the current year.

Determine whether the opening balances reflect the application of appropriate accounting policies.

Review the prior auditor’s working papers to obtain evidence regarding opening balances.

|ACCA P7 QBR 6

If this is not possible, consider whether procedures performed in the current period provide evidence

over the opening balances.

In exceptional cases the auditor may need to perform specific audit procedures to obtain evidence

regarding the opening balances.

(i) ISQC 1 Quality Control for Firms That Perform Audits and Reviews of Historical Financial Information and Other

Assurance and Related Services Engagements provides guidance on the overall quality control systems that

should be implemented by an audit firm. ISA 220 Quality Control for Audits of Historical Financial Information

specifies the quality control procedures that should be applied by the engagement team in individual audit

assignments.

Procedures include the following:

Client acceptance procedures

There should be full documentation, and conclusion on, ethical and client acceptance issues in each audit

assignment. The engagement partner should consider whether members of the audit team have complied with

ethical requirements, for example, whether all members of the team are independent of the client. Additionally,

the engagement partner should conclude whether all acceptance procedures have been followed, for example,

that the audit firm has considered the integrity of the principal owners and key management of the client. Other

procedures on client acceptance should include:

– Obtaining professional clearance from previous auditors

– Consideration of any conflict of interest

– Money laundering (client identification) procedures.

Engagement team

Procedures should be followed to ensure that the engagement team collectively has the skills, competence and

time to perform the audit engagement. The engagement partner should assess that the audit team, for example:

– Has the appropriate level of technical knowledge

– Has experience of audit engagements of a similar nature and complexity

– Has the ability to apply professional judgement

– Understands professional standards, and regulatory and legal requirements.

Direction

The engagement team should be directed by the engagement partner. Procedures such as an engagement

planning meeting should be undertaken to ensure that the team understands:

– Their responsibilities

– The objectives of the work they are to perform

– The nature of the client’s business

– Risk related issues

– How to deal with any problems that may arise; and

|ACCA P7 QBR 7

– The detailed approach to the performance of the audit.

The planning meeting should be led by the partner and should include all people involved with the audit. There

should be a discussion of the key issues identified at the planning stage.

Supervision

Supervision should be continuous during the engagement. Any problems that arise during the audit should be

rectified as soon as possible. Attention should be focused on ensuring that members of the audit team are

carrying out their work in accordance with the planned approach to the engagement. Significant matters should

be brought to the attention of senior members of the audit team. Documentation should be made of key

decisions made during the audit engagement.

Review

The review process is one of the key quality control procedures. All work performed must be reviewed by a more

senior member of the audit team. Reviewers should consider for example whether:

– Work has been performed in accordance with professional standards

– The objectives of the procedures performed have been achieved

– Work supports conclusions drawn and is appropriately documented.

The review process itself must be evidenced.

Consultation

Finally the engagement partner should arrange consultation on difficult or contentious matters. This is a

procedure whereby the matter is discussed with a professional outside the engagement team, and sometimes

outside the audit firm. Consultations must be documented to show:

– The issue on which the consultation was sought; and

– The results of the consultation.

(ii) Consultation – it may not be possible to hold extensive consultations on specialist issues within a small firm,

due to a lack of specialist professionals. There may be a lack of suitably experienced peers to discuss issues arising

on client engagements. Arrangements with other practices for consultation may be necessary.

Training/Continuing Professional Development (CPD) – resources may not be available, and it is expensive to

establish an in-house training function. External training consortia can be used to provide training/CPD for

qualified staff, and training on non-exam related issues for non-qualified staff.

Review procedures – it may not be possible to hold an independent review of an engagement within the firm due

to the small number of senior and experienced auditors. In this case an external review service may be purchased.

Lack of specialist experience – where special skills are needed within an engagement; the skills may be bought in,

for example, by seconding staff from another practice. Alternatively if work is too specialised for the firm, the

work could be sub-contracted to another practice.

Working papers – the firm may lack resources to establish an in-house set of audit manuals or standard working

papers.

