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ACCA Paper P7 (INT) Advanced Audit & Assurance June 2011 Final Assessment – Answers To gain maximum benefit, do not refer to these answers until you have completed the corporate mock questions and submitted them for marking.

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Page 1: ACCA P7 INT Final Assessment Ans J11 With Marks

ACCA

Paper P7 (INT)

Advanced Audit & Assurance June 2011

Final Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the corporate mock questions and submitted them for marking.

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P A PER P7 ( INT) : ADV AN C ED A UD I T & AS S U RA N C E

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© Kaplan Financial Limited, 2010

The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials.

All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

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1 STAGECOACH

(a) Briefing notes

To: Engagement Team

Subject: Principal Audit Risks – Stagecoach Co

Date: 31 October 2009

Introduction

To assist with the planning of the year-end audit of Stagecoach Co please find enclosed a discussion of the known audit risks.

Revenue recognition

There is a risk that revenue is overstated and that liabilities are understated.

Stagecoach raises invoices in two stages: upon order and completion. 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 when the seller has performed their contractual obligations.

Stagecoach appears to receive payment from its customers in advance of performing any obligation as a deposit. If this is a non-refundable deposit then there will never be a requirement to repay the amount and it can be treated as income. However, if the deposit is refundable then no revenue should be recorded and a liability should be recognised equal to the amount received, representing the obligation under the contract.

Disputed receivable

There is a risk that receivable balances are overstated and expenses understated.

The $0.6mn owed from Yellow Ribbon Travel represents 1.25% of total assets and 21% of profit, which is material to the financial statements.

According to the FD the customer is withholding the payment due to faulty goods. To this end it may be prudent to record a bad debt provision in accordance with IAS 37.

Inventories

There is a risk that inventory balances have been overstated in the financial statements.

Finished goods represent 1.7% of total assets and are therefore material. The inventory count was held two weeks prior to the year end. There is an inherent risk that the valuation has not been correctly rolled forward to a year-end position.

Work in progress represents 2.7% of total assets and is therefore also material to the financial statements.

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The key risk is the estimation of the stage of completion of work in progress. This is subjective, and knowledge appears to be confined to the production manager. Inventory could be overvalued if components are assessed to be more complete than they actually are at the year-end. Absorption of labour/machine costs and overheads is a complex calculation and must be done consistently with previous years.

There are also indications of poor quality due to the complaints made by Yellow Ribbon Travel and Quiet Coach Tours. According to IAS 2 inventory should be valued at the lower of cost and NRV. Any poor quality could affect the resale value, which could mean an impairment of inventories is required.

Overseas supplier

There is a risk that foreign trade payable balances are misstated. The balance represents 1.9% of total assets and is therefore material.

As the supplier is new, controls may not yet have been established over the recording of foreign currency transactions. Inherent risk is high as the trade payable should be retranslated using the year end exchange rate, as required by 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 exchange rate between the purchase date and the year-end.

Defined Benefit Pension Scheme

There is a risk that actuarial gains (and hence profits) are overstated. The actuarial gain represents 7% of profits and is therefore material.

Year-end pension balances and associated gains/losses have to be accounted for in accordance with IAS 19 Employee Benefits. Firstly calculation of balances requires significant estimates and assumptions, such as: employee turnover; employee mortality; salary inflation; returns on plan assets; and discount rates. It is difficult to effectively estimate these and due to the nature of assumptions there is an inherent risk of misstatement (both intentional and unintentional).

Mr Ford also stated that Stagecoach has recognised actuarial gains immediately in the year. Whilst IAS 19 does permit this method it must be applied consistently year-on-year and to both gains and losses. There is a significant risk that this method of recognising actuarial gains is not consistent with previous years, when they may have adopted the preferred, benchmark treatment known as the ‘10% corridor approach.’

Warranty provision

There is a risk that warranty provisions are understated. The provision represents 3.5% of total assets and is therefore material to the accounts.

Adequate provisions should be made in accordance with IAS 37. However, whilst revenues have increased by 21% in the year the warranty provision has actually fallen by 5.6%. This could indicate an under-provision as 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 components manufactured. This appears unlikely given the customer claims made during the year. This is of special concern given that it is the MD and majority shareholder who estimates the warranty provision.

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Legal claim

There is a risk that provisions for legal costs/claims are understated at the year-end or that there are insufficient contingent liability disclosures.

According to IAS 37 adequate provision should be made for all probable costs but contingent liabilities should be recorded for possible ones. Stagecoach can only ignore the potential costs if they are remote.

The legal claim by Quiet Coach Tours should be investigated seriously by Stagecoach. The MD’s opinion that the claim will not result in any financial consequence for Stagecoach is far too relaxed. Damages could be awarded against Stagecoach if it is found that their components are at fault. The level of warranty provision implies that faults are common and the claims of poor quality made by Yellow Ribbon Travel strengthen this argument.

Given this argument it appears unlikely that the possibility of incurring costs can be considered remote and Stagecoach should at least record a contingent liability.

A further risk is that any legal fees associated with the claim have not been accrued within the financial statements. As the claim has arisen during the year, the expense must be included in this year’s income statement, even if the claim is still ongoing at the year-end.

Going Concern

There is a risk that the correct basis of accounting has not been used in the year-end financial statements.

Stagecoach are reliant on four key customers for 60% of their trade. Without these customers it is unlikely that the company could continue in business. Two of the key customers, Yellow Ribbon Travel and Quiet Coach Tours, are locked in dispute with Stagecoach at the year-end. The latter also appears to have ceased trading with Stagecoach already. The worst case scenario is that Stagecoach could lose 30% of all its business.

The impact of the legal claim must also be considered. If there is any suggestion that the accident was caused by faulty Stagecoach goods this could affect future sales with other customers. These issues would put significant pressure on the business and could mean that a break-up basis of accounting is required at the year-end. The auditors should plan to extend the going concern work programme to incorporate the issues noted above.

