p7 tuition study note dec2013

1 Accounting Practise Center (A.P.C) www.accaapc.com

ACCA P7 ADVANCED AUDIT & ASSURANCE

Tuition Note

For exams in DEC 2013

© Lesco Group Limited, April 2014

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CONTENTS CHAPTER1，BEFORE THE ENGAGEMENT SERVICES: ....................... 5

CHAPTER 1 ADVERTISING: (DEC2010 Q4) ......................................................... 6

CHAPTER 1 ADVERTISING: (JUNE 2004) ............................................................. 8

CHAPTER 1 TENDERING+FEES (JUNE09 Q2) ........................................................ 9

CHAPTER 1 FACTORS TO BE CONSIDERED JUNE2008Q1(C) ...................................... 14

CHAPTER 1 QUALITY CONTROLDEC2007 Q1(C).................................................. 20

CHAPTER 1 ETHICS THEORY: .......................................................................... 23

CHAPTER 1 JUNE2008 Q4 (SMITH & CO) ......................................................... 25

CHAPTER 1 DEC2008 Q4(BECKER & CO) ......................................................... 29

CHAPTER 1 ENGAGEMENT LETTER Q: ................................................................ 34

CHAPTER 1 MONEY LAUNDERING (DEC2009 Q2(C)) ............................................ 35

CHAPTER 1 ISA250 ................................................................................... 37

CHAPTER2 PERFORM AN ENGAGEMENT SERVICE: ........................ 38

CHAPTER 2 Q1: WHAT DOES AN AUDIT FLOWCHART LOOK LIKE? ................................ 38

CHAPTER 2 Q2:JUNE2009 Q1(A) .................................................................. 39

CHAPTER2 Q3:DEC2009 Q1(A)(B) ............................................................... 42

CHAPTER2 Q4: JUNE2008 Q1 (A+B)(BUSINESS RISKS) ........................................ 44

CHAPTER2 Q5:JUNE2012 Q1(RISK OF MATERIAL MISSTATEMENT/AUDIT RISKS) ............ 50

CHAPTER2 Q6: SATGE 3:JUNE2010 Q2 ........................................................... 55

CHAPTER2 Q7: BIG ACCOUNTING QUESTIONS ..................................................... 60

Chapter2 Q7: 1, conceptual framework: ................................................. 61

Chapter2 Q7: 2,IAS1 Presentation of Financial Statements ....................... 63

Chapter2 Q7: 3,IAS2 Inventories .......................................................... 64

Audit Question [ DEC2009 Q2] IAS2 ............................................................... 65

Chapter2 Q7: 4, IAS7 Statement of cash flows ........................................ 66

Chapter2 Q7: 5,IAS8 Accounting Policies, Changes in Accounting Estimates and

errors ................................................................................................ 67

Audit question [DEC2011 Q3 ] IAS 8 ............................................................... 69

Chapter2 Q7: 6,IAS10 Events after the Reporting Period .......................... 71

Audit question ISA560 [DEC2009 Q5] ............................................................. 72

Chapter2 Q7: 7,IAS 11 Construction Contracts ........................................ 75

Audit question [june2011 Q2] IAS11: .............................................................. 77

Chapter2 Q7: 8,IAS12 Income Taxes ..................................................... 79

Audit question: [Q11:DEC2008 Q1] IAS 12 ...................................................... 83

Chapter2 Q7: 9,IAS16 Property, Plant and Equipment .............................. 84

Chapter2 Q7: 10,IAS17 Leases ............................................................. 88

Audit question1: [June2009Q3] leases ............................................................ 92

Chapter2 Q7: 11,IAS 18 Revenue .......................................................... 94

Audit questions: (IAS18 revenue recognition) .................................................. 95

Q Harrier (June2004) (IAS18 revenue recognition) ........................................... 96


Chapter2 Q7: 12,IAS 19 Employee Benefit ............................................. 97

Audit question (June2012 Q5(b)) IAS19 .......................................................... 99

Chapter2 Q7: 13,IAS 20 Accounting for Government Grants and Disclosure of

Government Assistance ...................................................................... 101

Audit Question [june2010 Q1 (c)(ii)] IAS 20 .................................................. 103

Chapter2 Q7: 14,IAS 21 The effects of Changes in Foreign Exchange Rates

....................................................................................................... 104

Audit question: Grissom Co (June2010 Q1 extract) ......................................... 105

Chapter2 Q7: 15,IAS 23 Borrowing Costs ............................................. 106

Audit question:[june2012 Q5] IAS23 Borrowing cost ....................................... 108

Chapter2 Q7: 16,IAS 24 Related Party Transactions .............................. 110

Audit question:[Q15june2008 Q3]related party transactions ............................ 112

Chapter2 Q7: 17,IAS28 Investments in Associates ................................ 116

Audit Question [June2010 Q1] IAS28 ............................................................ 118

Chapter2 Q7: 18, Financial instruments IAS32,37,39 IFRS9 ................... 119

Audit question [Q17] IAS32,39 IFRS7 ........................................................... 125

Audit question:[DEC2011 Q3(b)] Financial instruments(relating to 3rd party work)

................................................................................................................ 126

Chapter2 Q7: 19,IAS33 Earnings Per share .......................................... 127

Audit question [june2009 Q5 Pluto] IAS 33: (Ajusted) ................................... 130

Chapter2 Q7: 21,IAS 36 Impairment of Assets ...................................... 131

Audit question: [Q] impairment IAS36 .......................................................... 133

Audit question [DEC2010 Q3 Clooney]impairment IAS36 ................................. 135

Chapter2 Q7: 22,IAS 37 Provisions, Contingent liabilities and Contingent Assets

....................................................................................................... 137

Audit question [ DEC2007 Q1(b)] provision .................................................... 139

Chapter2 Q7: 23,IAS38 Intangible Assets ............................................. 141

Audit question IAS 38 [ june2008 Q5] Blod .................................................... 144

Audit question [ DEC2011 Q1] IAS 38 ........................................................... 146

Chapter2 Q7: 24, IAS40 Investment Property ....................................... 147

Audit question [DEC2008 Q3] IAS40 ............................................................. 149

Chapter2 Q7: 25, IFRS2 Share-based Payment ..................................... 152

Audit question [ DEC2008 Q1(b)(i)] IFRS2 share based payment: .................... 155

Chapter2 Q7: 26, IFRS5 Non-current Assets Held for Sale and Discontinued

Operations........................................................................................ 157

Audit question1 IFRS 5 [ DEC2007(a) ] ......................................................... 160

Audit question2 [june2011 Q1a]IFRS 5.......................................................... 162

Chapter2 Q7: 27, IFRS8 Operating Segments ....................................... 165

Audit question1 IFRS8 [ DEC2009 Q1(d)] ...................................................... 167

Chapter2 Q7 :28, IFRS10,11,12 .......................................................... 169

Audit question [Shire DEC2005] IFRS11 Joint Arrangements ............................ 172

Chapter2 Q7 :29, IFRS13 Fair Value Measurement ................................ 173

Audit question [DEC2008 Q3(a)]fair value ..................................................... 175

Chapter2Group audit ............................................................................................................ 176


June2012 Q1(a(i+iii)): Group audit ............................................................... 177

STAGE 5 OF AUDIT FLOWCHART ................................................ 181

DEC2012 Q2 AUDIT FINDINGS ................................................................... 182

CHAPTER 2 JUNE2011 Q3 OPENING BALANCES (ISA510&ISA710)(B) .................. 189

CHAPTER2 :DEC2010 Q2 NEWMAN & CO(C) [ISA720 OTHER INFORMATION] ........... 191

STAGE 6 AUDIT REPORT ............................................................ 193

CHAPTER 2 JUNE2012 Q5(B) ...................................................................... 193

CHAPTER 2 JUNE2011 Q5 NASSAU GROUP ...................................................... 195

NON AUDIT ENGAGEMENT SERVICES ......................................... 199

INTERIM FINANCIAL INFORMATION DEC2012 Q5(B) ........................................... 200

PROSPECTIVE FINANCIAL INFORMATION CHAPTER 2 JUNE2012 Q2(A) ..................... 202

DUE DILIGENCE REVIEW CHAPTER 2 JUNE2008 Q2 ............................................. 207

FORENSIC AUDIT （CHAPTER 2 DEC2008 Q2） ............................................... 211

SOCIAL AND ENVIRONMENTAL AUDIT DEC2008 Q1(C) ........................................ 216

JUNE2012 Q2(B)(II): SOCIAL AND ENVIRONMENTAL AUDIT ................................... 218

CHAPTER 2 DEC2010 Q2(B) SOCIAL AND ENVIRONMENTAL AUDIT ......................... 220

CHAPTER3 CURRENT ISSUES ..................................................... 221

CHAPTER3 JUNE2009 Q2(D) TRANSNATIONAL AUDIT ......................................... 222

CHAPTER3 DEC2009 Q4 ........................................................................... 225

JUNE2008 Q2(C) JOINT AUDIT .................................................................... 227

CHAPTER3 Q5 DEC2010 NEESON&CO(B) Q4 .................................................. 229

CHAPTER3 JUNE2010 Q5(B) AUDITORS’ LIABILITY ........................................... 231


Chapter1，Before the engagement services:

In this chapter we will be going through:

1. Advertisement issues

2. How to draft a tendering document

3. Professional appointment issues

4. Quality control issues

5. Regulatory issues

The best way to learn these knowledge is to copy note from tuition video.


Chapter 1 Advertising: (DEC2010 Q4) Neeson&Co

An advertisement could be placed in national newspapers to attract new clients.

The draft advertisement has been given to you for review:

Neeson & Co is the largest and most professional accountancy and audit

provider in the country. We offer a range of services in addition to audit, which

are guaranteed to improve your business effi ciency and save you tax.

If you are unhappy with your auditors, we can offer a second opinion on the

report that has been given.

Introductory offer: for all new clients we offer a 25% discount when both audit

and tax services are provided. Our rates are approved by ACCA.

Required:

Evaluate each of the suggestions made above, commenting on the ethical and

professional issues raised. （8marks）


Answer to Neeson&Co:

Back up

Any comments made by the advertisement should be backed up with evidence.

For example it says Neeson&Co is the largest and most professional

accountancy provider in the country so sales revenue and number offices should

be made to back up this evidence.

Definitely clear

The advertisement should be definitely clear.The business efficiency can not be

guaranteed by the firm and this seems that it’s not honest by Neeson.

The second opinion offered by Neeson&Co may imply that the audit work done

by Neeson&Co is low and as a result client would not be happy with the first

opinion given and hence second opinion would be issued again. And this

comment in the advertisement is not professional.

Ensure to comply with laws and regulation

The advertisement should comply with laws and regulation.

The guarantee to save tax means maybe Neeson would use some tricks to help

client save time which may not comply with laws and regulation because not in

every circumstance that the tax can be saved.

Fundamental ethics

Neeson&Co can’t quote rates are approved by ACCA because ACCA does not

approve any rates and this would be seen as unprofessional.

Legal obligation

It seems that if taxes can’t be saved and also business efficiency hasn't been

improved so that client may take potential legal action against Neeson&Co

resulting in further future cash outflow from Neeson&Co.

Low balling

The 25% of introductory fees is low balling and it’s not prohibited but

Neeson&Co should need to make sure by charging such a low amount of fees the

quality of the work should be maintained, ie, following ISAs to do the audit

work.


Chapter 1 (June 2004)Hawk Assocaite

Displaying business cards alongside those of local tradesman and service

providers in supermarkets and libraries. The cards would read:

“Hawk ACCA Associates

For PROFRSSIONAL Accountancy, Audit,

Business Consultancy and Taxation services

Competitive rates. Money back guarantees.”

(4marks)

Answer to June2004 Hawk Associate:

Advertisement in the super markets and libraries is not professional and

they should advertise their firm using eg, financial magazines.

Professional is in capital and this implies only their firm is professional while

others are not and firms shouldn’t criticize others.

Competitive rate is vague and compare to whom? So this information is

misleading.

Money back guarantees may mean they can help company save tax and if

not they would give money back to them and this will:

Firstly involving some illegal techniques to help company save tax and

hence it’s a breach of laws and regulations.

Secondly it implies that the quality of services provided to the company

may not be good and hence give their money back.


Chapter 1 tendering+Fees (June09 Q2)

The Dragon Group is a large group of companies operating in the furniture retail

trade. The group has expanded rapidly in the last three years, by acquiring several

subsidiaries each year. The management of the parent company, Dragon Co, a

listed company, has decided to put the audit of the group and all subsidiaries out to

tender, as the current audit firm is not seeking re-election. The financial year end of

the Dragon Group is 30 September 2009.

You are a senior manager in Unicorn & Co, a global firm of Chartered Certified

Accountants, with offices in over 150 countries across the world. Unicorn & Co has

been invited to tender for the Dragon Group audit (including the audit of all

subsidiaries). You manage a department within the firm which specialises in the

audit of retail companies, and you have been assigned the task of drafting the

tender document. You recently held a meeting with Edmund Jalousie, the group

finance director, in which you discussed the current group structure, recent

acquisitions, and the group’s plans for future expansion.

Meeting notes – Dragon Group

Group structure

The parent company owns 20 subsidiaries, all of which are wholly owned. Half of the

subsidiaries are located in the same country as the parent, and half overseas. Most

of the foreign subsidiaries report under the same financial reporting framework as

Dragon Co, but several prepare financial statements using local accounting rules.

Acquisitions during the year

Two companies were purchased in March 2009, both located in this country:

(i) Mermaid Co, a company which operates 20 furniture retail outlets. The audit

opinion expressed by the incumbent auditors on the financial statements for the

year ended 30 September 2008 was qualified by a disagreement over the

non-disclosure of a contingent liability. The contingent liability relates to a court

case which is still on-going.

(ii) Minotaur Co, a large company, whose operations are distribution and

warehousing. This represents a diversification away from retail, and it is hoped that

the Dragon Group will benefit from significant economies of scale as a result of the

acquisition.

