ACCA Paper P7 Advanced Audit and Assurance

Mock Exam

Question Paper

Time allowed 3 hours 15 minutes

This paper is divided into two sections

Section A These questions are BOTH compulsory and must be attempted

Section B TWO questions ONLY to be attempted

Instructions: Take a few moments to review the notes on the inside of this page titled, 'Get into good exam habits now!' before attempting this exam.

DO NOT OPEN THIS PAPER UNTIL YOU ARE READY TO START UNDER EXAMINATION CONDITIONS

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Get into good exam habits now! Take a moment to focus on the right approach for this exam.

Effective time management Watch the clock, allow 1.95 minutes per mark. Work out how long you can spend on each

question and do not exceed that time.

Take a few moments to think what the requirements are asking for and how you are going to answer them.

Effective planning This paper is in exactly the same format as the real exam. You should read through the paper and

plan the order in which you will tackle the questions. Always start with the one you feel most confident about and take time to choose the questions you will answer in sections with choice.

Read the requirements carefully: focus on mark allocation, question words (see below) and potential overlap between requirements.

Identify and make sure you pick up the easy marks available in each question.

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Section A – BOTH questions are compulsory and MUST be attempted

1 Medix You are Charlie Banks, an audit senior in Mitchell & Co, a firm of Chartered Certified Accountants. Gavin Jones is an audit manager in your firm who has recently returned to practice after working for some years in industry. You have just received the following email from him.

To: Charlie Banks, audit senior From: Gavin Jones, audit manager Subject: Potential new client – Medix Co

Charlie,

I would like you to prepare some briefing notes for me to use to help me decide whether or not to proceed with the appointment as auditor to a new client, Medix Co. There are a number of pieces of information that you'll need to take into account when preparing them.

I recently held a meeting with the finance director of Medix Co, Ricardo Feller, and I've attached my notes from it to this email (Attachment 1). I have also held a discussion with the current audit partner of Medix Co, Mick Evans, who runs a small accounting and audit practice in which he is one of two partners. I have attached an extract from an email that I recently received from him (Attachment 2). Finally, I have come across an article in a local newspaper that mentions Medix Co, but I haven't had a chance to read through it yet. I've attached some extracts from it (Attachment 3).

Be sure that your notes include the following.

(a) An assessment of the professional, ethical and other issues to be considered in deciding whether to proceed with the appointment as auditor of Medix Co (10 marks)

(b) (i) A discussion of the relationship between the concepts of 'business risk' and 'risk of material misstatement' (4 marks)

(ii) Identify and explain the potential risks of material misstatement caused by the breach of planning regulations discussed in the press cutting (6 marks)

(c) Identify and explain the principal business risks facing Medix Co. (11 marks)

Thanks for your help with this.

Gavin

Attachment 1

Meeting notes – meeting held 1 June 20X8 with Ricardo Feller

Medix Co is a provider of specialised surgical instruments used in medical procedures. The company is owner managed, has a financial year ending 30 June 20X8, and has invited our firm to be appointed as auditor for the forthcoming year end. The audit is not going out to tender. Ricardo Feller has been with the company since January 20X8, following the departure of the previous finance director, who is currently taking legal action against Medix Co for unfair dismissal.

Medix Co manufactures surgical instruments which are sold to hospitals and clinics. Due to the increased use of laser surgery in the last four years, demand for traditional metal surgical instruments, which provided 75% of revenue in the year ended 30 June 20X7, has declined rapidly. Medix Co is expanding into the provision of laser surgery equipment, but research and development is at an early stage. The directors feel confident that the laser instruments currently being designed will eventually receive the necessary licence for commercial production, and that the laser product will replace surgical instruments as a leading source of revenue. There is currently one

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scientist working on the laser equipment, subcontracted by Medix Co on a freelance basis. The building in which the research is being carried out has recently been significantly extended by the construction of a large laboratory.

A considerable revenue stream is derived from agents who are not employed by Medix Co. The agents earn a commission based on the value of sales they have secured for Medix Co during the year. There are many suppliers into the market and agents are used by all manufacturers as a means of marketing and distributing their products.