Majority shareholder

Henry Thursday exerts control over Stagecoach via his majority shareholding, and MD status. This greatly increases the inherent risk that the financial statements could be deliberately misstated, i.e. overvaluation of assets, undervaluation of liabilities, and thus overstatement of profits. In particular Henry Thursday is responsible for the warranty provision – the calculation of which has already been scrutinised – and has ignored the legal claim in the accounts. This indicates that profits may have been materially overstated so as not to threaten Mr Thursday’s share valuation and dividend.

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Related party transactions

Henry Thursday controls Stagecoach. His wife is the main shareholder in Apache Commercial Properties. 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, in particular, any amounts owed from Stagecoach to Apache at 31August 2009 should be disclosed.

Other issues

This is the first year of audit and therefore the audit team will be working with a steep learning curve. Audit procedures may take longer than originally planned.

Henry Thursday may exert considerable influence on the members of the audit team to ensure that the financial statements show the best possible position of Stagecoach Co in view of his shareholding. It is crucial that the audit team members adhere strictly to ethical guidelines and that independence is beyond question.

Due to the seriousness of the matters noted above, a final matter to be considered at the planning stage is that a second partner review (Engagement Quality Control Review) should be considered for the audit this year. A suitable independent reviewer should be identified, and time planned and budgeted 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 Stagecoach Co will be a relatively high risk engagement.

(b) Procedures Regarding Actuarial Gain

Obtain a copy of the actuarial gain calculation from management to assist with verification of the following balances:

• Opening liability;

• Unwinding of liability discount;

• Return on plan assets;

• Servicing costs;

• Contributions paid into scheme during year;

• Benefits paid to scheme members;

• Closing liability;

• Actuarial gain.

Compare the opening liability to the closing liability recorded in the audited and published accounts for the year-ended 31 August 2008.

Obtain human resources/payroll records to confirm contributions paid during the year.

Inspect the cashbook to confirm monthly contributions paid into scheme.

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Inspect the annual statement sent by the actuary to confirm annual service costs, return on plan assets, contributions paid into the scheme during the year and benefits paid during the year.

Recalculate the unwinding of the scheme liability using the discount rate given in the actuary’s report.

Recalculate the actuarial gain or loss.

Obtain a copy of the actuary’s report to confirm the closing value of the scheme liabilities and to assess whether the assumptions are in line with the auditor’s understanding of the business and the general economic climate. For example;

• Employee turnover: analytically review Stagecoach starters and leavers by obtaining human resources records to formulate an understanding of historical employee turnover.

• Wage inflation: analytically review Stagecoach wage and salary movements to formulate an understanding of historic rates of inflation;

• Review assumptions regarding employee mortality in comparison to current national and regional average life expectancies.

(c) Purpose of the Clarity Project

The broad aim of the Clarity Project is to enhance the understandability of International Standards of Auditing. This should encourage audit firms to consistently apply the guidelines in the standards which should, ultimately, lead to an improvement in audit quality worldwide. In addition the requirements for monitoring audit quality should become clearer.

It is also hoped that the project will assist with the adoption of ISAs around the world, thus facilitating international convergence.

As a result of the project 19 ISAs and ISQC 1 have been redrafted, 16 ISAs have been revised – to include substantive changes – and one new standard, ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management, has been issued.

The redrafted standards have been re-written to make them simpler to understand and restructured to make them more consistent. Each standard now has the following sections:

• Introduction;

• Objective;

• Definitions;

• Requirements;

• Application and Other Explanatory Material.

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The revised standards include new requirements that are aimed at modernising audit and strengthening practice in a number of areas where there were perceived weaknesses, for example:

• ISA 315 – risk assessment;

• ISA 320 – materiality;

• ISA 550 – related party transactions;

• ISA 580 – written representations;

• ISAs 700 – 706 – auditor’s opinions.

It is also hoped that the clarification process will greatly reduce the need for national audit regimes to issue supplementary requirements. For example: in the UK there are a number of supplementary requirements that are considered necessary to comply with local legislation and regulation.

Despite the reduction in national supplements, there will still be some localised differences. Again, the UK and Ireland are issuing their own version of ISA 700 The Auditor’s Report on Financial Statements.

As well as restructuring the standards the IAASB has moved towards a more prescriptive approach (i.e. more rules-based). Some of the language used in the requirements section has been altered to reflect this. For example: phrases such as ‘ought to’ and ‘should’ have been replaced by stronger guidance, such as ‘the auditor shall.....’ This makes the guidance less ambiguous and open to interpretation.

(d) Practical Impact of the Clarity Project

All audit firms who have to follow international standards of auditing must, for audits of financial statements for periods beginning on or after 15 December 2009, follow the requirements of the new clarified standards.

This will have a significant impact on the firm’s approach to audit. This means that internal audit methodologies and manuals will need to be revised and audit programmes and procedures will need to be updated.

To facilitate the change firms will need to provide training for all levels of audit staff. It will then be up to the leaders of the audits (namely the partners and senior managers) to incorporate the new guidance into audit planning, performance and review.

Audit firms will need to closely monitor how effectively audit engagements are being conducted in response to the changes to make sure they are following the new guidance but also ensuring that they continue to provide the best possible service for their clients.

This process could undoubtedly lead to significant costs being incurred during the transition phase from old to new standards. In response this may lead to an increase in audit fees being charged to clients.