Other matters

The acquisitive strategy of the group over the last few years has led to significant

growth. Group revenue has increased by 25% in the last three years, and is

predicted to increase by a further 35% in the next four years as the acquisition of

more subsidiaries is planned. The Dragon Group has raised finance for the


acquisitions in the past by becoming listed on the stock exchanges of three different

countries. A new listing on a foreign stock exchange is planned for January 2010.

For this reason, management would like the group audit completed by 31 December

2009.

Required:

(a)Recommend and describe the principal matters to be included in your

firm’s tender document to provide the audit service to the Dragon Group.

(10 marks)

(b) Explain FOUR reasons why a firm of auditors may decide NOT to seek

re-election as auditor. (6 marks)

(c) Using the specific information provided, evaluate the matters that

should be considered before accepting the audit engagement, in the

event of your firm being successful in the tender. (7 marks)

Professional marks will be awarded in part (c) for the clarity and presentation of the

evaluation. (4 marks)


Answer to June2009 Q2a-c:

(a)

Recourses

Detailed background of our firm should be included for example the expertise

and clients we serve.

Clients needs

Because Dragon group is going to go listed onto the stock exchange and so we

can provide non audit services such as corporate governance advice relating to

the listing.

We have offices in over 150 countries across the world so we can deal with audit

with your subsidiaries all around the world more effectively.

Way to do the audit

We should include how we perform the audit service to ensure appropriate

quality of work maintained such as following ISA to do the risk assessment.

Also we ensure quality during the audit by having appropriate quality control

procedures during the audit such as hot review on the audit work we have done.

Extra benefit

We can provide recommendation to address internal control weakness to

management in the management letter as an extra service for example.

Fees

Fees should be broken down into how it’s calculated by clearly laying out

different classes of staff involved, such as hourly rate for audit manager and

partner.


(b)

Overdue fees

Where a client hasn't paid their fees there has been outstanding for some time

and such overdue fees would be seen as loan to client which may cause a self

interest threat, ie, in order to keep the loan auditor may issue whatever opinion

that client wants so that a safeguard for this is not to seek re-election.

Resources

As the company expands the audit firm may not have enough resources to do

the audit any more. Such as the company is listing on a stock exchange and the

audit firm is a lack of relevant experts who know the regulation of the stock

exchange and so the firm may not seek re-election.

Integrity

When the management doesn't comply with specific accounting standards such

as a deliberate failure to provide a provision in the financial statements and this

action would be seen as a lack of integrity.

So in order for the audit firm to remain good reputation they should not seek

re-election.

Conflict of interest

Such as the existing company we are auditing is damaging the environment and

didn't disclose the fact.

Another company is waiting for out firm’s tendering but they are competitors

and if we audit both companies which would cause a conflict of interest so we

should resign the first company as by continuing to be an auditor for this would

damage our firm’s reputation.


(c)

Evaluation of matters to be considered:

Recourses

As dragon group has expanded rapidly in the last three years so we must ensure

we have enough audit staff to audit those components.

Management integrity

As a qualified opinion issued by previous auditor over a deliberate

non-disclosure of contingent liability we should question management’s

integrity and if they not integrate then we should not accept the engagement

service because if after conducting the service and we find information we

obtained is fake then it will still have an impact on our audit opinion.

Previous auditor

It would be necessary to contact previous auditor to gather information

regarding the non disclosure of contingent liability with client’s permission of

whether it should be disclosed in the individual financial statements of Mermaid

Co, and at group level.

Experiences

Given Minotaur Co is involved in distribution and warehousing but this is not a

very complicated industry for Unicorn&Co because it has its offices over

150countries and it should have relevant experience into auditing this eg,

bringing in staff from a different department more experienced in clients with

distribution operations

Time

There will be only 3months for Unicorn&Co to complete the audit and

Unicorn&Co should consider whether to allocate more recourses to this

engagement given this client is large and it needs to spend more time into it.


Chapter 1 June2008Q1(c)

You are a senior audit manager in Mitchell & Co, a firm of Chartered Certified

Accountants. You are reviewing some information regarding a potential new audit

client, Medix Co, a supplier of medical instruments. Extracts from notes taken at a

meeting that you recently held with the finance director of Medix Co, Ricardo Feller,

are shown below:

Meeting notes – meeting held 1 June 2008 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 2008, 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 2008, following the departure of the previous

finance director, who is currently taking legal action against Medix Co for unfair dismissal.

Company background

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 2007, 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 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.


After receiving permission from Medix Co, you held a discussion with the current

audit partner of Medix Co, Mick Evans, who runs a small accounting and audit

practice of which he is one of two partners. Mick told you the following:

‘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.’

You have also found a recent press cutting regarding Medix Co:

Extract from local newspaper – business section, 2 June 2008

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 2003 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:

Prepare briefing notes, to be used by an audit partner in your firm,

assessing the professional, ethical and other issues to be considered in

deciding whether to proceed with the appointment as auditor of Medix

Co.

Note: requirement (c) includes 2 professional marks. (12 marks)


Answer: June2008 Q1(c)

Briefing notes

To: Audit partner

From: Audit manager

Date: exam date

Subject: Factors to consider regarding appointment as auditor of Medix Co

Introduction:

This briefing note summarises the main factors we should consider in deciding

whether to take the appointment further.

Time to build up knowledge

Because this is the last month before the financial statement year end we would

questions whether we have enough time to quickly build up the knowledge of

Medixcompany.

Expertise

Given Medix company operates in a very sophisticated industry so we need to

question whether we should refer to expertise when doing the audit and if yes

this will increase audit fees charged to client and given client wants to keep the

audit costs as low as possible this may not be acceptable.

Control system

Given Medix company has a weak internal control system so we should not rely

on its system but rather we should use full substantive testing approach and this

increases the costs and also time spent as well and it may not be acceptable by

client given he wants to keep the costs down.

Opening balance

Because this is a new audit client and we should consider extra work done on the

opening balance of its financial statement given a weak internal control system

exists.

Management style

Medix company is being sued by previous finance director and previous auditor

resigned as a result of a disagreement with the management so the history

shows we may find it difficult to maintain the good relationship with

management.

Fee pressure

Medix company is now struggling to raise finance and so there would be a risk

that after we become its auditor we can’t collect our money back as audit fee

and as a result this creates lots of threats to objectivity, ie, intimidation threat

by threatening not to pay for us unless to give a wrong audit opinion satisfying

client.


Reputation

Medix company has been in breach of laws an regulation and this has impair its

reputation within the industry and if we were to become its auditor then it will

impact on our reputation as well.

Advocacy threat

Medixcompany has in breach of laws and if we were to become an auditor of

them then we would be seen as promoting its status saying client’s breach of

laws is right and hence this will impair our objectivity in expressing an audit

opinion.

Competence

Medixcompany is in such a sophisticated industry and we should question

ourselves whether we have competence in carrying out such an audit, eg,

experience before in auditing the work in progress in a similar industry.

Public interest

Medix company has in breach of laws before involving in activities damaging the

environment and its doing harm to public interest so we would be better not to

become its auditor.

Time

It seems that there would be only 1 month before we start our audit and given

the complexity of client’s business activities we may not have enough time to

carry out such an audit service.

Integrity

Given there are two cash book presented by managing director and we can

reasonably assume that fraudulent transactions may occur here and hence we

should question the integrity of management and if they are lying then we

shouldn't accept as an auditor.

Staff and resources

We should consider whether we have enough staff and recourses to carry out

the audit given part of its Medixcompany’s operations are overseas and if no we

shouldn't accept as an auditor.

Easy

It seems that medix company is going to raise finance from the bank and the

audit report may be relied on by bank as well and this creates higher risk for us

because given time, recourses, expertise analysis maybe we don't have time to

carry out this audit as expected.


Conclusion:

So from the above analysis it would be better for us not to be as an auditor for

Medixcompany.


DEC2007 Q1(c)

(e) (i) Identify and describe FOUR quality control procedures that are

applicable to the individual audit engagement; and (8 marks)

(ii) Discuss TWO problems that may be faced in implementing quality

control procedures in a small firm of Chartered Certified

Accountants, and recommend how these problems may be

overcome. (4 marks)


Answer to DEC2007 Q1(c):

(i)

Pre appointment checks

Auditors should check the client before accepting this engagement such as:

Obtaining professional clearance from previous auditors to ensure there’s no

problem to accept this engagement letter from previous auditors’

perspective.

Considering any conflict of interest among its existing clients.

Due diligence in client whether they are involved in money laundering

activities.

Planning

Auditor should plan their audit before it’s actually implemented by clearly

setting up appropriate audit strategy and detailed audit plan.

Planning meeting

Auditors should hold a planning meeting before audit is implemented by clearly

stating the responsibility of members for example.

Documenting the work

During the audit auditors should document the work properly according to ISA.

Direction, supervision and review of work

During the audit there should be an audit supervisor or manager directing the

audit work, eg, act as a mentor during the audit and if any problems arise from

audit junior they can come to supervisor or manager for a solution.

Audit work should be reviewed after the work has been done, ie, hot review on

the work before audit report is signed to identify any mistakes within the audit

work.

Delegate work based on knowledge and experience

Auditors should be delegated work based on knowledge and experience this

means for example audit junior should not be delegated the work to audit fair

value.


(ii)Competence

Problem:

In order to keep up to date with the knowledge particularly for ISA and IFRS

staff should be trained but it’s too expensive to set up an inhouse training within

the small firm.

Recommendation:

So this can be outsourced to an external training company to do so because due

to economic of scale within that external training company a lower cost incurred

comparing to setting up in house.

Review

Problem:

It may not be possible to hold an independent review of an engagement within

the firm because of the small number of senior and experienced auditors.

Recommendation:

An external review service may be purchased.


Chapter 1 Ethics:

Basic knowledge:

ACCA particularly identifies there are 5 principles we need to follow:

Professional behavior:

We shouldn’t do anything that discredits ACCA’s reputation.

Integrity:

Both accountant and auditor should lie to others.

Competence and due care:

Professional accountants should pass ACCA exams and accumulate relevant

experience and do annual continues professional development.

They should also follow rules to do the work and finish the work within the

reasonable amount of time.

Confidentiality

Professional accountants should keep client’s confidential information and

should not disclose them to 3rd parties.

If client’s company is involved in illegal activities and we can:

1. Seek legal advice

2. Disclose those to appropriate authority.

Objectivity

This means audit opinion should be trustable.


And there are 6 threats to objectivity:

1. Self interest threat

In order for auditor to keep benefit then auditor helps to cover up the fraud by

client making its opinion not objective.

2. Self review threat

Checking auditor’s own work would mean auditor will lose profeesional

skepticism when trying to audit client and the opinion given wouldn’t be

objective.

3. Advocacy threat

It may seem that auditor is trying to promote the status of client’s company

making any audit opinion subsequently issued not objective.

4. Familiarity threat

This means there is a close relationship between auditor and Client Company

and this would mean:

a. auditor will cover up fraud made by client’s company;

b. auditor may lose professional skepticism when auditing the client’s company.

So it will make audit opinion not objective.

5. Intimidation threat

Client’s Company threatens auditors and in order to keep benefit auditor would

issue whatever opinion that client’s wants and making it not objective.

6. Management threat

Audit form makes a management decision on behalf of client’s company and this

may run a risk that client’s company would fail.

In order not being affected by client’s company audit firm would issue an audit

opinion which is not trustable.


Chapter 1 June2008 Q4 (Smith & Co)

You are an audit manager in Smith & Co, a firm of Chartered Certified

Accountants. You have recently been made responsible for reviewing invoices

raised to clients and for monitoring your firm’s credit control procedures.

Several matters came to light during your most recent review of client invoice

files:

Norman Co, a large private company, has not paid an invoice from Smith & Co

dated 5 June 2007 for work in respect of the financial statement audit for the

year ended 28 February 2007. A file note dated 30 November 2007 states that

Norman Co is suffering poor cash flows and is unable to pay the balance. This is

the only piece of information in the file you are reviewing relating to the invoice.

You are aware that the final audit work for the year ended 28 February 2008,

which has not yet been invoiced, is nearly complete and the audit report is due

to be issued imminently.

Wallace Co, a private company whose business is the manufacture of industrial

machinery, has paid all invoices relating to the recently completed audit

planning for the year ended 31 May 2008. However, in the invoice file you notice

an invoice received by your firm from Wallace Co. The invoice is addressed to

Valerie Hobson, the manager responsible for the audit of Wallace Co. The

invoice relates to the rental of an area in Wallace Co’s empty warehouse, with

the following comment handwritten on the invoice: ‘rental space being used for

storage of Ms Hobson’s speedboat for six months – she is our auditor, so only

charge a nominal sum of $100’. When asked about the invoice, Valerie Hobson

said that the invoice should have been sent to her private address. You are

aware that Wallace Co sometimes uses the empty warehouse for rental income,

though this is not the main trading income of the company.

In the ‘miscellaneous invoices raised’ file, an invoice dated last week has been

raised to Software Supply Co, not a client of your firm. The comment box on the

invoice contains the note ‘referral fee for recommending Software Supply Co to

several audit clients regarding the supply of bespoke accounting software’.


Required:

Identify and discuss the ethical and other professional issues raised by

the invoice file review, and recommend what action, if any, Smith & Co

should now take in respect of:

(a) Norman Co; (8 marks)

(b) Wallace Co; and (5 marks)

(c) Software Supply Co. (4 marks)

(17 marks)


Answer to June2008 Q4:

(a)

Matters to consider:

In order to secure the payment, audit firm would issue a wrong audit opinion to

maximize its benefit and hence creating self interest threat to objectivity.

Audit firm is not chasing money from client company would suggest there is a

good relationship between them and a familiarity threat exists meaning audit

firm may help company conceal some mistakes in the financial statements but

still issue a clean audit report.