In this case documentation can be provided by external firms or professional bodies.

|ACCA P7 QBR 8

Answer Two

(a) ‘Forensic auditing’

Definition

The process of gathering, analysing and reporting on data, in a pre-defined context, for the purpose of finding

facts and/or evidence in the context of financial/legal disputes and/or irregularities and giving preventative advice

in this area.

Tutorial note: Credit will be awarded for any definition that covers the key components: An ‘audit’ is an

examination (eg of financial statements) and ‘forensic’ means used in connection with courts of law. Forensic

auditing may be defined as ‘applying auditing skills to situations that have legal consequences’.

Application to fraud investigation

As a fraud is an example of an irregularity, a fraud investigation is just one of many applications of forensic

auditing, where evidence about a suspected fraud is gathered that could be presented in a court of law. The pre-

defined objective of a fraud audit is:

– to prove or disprove the suspicions; and, if proven,

– to identify the persons involved;

– to provide evidence for appropriate action, possibly criminal proceedings.

As well as being ‘reactive’, forensic auditing can be ‘proactive’ by being preventative. That is, the techniques of

forensic auditing can be used to identify risks of fraud with a view to managing those risks to an acceptable level.

(b) Prior to commencement of the investigation

Discuss the assignment with Xzibit’s management to determine the purpose, nature and scope of the

investigation. In particular, discuss whether any irregularity (theft/fraud) is suspected and, if so, whether

evidence gathered will be used:

o in criminal proceedings;

o in support of an insurance claim.

Obtain clarification of terms of reference (TOR) in writing from Xzibit’s management.

The TOR should give the investigating team full access to any aspect of Efex Engineering’s operations

relevant to their investigation.

Investigation will involve consideration of:

o possible understatement of inventory value at 30 June 2015;

o high material consumption for the quarter ended 30 June 2015.

Determine the level of experience of staff required for the investigation and the number of staff of each

grade.

The availability of suitable staff may affect the proposed start of the investigation. Alternatively, the

timing of other assignments may have to be rescheduled to allow this investigation to be started

immediately.

Xzibit’s management will presumably want the investigation completed before the next inventory count

(at 30 September 2015) to know if the findings have any implications for the conduct of the count and the

determination of year-end inventory.

|ACCA P7 QBR 9

The investigation may have been commissioned to give credence to the period-end’s accounts. The

investigation may therefore be of the nature of a limited audit.

Produce a budget of expected hours, grades of staff and costs. Agree the anticipated investigative fee

with Xzibit’s management.

The depth of the investigation will depend on matters such as:

o the extent of reliance expected to be placed on the investigation report;

o whether the report is for Xzibit’s internal use only or is it likely to be circulated to bankers and/or

shareholders.

The type of assurance (eg ‘negative’, reasonable) is likely to have a bearing on:

o any caveats in the report;

o the level of risk/potential liability for any errors in conclusions given in the final report;

o the level of necessary detailed testing required (even if an audit is not requested).

An engagement letter must be drafted and Xzibit’s management must agree to its terms in writing before

any investigative work can begin. The letter of engagement should include:

o details of work to be carried out;

o likely timescale;

o basis of determining fee;

o the reliance that can be placed on the final report and results of the investigation;

o the extent of responsibilities agreed;

o any indemnity agreed;

o the information to be supplied as a basis for the investigation; and

o any areas specifically excluded.

Assess the appropriateness of an exclusion clause; for example: ‘CONFIDENTIAL – this report has been

prepared for the private use of Xzibit only and on condition that it must not be disclosed to any other

person without the written consent of the preparing accountant’.

(c) (i) Inventory undervaluation – matters to consider

Physical inventory count

Inventory will be undervalued at 30 June 2015 if all inventory is not counted. The investigation should

consider the adequacy of quarterly physical count procedures. For example, whether or not:

o all items are marked when counted;

o management carries out test checks;

o stocksheets are pre-numbered and prepared in ink;

o a complete set of stocksheets is available covering all categories of inventory;

o Efex Engineering’s management uses the stocksheets to produce the inventory value.

Tutorial note: Inventory will not be undervalued if it does not exist (eg because it has been stolen). Theft would be

reflected in higher than normal materials consumption (see (d)).