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Marking scheme (a) Audit Risks – Stagecoach

Generally ½ mark per identification with a further 1 mark for explanation/ application to the case scenario. ½ mark for each correct calculation of materiality, to a max of 2. ½ mark for each correctly referenced accounting standard, to a max of 2. Professional marks: ½ for structure, ½ for introduction, 1 for clarity/professionalism Ideas

• Overstatement of deposit revenue (IAS 18);

• Overstatement of receivables (IAS 37);

• Misstatement of finished goods;

• Overstatement of WIP (IAS 2);

• Misstatement of foreign payables (IAS 21);

• Overstatement of actuarial gains (IAS 19);

• Overstatement of warranty provision (IAS 37);

• Understatement of legal provisions/contingencies (IAS 37);

• Inappropriate use of going concern basis of accounting;

• Misstatement of related party transactions (IAS 24);

• Other professional issues – ½ mark each 15 marks (b) Actuarial Gain

Generally 1 mark per explained procedure (½ mark for simply listing tests). Ideas

• Review calculation (up to 2 marks for discussing which elements are being assessed);

• Analytically review opening & closing liability;

• HR records;

• Actuary’s statement;

• Recalculate unwinding of discount;

• Recalculate gain/loss;

• Review actuary assumptions. 6 marks (c) Changes Re. Clarity Project

Generally 1 mark per point of explanation (½ for brief lists) Ideas

• Enhance understandability of standards;

• Improve audit quality worldwide;

• Facilitate international convergence;

• 19 redrafts, 16 revisions, 1 addition’

• Structure of new standards;

• Examples of revised standards;

• National variances;

• Prescriptive approach. 7 marks (d) Practical Implications of Clarity Project

Generally 1 mark per point of explanation (½ for brief lists) Ideas

• Periods beginning after 15 Dec ’09;

• Update methods/manuals;

• Training;

• Monitoring;

• Costs. 4 marks

Total for Question 32 marks

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2 STAYBURYS

(a) Purpose of a ‘due diligence’ review

‘Due diligence’ may be defined as the process of systematically obtaining and assessing information relevant to the acquisition of a target company on behalf of a client.

The purpose of such an assignment is to identify and assess issues relevant to a client’s acquisition of a subsidiary in order to reduce the risks associated with the acquisition to an acceptable level.

(b) Difference between due diligence and audit

Requirements

Year end audits are legally required for all limited companies exceeding the minimum audit thresholds. They are also subject to strict regulations in the guise of International Standards of Auditing.

Due diligence is initiated at the request of directors and subject to fewer prescribed rules. An outline of the processes that should be followed can be found in: ISRE 2400 Engagements to Review Financial Statements; ISRS 4400 Engagements to Perform Agreed Upon Procedures Regarding Financial Information; ISAE 3400 The Examination of Prospective Financial Information; and ISAE 100 Assurance Engagements.

Audience

An audit opinion is offered to the shareholders of the business subject to audit. In contrast, the reports from due diligence engagements are provided to the directors of the company.

Form of Assurance

The opinion offered on an audit is one of reasonable assurance. This means that sufficient, appropriate evidence has been gathered to support an opinion as to whether the accounts are free from material misstatement.

Absolute assurance cannot be given for reasons such as: the use of accounting estimates; the nature of fraud (i.e. it is hidden); and the necessary use of audit sampling.

As the timescale for a due diligence review is often relatively short but wide in scope clients may not always request the expression of an opinion. However the accountant will be engaged to report upon certain criteria requested specifically by the client.

If sought, the assurance offered would be limited assurance.

Wording of Opinion

In an audit report a positive statement of opinion is offered as to whether the accounts are – or are not – a true and fair representation of the position and performance of the business under scrutiny.

In a limited assurance report a negative statement of opinion is given. This indicates whether anything has come to light during the review to indicate a departure from the criteria initially agreed with the client.

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Evidence

During an audit evidence is usually gathered using a mixture of analytical review, enquiry, inspection of documentation, observation of procedures, and recomputations of certain balances.

During due diligence evidence is restricted, at least initially, to analytical review and enquiry. Further corroborative evidence might be sought if any material concerns were identified.

(c) Matters to be considered before accepting the engagement

(Although candidates may approach this from a rote-learned list of ‘matters to consider’ it is important that answer points be tailored as far as possible to the scenario to gain full marks).

The Purpose and Audience of the Report

Borthwick should identify what the relationship is between Phil Vickery and Stayburys to identify what authority he has to approach them to undertake the assignment. It is important to verify whether it is worthwhile incurring costs putting a proposal together.

The purpose of the assignment must also be clarified. Mr Vickery’s request was for Borthwick ‘to advise on a bid’. It should be made clear to Stayburys that Borthwick cannot make decisions on their behalf. They can only provide a report stating facts of material interest and it is up to Stayburys’ management team to decide whether or not to bid and, if so, how much to bid.

It should be made clear from the beginning that any report produced/opinion provided will be for the board of directors of Stayburys only and that a reference to this disclaimer will be made in the final engagement report. Borthwick should discuss this with Stayburys and confirm a distribution list for the report. If the directors wish to pass the report to any third parties, such as a bank to make any loan decisions, then this will significantly increase the risk of the engagement and this will be reflected in the fee.

The Scope of the Engagement

It seems likely that Stayburys will be interested in acquiring all of Nutto’s business as its areas of operation coincide with Stayburys’. However, it must be confirmed whether Stayburys is interested in the whole company or merely acquiring the national or international business of Nutto.

Borthwick should seek clarification of what Mr Vickery means by ‘advice on a potential acquisition.’ A series of criteria/objectives would need to be agreed with the client before Borthwick could confirm whether they have the competence and resources available to perform the engagement.

Due diligence is not subject to the same strict regulations of audit and therefore the criteria could be to perform a review of the past historic accounts, or to review the forecasts of Nutto, or to assess the impact on the financial position and performance of the group, or simply to provide technical advice about how to account for the subsidiary company. Each engagement carries different risks and requires different competencies.

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It will be of vital importance to assess whether Stayburys will impose any urgent deadlines. Borthwick must have sufficient time to find all facts that would be of material interest to Stayburys before disclosing their findings. If the deadlines imposed are soon Borthwick may simply not have the human resources available to complete the assignment.

There should also be a discussion of whether there will be any restrictions on Borthwick’s access to information held by Nutto and/or key personnel who will be required for enquiry. Given the degree of secrecy usually surrounding mergers and acquisitions – due to fears of job security – this is common.