Because Norman is suffering poor cash flows and is unable to pay for audit firm

and this may create intimidation threat meaning Norman may threaten not to

pay the firm unless a clean audit report is given.

Before accepting an engagement letter to Norman company auditors should do

a detailed pre-appointment check to ensure this client is a going concern entity.

Actions:

1. Auditor should raise this issue to audit committee to secure payments.

2. Auditors should quickly invoice management about the audit work service

fees.

3. Auditor should have a detailed pre-appointment check client in the future

before working for them.

4. Auditors should perform an independent partner check for last year audit

work as well since they haven’t paid the firm in the last year.


(b)


In order to keep the cheap rental expense of $100 auditor would issue a wrong

audit opinion and hence leads to self interest threat.

The $100 nominal value would suggest there’s a good relationship between

client and audit firm and hence familiarity threat would exist meaning auditors

would lose professional skepticism when doing the audit and hence giving a

wrong audit opinion.

The nominal $100 would create an intimidation threat as well because client

would threaten to withdraw this offer unless a clean audit report is given by

auditors.

This is about manager’s work and hence it’s senior so all its work done would

have a big impact onto the overall opinion given.

Actions:

1. Partners should perform an independent review on work done by audit

manager.

2. When necessary report to ACCA about this issue.

3. Remove managers from the audit team for this client.

4. Carefully check whether there are any relationships that manager with other

clients and if yes then remove him/her from other services as well.

(c)


This will increase business risk because if the software quality is bad then it

would be seen that audit firm’s work quality would be bad as well and hence

leads to an impairment of audit firm’s reputation.

Actions:

1. Tell client about the referral fees.

2. Make written confirmation that client knows about referral fees.

3. Make sure that other audit staff involved in audit have no further interest in

software company because if yes then any other threats to objectivity would be

created.


Chapter 1 DEC2008 Q4(Becker & Co)

You are a senior manager in Becker & Co, a firm of Chartered Certified

Accountants offering audit and assurance services mainly to large, privately

owned companies. The firm has suffered from increased competition, due to two

new firms of accountants setting up in the same town. Several audit clients have

moved to the new firms, leading to loss of revenue, and an over staffed audit

department. Bob McEnroe, one of the partners of Becker & Co, has asked

you to consider how the firm could react to this situation. Several possibilities

have been raised for your consideration:

1. Murray Co, a manufacturer of electronic equipment, is one of Becker & Co’s

audit clients. You are aware that the company has recently designed a new

product, which market research indicates is likely to be very successful.

The development of the product has been a huge drain on cash resources. The

managing director of Murray Co has written to the audit engagement partner to

see if Becker & Co would be interested in making an investment in the new

product. It has been suggested that Becker & Co could provide finance for the

completion of the development and the marketing of the product. The finance

would be in the form of convertible debentures.

Alternatively, a joint venture company in which control is shared between

Murray Co and Becker & Co could be established to manufacture, market and

distribute the new product.

2. Becker & Co is considering expanding the provision of non-audit services.

Ingrid Sharapova, a senior manager in Becker & Co, has suggested that the firm

could offer a recruitment advisory service to clients, specialising in the

recruitment of finance professionals. Becker & Co would charge a fee for this

service based on the salary of the employee recruited. Ingrid Sharapova worked

as a recruitment consultant for a year before deciding to train as an accountant.

3. Several audit clients are experiencing staff shortages, and it has been

suggested that temporary staff assignments could be offered. It is envisaged

that a number of audit managers or seniors could be seconded to clients for

periods not exceeding six months, after which time they would return to Becker

& Co.


Required:

Identify and explain the ethical and practice management implications

in respect of:

(a) A business arrangement with Murray Co. (7 marks)

(b) A recruitment service offered to clients. (7 marks)

(c) Temporary staff assignments. (6 marks)

(d) I heard one of the audit managers say that our firm had lost an

audit client to a competitor because of lowballing. What is lowballing

and is it allowed?

(3 marks)(DEC2009 Q4)

(23 marks)


Answer to DEC2008 Q4:

(a)

In order to make investment in the product more successful audit firm would

issue a favorable audit opinion to client’s company even though its financial

statements are wrong and this creates self interest threat.

By starting up a joint venture it may suggest audit firm and Murray Company

are close friends and hence this creates familiarity threat meaning Audit firm

would lose professional skepticism when doing the actual audit.

The finance is in the form of convertible loan meaning it can be converted

into cash or equity at the end of the life of project and an intimidation threat

exists meaning if audit firm is not going to issue a clean audit report then

Murray Company may not pay for audit firm for cash/equity.

A management threat arises as well because a joint venture is set up and

any management decision made by the audit firm may result in company

failure and hence there is a risk that audit firm may get sued and hence in

order not being sued by Murray company, audit firm would issue whatever

opinion that they want.

By investing in such a project there is a business risk that audit firm

reputation would be impaired if the project goes badly and hence there

might be less future clients go to Becker&Co.

Audit firm would have 2 choices including:

1. Accept the offer but IFAC code of ethics says “the threats to objectivity

making opinion not objective to be so significant and no safeguard would put in

place to minimize the threat and hence audit firm would be better not doing

audit services for this client.”

2. Reject the offer and continue to provide audit service to this client.


(b)

By receiving more income from the audit client would creates a self interest

threat because in order to keep this interest audit firm would issue whatever

opinion that client wants.

Because Becker & Co would charge a fee for this service based on the salary

of the employee recruited so the higher salary that Becker&co argues then

higher income stream would flow into audit firm and hence greater self

interest threat.

By recruiting members to do the financial work the employees and audit firm

would become friends and hence familiarity threats is created because by

subsequently checking work done by those staff auditor would lose

professional skepticism.

Intimidation threat would be created because if the quality of recruited staff

is poor then client would sue us or require a clean audit report even though

the financial statements are not true and fair.

If the staff recruited is poor quality then there would be an impairment on

audit firm’s reputation and hence future client may not go to Becker&Co for

those services including audit service any more.

(c)

Audit firm would have an incentive to send higher level staff to the company

and hence earn more fees and this creates a higher self interest threat.

After auditor working on this company they may have a good relationship

with staff there and hence a familiarity threat is created meaning auditor

would lose professional skepticism when doing the actual audit or ignore the

mistakes staff have made as well.

If quality of auditor sent to client’s company is poor then an intimidation

threat would create meaning client would choose to sue us for negligence or

we give a clean audit report in order not get sued.

Audit manager or partner sent would be so senior and hence they would

have a big impact on the audit work so this needs to be carefully checked.


(d)

Low balling means audit firm would charge a low fee to attract audit service

from client in the hope to win the tender contact and provide future services

to client.

This is not banned by ACCA as long as audit firm can demonstrate they

would complete the work with competence and due care.

But as the fees is cut back then auditor may not spend enough time doing

the work and stick to auditing standards and hence quality of the audit work

would be lowered down.


Chapter 1 Engagement Letter Q:

State 6 items that could be included in an engagement letter.(3marks)

Fee cover note: how the fees are calculated.

Address to directors.

Responsibilities of auditors and directors.

Scope of audit.

Extra services provided to client

Signature and date.


Chapter 1 Money Laundering (DEC2009 Q2(c))

There are specific regulatory obligations imposed on accountants and auditors

in relation to detecting and reporting money laundering activities. You have

been asked to provide a training session to the new audit juniors on auditors’

responsibilities in relation to money laundering.

Required:

Prepare briefing notes to be used at your training session in which you:

(i)Explain the term ‘money laundering’. Illustrate your explanation with

examples of money laundering offences, including those which could be

committed by the accountant; and

(ii)Explain the policies and procedures that a firm of Chartered Certified

Accountants should establish in order to meet its responsibilities in relation to

money laundering.

(10 marks)

Professional marks will be awarded in part (c) for the format of the answer, and

the quality of the explanations provided.

(2 marks)



(i)

Definition:

Money laundering is to convert crime money into a legitimate form.

3 stages:

Placing

It seems that Heron co receives cash from customer and this is placing and cash

may be illegal from customers.

Layering

$2m of electronic bank transfer to an overseas financial institution would be a

layering, ie, creating transactions to cover the true source of money.

Integration

Then getting money out from the financial institution of $2m then the source of

money would become legitimate.

Offences:

Auditor committee money laundering activities.

Auditor helps client to establish money laundering system.

Doing tipping off meaning auditors would inform client about the potential

investigation of money laundering activities by other departments and

hence interrupt the investigation process.

(ii)

Train all relevant staff to money laundering issues.

Appoint a money laundering reporting officer to deal with money laundering

activities and this will often be a senior audit partner.

Due diligence review of client’s company including their address, directors

register etc.

Review procedures would be put in place to review working papers of client’s

company to see if they are involved in money laundering activities.

Quality control procedures would be put in place like pre appoint check of the

client’s company whether it would involve in money laundering activities.


Chapter 1 ISA250

The purpose of ISA250 Consideration of Laws and regulations in an audit of

financial statements is to establish standards and provide guidance on the

auditor’s responsibility to consider laws and regulations in an audit of financial

statements.

Required:

Explain the auditor’s responsibilities for reporting non-compliance that comes to

the auditor’s attention during the conduct of an audit. (5marks)

Answer to ISA250:

Auditors are not responsible for the non-compliance with laws by client.

But if the non-compliance with laws would result in a material misstatement

in the client’s financial statements then auditors should modify its audit

report.

Before that auditors should raise this issue to audit committee.

If this is not applicable then auditor should seek legal advice first.

If Client Company is involved in money laundering issues then auditor

should report this to relevant authority.


Chapter2 Perform an engagement service:

Chapter 2 Q1: What does an audit flowchart look like?


Chapter 2 Q2:June2009 Q1(a)

Required:

(a)

(i) Identify and explain the aspects of a client’s business which should be

considered in order to gain an understanding of the company and its operating

environment; and

(6 marks)

(ii) Recommend the procedures an auditor should perform in order to gain

business understanding.

(4 marks)

Professional marks will be awarded in part (a) for the clarity, format

and presentation of the briefing notes.

(2 marks)


Answer to June2009 Q1(a):

(i)

Internal control system

Auditors need to review client’s internal control system including its control

environment, internal control procedures etc to better understand whether a

control testing approach or full substantive testing approach to audit would be

used.

External factors

Auditors need to review the level of competition within the industry because for

example if the industry is so competitive then in order for the company to keep

up with the industry average profit then company would have an incentive to

manipulate the financial statements.

Auditors need to review the laws and regulations as well because if client’s

company’s activity is not fulfilling the current laws and regulations then there

might be risks that financial statements would be misstated, eg, failure to

disclose contingent liability to the note of the Financial statements.

Performance measurement

Auditors need to review company’s performance measurement as well because

for example if manager is measured based on profit then profit would be

overstated in order to earn more bonus.

Company’s structure and its accounting policy

Auditors need to review its structure and its accounting policy and if the

company’s structure is so complicated then during the actual consolidation

there would be potential misstatements to the financial statements as well.

Company’s strategy, plan and its related business risks

For example company’s strategy would be a market leader in the industry so its

plan would be launching a new product and there is a business risk that this may

fail resulting in the financial statements being misstated.


(ii)

Perform analytical procedure to identify any unusual transactions and this

can help auditors to identify whether trends for the financial statements

would be reasonable, ie, consistent with growth in economy.

Enquire with internal auditors about internal control system of company to

understand its its effectiveness.

Inspect business plan by management to understand its potential business

risks.

Observe internal control operations physically to verify internal control

procedures are working effectively.

Recalculate some material balances to verify its accuracy.


Chapter2 Q3:DEC2009 Q1(a)(b)

ISA 520 Analytical Procedures requires that the auditor performs analytical

procedures during the initial risk assessment stage of the audit. These procedures,

also known as preliminary analytical review, are usually performed before the year

end, as part of the planning of the final audit.

Required:

(i) Explain, using examples, the reasons for performing analytical

procedures as part of risk assessment; and

(ii) Discuss the limitations of performing analytical procedures at the

planning stage of the final audit.

(6 marks)

(b) Explain and differentiate between the terms ‘overall audit strategy’

and ‘audit plan’.

(4 marks)


Answer to DEC2009 Q1(a)(b):

(i)

It can help auditors better understand the client.

Eg, perform analytical procedures for new client by comparing its profit with

its competitor would provide the auditor with a better picture about the

relative performance of the entity within its business environment.

It can help auditors better identify high risk areas.

Eg, preform analytical procedures by comparing its financial

information,eg200% increase in profit with the non- financial information

such as economic recession happens outside the market would clearly show

that revenue may be overstated and hence this is a high risk area.

(ii)

It may not reflect the whole year figure because this is done based on

interim financial information.

Because it’s not done at the year-end so some figures such as impairment

should be ignored.

For some companies internal control system would be weak during the year

and hence the analytical procedure on these results may not be correct.

(b)

Audit strategy sets out the scope, timing, nature and direction of the audit

and it tells auditor which audit approach should be used, ie, system based or

full substantive approach and how the recourses would be allocated.

Audit plan sets out the risk assessment, materiality and potential audit

procedures to be used.

Audit strategy leads to audit plan meaning that audit plan, ie, if system

based approach is used then less audit procedures would be included in the

audit plan.

Any changes in the audit plan should lead to a change in the audit strategy

as well, eg, during the audit a material risky balance is omitted so further

procedures should be planned and recourses allocation schedule would also

be changed.


Chapter2 Q4: June2008 Q1 (a+b)(business risks)

You are a senior audit manager in Mitchell & Co, a firm of Chartered Certified

Accountants. You are reviewing some information regarding a potential new audit

client, Medix Co, a supplier of medical instruments. Extracts from notes taken at a

meeting that you recently held with the finance director of Medix Co, Ricardo Feller,

are shown below:

Meeting notes – meeting held 1 June 2008 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

2008, 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 2008, following the departure of the previous finance director, who is

currently taking legal action against Medix Co for unfair dismissal.

Company background

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 2007, 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 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.