Cutoff

Inventory will be undervalued at 30 June 2015 if:

o any goods set aside for sale in July were excluded from the count;

o a liability was recognised at 30 June 2006 for goods that were excluded from inventory (eg in

transit from the supplier);

|ACCA P7 QBR 10

o production did not cease during the physical count and raw materials being transferred between

warehouse and production were omitted from inventory.

Scrap materials

Inventory will be undervalued if any scrap from materials used in production that has a value (eg because

it can be recycled) is excluded. Inventory may be undervalued compared with the previous quarter if

there is any change in Efex’s scrap/wastage policy (eg if previously it was valued in inventory but now it is

excluded).

If production problems increased wastage in the last period this would account for the lower value of

inventory and higher materials consumption.

(ii) Tests to quantify the amount of any undervaluation

Physical count

Inspect the warehouse/factory areas to identify high value inventory items and confirm their inclusion on

the stocksheets at 30 June 2015 (or otherwise vouch to a delivery note raised after that date).

Recast all additions and recalculate all extensions on the stocksheets to confirm that there have been no

omissions, transposition errors or other computational discrepancies that would account for an

undervaluation.

Cutoff

Ascertain the last delivery notes and despatch notes recorded prior to counting and trace to

purchase/sales invoices to confirm that an accurate cutoff has been applied in determining the results for

the quarter to 30 June 2015 and the inventory balance at that date.

Trace any large value purchases in June to the 30 June stocksheets. If not on the stocksheets inquire of

management whether they are included in production (or sold). Verify by tracing to production records,

goods despatch notes, etc.

Analytical procedures

Compare large volume/high value items on stocksheets at 31 March with those at 30 June to identify any

that might have been omitted (or substantially decreased). Inquire of management if any items so

identified have been completely used in production (but not replaced), scrapped or excluded from the

count (eg if obsolete). Any inventory excluded should be counted and quantified.

Compare inventory categories for 30 June against previous quarters. Inventory value at 30 June is 10%

less than at 31 March, though revenue is 28% higher. An increase in inventory might have been expected

to support increased revenue if there is a general increase in trading activity. (Alternatively, a decrease in

inventory may reflect difficulties in obtaining supplies/maintaining inventory levels if demand has

increased).

Scrap materials

Make inquiries of Efex Engineering’s warehouse and production officials regarding the company’s

scrap/wastage policy and any records that are kept.

Review production records on a month-on-month basis and discuss with the factory manager whether

any production problems have increased wastage in the quarter to 30 June 2015.

Pricing test

|ACCA P7 QBR 11

Raw materials – select a sample of high value items from the 31 March 2015 inventory valuation and

confirm that any unit price reductions as shown by the 30 June 2015 valuation are appropriate (eg vouch

lower unit price to recent purchase invoices or write down to net realisable value).

WIP and finished goods – agree a sample of unit prices to costing records (eg batch costings). Recalculate

unit prices on a sample basis and vouch make-up to invoices/payroll records, etc.

(d) (i) High materials consumption – matters to consider

Tutorial note: Materials consumption has increased from 70% of revenue to 78%. There could be valid business

reasons for this (eg there could be an abnormally high level of wastage) or accounting errors that result in

overstatement of materials.

Cut off

Raw material purchases: Materials consumption will be overstated if goods delivered after the quarter-

end have been included (incorrectly) in purchases to 30 June 2006 although excluded (correctly) from the

June count.

Revenue: Materials consumption will be overstated as a percentage of revenue if revenue is understated

(eg if goods sold before 30 June 2015 are recorded in the next quarter).

Losses

Materials consumption will be higher than normal if there is an abnormally high level of raw materials

scrapped or wasted during the production process. This could be due to inferior quality raw materials or

technical problems with the manufacturing process.

Materials consumption will also be overstated if raw materials recorded as being used in production are

stolen. Obsolete or redundant inventory

Materials consumption will appear higher if inventory at 30 June 2006 is lower. For example, if slow-

moving, damaged or obsolete inventory identified at the count was excluded or written-down (although

included in the previous quarter’s inventory valuation).