Ethical and Professional Issues

Borthwick must consider whether they can provide the required services with sufficient competence. They should not accept the engagement unless the firm has sufficient experience in undertaking due diligence assignments. Even then, the firm must have sufficient knowledge of the territories in which the businesses operate to evaluate whether all facts of material interest to Stayburys have been identified.

In addition, Borthwick must consider whether it has sufficient resources (e.g. representatives/ associated offices) in Europe and Asia to investigate Nutto’s international business, or whether such investigations can be undertaken efficiently and effectively with domestic staff.

As with any engagement, Borthwick must consider any factors which might impair their independence and objectivity when reporting to Stayburys. For example, if Phil Vickery is closely connected with a partner in Borthwick or if Borthwick provides audit services to The Barrier Corporation.

Note: Candidates will not be awarded marks for going into ‘autopilot’ on independence issues. For example, this is a one-off assignment so size of fee is unlikely to be relevant. Borthwick LLP holding shares in Nutto is also not possible as it is wholly owned.

Rationale for the Acquisition

Stayburys’ rationale for wishing to acquire Nutto should be ascertained. It is presumably significant that Nutto operates in the same territories as Stayburys. Stayburys may want to provide extensive internal training programs in management, communications and marketing to its workforce.

It should be ascertained if there is any existing relationship between Stayburys and Nutto. Stayburys may be a major client of Nutto. That is, Stayburys is currently out-sourcing training to Nutto. Acquiring them would bring training in-house. This will have an important bearing on the expected synergies from the merger. These will be different if the purpose of the investment is purely for internal training or if it is to diversify into other profitable business areas. This will have a significant impact on the focus of the DD work performed and the nature of the report provided.

Other Issues

It should perhaps be discussed why Stayburys have not requested that their current auditors conduct the due diligence review, especially as they are responsible for (and therefore capable of undertaking) the group audit covering the relevant countries.

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Borthwick should ask permission to communicate with Stayburys’ current auditor to inform them of the nature of the work they have been asked to undertake and to enquire if there is any reason why they should not accept the assignment.

In taking on Stayburys as a new client Borthwick may have a later opportunity to offer other services to Stayburys. This could therefore prove to be a sensible path to take in terms of Borthwick’s strategic growth.

(d) Due Diligence Procedures

(i) Enquiries

Tutorial note: These should be focussed on uncovering facts that may not be revealed by the audited financial statements or reflected in the forecasts of NUTTO (e.g. off statement of financial position finance, contingencies, commitments and contracts) especially where knowledge may be confined to management.

• Do any members of Nutto’s senior/executive management have contractual terms that will result in significant payouts to them (e.g. on change of ownership of the company or their being made redundant)?

• What contracts with clients, if any, will lapse or be made void in the event that Nutto is purchased from The Barrier Corp

• Are there any contracts that Stayburys would have to honour if they acquired the trade and assets of Nutto and would there be any financial penalties if they failed to deliver these services?

• What synergy or inter-company trading, if any, currently exists between Nutto and The Barrier Corporation? For example, The Barrier Corp may publish Nutto’s training materials. If Stayburys were to acquire Nutto would The Barrier Corporation be free to cease these services or are there contracts in place enforcing them?

• Do Nutto have any major clients who are in direct competition with Stayburys who, hence, are likely to be lost if Nutto is purchased?

• What are the principal terms of the operating leases relating to the International business’s premises? Most importantly; when are the leases due to expire?

• What penalties should be expected to be incurred if operating leases and/or contracts with training consultants are terminated?

• Has Nutto entered into any purchase commitments since 31 December 2009 (e.g. to buy or lease further premises, or indeed to hire further employees)?

Who are the best trainers that Stayburys should seek to retain after the purchase of Nutto?

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• What events since the audited financial statements to 31 December 2009 were published have made a significant impact on Nutto’s assets, liabilities, operating capability and/or cash flows? (For example storm damage to premises, major clients defaulting on payments, significant interest/foreign-exchange rate fluctuations, etc.)

• What is the progress of all contingent liabilities disclosed in the accounts to 31 December 2009?

• Are there any unresolved tax issues which have not been provided for in full?

• Are there any loans and, if so, do they contain any covenants? Will the acquisition affect any covenants? For example, term loans may be rendered repayable on a change of ownership.

(ii) Analytical Procedures

Note: The range of valid answer points is very broad for this part. The responses below are a guideline only and not an exclusive list.

• Review the trend of Nutto’s profit (gross and net) for the last five years, say, to identify historic performance. Similarly earnings per share and gearing. This should be compared with forecasts. The purpose of which is to, firstly, assess the relative merits and success of the business and, secondly, to ensure that forecasts appear consistent with proven performance and do not look misleading.

• For both the national and international businesses compare:

– Historic trends in gross profit, net profit, and return on assets;

– Full-time salaries;

– Freelance consultancy fees;

– Premises costs (e.g. depreciation, lease rentals, maintenance, etc);

– Monthly revenue (also costs and profit) by centre.

• Review projections of future profitability of Nutto against net profit percentage at 31 December 2009 for:

– The National business (13.5%);

– The International business (35.1%); and

– Overall (20.4%).

• Review of disposal value of owned premises against book values.

• Compare actual cash balances on a monthly basis and compare borrowings against loan and overdraft agreements. Identify whether there are any covenants and review their terms.

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• Compare the average collection period for International’s trade receivables month on month since 31 December 2009 (when it was nearly five months, i.e. $3.6/$9.4 × 365 days) and compare with the National business. This appears high and should be clarified with directors.

• Compare financial ratios for each of the national centres against the National business overall (and similarly for the International Business). For example:

– gross and net profit margins;

– return on centre assets;

– average collection period;

– average payment period;

– liquidity ratio.

• Compare key performance indicators across the centres for the year to 31 December 2009 and 2008 to date. For example:

– number of corporate clients;

– number of delegates;

– number of training days;

– average revenue per delegate per day;

– average cost per consultancy day.