After receiving permission from Medix Co, you held a discussion with the current

audit partner of Medix Co, Mick Evans, who runs a small accounting and audit

practice of which he is one of two partners. Mick told you the following:

‘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.’

You have also found a recent press cutting regarding Medix Co:

Extract from local newspaper – business section, 2 June 2008

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 2003 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:

(a) Using the information provided, identify and explain the principal

business risks facing Medix Co.

(12 marks)

(b) (i) Discuss the relationship between the concepts of ‘business risk’ and

‘risk of material misstatement’; and

(4 marks)


Answer to June2008Q1(a+b):

(a)

Demand

Demand of traditional market is declining.

There is a risk that continues decline in demand in the traditional market will

result in less profit made by company.

R&D

The research and development would be costly for company.

There is a risk that given poor liquidity position of company because company

seems to make uses of the facility most months and because R&D expenses are

huge cost to company so company may not have enough money to invest in this

area hence making this unsuccessful.

License

Management is confident that licence is received for commercial production in

the future.

There is a risk that license may not be received by company given this is a highly

regulated country and hence this will make the future production not successful

decreasing shareholders wealth as a result.

Scientist

There is just one scientist working in the company.

There is a risk that this scientist may leave the company and hence stop

researching and developing of products process and this will result in company

suffering greater loss given huge expenses input in the R&D process.

Scientist is subcontracted not employed by the company.

There is a risk that scientist may bring his knowledge and research results out

from company to its competitors and if this is the case company’s financial

position will be again threatened resulting in decrease in profit and shareholders

wealth.

Agent

A large amount of revenue is from agent.

There is a risk that if the agent is not successful in selling products which may

result in a further decrease in profit and cash flow from company.

There is a risk that agent may try to overstate the sales revenue in order to

maximize commission received and given a weak internal control system exists

within company and this may not be easily detected.


Oversea

The manufacturing facility is located overseas.

There is a risk that quality of product may not be guaranteed and if the quality

of product is poor then it will impact on the demand of products and hence

impair the profitability of company.

There is a risk that company will have to pay high expenses in importing goods

from other country and hence this will decrease the profit of company.

There is a risk that company will have to suffer foreign exchange rate risk and

hence it will decrease it profit given an increase in the expenses.

Old asset

The overseas plant and equipment were built 12 years ago.

There is a risk that given the assets are too old and it may not have sufficient

future capacity to produce new products in the future and hence decrease profit

of company.

Bank overdraft

Company relies very much on the bank overdraft and this is more expensive

than other bank loans.

There is a risk that it will further impair its profitability because company has to

pay more as a result of the expensive expense.

Weak internal control system

The internal control system of client’s company is so weak.

There is a risk that fraudulent transactions happened which can’t be detected

and it may lead to company suffering a loss.

Tax authority

Two tax investigations into company happened.

There is a risk that company may not comply with tax regulations which would

result in further penalties paid by company as a result and hence impair its

profitability position.

Shut down

The building has no local authority approval.

There is a risk that building may be shut down and as a result company needs to

find another place to building the building which may be expensive to company

and hence impair its profitability position.


Regulations

Company has been in breach of local planning regulations.

There is a risk that company will need to pay related penalty which would impair

its liquidity position.

Reputation

Company breaches the regulation.

There is a risk that demands for the product by customers will decrease as a

result of the bad publicity company creates, ie, breaches in regulation.

Impairment of building

The building has been impaired last year.

There is a risk that company may find it more difficult to raise finance because

of a worsen position in its non-current assets.

(b)

(i)

Business risk is the risk that business fails, ie, as a result of this risk

company will have to pay more expenses.

Risk of material misstatement is the risk that the financial statement of

client’s company may be misstated.

Business risk will lead to risks of material misstatement, ie, in Medix Co the

decline in demand of products by customers is a business risk and this would

lead to risk of material misstatement in financial statement, ie, risk of

inventory being overstated.

Business risk would relate to going concern status of company as well. Ie, in

Medix Co it is struggling to raise finance given poor quality assets it has and

as a result of the lack of finance it would impact on its going concern status,

ie, doesn't have enough cash flow to operate its business.


Chapter2 June2012 Q1(Risk of material misstatement/Audit risks)

You are a manager in Magpie & Co, responsible for the audit of the CS Group. An

extract from the permanent audit file describing the CS Group’s history and

operations is shown below:

Permanent file (extract) Crow Co was incorporated 100 years ago. It was founded

by Joseph Crow, who established a small pottery makingtableware such as dishes,

plates and cups. The products quickly grew popular, with one range of products

becominghighly sought after when it was used at a royal wedding. The company’s

products have retained their popularity overthe decades, and the Crow brand

enjoys a strong identity and good market share.

Ten years ago, Crow Co made its first acquisition by purchasing 100% of the share

capital of Starling Co. Both companies benefited from the newly formed CS Group,

as Starling Co itself had a strong brand name in the pottery market. The CS Group

has a history of steady profitability and stable management.

Crow Co and Starling Co have a financial year ending 31 July 2012, and your firm

has audited both companies for several years.

Acquisition of Canary Co

The most significant event for the CS Group this year was the acquisition of Canary

Co, which took place on 1 February 2012. Crow Co purchased all of Canary Co’s

equity shares for cash consideration of $125 million, and further contingent

consideration of $30 million will be paid on the third anniversary of the acquisition,

if the Group’s revenue grows by at least 8% per annum. Crow Co engaged an

external provider to perform due diligence on Canary Co, whose report indicated

that the fair value of Canary Co’s net assets was estimated to be $110 million at the

date of acquisition. Goodwill arising on the acquisition has been calculated as

follows:

$m

Fair value of consideration: 125

Cash consideration 30

Contingent consideration 155

Less: fair value of identifiable net assets acquired (110)

Goodwill 45

To help finance the acquisition, Crow Co issued loan stock at par on 31 January 2012,

raising cash of $100 million. The loan has a five-year term, and will be repaid at a

premium of $20 million. 5% interest is payable annually in arrears. It is Group

accounting policy to recognise financial liabilities at amortised cost.


Canary Co manufactures pottery figurines and ornaments. The company is

considered a good strategic fit to the Group, as its products are luxury items like

those of Crow Co and Starling Co, and its acquisition will enable the Group to

diversify into a different market. Approximately 30% of its sales are made online,

and it is hoped that online sales can soon be introduced for the rest of the Group’s

products. Canary Co has only ever operated as a single company, so this is the first

year that it is part of a group of companies.

Financial performance and position

The Group has performed well this year, with forecast consolidated revenue for the

year to 31 July 2012 of $135 million (2011 – $125 million), and profit before tax of

$8·5 million (2011 – $8·4 million). A breakdown of the Group’s forecast revenue and

profit is shown below:

Crow Co Starling Co Canary Co CS Group

$ million $ million $ million $ million

Revenue 69 50 16 135

Profit before

tax

3·5 3 2 8.5

Note: Canary Co’s results have been included from 1 February 2012 (date of

acquisition), and forecast up to 31 July 2012, the CS Group’s financial year end.

The forecast consolidated statement of financial position at 31 July 2012 recognises

total assets of $550 million.

Other matters

Starling Co received a grant of $35 million on 1 March 2012 in relation to

redevelopment of its main manufacturing site. The government is providing grants

to companies for capital expenditure on environmentally friendly assets. Starling Co

has spent $25 million of the amount received on solar panels which generate

electricity, and intends to spend the remaining $10 million on upgrading its

production and packaging lines.

On 1 January 2012, a new IT system was introduced to Crow Co and Starling Co,

with the aim of improving financial reporting controls and to standardise processes

across the two companies. Unfortunately, Starling Co’sfinance director left the

company last week.

Required:

Evaluate the risks of material misstatement to be considered in the audit planning of

the individual and consolidated financial statements of the CS Group

(18 marks)



Contingent consideration

Step1:Contingent consideration is $155m.

Step 2:According to IFRS3 business combination that contingent consideration

should include the probability of payment and also should discount to present

value.

Step 3:There’s a risk that $155m hasn't included the probability of being paid

and hasn't been discounted to its present value resulting in

over/understatement of goodwill figure.

Net assets

Step 1:Fair value of identifiable net assets is $110m.

Step 2:According to IFRS3 business combination that this should net of deferred

tax implication.

Step 3:There is a risk that $110m hasn't included deferred tax implication, ie,

net of deferred tax liability resulting in misstatement in identifiable net assets

figure.

Goodwill

Step 1:Goodwill is $45m.

Step 2:According to IAS36 impairment of assets management should conduct

an impairment test for goodwill at the year-end by comparing its carrying value

and its recoverable amount.

Step 3:There is a risk that an impairment test has not been done resulting in

overstatement of goodwill in statement of financial position and understatement

of expenses in the statement of profit or loss.

Loan stock

Step 1:Crow co issued a loan stock at par.

Step 2:According to IFRS9 financial instrument when calculating the fair value

of financial liability at inception the repayment at premium of $20m should be

included.

Step 3:There is a risk that this is not done which would impact on the calculation

of finance cost and hence resulting in understatement of expenses in statement

of profit or loss and financial liability in the statement of financial position.

Financial cost

Step 1:Interest is paid annually and to its year end it’s half a year now.

Step 2:Finance cost should be accrued at the year end, ie, half a year amounts

to $2.5m($100mX5%X1/2) by DR I/S $2.5m, CR interest payable $2.5m.

Step 3:There is a risk that this is not done which would result in understatement

of expenses in the statement of profit or loss and liability in the statement of

financial position.


Online sales

Step 1:30% of sales are made online.

Step 2:According to IAS18 revenue recognition sales revenue is recognized

when the risks and rewards of products have been transferred from seller to

buyer; no managerial involvement on the goods; related expenses can be

measured reliably. So company should recognize a sales revenue when the

above conditions are met.

Step 3:There is a risk that company may not record the sales revenue correctly

given complexity in online sales system which would result in revenue figure

being misstated in statement of profit or loss and relating assets such as

receivable or cash being misstated in statement of financial position.

Canary revenue and profit before tax

Step 1:Canary Co revenue and profit before tax are $16m and $2m.

Step 2+3:There is a risk that Canary Co may overstate its revenue and profit

before tax figure in order to argue for a better price.

Group position

Step 1:The forecast revenue without including Canary co is

$119m($135m-$16m) and the profit before tax is $6.5m ($8.5m-$2m) which

are less than the actual 2011 figure of $125m and $8.4m.

Step 2+3:There is a risk that both revenue and profit before tax figures are

understated given a new incorporation of Canary Co into the group happens.

Grant

Step 1:Starling Co received a grant of $35m.

Step 2:According to IAS20 Government Grant the receipt of grant should be

deferred and released over the life of the asset to recognize income in statement

of profit or loss.

Step 3:There is a risk that Starling Co may recognize the full $35m at inception

and hence this would result in overstatement of revenue in statement of profit

or loss and understatement of liability in statement of financial position.

Grant repayment

Step 1:Starling Co has not spent the rest of grant of $10m.

Step 2:If Starling Co hasn't spent this $10m onto the qualifying assets then it

may become repayable and According to IAS37 provision, contingent liability

and contingent assets if the cash outflow is possible then a contingent liability

should be disclosed to the financial statement and if the repayment becomes

probable then a provision should be recognized.

Step 3:There is a risk that this is not done resulting in either under disclosure or

understatement of expenses in statement of profit or loss and liability in the

statement of financial position.


New IT system

Step 1:New IT system as introduced to both companies.

Step 2:Because of the unfamiliarity of the system there would be a risk that

errors may occur in transferring data from old to new system.

Step 3:This would result in the overall financial statement being misstated.

Finance director

Step 1:Finance director left Starling Co last week.

Step 2+3:This would increase the likelihood of misstatement in the individual

financial statement because of a lack of expertise in the financial reporting

process.


Chapter2 Q7: June2010 Q2

Mac Co is a large, private company, whose business activity is events management,

involving the organisation of conferences, meetings and celebratory events for

companies. Mac Co was founded 10 years ago by Danny Hudson and his sister,

Stella, who still own the majority of the company’s shares. The company has grown

rapidly and now employs more than 150 staff in 20 offices.

You are a manager in the business advisory department of Flack & Co. Your firm has

just been engaged to provide the internal audit service to Mac Co. In your initial

conversation with Danny and Stella, you discovered that currently there is a small

internal audit team, under the supervision of Lindsay Montana, a recently qualified

accountant. Before heading up the internal audit department, Lindsay was a junior

finance manager of the company. The members of the internal audit team will be

reassigned to roles in the finance department once your firm has commenced the

provision of the internal audit service.

Mac Co is not an existing client of your firm, and to gain further understanding of the

company, you held a meeting with Lindsay Montana. Notes from this meeting are

shown below.

Notes of meeting held with Lindsay Montana on 1 June 2010

The internal audit team has three employees, including Lindsay, who reports to the

finance director. The other two internal auditors are currently studying for their

professional examinations. The team was set up two years ago, and initially focused

on introducing financial controls across all of Mac Co’s offices. Nine months ago the

finance director instructed the team to focus their attention on introducing

operational controls in order to achieve cost savings due to a cash flow problem

being suffered by the company. The team does not have time to perform much

testing of financial or operational controls.

In the course of her work, Lindsay finds many instances of management policies not

being adhered to, and the managers of each location are generally reluctant to

introduce controls as they want to avoid bureaucracy and paperwork. As a result,

Lindsay’s recommendations are often ignored.

Three weeks ago, Lindsay discovered a fraud operating at one of the offices while

reviewing the procedures relating to the approval of new suppliers and payments

made to suppliers. The fraud involved an account manager authorizing the payment

of invoices received from fictitious suppliers, with payment actually being made into

the account manager’s personal bank account. Lindsay reported the account

manager to the finance director, and the manager was immediately removed from

office. This situation has highlighted to Danny and Stella that something needs to be


done to improve controls within their organisation.

Danny and Stella are considering taking legal action against Mac Co’s external audit

provider, Manhattan & Co, because their audit procedures did not reveal the fraud.