The company's manufacturing facility is located in another country, where operating costs are significantly lower. The facility is under the control of a local manager who visits the head office of Medix Co annually for a meeting with senior management. Products are imported via aeroplane. The overseas plant and equipment is owned by the company and was constructed 12 years ago specifically for the manufacture of metal surgical instruments.

The company has a bank overdraft facility and makes use of the facility most months. A significant bank loan, which will carry a variable interest rate, is currently being negotiated. The terms of the loan will be finalised once the audited financial statements have been viewed by the bank.

Attachment 2

Extract from email from Mick Evans

'Medix Co has been an audit client for three years. We took over from the previous auditors following a disagreement between them and the directors of Medix Co over fees. As we are a small practice with low overheads we could offer lower fees than our predecessors. We could also do the audit very quickly, which pleased the client, as they like to keep costs as low as possible.

'During our audits we have found the internal systems and controls to be quite weak. Despite our recommendations, there always seemed to be a lack of interest in making improvements to the accounting systems, as this was seen to be a "waste of money". There have been two investigations by the tax authorities, which we did not deal with, as we are not tax experts. In the end the directors sorted it all out, and I believe that the tax matter is now resolved. We never had a problem getting access to accounting books and records. However, the managing director, Jon Tate, once gave us what he described as "the wrong cash book" by mistake, and replaced it with the "proper version" later in the day. We never found out why he was keeping two cash books, but cash was an immaterial asset so we didn't worry about it too much.

'We are resigning as auditors because the work load is too much for our small practice, and as Medix Co is our only audit client we have decided to focus on providing non-audit services in the future.'

Attachment 3

Extract from local newspaper – business section, 2 June 20X8

'It appears that local company Medix Co has breached local planning regulations by building an extension to its research and development building for which no local authority approval has been given. The land on which the premises is situated has protected status as a "greenfield" site which means approval by the local authority is necessary for any modification to commercial buildings.

'A representative of the local planning office stated today: "We feel that this is a serious breach of regulations and it is not the first time that Medix Co has deliberately ignored planning rules. The company was successfully sued in 20X3 for constructing an access road without receiving planning permission, and we are considering taking legal action in respect of this further breach of planning regulations. We are taking steps to ensure that these premises should be shut down within a month. A similar breach of regulations by a different company last year resulted in the demolition of the building."'

Required Respond to Gavin's email. (31 marks)

Professional marks will be awarded for the appropriateness of the format and presentation of the notes and the effectiveness with which the information is communicated. (4 marks)

(Total = 35 marks)

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2 Murray You are an audit manager in Ross & Co, a firm of Chartered Certified Accountants. The principal activity of one of your audit clients, Murray, is the manufacture and retail sale of women's fashions and menswear throughout the capital cities of Western Europe. Murray is not a listed company.

The following financial information has been extracted from Murray's most recent consolidated accounts:

Year ended 31 March 20X8 20X7 $'000 $'000 Revenue 36,367 27,141 Gross profit 22,368 16,624 Profit before tax 5,307 4,405 Intangible assets: goodwill 85 85 trademarks 52 37 Property, plant & equipment 7,577 4,898 Current assets 13,803 9,737 Total Assets 21,517 14,757 Equity 13,226 10,285 Non-current liabilities (provisions) 201 87 Current liabilities (payables) 8,090 4,385 Total equity & liabilities 21,517 14,757

In May 20X8 Murray purchased 100% of the shareholding of Di Rollo Co. Di Rollo manufactures fashion accessories (for example, jewellery, scarves and bags) in South America that are sold throughout the world by mail order. Murray's management is now planning that clothes manufacture will expand into South America and sold into Di Rollo's mail order market. Additionally, Di Rollo's accessories will be added to the retail stores' product range.

Murray is a member of an ethical trade initiative that aims to improve the employment conditions of all workers involved in the manufacture of its products. Last week Di Rollo's chief executive was dismissed following allegations that he contravened Di Rollo's policy relating to the environmentally-friendly disposal of waste products. The former chief executive is now suing Di Rollo for six months' salary in lieu of notice and a currently undisclosed sum for damages.