Individual contracts

Materials consumption will be higher if the increase in revenue is attributable to a small number of large

contracts for which substantial discounts have been negotiated.

Materials consumption will be higher if the cost of materials on customers’ specifications has been

underestimated in the determination of selling prices.

Purchasing

Materials consumed will increase if Efex Engineering has changed to a more expensive supplier in the

quarter to 30 June 2015.

(ii) High materials consumption – tests

Cutoff

Purchases: Select a sample of invoices included in purchases to 30 June 2015 and match to goods

received notes to confirm receipt at 30 June 2015 and hence inclusion in inventory at that date.

Revenue: Inspect despatch notes raised on or shortly before 30 June 2015 and trace goods sold to

invoices raised on or before 30 June 2015.

|ACCA P7 QBR 12

Scrap

Inquire of production/factory and warehouse officials the reasons for scrap and wastage and how normal

levels are determined.

Inspect records of materials wastage and confirm the authorisation for scrapping materials and/or

reissuing replacement materials to the production process.

Physically inspect scrap, if any, to confirm that its condition renders it unsuitable for manufacture (and

hence confirm its exclusion from inventory at 30 June 2015).

Review credit notes received after 30 June 2015 to identify materials returned (eg of inferior quality).

Obsolete or redundant inventory

Inspect the stocksheets at 30 June 2015 for goods identified as obsolete, damaged, etc and compare with

the level (and value) of the same items identified at the previous quarter’s count.

Individual contracts

Compare discounts given on new contracts with normal discount levels and confirm the authority of the

person approving discounts.

Calculate actual material cost as a percentage of revenue on individual major contracts and compare with

the 70% benchmark.

Tests of controls

Purchases: Inspect goods received notes to confirm that raw materials are being checked for quality and

quantity upon receipt. Inspect invoices recorded to confirm that goods have been received (as evidenced

by a goods received note).

o Review goods returns recorded on pre-numbered goods return notes and confirm matched to

subsequent credit notes received.

o Observe gate controls and other physical security over inventory and review the segregation of

duties that seek to prevent or detect theft of inventory.

Sales: Review goods despatch notes and confirm matching to sales invoices that have been raised

promptly and recorded on a timely basis.

Sales returns: Review credit notes for authorisation and matching to goods returns notes.

|ACCA P7 QBR 13

Answer Three

(a) Benefits specific to Mac Co of outsourcing the internal audit function

Quality

The service provider will have good quality staff with experience of financial reporting, auditing techniques and

commercial and business awareness. This will enhance the credibility and efficiency of the work they are

performing. Lindsay, being only recently qualified, may have limited experience, and the more junior members of

her team who are studying for their professional examinations may not be technically competent in all of the

areas that the internal audit team are responsible for.

Authority/status

Lindsay comments that many of her recommendations are ignored. This may be because she is seen to lack status

and authority within the company, as she was a junior manager before heading the internal audit function, and

because she is recently qualified. If the recommendations come from an independent source, which has authority

and is supported by senior management, they are more likely to be followed. The current team lacks

independence as they are employees who report to the finance director. The team may be reluctant to overly

criticise the operations of the finance function.

Resources

It appears that Mac Co’s internal audit function is currently under-resourced, as there are only three people to

provide internal audit for a growing company, with multiple locations. Outsourcing the function will allow an

immediate increase in the resource base, meaning that more work can be quickly performed e.g. the investigation

into fraud can commence immediately.

Focus/range of work

From Lindsay’s comments, it seems that the team currently lacks a consistent focus. They are directed by the

finance director, who has changed the focus from financial reporting controls to operational controls, and it

seems the team is too small to do both. Outsourcing the function will provide as many staff as necessary (cost

permitting) to cover a range of activities. Also, the team will be better focused and be able to prioritise objectives

from an independent point of view.

Reallocation of staff

Lindsay and the rest of her team can be reallocated to other parts of the business. The finance team may benefit

from extra resources if the company continues to grow. Internal controls are more likely to become embedded in

the organisation as the finance function will have more knowledge and experience of developing and

implementing controls.

|ACCA P7 QBR 14

Tutorial note: Credit will be awarded for discussion of other, relevant benefits, e.g. Flack & Co employees may be

more technically up-to-date, can bring new technology to the internal audit function, a stronger internal audit

function may serve as a preventative and detective control to make frauds less likely in the future.