Danny and Stella are deciding whether to set up an audit committee. Under the

regulatory framework in which it operates, Mac Co is not required to have an audit

committee, but a disclosure note explaining whether an auditcommittee has been

established is required in the annual report.

Required:

(a) Evaluate the benefits specific to Mac Co of outsourcing its internal audit

function. (6 marks)

(b) Explain the potential impacts on the external audit of Mac Co if the

decision is taken to outsource its internal audit function. (4 marks)

(c) Recommend procedures that could be used by your firm to quantify the

financial loss suffered by Mac Co as a result of the fraud. (4 marks)

(d) Prepare a report to be presented to Danny and Stella in which you:

(i) Compare the responsibilities of the external auditor and of

management in relation to the prevention and detection of fraud; and (4

marks)

(ii) Assess the benefits and drawbacks for Mac Co in establishing an audit

committee. (4 marks)

Professional marks will be awarded in respect of requirement (d) for the

presentation of your answer, and the clarity of your discussion. (4 marks)

(26 marks)



(a)

Roles assigned

After outsourcing the internal audit function the role of financial manager may

be reassigned to other parts of the company and this will benefit the company

for having extra resources for having such employees.

External expertise

Because currently there are two internal auditors within the client’s company

not being qualified so a decision of outsourcing the internal audit function will

have extra expertise to do the internal service for client and this will improve the

overall internal audit quality as well.

Focus

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 to cover a

range of activities.

Time

Because currently there are two internal auditors within the client’s company so

for outsourcing the internal audit function that it will have extra resources to

focus on other areas of the company.

(b)

Audit strategy

If after outsourcing its internal audit function then the internal control system

off client company improved and so the external audit firm may rely on the

internal control system and hence spent less time doing the full substantive

testing and this would result in less audit fees charged.

Assessable of the working papers by outsourcing firm

If the outsourcing firms working papers are accessible by external auditor and

this will reduce the work done by external auditor and hence reduce the fees

charged.

Internal control system changes

If the internal control system changes and this will impact on the amount of

work done by audit firm and hence impact on its fees as well.


Report

If external auditor replies on type2 report then this will decrease its work load

and hence fees charged as well.

(c)

Enquire with the police and lawyer to verify if the amount can be reimbursed

ith client’s permission.

Inspect the insurance policy to verify if it covers this situation and the losses

can be reimbursed.

Compare a list of unapproved suppliers to a list of actually approved

suppliers by the company to identify the discrepancies of suppliers and its

related amount.

Use computerized assisted audit techniques to identify the suppliers with the

same bank account to the accountant manager.

(d)

Report to: Danny and Stella Hudson

Content: Responsibilities in respect of fraud

Audit committees: benefits and drawbacks

Introduction: The objective of the report is to compare the responsibilities of the

external auditor and of management in relation to the detection of fraud, and

also to outline the benefits and drawbacks for Mac Co of establishing an audit

committee.

(i) Responsibilities of the external auditor and of management in

relation to the detection of fraud

Management has a primary responsibility in establishing a sound internal

control system to prevent and detect of fraud.

Management should assess the internal control system continuously.

Auditor would be responsible for the fraud happened within company if they are

material to the financial statements. This means auditors would focus more on

the fraud impact on the accounts rather than its operational issues.

Auditor would assess the internal control system at the planning stage of audit

to determine its audit strategy.


(ii)

Benefits

This can improve the overall internal control system which client’s company

because originally Lindsay reports internal control system weaknesses to the

finance director and if the control environment is weak then it will have an

impact on the quality of internal control system if finance director refuses to

change the internal control system required by Lindsay.

Audit committee would have more power and status not like Lindsay who is just

the current junior financial manager then they may adopt the internal control

recommendations more easily.

Drawbacks

It’s difficult in the real world to recuitstaff who are independent and with

relevant skills.

They may not have 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.

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.


Chapter2 Q7: Big Accounting questions

Please outline all the accounting standards contents in ACCA paper and related

audit work to it.(35 accounting standards outlined below)


Chapter2 Q7: 1, conceptual framework:

Its objective is to provide useful information to users of financial statements but

how?

We need to make sure information in the FS is:

Relevant To help users making their economic decisions like using fair

value;

Reliable To ensure financial statement figures are correct(audited);

From past event(shown in the contract);

Free from bias(no window dressing);

not overstating value(prudence);

Showing substance of transaction like recognize finance

lease rather than operating lease(substance over form);

No missing information(complete).

Comparable Disclosing diluted EPS and its comparative figures to help

users to make their decisions.

Understandable Information should be translated in easy language to be

understood by to users with reasonable business and

accounting knowledge and should be clear and precise as

well.


Of course when preparing the financial statements the underlying assumptions

would be:

1.Going concern. This means company can operate its business for more

than 12 months and hence non-current assets and

liabilities would need to be recognized. When a company is

not a going concern entity any more then company needs

to prepare its financial statements under break up basis

and this means to reclassify its non-current assets and

liabilities into current assets and liabilities.

If there is significant uncertainties about the going

concern status of the company then company should

disclose those uncertainties in the note of the financial

statement as per IAS1 presentation of financial

statements. Auditor should bring shareholders attention

by adding emphasis of matter paragraph after the actual

opinion paragraph as well.

2. Accruals. This means company should recognize its revenue

provided the expenses can be matched against each other

like in IAS20 government grant.

This is also against cash basis where looking at sales

revenue-we will not recognize sales revenue until we

receive the cash but rather we would DR receivable CR

sales revenue even if we haven’t received cash payment.


Chapter2 Q7: 2,IAS1 Presentation of Financial Statements

Accounting Issues:

Statement of Financial Position(not balance sheet);

Statement of profit or loss and other comprehensive income;

Statement of changes in equity.

Audit Works:

Inspect the financial statements to ensure company has used break up basis,

ie, to reclassify all non-current assets and liabilities into current assets and

liabilities if company is not a going concern entity.

Inspect disclosures made by management regarding certainties about going

concern status of the company is adequate.

Obtain a written representation from management to confirm company is a

going concern entity at the review stage.


Chapter2 Q7: 3,IAS2 Inventories

Accounting Issues:

1,what’s the difference between inventory and property, plant and equipment?

Aim:

The aim of inventory is “held for sale”;

The aim of PP&E is to hold for production of goods or delivery of services

or for administrative purposes.

Period:

Inventory is within 1 year; while PP&E is more than 1 year.

2, How can we measure inventory?

Initial measurement:

The initial cost of inventory would be including all costs of purchase,

plus the costs of conversion and other costs incurred in bringing the

inventories to their present location and condition.

Subsequent measurement:

Value at the lower of Cost and Net Realizable Value(Estimated selling

price-Estimated costs to sell)

Costs are usually measured using FIFO, Weighted average cost.(LIFO is

banned)

Audit Works:

1, initial measurement:

Costs should be agreed to invoices and purchase agreement and

bank statement and cash book;

If manufactured, costs should be agreed to material requisitions,

timesheets, personnel records;

2, subsequent measurement:

NRV should be agreed to post year-end selling prices and invoices.

Inspect inventory condition and if it’s damaged then it should be

valued using NRV.


Audit Question [ DEC2009 Q2] IAS2

Banana Co designs specific items for customers according to contractually agreed

specifications. And you are at the review stage of audit.

After the year end, Cherry Co, a major customer with whom Banana Co has several

significant contracts, announced its insolvency, and that procedures to shut down

the company had commenced.

The amount of contract is $50,000 while the total asset within statement of

financial position is $500,000.

Required:

Comment on the matters to be considered relating to the above inventory.

Answer:

Materiality

The inventory of $50,000 accounts for 10% of total asset and it's material to


Accounting treatment

Because the inventory is for specific use and Cherry Co is in insolvency and

hence inventory can’t be used by Cherry co and they are with no use any more

so according to IAS2 the value should be written down to lower of cost and net

realizable value according to IAS2.

Audit opinion

If this is not done properly then a qualified audit opinion with an except for

qualification due to material misstatement should be given.

(Tutor tips: this is at the review stage of audit and hence any matters to be

considered should be taking into account the impact on audit report if the

adjustment is not done properly)


Chapter2 Q7: 4, IAS7 Statement of cash flows

Accounting Issues:

It incorporates operating cash flows, investing cash flows and financing

cash flows.

In operating cash flows element, non-cash flow items should be added it

back.

Audit works:

Agree opening cash flows to last year end cash flow to verify its accuracy.

Review and verify the non-cash item such as depreciation is added back to

the operating cash flows.

(Statement of cash flow is often in the form of prospective financial information

(forecast) and it requires audit work to be performed to verify its

reasonableness, eg, check the assumptions. )


Chapter2 Q7: 5,IAS8 Accounting Policies, Changes in

Accounting Estimates and errors

Accounting Issues:

If the company is going to use another accounting policy this year and find an

error relating to last year’s account then the company should adjust for this year

and last year’s financial statements.(retrospective adjusting)

If the company is going to use another accounting estimate this year and the

company should adjust for current year financial statements and future

one.(prospective adjusting)

But how to determine whether this is a change in accounting policy or estimate?

Well, if there’s a change in

Measurement basis of the figure, eg, value the inventory using FIFO but

now use weighted average method; use replacement cost rather than

historic cost.

Recognition basis of the figure, eg, recognize as an expense before but

now for asset(eg,IAS 23 borrowing costs)

Presentation basis of the figure, eg, recognize the depreciation expense

into cost of sales now rather than in administrative expenses before.

You are going to change in the accounting policy only if:

1, a change in laws / accounting standards and you are required to do so;

2, gives a fairer presentation to the users of FS.

And anything that is not changing the measurement, recognition or

presentation of figures are deemed to be a change in accounting estimate such

as:

Allowance for receivables;

Useful life/ depreciation method of the non-current assets;

Warranty provision relating to return of goods from customers.

An error may happen if there’s a

Misuse of the accounting standard last year;

Fraud happened last year;

Omit some figures in last year’s account.


Summary:

Changes in accounting policy this year:

Assume it happens in last year as well and of course this year happens;

Adjust for last year closing retained earnings taken into account in the changes

to be brought forward in this year’s statement of changes in equity.

Material prior period errors found:

Correct last year’s material errors;

Adjust for last year closing retained earnings taken into account in the error

effect to be brought forward in this year’s statement of changes in equity.

Changes in accounting estimate:

Use the new one to continue the calculation.

Audit works:

1, Inspect the changes in accounting policy and ensure it’s consistent and

properly disclosed.

2, Inspect the changes in accounting estimate and verify the nature and the

amount have been disclosed properly.


Audit question [DEC2011 Q3 ] IAS 8

Pine Co

Pine Co operates a warehousing and distribution service, and owns 120 properties.

During the year ended 31 July 2011, management changed its estimate of the

useful life of all properties, extending the life on average by 10 years. The financial

statements contain a retrospective adjustment, which increases opening

non-current assets and equity by a material amount. Information in respect of the

change in estimate has not been disclosed in the notes to the financial statements.

Required:

Identify and explain the potential implications for the auditor’s report of

the accounting treatment of the change in accounting estimates.

(5 marks)


Answer to audit question [DEC2011 Q3 ] IAS 8:

Pine Co

Materiality

The increase in non-current asset amount is material by question.


This is a change in accounting estimate not change in accounting policy so this

does require prospective adjustment not retrospective adjustment.

This means management shouldn't restate the opening balance of non current

asset and retained earnings.

Audit report implication

If management has corrected this mistake then an unmodified audit report

would be given.

If management still insist to restate the opening balance of non-current asset

and retained earnings then an modified audit report with qualified audit opinion

would be given with an except for material misstatement in the financial

statement.

Auditor should explain the reasons why a qualified audit opinion would be given

in the basis of opinion paragraph.

And this paragraph would be placed before the actual opinion paragraph.


Chapter2 Q7: 6,IAS10 Events after the Reporting Period

Accounting Issues:

Time line:

This is the event happened between financial statement year end and the

financial statements are authorized to be issued to the shareholders to be

discussed at the AGM(annual general meeting).

They will be either adjusting events or non-adjusting events

Magical way to distinguish the adjusting events and non-adjusting events:

Is it because of this event then it will affect the figure as at the year end?

-Adjusting events

Change in judgments, estimate or assumptions after the year end.

Eg, 1, inventory sold at a loss? Change in assumptions that closing inventory should be valued at the

lower of cost and net realizable value (IAS 2);

2, Customers go bankruptcy so that recoverability of the receivable balance at the year end has

been changed.

3, If company is involved in going concern problems after the year end and because the financial

statement should be prepared under going concern basis and now this is changed.

-Non-adjusting events

There’s no link between financial statement figures at the year end and events after the FS year end.

Eg, 1, fire destroyed the inventory after the year end (cant’s predict!)

2, dividends are declared after the year end or share issues after the year end (no link between

figures and events)

Audit works:

Can be active responsibility; passive responsibility. And this is according to

ISA560 subsequent events.

YR start YR end

Audit

report

signed

FS

authorized

to issue


Audit question ISA560 [DEC2009 Q5]

Subsequent events

(a) Guidance on subsequent events is given in ISA 560 (Redrafted) Subsequent

Events.

Required:

Explain the auditor’s responsibility in relation to subsequent events. (6

marks)

(b) You are the manager responsible for the audit of Lychee Co, a manufacturing

company with a year ended 30 September 2009. The audit work has been

completed and reviewed and you are due to issue the audit report in three days. The

draft audit opinion is unmodified. The financial statements show revenue for the

year ended 30 September 2009 of $15 million, net profit of $3 million, and total

assets at the year end are $80 million.

The finance director of Lychee Co telephoned you this morning to tell you about the

announcement yesterday, of a significant restructuring of Lychee Co, which will take

place over the next six months. The restructuring will involve the closure of a factory,

and its relocation to another part of the country. There will be some redundancies

and the estimated cost of closure is $250,000. The financial statements have not

been amended in respect of this matter.