• Review lease agreements and contracts of employment to ensure such costs are appropriately forecast.

• Identify any possible restrictive terms within agreements and contracts that could result in penalties against Stayburys if their acquisition proceeds.

• Review the forecasts for the year to 31 December 2009 and compare to actual, audited results. This will help assess the ability of Nutto’s management to accurately forecast.

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Marking Scheme (a) Due Diligence

Generally 1 mark each thoroughly explained point.

Ideas

• Definition;

• Purpose. 2 marks

(b) Due diligence versus audit

Generally 1 mark per thoroughly discussed point (½ mark for simply listing rote learned points without explanation).

Ideas

• Requirements;

• Audience

• Assurance;

– Reasonable (+ explanation);

– Limited (+ explanation).

• Wording of opinion;

• Evidence gathered. 5 marks

(c) Matters to consider prior to accepting engagement Generally ½ mark per point identified and a further 1 mark for thorough explanation. NB: Rote learned responses that do not refer to the unique circumstances in the scenario should score max ½ mark. Ideas

• Purpose & Audience: – Authority of Phil Vickery; – Ultimate decision; – 3rd Parties.

• Scope – Trade & assets purchase? – Advice sought/objectives; – Deadlines/other restrictions.

• Ethics/Professional issues: – Competence/resources; – Independence.

• Rationale: – Strategy; – Synergies expected.

• Other issues: – Professional clearance (max 1 mark); – Additional services (max 1 mark). 2 professional marks for: structure, headings, use of short paragraphs (no bullet points), clarity of explanation, relevance to scenario, relevance to accepting engagement. 15 marks

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(i) Enquiries

Generally 1 mark for each well explained consideration.

Ideas

• Director payments;

• Client contracts;

• Trade with Barrier Corp;

• Clients in competition to Stayburys;

• Leases;

• Purchase commitments;

• Trainers worth retaining;

• PBSEs;

• Contingencies;

• Tax issues;

• Loan covenants. 5 marks

(ii) Analytical reviews

Generally 1 mark for each well explained consideration.

Ideas

• Historic profits;

• National vs. International;

• Forecast profits;

• Covenants review;

• Receivables days review;

• Relevant ratio analysis;

• Relevant KPI analysis;

• Lease agreements;

• Restrictive terms;

• Forecasts vs. actual. 5 marks

Total for Question 2 32 marks

3 GRENDEL

(a) Accounting Estimates

Management is responsible for making accounting estimates included in the financial statements. Given the uncertain nature of estimations management should be as informed as possible before making assumptions about future events and should make the final estimate as prudently as possible.

The uncertainty surrounding the outcome of events that require some form of estimation increases the risk of material misstatement. As per the requirements of ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment the auditor is required to consider the risk of material misstatement in order to design adequate audit procedures. It is therefore imperative to identify where estimations have been made by management and how significantly they impact the financial statements.

According to ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures the auditor should design further audit procedures to obtain sufficient appropriate audit evidence as to whether the entity’s accounting estimates are reasonable in the circumstances and, when required, appropriately disclosed.

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Evidence concerning estimates may often be more difficult to obtain than for other areas of the financial statements. To this end ISA 540 recommends that auditors adopt one or a combination of the following approaches to audit estimates:

(i) Review and test the process used by management to develop the estimate;

This includes: the evaluation of assumptions of management; testing of the calculations involved; comparison with prior period estimates; and consideration of management approval procedures.

(ii) Use an independent estimate, either made or obtained by the auditor, for comparison with that prepared by management; or

(iii) Review subsequent events which provide audit evidence of the reasonableness of the estimate made.

(b) Grendel

Cessation of Home Delivery Service

Matters to consider when doing a file review

$1.6 million represents 2.2% of reported revenue (prior year 2.6%) and is therefore material.

NB: it is clearly not of such significance that it should raise any doubts whatsoever regarding the going concern assumption. (On the contrary, as revenue from this service has declined since last year.)

The home delivery service does not classify as a discontinued operation, as described in IFRS 5 Non-current Assets Held for Sale and Discontinued Operations, for the following reasons:

• 2.2% of revenue does not represent a major line of business or geographical area of operations:

• The closure is not part of a coordinated plan to dispose of a major line of business or geographical area of business; and

• The service is not a subsidiary acquired exclusively with a view to resale.

For this reason there should not be any separate disclosures in the financial statements, either in the statement of comprehensive income or in the notes, of discontinued operations.

The delivery vehicles should only be classified as held for sale if their carrying amount will be recovered principally through a sale transaction rather than through continuing use. For this to be the case the following criteria must be met, according to IFRS 5:

• Management must have committed to a plan to sell the vehicles;

• The vehicles must be available for immediate sale in their present condition;

• Their sale must be highly probable;

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• The vehicles are being marketed at a reasonable price compared to its fair value; and

• It is unlikely that significant changes will be made to the plan.

However, even if the classification as held for sale is appropriate the measurement basis is not. Non-current assets classified as held for sale should be carried at the lower of carrying amount and fair value less costs to sell.

The vehicles are currently being valued at a fair value of $1mn, whereas the carrying value is $0.5mn. The vehicles have been overstated by $0.5mn. This error represents 6.8% of profits and 2.7% of total assets, which is material to the financial statements.

The directors should be asked to adjust the error and the issue should be brought to the attention of those charged with governance. Failure to amend would lead to a modification of the audit opinion due to a material misstatement. Hence and ‘except for...’ opinion would be given.

In addition to the valuation it is now important that the vehicles in question are no longer depreciated.

According to IAS 37 the directors must make adequate provisions for all probable costs incurred as a result of the closure. The main issues likely to require provisions are redundancy costs, legal costs incurred contesting any contractual obligations (maybe with customers or suppliers) and the likely compensation that will have to be paid out.

Audit evidence that should be on file:

A copy of the board minute documenting management’s decision to cease home deliveries (and any press releases/internal memoranda to staff).