(b) Impact of outsourcing on the external audit

The external audit providers, Manhattan & Co should assess the impact of the outsourcing arrangement by

reference to ISA 610

ISAs require that the auditor determines the significance of the service organisation’s activities to the client, and

the relevance to the audit.

Manhattan & Co should consider the extent of reliance they may wish to place on the work of Flack & Co. It is

likely that more reliance will be placed on internal audit than previously, which should increase the efficiency of

the external audit. The fees charged by Manhattan & Co could be affected by this. As Mac Co is short of cash, the

fee could be an important consideration for the company.

The internal auditors may suggest changes to accounting systems and controls. When these changes occur, the

external audit firm will need to document and evaluate the new procedures, which may be time consuming. (It

could be argued that new systems and controls could reduce the reliance placed on them.)

The control environment is likely to be improved over time. This means that Manhattan & Co should reassess

their audit strategy, which will probably mean a reduction in the extent of substantive procedures that need to be

carried out.

Manhattan & Co will need to consider access to records and working papers held by Flack & Co, as information

relevant to the external audit, especially in relation to the testing of controls, is likely to be held by the service

provider.

(c) Procedures to quantify the financial loss

A review of the procedure for adding to the approved suppliers list, to help identify how many suppliers

have been added by the account manager.

A review of the payments approved by the manager, and a comparison of the suppliers paid on his

approval to the list of approved suppliers. This will help to identify any unapproved suppliers paid, and

the amounts paid to them.

Computer-assisted audit techniques could be used to identify any suppliers with the same bank account

details as the account manager, and then to trace payments made to them.

Review the completeness of supplier statements compared to a list of suppliers paid, as fictitious

suppliers will not have supplied a statement.

For each supplier, an invoice received could be selected, and details traced back to a signed

order/delivery note/service or time sheet for services provided. If none of these can be found, the invoice

and supplier is likely to be fictitious.

A review of the terms of any insurance cover that Mac Co has taken out to cover instances of fraud. Any

potential reimbursement will reduce the loss suffered by the company.

A discussion with management and the police and lawyers (assuming management has reported the

fraud) to ascertain if any of the amount stolen could be reimbursed by the account manager, in the event

that he is prosecuted successfully.

|ACCA P7 QBR 15

d)

Benefits and drawbacks of an audit committee

Improved credibility of the financial statements should result from the various activities of the audit committee,

particularly from their impartial review of the financial statements, and their discussion of significant issues with

the external auditors.

The external auditor’s opinion will also attract more confidence, as it will be transparent that the audit committee

has monitored the independence of the auditors.

A stronger control environment will be encouraged by the presence and actions of an audit committee. The fact

that the internal audit function would report to the committee, rather than to the finance director, as is currently

the situation, strengthens their independence within the company, and should add weight to their

recommendations, which currently are sometimes ignored. A stronger emphasis on controls will help the smooth

running of the business and hopefully reduce business risks, as well as opportunity for fraud.

This improved credibility and control environment could be important for a large and growing private company

like Mac Co for a number of reasons. Mac Co appears to be short of cash, and in the event of raising finance, it

will be easier and possibly cheaper to raise finance if there is a perception of good governance created by the

presence of an audit committee.

In addition, management may decide at some point in the future, to achieve listed company status. It is usually a

component of listing requirements that a company has an audit committee, or at least evaluates the need for

such a committee. If Mac Co already has an audit committee established, it will be easier to meet listing

requirements in the future.

The audit committee should also bring valuable skills, knowledge and expertise to the company. The committee

would comprise non-executive directors, who will have a variety of business backgrounds and will be

independent. The executive directors should view the members of the committee as a sounding board, which can

provide impartial advice and guidance to the executive directors. In a family-owned and managed company like

Mac Co, this source of external experience could prove invaluable. Also it will enable the executive directors to

devote their attention to management.