Ross & Co has recently been invited to accept nomination as auditor to Di Rollo. Murray's management has indicated that the audit fee for the enlarged Murray group should not exceed 120% of the fee for the year ended 31 March 20X9. You have been provided with the following information relating to the acquisition of Di Rollo:

Carrying Fair value Fair value to amount adjustment the group $'000 $'000 $'000 Di Rollo brand name – – 600 Plant and equipment 95 419 514 Current assets 400 – 400 Current liabilities (648) – (648) Net assets at date of acquisition (153) 419 866 Goodwill arising on acquisition 859 Cash consideration 1,725

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Required

(a) Using the information provided, explain the matters that should be considered before accepting the engagement to audit the financial statements of Di Rollo Ltd for the year ending 31 March 20X9. (8 marks)

(b) Explain what effect the acquisition of Di Rollo Ltd will have on the planning of your audit of the consolidated financial statements of Murray Co for the year ending 31 March 20X9. (10 marks)

You have been making preliminary inquiries regarding matters arising from the previous year's audit of Di Rollo. It has been revealed that no action has been taken in response to the management letter prepared by the previous auditors. Di Rollo's management has explained that this was because it was 'poorly prepared' and 'unhelpful'.

Required

(c) Briefly describe various criteria against which the effectiveness of a report to management on deficiencies in internal control ('management letter') may be assessed. (7 marks)

(Total = 25 marks)

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Section B – TWO questions ONLY to be attempted

3 Visean

You are the manager responsible for the audit of Visean which manufactures health and beauty products and distributes them through a chain of 72 retail pharmacies. The draft accounts for the year ended 30 June 20X8 show operating profit before taxation of $1.83 million (20X7 – $1.24 million) and total assets $18.4 million (20X7 – $12.7 million).

The following issues are outstanding and have been left for your attention:

(a) Visean owns nine brand names of fragrances used for ranges of products (eg perfumes, bath oils, soaps, etc) four of which were purchased and five self-created. Purchased brands are recognised as an intangible asset at cost amounting to $589,000 and amortised on a straight-line basis over ten years. The costs of generating self-created brands and maintaining existing ones are recognised as an expense when incurred. Demand for products of one of the purchased fragrances, 'Ulexite', fell significantly in July 20X8 after a marketing campaign in June caused offence to customers. (8 marks)

(b) In June 20X8 the directors announced plans to discontinue the range of medical consumables supplied to hospital pharmacies. The factory manufacturing these products closed in July 20X8. A provision of $800,000 has been made as at 30 June 20X8 for the compensation of redundant employees and a further $450,000 for the three years unexpired lease term on the factory premises. (7 marks)

(c) Historically the company's statement of cash flows has reported net cash flows from operating activities under the 'indirect method'. However, the statement of cash flows for the year ended 30 June 20X8 reports net cash flows under the 'direct method' and the corresponding figures have been restated. (5 marks)

Required

For each of the above issues:

(i) Comment on the matters that you should consider (ii) State the audit evidence that you should expect to find in undertaking your review of the audit

working papers and financial statements of Visean

Note. The mark allocation is shown against each of the three issues. Assume it is 11 December 20X8.

(Total = 20 marks)

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4 Carter You are a manager in the audit department of Carter & Co, and you are dealing with several ethical and professional matters raised at recent management meetings, all of which relate to audit clients of your firm:

(1) Fernwood Co has a year ending 30 June 20Y0. During this year, the company established a pension plan for its employees, and this year end the company will be recognising for the first time a pension deficit on the statement of financial position, in accordance with IAS 19 Employee benefits. The finance director of Fernwood Co has contacted the audit engagement partner, asking if your firm can provide a valuation service in respect of the amount recognised.

(2) The finance director of Hall Co has requested that a certain audit senior, Kia Nelson, be assigned to the audit team. This senior has not previously been assigned to the audit of Hall Co. On further investigation it transpired that Kia Nelson is the sister of Hall Co's financial controller.