An analysis of revenue (e.g. extracted from management accounts) showing the amount attributed to home delivery sales to confirm that the service is not a major component.

Copies of the contracts of employment for individuals made redundant (most likely drivers) to confirm the terms of their redundancy payments.

A recalculation of the redundancy provision to confirm the reasonableness/ completeness of the redundancy provision (e.g. number of drivers × sum of years employed × payment per year of service).

Copies of any legal correspondence indicating the likelihood of contractual disputes following the cessation of services and any probable costs that might be incurred.

A schedule of depreciated cost of delivery vehicles extracted from the non-current asset register to confirm that the vehicles are no longer being depreciated.

Notes of enquiries made with management asking how they assessed the fair values of the vehicles held for resale.

The formation of an independent estimate of the fair value of the vehicles by comparison with second hand market prices (as published/advertised in used vehicle guides).

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If any vehicles have sold after the year-end the net proceeds should be inspected in the cash book and bank statements. These proceeds should be checked in comparison to the fair value estimates.

After-date net sale proceeds from sale of vehicles and comparison of proceeds against estimated fair values.

Comments regarding the physical condition of unsold vehicles identified during an inspection that might indicate the need for impairment.

Copies of the relevant element of the statement of financial position confirming that assets held for sale have been separately identified and copies of the notes showing the assets held for sale in the reconciliations of non-current assets.

Discontinuance of Soft Furnishings

Matters to consider when doing a file review

Soft furnishing revenue represented 11.2% of total revenue in 2009 (2008: 15.4%) and is therefore a major segment of the business.

However, according to IFRS 5 operations should only be treated as discontinued if they were either:

• Formally discontinued before the year-end; or

• Are being held for sale at the year-end.

Given that the announcement came two months after the year-end the first criterion has not been met. Neither is the business being held for sale, it has ceased activity, so the second criterion has not been met. Therefore the soft furnishings should not be classified as discontinued operations in the financial statements of Grendel in the year-ending 30 September 2009. They would be considered as discontinued in the following accounting year.

The directors should be asked to amend the financial statements and the error should be communicated to those charged with governance. Failure to amend would lead to a material misstatement with regard to the application of IFRS 5 and would require an ‘except for’ modification.

A separate issue is that the discontinuance is an event after the reporting period and provides evidence that certain adjustments may be required in the financial statements for the year-ending 30 September 2009. Possible adjustments include:

• Provisions for credit notes due to poor quality goods sold before the year-end;

• Provision (or possible write-off) for all unsold inventory, or at least items of dubious quality;

• Plant and equipment used exclusively in the production of the soft furnishings range should be tested for impairment;

• Provisions or contingent liabilities may be required for any legal claims.

Audit evidence that should be on file:

A copy of Grendel’s announcement (external ‘press release’ and any internal memorandum) to discontinue the product line, dated November 2009.

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Copies of credit notes raised after the year-end for faulty products sold before 30 September 2009 and a reconciliation of these amounts to any year-end provisions.

Copies of cash book entries for refunds paid to customers after the year-end, once again traced back to any year-end provisions.

Notes from the year-end inventory count discussing how poor quality/returned items are held separately (or at least identified) so they may be separately valued at the year-end.

Notes of enquiries with management discussing how they have valued inventory, in particular how they have identified the required impairment to remaining inventories.

Enquiries should include discussion of whether management have found any alternative sales channels for their remaining soft furnishings. If they have the expected NRV should have been discussed.

Copies of any post year-end sales invoices for obsolete inventory items with a reconciliation back to original cost (cost vs. NRV).

Copies of legal/correspondence from customers requesting claiming reimbursement for poor quality items.

Marking scheme (a) Accounting Estimates

Generally 1 mark per point of explanation.

Ideas

• Management responsible for preparing estimates;

• Risk assessment (ISA 315);

• ISA 540 (½ mark);

• Difficulty of obtaining evidence;

• Procedures (1 each max of 2):

− Review process;

− Independent estimate;

− Subsequent events. 5 marks

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(b) (i) Cessation of Home Delivery

Generally 1 mark per point of explanation. ½ mark to be awarded to any appropriate standard reference.

Answer must be split between matters and evidence. Cap at 4 if this is not done.

Ideas

Matters

• 2.2% of revenue – material but not major;

• Failure to meet IFRS 5 criteria;

• No separate disclosure of discontinued operations;

• Vehicles held for sale of they meet criteria;

• Inappropriate valuation of vehicles;

• Communicate to those charged with governance;

• Impact on opinion – ‘except for’ disagreement;

• Provisions (IAS 37)

Evidence

• Board minutes;

• Employee contracts;

• Recalculate provisions;

• Legal correspondence;

• Enquiries re. fair value;

• Independent estimate of fair value;

• After date sales proceeds. 7 marks

(ii) Soft Furnishings Discontinuance

Generally 1 mark per point of explanation. ½ mark to be awarded to any appropriate standard reference.

Answer must be split between matters and evidence. Cap at 3 if this is not done.

Ideas

Matters

• 11.2% = major line;

• IFRS 5 requirements;

• Not discontinued operation in 2009 year-end;

• Ask for amendment to financial statements;

• Impact on opinion – ‘except for’ disagreement;

• Subsequent events (IAS 10)

Evidence

• Copy of Grendel’s announcement;

• Post year-end credit notes or cash receipts;

• Inventory count notes and enquiries with directors;

• Alternative sales channels for obsolete goods;

• Legal correspondence. 6 marks

Total for Question 18 marks

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4 METALBASHA

(a) Ethical/professional issues and responses

(i) Damage Inc

Ethical Issues

Where internal and external audit services are provided by the same firm, a self-review threat exists. This is particularly apparent when internal audit services review the control environment of the client because this also has to be assessed by the audit team as part of their audit risk assessment.

It should also be considered whether Hetfield can objectively report on the internal control system of Damage Inc. Internal audit is part of this control system, therefore Hetfield would have to make an assessment of its own competence.