However, it can be difficult to recruit appropriate members to the committee. In practice, there are few people

with the relevant skills and experience who are also independent of the company, who have the time to devote to

their role as a member of the committee. This could be a problem for Mac Co, whose business activities are quite

specialised. But, with appropriate advertising and by offering a reasonable fee, it should be possible to recruit

some non-executive directors with experience in the hospitality business.

This then links to the final downside, which is expense. The audit committee members should expect to receive a

fee commensurate with their level of experience and knowledge, so the fees may be significant. This could be an

issue for Mac Co due to its cash flow problem.

Conclusion

This report has indicated that establishing an audit committee can bring valuable benefits to an organisation, as a

result of the varied responsibilities of the members of the committee. Certainly for Mac Co, which appears to

have a fairly weak control environment, the committee could help to establish some much-needed discipline.

However, the difficulties and costs of setting up an audit committee should be assessed before a final decision is

made.

|ACCA P7 QBR 16

|ACCA P7 QBR 17

Answer Four

(a) Money laundering is the process by which criminals attempt to conceal the true origin and ownership of the

proceeds of criminal activity, allowing them to maintain control over the proceeds, and ultimately providing a

legitimate cover for their sources of income.

The objective of money laundering is to break the connection between the money, and the crime that it resulted

from.

It is widely defined, to include possession of, or concealment of, the proceeds of any crime. Examples include

proceeds of fraud, tax evasion and benefits of bribery and corruption.

Client procedures should include the following:

Client identification:

Establish the identity of the entity and its business activity e.g. by obtaining a certificate of incorporation.

If the client is an individual, obtain official documentation including a name and address, e.g. by looking at

photographic identification such as passports and driving licenses.

Consider whether the commercial activity makes business sense (i.e. it is not just a ‘front’ for illegal

activities).

Obtain evidence of the company’s registered address e.g. by obtaining headed letter paper.

Establish the current list of principal shareholders and directors.

Client understanding:

Pre-engagement communication may be considered, to explain to Marcellus Fisher and the other

directors the nature and reason for client acceptance procedures.

Best practice recommends that the engagement letter should also include a paragraph outlining the

auditor’s responsibilities in relation to money laundering.

(b) There are several issues that must be addressed as a matter of urgency: Errors in the accounting system Extra

work must be planned to discover the extent of the breakdown in internal controls that occurred during the year.

It is important to decide whether the errors were isolated, or continued through the accounting period and

whether similar errors have occurred in other areas e.g. cash receipts from existing customers or cash payments.

A review of the working papers of the internal audit team should be carried out as soon as possible. The

materiality of the errors should be documented.

Errors discovered in the accounting systems will have serious implications for the planned audit approach of new

customer deposits. Nate & Co must plan to expand audit testing on this area as control risk is high.

Cash deposits will represent a significant class of transaction in CF Co. A more detailed substantive approach than

used in prior year audits may be needed in this material area if limited reliance can be placed on internal controls.

A combination of the time spent investigating the reasons for the errors, their materiality, and a detailed

substantive audit on this area means that the audit is likely to take longer than previously anticipated. This may

have cost and recoverability implications.

Extra staff may need to be assigned to the audit team, and the deadline for completion of audit procedures may

need to be extended. This will need to be discussed with CF Co.

CF Co is likely to be a highly regulated company as it operates in financial services, increasing possible attention

focused on the audit opinion as a public interest entity.

|ACCA P7 QBR 18

Due to the increased audit risk, Nate & Co should consider increasing review procedures throughout the audit.

This indicates that a second partner review should be performed.

Jin Sayed A separate issue is that of Jin Sayed offering advice to the internal audit team. The first problem raised is

that of quality control. A new and junior member of the audit team should be subject to close direction and

supervision which does not appear to have been the case during this assignment.

Secondly, Jin Sayed should not have offered advice to the internal audit team. On being made aware of the errors,

he should have alerted a senior member of the audit team, who then would have decided the action to be taken.

This implies that he does not understand the limited extent of his responsibilities as a junior member of the audit

team.

Nate & Co may wish to review the training provided to new members of staff, as it should be made clear when

matters should be reported to a senior, and when matters can be dealt with by the individual.