(3) Collier Co has until recently kept important documents such as title deeds and insurance certificates in a safe at its head office. However, following a number of thefts from the head office the directors have asked if the documents could be held securely at Carter & Co's premises. The partners of Carter & Co are considering offering a custodial service to all clients, some of whom may want to deposit tangible assets such as paintings purchased as investments for safekeeping. The fee charged for this service would depend on the value of item deposited as well as the length of the safekeeping arrangement.

(4) Several audit clients have requested that Carter & Co provide technical training on financial reporting and tax issues. This is not a service that the firm wishes to provide, and it has referred the audit clients to a training firm, Gates Co, which is paying a referral fee to Carter & Co for each audit client which is referred.

Required

Identify and evaluate the ethical and other professional issues raised, in respect of:

(a) Fernwood Co (6 marks) (b) Hall Co (6 marks) (c) Collier Co (5 marks) (d) Gates Co (3 marks)

(Total = 20 marks)

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5 Topper (a) Critically evaluate the use of a standardised auditor's report, referring to the report included in ISA

700 Forming an opinion and reporting on financial statements. (6 marks)

(b) You are the manager responsible for the audit of three clients. The year end in each case is 30 September 20X2.

You are currently reviewing the working paper files produced by the audit teams including the various seniors' recommendations for the auditors' reports. Details are as follows:

(i) The Chairman's statement of Mouse, a public company, states that property rent now forms a major part of operating income. From the trading profit note in the financial statements, property rental income represents only 0.4% of total revenue. The audit senior is satisfied that the revenue figure in the financial statements is not misstated. He has noted the discrepancy but states that, since the opinion in the auditor's report does not extend to the Chairman's statement, an unmodified opinion should be expressed.

(4 marks)

(ii) During the year Rocky, a limited liability company, entered into the following transactions.

(1) A loan of $2,000 to Mr Wright, a director of Rocky (2) A loan of $15,000 to Mr Oldfield, a director of Rocky

Neither of these has been disclosed as transactions with related parties in the company's financial statements. The audit senior suggests that, as the amounts are small, an unmodified opinion should be expressed. (4 marks)

(iii) The audit of one of your clients, the global listed Mighty Group, has the following outstanding points:

(1) It has decided not to consolidate the subsidiary, Minor, acquired during the year as it claims that the subsidiary was purchased with the intention to exercise only temporary control.

(2) On purchasing another subsidiary, Merry, Mighty Group has recognised negative goodwill under Intangible Non-Current Assets.

The audit senior suggests that the points above should lead to some changes to the standardised auditor's report, but is unsure what they should be. (6 marks)

Required

For each situation, comment on the suitability or otherwise of the seniors' proposals for the auditors' reports and specify the type of modification required, where it is required. Where you disagree, indicate what kind of audit opinion modification (if any) should be given instead.

Note. Mark allocations are shown beside each of the seniors' suggestions. (Total = 20 marks)

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Student self assessment Having completed this paper take a few minutes to consider what you did well and what you found difficult. Use this as a basis to focus your future study on effectively improving your performance.

Common problems Future emphasis if you answer Yes

Timing and planning Did you finish too early? Y/N Focus your planning time on generating more ideas.

Use models to help develop width to your thinking.

Did you overrun? Y/N Focus on allocating your time better. Practise questions under strict timed conditions. If you get behind leave space and move on.

Did you waffle? Y/N Focus your planning time on developing a logical structure to your answer.

Layout Was your answer difficult to follow? Y/N Use headings and subheadings.

Use numbering sequences when identifying points. Leave space between each point.

Did you fail to explain each point? Y/N Show why the point identified answers the question set.

Were some of your workings unclear? Y/N Give yourself time and space to make the marker's job easy.

Content Did you struggle with:

Interpreting the questions? Y/N Learn the meaning of question words (inside front cover). Learn subject jargon (study text glossary). Read questions carefully noting all the parts. Practise as many questions as possible.

Understanding the subject? Y/N Review your notes/text. Work through easier examples first. Contact a tutor for help.

Remembering the notes/text? Y/N Quiz yourself constantly as you study. You need to develop your memory as well as your understanding of a subject.

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