Required:

In respect of the announcement of the restructuring:

(i) Comment on the financial reporting implications, and advise the further

audit procedures to be performed; and

(6 marks)

(ii) Recommend the actions to be taken by the auditor if the financial

statements are not amended.

(4 marks)

(16 marks)


Answer to ISA560 [DEC2009 Q5]Subsequent Events

(a)

Events between FS year end and audit report is signed:

Auditor would have active responsibility to identify any subsequent events.

Procedures would include for example:

Enquire with management to verify any subsequent events have occurred.

Reading minutes of meetings of shareholders and management to verify any subsequent

events have occurred.

Reviewing the latest interim financial statements to verify any subsequent events have

occurred.

Events between audit report signed and the FS are issued:

Auditor would have a passive responsibility to identify any subsequent events.

Ie, they don't need to perform procedures actively to identify those events.

But management would have the responsibility to tell auditors any subsequent events.

If any events occurred which would materially affect the FS then this matter should be

discussed with management.

If this matter has been dealt with by management either disclose or amend it then auditors

should perform additional audit procedures relating to this issue and a new audit report would

be issued.

If management refuses to deal with this event and it is material to the FS then a qualified

audit opinion should be issued by auditors.

Events after financial statements are issued:

Auditor would have a passive responsibility to identify any subsequent events.

Ie, they don't need to perform procedures actively to identify those events.

If any events occurred which would materially affect the FS then this matter should be

discussed with management.

If this matter has been dealt with by management either disclose or amend it then auditors

should perform additional audit procedures relating to this issue and a new audit report would

be issued.

If management refuses to deal with this event and it is material to the FS then a qualified

audit opinion should be issued by auditors.


(b)

(i)

Materiality:

Based on revenue: $250,000/15 million = 1·67%

Based on profit: $250,000/3 million = 8·3%

Based on assets: $250,000/80 million = <1%

So this is material to statement of profit or loss and other comprehensive income.

Accounting:

A note detailing the nature of the event and the amount should be provided according to

IAS10.

Company needs to determine the probability of cash outflow to see whether provision or

contingent liability should be accounted for disclosed to the note of the financial statement.

Audit procedures:

Enquire with management and read board minutes relating to this to gain an understanding

about the reason for the restructuring.

Inspect the note to financial statements which should disclose the non-adjusting event,

providing a brief description of the event, and an estimate of the financial effect.

Inspect detail copy of the announcement about the nature of the restructuring, ie, the

number of employees to be affected.

Agree the $250,000 potential cost of closure to supporting documentation like a schedule

showing the number of staff to be made redundant and these should be supported by payroll

details.

(ii)

Auditor should raise this issue to those charged with governance, ie, audit committee to

persuade them to correct this misstatement.

If misstatement still exists then auditor should modify his audit report by giving a

qualification of audit opinion due to material misstatement in the fiancnial statement.

Auditor should explain the reasons for the qualification in the basis of opinion paragraph

and this is before the actual opinion paragraph.

Auditor can choose to raise this issue to the annual general meeting to shareholders.


Chapter2 Q7: 7,IAS 11 Construction Contracts

Accounting Issues:

1,When you’re trying to build this tower it may take you more than 1 year to

finish. After finishing off this tower and you may try to sell off to the client.

So before finishing off this tower will you keep it as a inventory?(IAS2)

The answer is no! Remember inventory is current asset which is less than 1

accounting year.

2,Next question is because the contractor is building this tower so he may have

to pay for material, labor costs etc. So when is the cost being recognized?

The contractor can get the sales revenue only when after selling off this tower to

client. So before selling off this tower, the contractor gets no cash from the client.

So does the contractor recognize no revenue at all?

To answer this question:

According to Prudence concept, the sales revenue should be recognized

after this tower has been sold off to the client.

According to Accruals concept, the expenses relating to the building of the

tower should be matched with the revenue from the tower.

So one is contradict with another. But here in this case, Accruals concept

wins.

3,But how much does the revenue and expenses should be recognized?

IAS 11 Construction Contract gives us the guidance.

4,

Guidance by IAS 11 construction contract (Diagram)

yes

No

yes

No

yes

Recognize based on stage of

completion

Outcome is certain?

Profit making contract?

Fixed Price or Mark up?

Revenue=costs(no profit/loss)

Recognize loss in full

Profit=price(cost+mark up)-cost Mark up


5, Stage of completion

Sales basis method (work certified method):

work certified to date

Contract price

Cost method:

Costs incurred to date

Total contract costs


Audit question [june2011 Q2] IAS11:

Construction Contract(attachment1)

In the last week, two significant issues have arisen at Bill Co. The first issue

concerns a major contract involving the development of an old riverside warehouse

into a conference centre in Bridgetown. An architect working on the development

has discovered that the property will need significant additional structural

improvements, the extra cost of which is estimated to be $350,000. The contract

was originally forecast to make a profit of $200,000. The development is currently

about one third complete, and will take a further 15 months to finish, including this

additional construction work. The customer has been told that the completion of the

contract will be delayed by around two months. However, the contract price is fixed,

and so the additional costs must be covered by Bill Co.

Forecast profit before tax is $2·5 million.

Hello

Thanks for taking on the role of audit manager for the forthcoming audit of

Bill Co.

(i) I have just received some information on two significant issues that have arisen

over the last week, from Sam Compton, the company’s finance director. This

information is provided in attachment 1. I am asking you to prepare briefing notes,

for my use, in which you explain the matters that should be considered in

relation to the treatment of these two issues in the financial statements, and also

explain the risks of material misstatement relating to them. I also want you to

recommend the planned audit procedures that should be performed in order to

address those risks.

(8 marks)


Answer to [june2011 Q2] IAS11

Matters to be considered

Materiality:

The loss on the contract of $150,000 represents 6% of the forecast profit before tax and is

therefore material to the statement of profit or loss.

Accounting treatment:

1. The $150,000 loss needs to be recognized immediately to the statement of profit and loss

and other comprehensive income.

2. the delay completion of contract would result in penalties and this should be accounted for

under IAS37 provision, contingent liabilities and contingent asset.

Risks of material misstatement:

There is a risk that loss of $150,000 has not been recognized in the statement of profit or loss

and hence overstate the profit figure by $150,000.

There is also a risk that a failure to provide for a provision or disclose contingent liability in the

note of the FS and this would result in understatement of liability and expense or under

disclosure.

Audit procedures:

Inspect the customer-signed contract to verify the fixed price and any penalty clauses

relating to late completion.

Recalculate the budget for the Bridgetown development to verify the accuracy of the

schedule and confirm the expected loss of $150,000.

Inspect report made by the architect regarding the structural improvements to verify the

estimate of the additional costs.

Discuss the additional costs with contractors to assess if the estimate appears

reasonable.

Review Bill Co’s cash flow forecast to ensure adequate funds to cover the additional costs.


Chapter2 Q7: 8,IAS12 Income Taxes

Accounting issues:

In the statement of profit or loss and other comprehensive income:

$

Sale revenue 1,000

Cost of sales (300)

Gross profit 700

Expenses (100)

Profit before tax 600

Tax expense (@30%) (50)

Profit after tax 550

You can see although tax rate is 30% but we use 30%Xprofit

before tax which does not equal to 50, why?

The reason being within the tax expense there are 3

components: (mnemonics: CPD)

Current tax payable (based on last year taxable

profit)

Provision (under/(over))

Deferred tax movement Because of permanent and temporary difference which leads to the difference in taxable

profit calculation and accounting profit calculation.

Permanent differences are the amounts which represent income or expense for accounting

purposes but are not taxable/allowable for tax purposes. Example: client entertaining.

Temporary differences are amounts which represent income or expense for accounting

purposes and tax purposes but in difference periods. Example: depreciation and capital

allowances.

Notice: The deferred tax transfer is not cash flow!!!

Before we look at deferred tax, why not start off by looking at current taxation? (this is what

you have already learnt in F3, just a recap.)


Current tax:

Companies have to pay tax on taxable profits. The tax charge is normally

ESTIMATED at the end of the financial year and charged to the statement of

comprehensive income, and paid in the following year.

The double entry for taxation would be:

DR Taxation expense (Statement of comprehensive income)

CR Taxation liability (Statement of financial position)

The double entry for when the tax is paid a few months later:

DR Taxation liability (Statement of financial position)

CR Bank (Statement of financial position)

Since the amount paid is likely to differ from the estimated tax charge originally

recognized, a balance will be left on the taxation liability account being an under

or over provision of the tax charge.


Deferred tax:

What is deferred tax?

Illustrate with an example:

Imagine you have a building with a carrying value of $1000. During the year you

have revalued this building to $1,100 then you make a profit from it of $100

which is not realized yet.

DR NCA 100

CR revaluation reserve 100

So for the tax man’s perspective, because you will somehow in the future

realized this profit when sold so they may require you to provide for a future tax

obligation(deferred tax) of $100Xtax rate although you are not paying money

now but you will in the future.

Concept:

So we know that deferred tax is a future obligation to be settled by company

depending on the future tax law. So deferred tax does not necessarily fulfill the

liability definition (present obligation).

Deferred tax arises because of temporary differences (TD). Temporary

difference is the difference between CV and TB.

DT=TD* X CT%

*TD=CV - TB

TD: Temporary difference between carrying value and tax base

CV: Carrying value of asset/liability.

TB: tax base in the tax man’s book.(in real practice we will try to refer to

different tax regulations to calculate the tax base)

DT: Deferred tax liability/asset

CT%: Corporation tax rate

Deferred tax is a future liability recognized today. And deferred tax is based on

temporary difference (timing difference between accounting and tax law). So

the amount we owe to the tax authority will be finally paid back to them in the

subsequent years.

Typically, in P7, Deferred Tax Asset is most commonly tested.

The recoverability of Deferred Tax Asset will be limited depending on the

forecast profit company will make.


Audit Works: [Q11:DEC2008 Q1] Income taxes IAS 12

So we usually focus on the profit forecast, management accounts for the

company performance to estimate the company future profit making ability to

establish if it can utilize the deferred tax asset (unutilized losses) to set against

the future profit.


Audit question: [Q11:DEC2008 Q1] IAS 12

(b) Describe the principal audit procedures to be carried out in respect of

the following:

(ii) The recoverability of the deferred tax asset.

(4 marks)

Answer to [Q11:DEC2008 Q1] Income taxes IAS 12

(ii) Principal audit procedures – recoverability of deferred tax asset

Agree figures in the current and deferred tax calculation to tax correspondence.

Inspect profitability forecast to agree there is enough forecast taxable profit to offset

against the loss.

Perform analytical procedure by evaluating assumptions used in the forecast to ensure

it’s in line with auditors’ business understanding.

Perform analytical procedure by assessing time taken to generate profit to recover tax

losses and if it takes many years to generate such profit and the recognition of deferred

tax asset would be restricted.

Inspect tax correspondence to verify there’s no restriction for company to carry forward

and use losses against future taxable profits.


Chapter2 Q7: 9,IAS16 Property, Plant and Equipment

Accounting Issues:

Initial measurement:

Capital expenditure

Capital expenditure is the costs of acquiring non-current assets.

According to IAS 16 the following costs may be capitalised in the statement of

financial position on acquisition of a non-current asset:

(Mnemonic: IIIID)

Initial cost (purchase price)

Import duty not refundable(if asset is bought from other

country)

Installation costs

Intended use relating costs (lawyer, surveyor costs)

Delivery costs

Finance cost (IAS 23 see F7 & P2)

Revenue expenditure

Revenue expenditure is expenditure on maintaining the capacity of noncurrent

assets. Costs that are regarded as revenue expenditure should be expensed in

the statement of comprehensive income and may not be capitalised according

to IAS 16 are:

(Mnemonic: RIM)

Repairs expenses

Insurance expenses

Maintenance expense

After we’ve purchased the non current asset the accountant needs to record

that non current asset into the non- current asset register.

A non-current asset register is generally maintained in the finance department.

Companies can purchase specifically designed packages or a register can simply

be maintained on an Excel spreadsheet.

And this is used to reconcile the NCA in the NCA register to the individual asset

in place, ie, an example of control procedure by company.


Sample of Non-current asset register:

Asset type Date purchased Description Cost Depreciation Carrying

value

Disposal

proceeds

Disposal date

Machine 1 July 2013 Drink

machine

$7m

Year ended 31 DEC 2013 $700,000 $6.3m

Year ended 31 DEC 2014 $3m Jan-2014

Subsequent measurement

Cost model: cost-accumulated depreciation*=carrying value

Depreciation method should be reviewed each year to see whether or not it is

reasonable. A change in depreciation method should be treated as a change in

accounting estimate and prospective adjusting method according to IAS 8

should be applied. Ie, disclose the depreciation method in the note of the

financial statements.

Revaluation Model: revalued amount

IAS 16 the test was whether the expenditure was Capital or Revenue e.g. an

improvement could be capitalised but maintenance or repair could not be

capitalized.

The following circumstances should be capitalized:

(mnemonics: LOSE)

L: Life extension

O: major overhaul cost

S: separate component, eg, new enguine for an aircraft

E: energy saving, eg, improving production capacity

Basic idea:

1, economic benefits are excessed

2, component treated seperatly

3, major overhaul cost


Revaluation

Basic Idea:

As time goes by initial costs of asset may be very different from their market

value.

Eg, if a company purchased a property 35 years ago and therefore subsequently

charged depreciation for 35 years, it would be safe to assume that the carrying

value of the asset would be significantly different from today’s market value.

If revaluation policy per IAS 16 may be adopted (i.e. the business has a choice),

and if so the following rules must be applied per the standard: (mnemonic:

CRRR)

1, No Cherry picking(If a company chooses to revalue an asset they must revalue all assets in that

category.)

2, Regular (Revaluations must be regular but IAS 16 doesn't specify how often)

3, Revalued amount(Subsequent depreciation must be based on the revalued amounts.)