Thirdly, Jin Sayed must be questioned to discover what exactly he advised the internal audit team to do. Despite

his academic qualification, he has little practical experience in the financial information systems of CF Co. He may

have given inappropriate advice, and it will be crucial to confirm that no action has been taken by the internal

audit team.

The audit partner should consider if Nate & Co are at risk because of the advice that has been provided by Jin

Sayed. As he is a member of the audit team, his advice would be considered by the client as advice offered by

Nate & Co, and the partner should ascertain by discussion with the client whether this advice has been acted

upon.

Review of the financial information technology systems Nate & Co should consider whether as a firm they could

provide the review of the financial information technology system, as requested by CF Co.

IFAC’s Code of Ethics, and ACCA’s Code of Ethics and Conduct [UK SYLLABUS: Ethical Standard 5 Non-audit

services provided to audit clients, places restrictions on the provision of non-audit services. Nate & Co must be

clear in what exactly the ‘review’ will involve].

Providing a summary of deficiencies in the system, with appropriate recommendations is considered part of

normal audit procedures. However, given the errors that have arisen in the year, CF Co may be requesting that

Nate & Co design and implement changes to the system.

This would constitute a self-review threat and should only be considered if significant safeguards are put in place,

for example, using a separate team to provide the non-audit service and/or having a second partner review of the

work.

(c) It is important that all students act with integrity at all times and can be trusted by clients and other members

of the audit firm. One way of looking at the incident is to say that the student lied about his examinations and

therefore cannot be trusted to act in a professional manner, and should be disciplined accordingly either by the

audit firm or by the ACCA.

His credibility with the audit senior has been tarnished and the question arises as to whether the student would

have informed the practice about the examinations he had taken if he had failed. If this attitude is taken then the

student may be asked to leave and the ACCA informed of the student’s conduct.

A more lenient view might be that the student was succumbing to the pressures of the accounting world and it

was his inexperience which caused him to react in this way and he should be cautioned and hi future conduct

scrutinised.

|ACCA P7 QBR 19

However, the student knowingly falsified information; he had a premeditated plan and chose to lie to his seniors

about a matter which could influence his career. Such an action would undermine his integrity and the matter

should be dealt with in the same manner as any breach of integrity.

A fundamental principle of the Code of Ethics and Conduct is the fact that students should behave with integrity

in all professional business and personal financial relationships.

Integrity implies not merely honesty but fair dealing and truthfulness. In this case the audit partner may consider

a complaint to the ACCA if the audit senior has formally complained to the partner.

This accusation about the student is in many ways more serious than the second one. If the student is falsifying

records then this has major implications for the firm and the student. Falsification of time records will affect the

time budgets, the audit fee and future audits.

Falsification of audit work will increase the audit risk and potentially lead to litigation against the audit

firm. However, before any action can be taken, evidence as to the truthfulness of the accusation must be

gathered. Audit tasks must be re‐performed by the audit senior and hours spent on these audit tasks carefully

analysed, scrutinised and compared with the norm for the tasks completed. Suspicions are not sufficient grounds

for disciplinary action against the student.

If the suspicions are proven and time is not being recorded, then the audit firm’s internal disciplinary system

should be adequate to deal with the problem. If audit tasks are not being performed as stated, then the ACCA

may be informed and appropriate disciplinary action taken. It is unlikely that the audit firm would wish to

continue employing the student. The image of the profession can only be maintained if students and members of

professional bodies act with integrity.

|ACCA P7 QBR 20

Answer Five

(a)The auditor is responsible for preventing non-compliance with laws and regulations. However, the auditor does

have some responsibilities for reporting non-compliance to management, users of the accounts and to the

regulatory and enforcement authorities.

The auditor should, as soon as practicable, either communicate with those charged with governance at the client

or obtain audit evidence that they are appropriately informed regarding any cases of non-compliance. If the

auditor believes the non-compliance to be intentional and material, he should communicate the findings as soon

as possible. However, if the auditor suspects that senior management at the client, including the board of

directors , are involved, he should report to the next higher level of authority, such as an audit committee or

supervisory board. If this does not exist or the auditor believes his report will not be acted upon or is unsure who

to report to, he should seek legal advice. In the case of suspected money laundering, it might be more

appropriate to report the matter directly to the relevant authority.