Given that Hetfield is likely to consider its own staff competent it is possible that it will not conduct the audit with the necessary due care, choosing instead to rely too heavily on the work of the internal audit team.

Internal audit may design its procedures with a view to enabling the external audit team to reduce its workload. Again this means that the internal audit would not be completed with the necessary objectivity to perform the required services for Damage Inc.

Hetfield must also consider the role of the internal audit function. Very often internal audit make recommendations for improving internal control systems. It is vital that Hetfield does not begin making decisions for Damage Inc as this exposes it to a significant risk of negligence.

Professional Issues

Hetfield must plan the audit to address areas of audit risk. The objectives of internal audit are not the same and, therefore, the outputs from the internal audit services cannot be entirely relied upon.

Hetfield may rely on the work of the internal audit team provided that they are satisfied with: the standard of work performed; the competence of the staff undertaking the work; and that the evidence is sufficient to support the audit risk assessment and to support the audit opinion. The usefulness of internal audit evidence must be considered at the planning stage of the external audit, when audit procedures are being designed.

To mitigate the threat posed by performing internal audit services and making decisions on behalf of management Hetfield must satisfy themselves that the client will, at all times, be responsible for:

• operating the overall system of internal control;

• determining the scope, risk and frequency of the internal audit procedures to be performed;

• considering and acting on the findings and recommendations provided by internal audit.

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To reduce the risk of self review different partners and teams should be allocated to perform the two services. This will also contribute to ensuring that each engagement is planned, performed and reviewed with a view to fulfilling their unique, respective objectives; not complementing the other service.

At the planning stage the relevant partner should ensure that staff used in the internal audit team are either specialists in internal audit or suitably competent for this service.

Sufficient reviews should take place to ensure that both engagements have been adequately performed and that there are no instances where quality has been compromised. In light of the situation an ethics partner review, or a partner not involved in either engagement, would appear appropriate.

If it is considered that both services cannot be offered without compromising the independence of Hetfield then they should resign from one of the roles.

(ii) Hammett

Ethical Issues

There is an obvious conflict of interest if Hetfield operates as adviser: both Hammett and Ulrich Enterprises are clients. Hammett will be seeking the best possible price for the sale of the shares and Ulrich Enterprises will be seeking to negotiate a reduced price for the purchase. Hetfield cannot objectively advise both parties in this matter.

In addition there is a danger that confidential information relating to the sale/purchase could be leaked to the opposite side as Hetfield will be privy to both parties.

There is also a risk that Hetfield may not act with total objectivity. It may act in favour of Ulrich Enterprises to safeguard future audit income streams.

Professional Issues

If Hetfield accepts the engagement it should plan to use different partners and staff with separate reporting lines. This will help prevent the transfer of confidential data. This should also ensure that each team acts competently by working towards the objectives of their respective client.

Hetfield must also plan to use experienced corporate finance/due diligence staff to advise and report in this manner to ensure that the work is performed with the necessary due care.

It will be vital that a senior partner, not involved in the engagement, regularly reviews working files and general progress to ensure that independence (or quality) is not being impaired.

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If adequate safeguards cannot be put in place Hetfield should only advise one party in this matter, or – more prudently – should refuse to act on behalf of either client. At the very least Hetfield should discuss this conflict of interest with both parties (i.e. act with integrity) and explain their ethical position. They may wish to advise their clients that their interests may, in the circumstances, be better served by a more independent firm.

If either Hammett or Ulrich Enterprises (or both) still wish to proceed with the engagement then written consent should be obtained confirming both parties are aware of the issues discussed above.

(b) Audit Committee

Having established an audit committee the company must determine its role and function. The objectives will depend upon the nature of the company and the regulatory regime under which it operates. Therefore the business segment and the country will be important factors to consider in establishing the role and function of the audit committee but general considerations include:

• The appointment of the external auditor, the setting of audit fees to be paid, and reviews of such fees, and any matters of external auditor dismissal or resignation.

• Review the nature and extent of non-audit services provided by the external auditor.

• Discussions with the external auditor before the audit commences regarding the nature and scope of the audit.

• If more than one audit firm is used, to co-ordinate the activities of the various parties involved.

• Review the interim and annual financial statements before submission to the board.

• Review compliance with regulatory requirements. This includes that accounting policies are in line with any legal regulations, corporate governance requirements, stock exchange reporting requirements and professional accounting standards.

• Discuss problems and reservations arising from the external audit. This can be very useful to the external auditor wanting to avoid a breach of confidentiality on a matter the auditor would like to discuss.

• Review the external auditor's management letter and management response. The audit committee should be in a position to ensure that the points made by the external auditor are followed up.

• Review the company's internal control systems and their effectiveness.

• Review any internal audit programme, ensuring that there is close co-ordination and co-operation between the internal audit function and the external auditors.

• Consider, and report on, the major findings of internal investigations and management's response. As such the committee also provides a channel for ‘whistleblowing.’

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Marking Scheme

(a) Ethical & Professional Issues

Generally 1 mark for each issue that is thoroughly discussed.

Ideas

Damage Inc

• Self review;

• Objectivity;

• Due care;

• Designing complimentary services when objectives are different;

• Management decisions;

• Separate teams;

• Specialist IA staff;

• Reviews;

• Resign. 6 marks

Hammett

• Conflict of interest;

• Confidentiality;

• Objectivity;

• Separate teams;

• Experienced CF staff;

• Review;

• Decline;

• Written confirmation. 6 marks

(b) Role/function of an audit committee

Generally 1 mark per explained procedure to a maximum of 8.

Ideas

• Appoint & set fees;

• Review services;

• Discuss nature/scope;

• Co-ordinate multiple auditors;

• Review accounts;

• Review compliance;

• Discuss audit issues;

• Review management letter;

• Review internal controls;

• Review internal audit;

• Whistleblowing. 8 marks

Total for Question 18 marks

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5 BROWN

(a) Subsequent Events

Management are required to consider events after the reporting period and make necessary adjustments to their accounts in line with IAS 10. For this purpose management should establish a system to identify and evaluate the impacts of post year-end events.