4, Revaluation Reserve (Gains from revaluations are taken to revaluation reserve rather than retained

earnings unless they are sold)

Calculation:

$

Revalued amount X

CV of asset on revaluation date (X)

Revaluation gain/(loss) X/(X)

Journal

DR Asset cost (Statement of financial position)

DR Accumulated depreciation (Statement of financial position)

CR Revaluation reserve (Statement of financial position)


Audit work:

IAS16 PP&E does not test it much, but if the asset involves finance cost and then

make sure it’s capitalized correctly.

Also, if it involves impairment issue ,then make sure an impairment test is

properly conducted by management. Also the discount rate used by

management to determine value in use of the asset should be verified for

reasonableness.


Chapter2 Q7: 10,IAS17 Leases

Accounting issues:

Introduction

You want to have a photocopier and you have two choices:

1, you can buy it and then you become the owner of the photocopier;

2, you can lease it from the lessor and then you would become the lessee.

Long term-finance lease

Short term-operating lease

But the key to differentiate between them is not just the time length it takes but

rather “substance over form”.

IAS 17 leases describes two types (forms) of leases:

*Finance lease: lease that transfers the risks and rewards of the asset from

the lessor to the lessee.

*Operating lease: any leases other than finance lease.

5 senarios

So the substance over form concept behind it can be summarized as follows:

IAS 17 prescribes there are 5 common scenarios that the lease is a finance

lese. (one of them fulfilled then it’s a finance lease and if none of them fulfills

then it’s an operating lease.)

1, ownership of asset has been transferred from lessor to lessee.

2, lessee has the option to purchase asset at a price which is sufficiently lower

than its FV.

3, lease term is almost the same as the major part of economic life of asset.

(IFRS doesn't specify the period but US GAAP has given us guidance of >75%.)

4, at the start of the lease, PV of minimum lease payment is close to FV of asset.

(again, IFRS doesn't specify the percentage but US GAAP has given us a

guidance of >90%.)

5, leased assets are specified nature and can only be used by lessee and they

can be used by others if any significant modification to assets occurs.


Risks and rewards

But the idea behind it is when the majority risks and rewards has been

transferred from the lessor to lessee then it’s considered to be a finance lease.

So the typical risks and rewards may include:

Risks:

costs of repairing, maintaining and insuring the assets.

Risk of obsolescence

Risks of losses from idle capacity of the asset (if machine breaks down then

lessee bears the loss)

Rewards:

Use of assets for almost all of its useful life.

Use of the assets is not disrupted.

Accounting Treatment:

Lessee

Lessor

Finance lease:

Initial measurement DR PPE

CR lease liability

DR lease receivable

CR lease asset

Subsequent measurement PPE:

DR I/S-depre expense

CR accumulated

depreciation

Lease liability:

DR lease liability

DR I/S-finance cost

CR cash

DR cash (from lessee)

CR lease receivable

CR I/S-interest income

Operating lease:

Expense the lease

payment on a straight line

basis

DR I/S

CR cash

Expense the lease revenue

received on a straight line basis

DR cash

CR I/S

Keep the assets in FS and

depreciates it.

DR I/S-depreciation expense

CR accumulated depreciation


Sale and leaseback transaction:

Idea: any abnormal gain/loss would be deferred and released back as income

over the life of the lease.

Accounting question:

Q: Finco Ltd

Finco Ltd has 4 sale and leaseback transactions during the year which can be

shown as follows:

Description Sale proceeds

$m

Fair value

$m

Book(carrying) value

$m

1, sale and finance lease back 50 50 32

2, sale at fair value operating lease back 80 80 55

3, sale at overvalue and operating lease back 85 65 70

4, sale at undervalue and operating lease

back

65 85 60

Required:

Show how to deal with the above transactions.


Audit work:

1The main piece of audit evidence is the lease agreement, as this will allow the

auditor to:

1Agree the length of the lease

2Agree the lease payments

3Assess how much of the rights and obligations of ownership have been

transferred.

2 For operating leases, any prepayment or accrual should be recalculated.

3 For finance leases, the present value of minimum lease payments should be

recalculated and the discount rate agreed as appropriate.

[June2009Q3] leases


Audit question1: [June2009Q3] leases

Robster Co is a company which manufactures tractors and other machinery to

be used in the agricultural industry. You are the manager responsible for the

audit of Robster Co, and you are reviewing the audit working papers for the year

ended 28 February 2009. The draft financial statements show revenue of $10·5

million, profit before tax of $3·2 million, and total assets of $45 million.

Two matters have been brought to your attention by the audit senior, both of

which relate to assets recognised in the statement of financial position for the

first time this year:

Leases

In July 2008, Robster Co entered into five new finance leases of land and

buildings. The leases have been capitalized and the statement of financial

position includes leased assets presented as non-current assets at a value of

$3·6 million, and a total finance lease payable of $3·2 million presented as a

non-current liability.

Required:

(a) In your review of the audit working papers, comment on the

matters you should consider, and state the audit evidence you should

expect to find in respect of:

(i) the leases (8 marks)


Answer to audit question1 [June2009Q3] leases

Matters to consider

Materiality

The amount recognised in non-current assets accounts for 8% of total assets, and the total

finance lease payable accounts for 7·1% of total assets so they are material to statement of

financial position.


Whether this is finance lease or operating lease and the key is to see whether risk and

reward of ownership of assets has been passed from lessor to lessee.

Indicators where risks and rewards have been transferred:

1. Robster Co is responsible for repairs and maintenance of the assets

2. Robster Co can obtain this asset at nominal value at the end of asset life.

3. The lease period is almost the same as useful life of the assets

4. The present value of the minimum lease payments is amounts to most of the fair value

of the asset.

Finance cost associated with leases would need to be expensed to statement of profit or

loss.

Leased asset should be depreciated over the shorter of lease term and economic useful

life of assets.

The finance lease payable recognised of $3·2 million should be split between current and

non-current liabilities in the statement of financial position.

Audit evidence

A review of the lease contract including consideration of the major clauses of the lease

which indicate whether risk and reward has passed to Robster Co.

A calculation of the present value of minimum lease payments and comparison with the

fair value of the assets obtained from lease contract at the start of the lease.

A recalculation of the finance charge expensed during the accounting period, and

agreement of the interest rate used in the lease contract.

Agreement to the cash book of amounts paid to the lessor.

A recalculation of the depreciation charged, and agreement that the period used in the

calculation is the shorter of the lease term and the useful life of the assets.

A recalculation and confirmation of the split of the total finance lease payable between

current and non-current liabilities.


Chapter2 Q7: 11,IAS 18 Revenue

Accounting issues:

The recognition criteria:

Stage of completion of service can be measured reliably.

Involvement (there’s no managerial involvement within business.)

Risks and rewards have been transferred from the seller to the buyer.

Reliably measure the future economic benefit.

The measurement of Revenue:

“Revenue” is measured at the fair value of consideration received or receivable,

net off trading discounts and rebate allowed by the entity.

Substance over form:

Such as “consignment stock”, sometimes risks and rewards of the goods have

not been transferred from the seller to the buyer. So liability and inventory may

be misstated?

Audit work:

Check whether risks and rewards have been transferred by inspecting customer

signed contract and terms attached to it-

--Whether the purchaser has the right to return the goods;

--Whether the seller can enforce return of the goods;

--Whether the seller has full control of the goods(eg, setting the selling price.)

Tips: revenue is often tested in Q1 such as audit risks, risks of material

misstatement. Remember when the question shows “deposit”, then a liability

should be recognized(because you’re not providing a service right now.)


Audit questions: (IAS18 revenue recognition)

Q Bluebell (DEC 2008) (IAS18 revenue recognition)

Revenue comprises sales of hotel rooms, conference and meeting rooms.

Revenue is recognised when a room is occupied. A 20% deposit is taken when

the room is booked.

Required

Risk of material misstatement of the above.

Answer:

20% deposit is taken when the room is booked.

According to IAS18 revenue recognition this amount should be presented as a

liability on the statement of financial position.

There is a risk that this amount has been recognized as a revenue and hence

leads to overstatement of revenue in the statement of profit or loss and

understatement of liabilities in statement of financial position.


Q Harrier (June2004) (IAS18 revenue recognition)

New cars are imported, on consignment, every three months from one supplier.

Harrier pays the purchase price of the cars three months after taking delivery.

Harrier does not return unsold cars, although it has a legal right to do so.

Required


Answer:

Harrier(consignee) would purchase the cars after 3 months after taking delivery

and it doesn't return cars back to consignor.

According to IAS18 revenue recognition if risks and rewards have been

transferred from consignor to consignee when cars are delivered then consignee

should recognize the expense and inventory in its account and here it’s the case.

There is a risk that this is not done, ie, not DR I/S CR payable; DR inventory CR

cost of sales and hence this will lead to understatement of expense and liability

as well as inventory.


Chapter2 Q7: 12,IAS 19 Employee Benefit

Accounting Issues:

Some companies will offer benefit to its employees. These benefits may include:

1, Short/long term and termination benefit:

Accounting: DR I/S

CR cash/liability

Short term benefit would include:

Monetary benefit:

Wages and salary

Paid sick leave

Compensated absence.

Non-monetary salary:

Medical care, housing, cars etc

Long term benefit would include: shares; bonus etc.

Termination benefit would include: redundancy payments etc.

2, Post-employment benefit: pensions etc.

2 types:

Defined contribution pension scheme: not guarantee to pay employee an

amount of money when they retire. So DR I/S CR cash

Defined benefit pension scheme: guarantee to pay employee an amount of

money when they retire.

The accounting for this is to separate assets and liabilities in the disclosure.

(remain in company’s account)

Disclosure:

Asset Liability

b/f bal b/f bal

Return on asset Interest cost

Contributions in Service cost

Benefits out Benefits out

Actuarial gains/losses Actuarial gains/losses

c/f bal c/f bal


Accounting journals:

b/f bal (c/f from last year by actuary)

Return on asset(discount rate X b/f)： DR asset CR I/S

Interest cost (discount rate X b/f): DR I/S CR liability

Contributions in (company putting money in): DR asset CR cash (only cash item)

Service cost (including current&past service cost: employees work for you and you

have to pay for them): DR I/S CR liability

Benefits out (money paid to those retired): DR liability CR asset

c/f(by actuary then b/f to next year)

Actuarial gains/losses:

Gain: DR liability CR OCI

Loss: DR OCI CR liability

By whom? The scheme surplus or deficit each year is valued by Actuary!

Audit work:

1,Perform analytical procedures on Scheme costs to verify its reasonableness.

(for example, an ageing workforce may be on higher average salaries and

nearer retirement, which may suggest a higher liability to the company – or

strong Stock Market performance may indicate that Scheme assets should

have grown faster than predicted, leading to a Surplus).

2, Agree the valuation figure, eg, closing assets and liabilities to the most recent

actuarial valuation.

3,Assess the reliability, experience, qualifications, experience and

independence of the actuary.

4, Compare actuary’s assumptions with other audit evidence (e.g. staff turnover

assumptions with personnel records).

5, Inspect a list of assets form Scheme’s investment manager to verify the

existence of assets.

6, Recalculate the pension expense recorded in the statement of profit or loss to

verify its accuracy.


Audit question (June2012 Q5(b)) IAS19

Snipe Co has in place a defined benefit pension plan for its employees. An

actuarial valuation on 31 January 2012 indicated that the plan is in deficit by

$10·5 million. The draft financial statements recognise revenue of $8·5 million,

profit before tax of $1 million, and total assets of $175 million

The deficit is not recognised in the statement of financial position. An extract

from the draft audit report is given below:

Auditor’s opinion

In our opinion, because of the significance of the matter discussed below, the

financial statements do not give a true and fair view of the financial position of

Snipe Co as at 31 January 2012, and of its financial performance and cash flows

for the year then ended in accordance with International Financial Reporting

Standards.

Explanation of adverse opinion in relation to pension

The financial statements do not include the company’s pension plan. This

deliberate omission contravenes accepted accounting practice and means that

the accounts are not properly prepared.

Required:

Critically appraise the extract from the proposed audit report of Snipe

Co for the year ended 31 January 2012. (7 marks)


Answer: (only 7 points required)

Basis of opinion paragraph:

Any qualified audit opinion is given then a basis of qualification opinion

paragraph should be placed before the actual opinion paragraph. In this case it’s

adverse opinion so basis for adverse opinion should be placed before the actual

opinion paragraph.

In the basis of opinion paragraph the $10.5m of defined benefit pension plan

should be quantified.

And auditor needs to state whether this $10.5m would be material to the

financial statement.

In the basis of opinion paragraph this auditor should state whether this $10.5m

would be a deficit or surplus.

Also auditor needs to state if the deficit has been recognized then liabilities

would increase by $10.5m and equity would decrease by $10.5m.

Auditor needs to consider whether other accounting entries have been omitted

as well such as service cost, gain on asset, finance costs, actuarial gains and

losses because these would impact on the statement of profit or loss as well.

There should be reference to IAS19 employee benefit to tell users that this

standard has been breached.

The word “deliberate” is not professional and auditor should use “The plan may

have been omitted in error and an adjustment to the financial statements may

have been suggested by the audit firm and is being considered by

management.”

Qualified opinion paragraph

Because the deficit of $10.5m only represents 6% of total asset and it’s material

to the financial statement but not pervasive so an adverse opinion would not be

correct and auditor should issue an “except for” qualification opinion due to

material misstatement in the financial statement.


Chapter2 Q7: 13,IAS 20 Accounting for Government Grants

and Disclosure of Government Assistance

Accounting Issues:

What is government grant?

Government grant is the cash or asset given by government to help company if

it fulfills the conditions set by government.

This may be categorized as:

Capital grants- grants which are made to contribute towards the acquisition of

asset

Revenue grants- grants which are made for other purposes like paying wages.

When recognized?

A grant can be recognized in the FS when:

1, entity complies with the condition set by government

2, the grants will be received.

Usually we will use the deferred income method to reverse the deferred income

over the useful life of asset.