If the auditor concludes that the non-compliance gives rise to a material misstatement, he should issue a qualified

or adverse opinion. If the auditor is prevented from obtaining sufficient audit evidence to assess whether non-

compliance that might be material or not has occurred or is likely to have, he should express an modified opinion

or disclaimer on the basis of an inability to obtain sufficient appropriate audit evidence. If the auditor is unable to

determine whether non-compliance has occurred because of limitations imposed by circumstances rather than by

the entity, he should consider the effect on the auditor’s report.

If the auditor becomes aware of an actual or suspected non-compliance which gives rise to a statutory duty to

report, he should make a report to the relevant authority without delay (subject to compliance with legislation

relating to ‘tipping off’).

(b) (i)

The title of the opinion section does not clarify whether the opinion is unqualified or qualified. The

quantitative effects of the failure to recognise the impairment losses have not been set out in the report,

but they should have been – the report imply states that they would increase the loss and reduce the

value of non-current assets if they had been recognised.

The wording of the opinion indicates that it is an adverse opinion but it is unlikely that this would be the

case - it is more likely to be a modified opinion rather than an adverse opinion if the reason for it is that

impairment losses on non-current assets have not been recognised. Without any quantifications of the

amount involved it is not clear why the auditors consider the matter to be pervasive.

The title of IAS 36 Impairment of assets should be given in full in the report.

It is not clear from the wording of the report whether the quantification is on the grounds of material

misstatement or an inability to obtain sufficient appropriate audit evidence. The first sentence suggests a

material misstatement but after in the report, it states that the directors have not been able to quantify

the amounts and this seems to indicate an inability to obtain sufficient appropriate audit evidence.

The prior year opinion was qualified on the same basis so the current year report should also be qualified

for the comparatives. The prior year qualification should be referred to in the current year auditor’s

report.

(ii)

|ACCA P7 QBR 21

Harrod Co is material to Chartwells. Therefore a modified auditor’s opinion on the financial statements of

Harrod Co may also affect the consolidated financial statements of Chartwells if the adjustments required

in Harrod Co’s accounts are material to the group accounts. If they were immaterial, there would be no

impact on the group auditor’s opinion.

If the adjustments required in Harrod Co’s accounts are made, then there would be no implication for the

auditor’s report on the consolidated financial statements. However, if the adjustments are not made,

then it is likely that the auditor’s opinion for the consolidated financial statements of Chartwells would be

except for.

(c)

Cooperation between auditors The group engagement team has the right to require from auditors of

subsidiaries the information and explanations they require, and to require the group management to

obtain the necessary information and explanations from subsidiaries. However, in practice, the degree of

cooperation may be limited by factors such as the component auditor not being subject to the

requirements of ISAs, but of different national practice or the group auditor not having any legal right to

contact the auditors of a component of the company preparing group accounts. ISA 600 states that the

group auditor should not accept a group audit if there are restrictions on his communication with

component auditors.

(ii) Multi-location audits

ISA 600 applies when the financial information of any component is included in the financial

statements audited by the group auditor. A component is defined as an entity or business activity

for which group or component management prepares financial information that should be

included in the group financial statements. Clearly any of these could be in a different location to

the parent company, so ISA 600 does apply to multi-location audits.

However, there is no specific guidance in ISA 600 or other standards on how to deal with the

particular problems caused by such multi-location situations. ISA 315 recognises that multi-

locations might give rise to a risk but does not suggest any solutions in a group context. This is an

area where additional guidance is required.

(iii) Joint audits

ISA 600 specifically excludes the situation where two or more auditors are appointed as joint

auditors.

Joint audits are rare because they are often costly, as both sets of auditors are responsible for the

audit opinion and therefore work can be replicated. However, they are used in some countries,

for example, France. In addition, in the wake of the Enron scandal joint audits have been

proposed as a potential solution to such problems occurring again.

Given this, joint audits are an area which requires guidance to be produced by the IESBA and the

IAASB.