Guidance for auditors is given in ISA 560 Subsequent Events. Their responsibilities are divided by reference to the time period:

(i) Events occurring up to the date of the auditor’s report;

(ii) Events discovered after the date of the auditor’s report but before the financial statements are issued; and

(iii) Events discovered after the financial statements have been issued.

In time period (i) the auditor should perform audit procedures designed to obtain sufficient appropriate evidence that all subsequent events have been appropriately reflected in the financial statements.

Typical procedures include:

• Reviewing management’s system for identifying subsequent events;

• Reading minutes of board meetings;

• Reading the latest available interim financial information, including forecasts;

• Inspecting correspondence with the client’s legal advisors;

• Obtaining written representations that directors have considered the effect of all subsequent events.

In time period (ii) the auditor has no responsibility to perform audit procedures. However, if the auditor becomes aware of facts that may materially affect the financial statements they should take appropriate action, including:

• Carrying out further audit procedures on the amended financial statements and issuing a new audit report;

• When the financial statements are not modified the auditor should either modify the audit report or, where the report has previously been issued to the client, they should communicate with those charged with governance and request that they do not publish the financial statements and the audit report;

• In the unlikely circumstance that the financial statements and the audit report are released by the client without the necessary amendments the auditor should take appropriate action to prevent reliance on the auditor’s report. The main course of action would be to communicate to the shareholders at the AGM. Depending on the legal advice obtained the auditor might also resign.

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Time period (iii) is also a period of passive duty for the auditor. However, in these circumstances if a subsequent event indicates a material error in the financial statements the auditor, through discussion with the client, should consider if revised accounts should be issued.

(b) Audit Reports

Balls Inc

The audit opinion states whether the financial statements:

• are presented fairly, in all material respects, in accordance with a relevant financial reporting framework; and

• comply with statutory requirements (where appropriate).

The Chairman’s report is not a part of the financial statements, as prepared under international accounting standards. However, according to ISA 720 The Auditor’s Responsibilities Relating to Other Information in Documents Containing Audited Financial Statements auditors have a professional responsibility to read the other reports included with the financial statements to identify material inconsistencies with the audited financial statements.

A material inconsistency exists when information presented in the unaudited reports contradicts information contained in the audited financial statements. In this instance the chairman of Balls Inc is suggesting that investment property rental is a ‘major’ revenue stream. This is clearly an over exaggeration due to the fact that this segment only contributes 1.6% of revenues. As a general rule of thumb business sectors usually have to contribute more than 10% of revenue before they are considered ‘major.’

For this reason the Chairman’s report may be considered misleading to a reader of the accounts.

Brown LLP must communicate with those charged with governance and request that the Chairman’s report is amended.

If they refuse then the audit senior is correct: the audit opinion may not be modified as it does not extend to the other reports. However, the auditor should modify the audit report by including an explanatory/other matter paragraph highlighting the inconsistency of information provided.

Miliband Co

The cash transfer is a non-adjusting post balance sheet event, as per IAS 10. It indicates that Harman was trading after the reporting period. However, that does not preclude Harman having commenced trading before the year-end.

The finance director’s oral representation is wholly insufficient evidence with regard to the existence (or otherwise) of Harman at 31 July 2009. If it existed at the year-end its financial statements should have been consolidated with Miliband’s accounts into a set of group financial statements.

The auditor must perform additional procedures before they can conclude on the nature of the audit report. At the very least they must ask the directors if any legal documents confirming the date of incorporation of the subsidiary exist.

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If such evidence has been sought but the directors cannot provide it to the auditor then the audit opinion will need to be modified on the basis of insufficient audit evidence.

Whilst the transaction itself may be immaterial, the information concerning the existence of a subsidiary, and the failure to consolidate group accounts, may – in the judgement of the auditor – be material to users. For this reason it appears appropriate to give an ‘except for’ qualification.

However, the nature of Harman is uncertain. If it did exist at the year-end, whilst it is unlikely that it will have any significant trading transactions, it may have significant assets and liabilities, such as non-current assets, investments and external finance. The failure to consolidate under these circumstances may be considered pervasive to the financial statements. In this case a disclaimer of opinion would be given in the modified audit report.

Whether material or pervasive is a matter of judgement and, in the absence of further information, it is up to the engagement partner to decide. However, if the necessary information is not forthcoming Brown must consider the motivations of management for withholding it. In this case it is likely that the auditor would take the most prudent action to restrict any possible legal action against themselves in the future.

Marking scheme (a) Subsequent Events

Generally 1 mark per point of explanation. ½ mark for appropriate references to standards

Ideas

• Management prepare accounts – IAS 10;

• Division of auditor responsibility – ISA 560;

• Up until date of audit report – perform procedures;

• Example procedures (1 each, max of 2);

• After date of report:

– Do not perform procedures;

– Update financial statements and audit report;

– Speak at AGM or resign.

• After issue of financial statements – possible revision 7 marks

(b) (i) Balls Inc

Generally 1 mark per point of explanation. ½ mark for each appropriate standard reference.

Ideas

• Chairman’s report outside scope of audit;

• ISA 720 (½ mark);

• Auditor considers unaudited reports;

• Explanation of material inconsistency;

• Communicate to those charged with governance;

• Cannot modify opinion.

• Emphasis of matter paragraph. 5 marks

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(ii) Miliband Co

Generally 1 mark per point of explanation. ½ mark for each appropriate standard reference.

Ideas

• Non-adjusting subsequent event (IAS 10);

• Insufficient evidence regarding existence of group at year-end;

• Additional procedures required;

• Without evidence – limitation of scope;

• Material – ‘except for’ qualification;

• Pervasive – ‘disclaimer’

• Matter of judgement for engagement team. 6 marks

Total for Question 18 marks