And this is based on “Accrual” concept or Matching principle.

Disclosure:

Accounting policy adopted, including method of presentation(net off or separate

method?)

Nature and extent of government grants recognised and other forms of assistance

received (eg, buy a machine?)

Unfulfilled conditions and other contingencies attached to recognised government

assistance (eg, repayment?)

Accounting treatment:

Step1: Treat the grant separately

DR cash

CR deferred income

Step2: Release deferred income matched with depreciation expense of asset:

DR deferred income (over life of asset)

CR I/S(revenue)


Audit work:

Inspect the grant agreement to verify:

-What is the grant for

-The total amount of the grant

-The conditions under which it would have to be repaid.

Inspect cashbook and bank statements to verify receipt of the grant.

Inspect Board Minutes to assess whether company has done anything (or is

about to do anything) that might make the grant repayable.

Recalculate any release of deferred grant income to ensure it matches with

the related expense.


Audit Question [june2010 Q1 (c)(ii)] IAS 20

Hodges Co

This company’s operations involve the manufacture and distribution of packaged

nuts and dried fruit. The government paid a grant in November 2009 to Hodges Co,

to assist with costs associated with installing new, environmentally friendly, packing

lines in its factories. The packing lines must reduce energy use by 25% as part of the

conditions of the grant, and they began operating in February 2010.

(c) Recommend the principal audit procedures that should be performed

on:

(ii) The condition attached to the grant received by Hodges Co.

(4 marks)

Answer to[june2010 Q1 (c)(ii)]: (only 4points required)

1. Inspect the grant agreement to verify:

-The conditions of 25% reduction in energy use is stated.

- Financial impact if company is to repay the grant and determine whether

company would pay in part or in full.

2. Inspect Board Minutes about whether management has put procedures

regarding energy saving into place to assess whether company has done

anything (or is about to do anything) that might make the grant repayable.

3. Enquire with management about how energy efficiency is monitored to verify

whether condition has been breached by company.

4. Enquire with employees about their views on how well the packing lines are

performing to verify whether condition has or would be breached by company.


Chapter2 Q7: 14,IAS 21 The effects of Changes in Foreign

Exchange Rates

Accounting issues:

This deals with 2 issues:

(i) foreign transaction:

When you purchase/sell goods from/to other company in other countries

Step1: You need to firstly translate this transaction in functional currency at

spot rate.

Step2: You need to retranslate the monetary item (Bank, receivable,

payable,NCL,CL) at the year end and leave non-monetary items(NCA, CA).

How to determine your functional currency?

Mainly this is the currency that when you’re trying to prepare your trial balance.

(ii) foreign subsidiary

Statement of financial position: closing rate

Statement of comprehensive income: average rate

To group company: Exchange differences on the subsidiary are taken to Equity.

In the SFP: Reserves

In the statement of profit or loss and other comprehensive

income: other comprehensive income

To single company: Exchange differences are taken to statement of profit or loss.

Audit works:

1, Agree the exchange rates used for all retranslation against published rates.

2, Inspect exchange differences have been recognized in the correct place

(statement of profit or loss or Equity as appropriate).


Audit question: Grissom Co (June2010 Q1 extract)

Brass Co

This company is a new and significant acquisition, purchased in January 2010. It

is located overseas, in Chocland, a developing country, and has been purchased

to supply cocoa beans, a major ingredient for the goods produced by Willows Co.

The company uses local currency to measure and present its financial

statements.

Required:


Answer:

Company financial statements are denominated in different currencies.

1. According to IAS21 The Effects of Changes in Foreign Exchange Rates before

consolidation, assets, liabilities, should be retranslated using closing exchange

rate but for income and expense they should be retranslated using average rate.

There is a risk that company has used the wrong rate to translate the above

resulting in misstatement of assets, liabilities, income and expense.

2. Gains or losses relating to retranslation should be recognized in equity or

other comprehensive income.

There is a risk that gains or losses have been recorded in the statement of profit

or loss leading to misstatement in profit or loss and equity.

3. cost of investment should be retranslated using the closing year end rate and

gains or losses should be taken into equity.

There is a risk that this is not done resulting misstatement of goodwill figure.


Chapter2 Q7: 15,IAS 23 Borrowing Costs

Accounting issues:

IAS 23 borrowing costs specifies that in some circumstances that these interest

expense can be capitalised as cost to the building.

1, it should be a qualifying asset:

the asset takes a substantial period of time to get ready for its intended use or sale.

Example:

*Inventories that require a substantial period of time to bring them to a

saleable condition, eg, a big ship

*Manufacturing plants

*Power generation facilities

*Investment properties

2, The amount to capitalise?

Borrowing costs – temporary investement income

General funds raised not specific for the asset? (use weighted average

borrowing costXasset value)

3, when to capitalise?

Start capititalisation:

Later of ABB(mncmonic)

A: activity begins (start building)

B:Borrowing costs incurred (take loan)

B: Buy something(buy the land)

Pause to be capitalised

When the activity is disruppted, eg, strike

Ceased to be capitalised

When the asset is intented for use not necessarily actually for use.

Disclosure:

Amount of borrowing cost capitalised during the period

Capitalisation rate used


Audit work:

Obtain breakdown of borrowing costs and recalculate them to verify its

accuracy.

Agree interest payments to bank statements and cash book.

Agree interest payments to loan documentation.

Inspect the loan agreement to verify whether this loan is directly attributable to

the asset and if not average rate may be used.


Audit question:[june2012 Q5] IAS23 Borrowing cost

You are the partner responsible for performing an engagement quality control

review on the audit of Snipe Co. You are currently reviewing the audit working

papers and draft audit report on the financial statements of Snipe Co for the year

ended 31 January 2012. The draft financial statements recognise revenue of $8·5

million, profit before tax of $1 million, and total assets of $175 million.

(a) During the year Snipe Co’s factory was extended by the self-construction of a

new processing area, at a total cost of $5 million. Included in the costs capitalised

are borrowing costs of $100,000, incurred during the six-month period of

construction. A loan of $4 million carrying an interest rate of 5% was taken out in

respect of the construction on 1 March 2011, when construction started. The new

processing area was ready for use on 1 September 2011, and began to be used on

1 December 2011. Its estimated useful life is 15 years.

Required:

In respect of your file review of non-current assets:

Comment on the matters that should be considered, and the evidence you

would expect to find regarding the new processing area. (8 marks)


Answer:

(a)


Materiality

The total cost of the new processing area of $5 million represents 2·9% of total

assets and is material to the statement of financial position. The borrowing costs

are not material to the statement of financial position, representing less than

1% of total assets; But they are material to profit because it represents 10% of

profit before tax.

Accounting

According to IAS23 the borrowing costs should be capitalized if it’s a qualifying

asset and the period to capitalize would be during the period of construction and

when construction is substantially completed then it should be ceased to be

capitalized.

New processing area was ready for use on 1 September, so capitalisation of

borrowing costs should have ceased at that point. It seems that the borrowing

costs have been appropriately capitalised at $100,000 ($4m x 5% x 6/12).

There should therefore be five months’ depreciation included in profit for the

year ended 31 January 2012, amounting to $138,889 ($5m/15 years x 5/12).

Evidence

A breakdown of the components of the $4·9 million capitalised costs

(excluding $100,000 borrowing costs) reviewed to ensure all items are

correct for capitalisation.

A copy of the approved budget or capital expenditure plan for the extension.

An original copy of the loan agreement, confirming the amount borrowed

and the interest rate.

Recalculation of the borrowing cost, depreciation charge and agree of all

figures to the draft financial statements.


Chapter2 Q7: 16,IAS 24 Related Party Transactions

Accounting issues:

Definition:

Parties are related if one party has control or significant influence over the other

party.

Scenario:

If A controls(>50%) or joint controls(=50%) B and have significant influence

over C then A&B are related parties, A&C are related parties as well. Also B&C

are related parties because A could have power to force one sub to do

something against another.

If A have significant influence over B&C then A&B, A&C are related parties but

B&C are not related parties because A can’t control over B or C to do something.

If a person has significant influence or control over A then this person&A are

related parties. (particularly if this person is a member of the key management

team in A or close family)

IAS 24 states there are particularly some situations which may be related

parties transactions:

Associate and subsidiary

Key management

Post-employment benefit: pension plan

Close family

Related party transactions are transactions between related parties.

So what should we disclose under IAS 24 related party disclosures?

Transaction: purchase/sale of goods?

Parties: X Company; Y Company.

Relationship: eg, parent and subsidiary

Value: $

Date

A

B C


Audit work:

1, To find out who are the related parties:

-Inspect shareholder register

-Inspect Board Minutes for evidence of directors raising related party issues

-Inspect prior year related party disclosures

2, Inspect abnormal contract to identify:

-At a price other than market price

-At an odd time

-Between 2 companies who have no obvious reason to do business

-Lacking in overall business logic.

3, Inspect the disclosure relating to related parties transactions to ensure the

following details have been disclosed:

Transaction:..

Parties.

Relationship.

Value.

Date


Audit question:[Q15june2008 Q3]related party transactions

3 (a) Discuss why the identification of related parties, and material related

party transactions, can be difficult for auditors. (5 marks)

You are an audit manager responsible for providing hot reviews on selected audit

clients within your firm of Chartered Certified Accountants. You are currently

reviewing the audit working papers for Pulp Co, a long standing audit client, for the

year ended 31 January 2008. The draft statement of financial position (balance

sheet) of Pulp Co shows total assets of $12 million (2007 – $11·5 million).The audit

senior has made the following comment in a summary of issues for your review:

‘Pulp Co’s statement of financial position (balance sheet) shows a receivable

classified as a current asset with a value of $25,000. The only audit evidence we

have requested and obtained is a management representation stating the following:

(1) that the amount is owed to Pulp Co from Jarvis Co,

(2) that Jarvis Co is controlled by Pulp Co’s chairman, Peter Sheffield, and

(3) that the balance is likely to be received six months after Pulp Co’s year end.

The receivable was also outstanding at the last year end when an identical

management representation was provided, and our working papers noted that

because the balance was immaterial no further work was considered necessary.

No disclosure has been made in the financial statements regarding the balance.

Jarvis Co is not audited by our firm and we have verified that Pulp Co does not own

any shares in Jarvis Co.’

Required:

(b) In relation to the receivable recognised on the statement of financial

position (balance sheet) of Pulp Co as at 31 January 2008:

(i) Comment on the matters you should consider. (5 marks)

(ii) Recommend further audit procedures that should be carried out. (4

marks)

(c) Discuss the quality control issues raised by the audit senior’s

comments. (3 marks)

(17 marks)


Answer to june2008 Q3:

(a)

Definition

Related party transaction is difficult to define. Ie “”transactions between parties

related by control or influence are disclosed.” But it’s difficult to define control or

influence in the real life.

Accounting system

It’s difficult to separate related party transactions from other transactions

unless management has classify the related party sales into other categories of

sales.

Disclosure

Disclosure of related party transactions may be reluctant by management

because it’s confined to management.

Apply

It’s difficult to apply materiality concept because some of the related party

transactions are not material by amount and auditors may not spot this during

the audit.

Concealment

Business may conceal related party transaction in order to cover up the fraud so

auditor may find it harder to reveal these transactions.


(b)

(i)


Accounting standards

According to IAS24 related party transactions only two senaior persons in

two different companies are not related parties unless one has significant

influcen or control over another.

In the working paper because Javis company is controlled by Pulb’s

chairman so transaction between the two would be related party transaction

The receivable balance has been over 1 year and current assets are within 1

year and so management should consider the recoverability of this

receivable and write off as a bad debt expense.

Maybe it’s because the management is going to window dress the financial

statement because by classifying the non current assets into current assets

this would make liquidity position of company look better.

Materiality

$25,000 is not material by amount but it’s related part transaction so its

material bby nature.


The classification of the receivable would constitute a material misstatement.

The lack of disclosure of related party transaction would constitute a material

misstatement so if these are not adjusted then auditor should issue an except

for qualification of audit opinion.

(ii)

Inspect management representation about parties involved in the transactions.

Enquire with management about the transaction to verify it’s in line with

auditor’s business common sense, eg, should this be classified as receivable or

long term investment.

Inspect the invoices relating to the transaction noticing if value of transaction is

significantly lower than the market rate.

Inspect the invoices relating to the transaction noticing if the date of transaction

is odd.


Auditors can perform analytical procedure by performing a liquidity analysis of

company and if it suggests that the liquidity position of company is poor then it

is running a risk that management would like to manipulate the financial

position, ie, window dress the liquidity position of company.

(c)

Because they failed to spot weakness of management representation and it

implies there was an inadequate independent review of work done last year.

There is no disclosure has been made to related party transaction this implies

there’s a poor planning meeting of audit has been held.

The delegation of task is not based on knowledge and experience because the

high risk area has been delegated to the audit senior who may lack of

experience to do so.


Chapter2 Q7: 17,IAS28 Investments in Associates

Accounting issues:

The investor will have significant influence if he has invested 20%-50% of

shares in another company (associate).

The significant influence is the power to participate into the decision making

process of the company.

The 20%-50% is just a subjective test and in reality even if company fails

this test, maybe it is still having/ having no significant influence over

another company:

-if you have 19% shares of another company but there are remaining

shareholdings around from 0.5%-1% and if this is the case, you have significant

power to participate into the decision making process regardless of the failure of the

test.

-If you have 25% shares of another company but there’s a very big shareholder

who is holding 70% of shares in the company and in this case you are too small and

even though you comply with the test(20%-50%) but you have no significant

influence.

How to account for an associate: (Cost + Growth) [Equity Accounting]

$

Investment at cost X

+group share of post-acquisition of associate (Growth) X

Investment in associate for CSOFP X

Presentation in CSOFP:

Non-current assets

Property, plant and equipment X

Goodwill X

Investment in associate X

Presentation in CSOCI:

Parent Subsidiary Adjustments Group

Gross profit X X - X

Expenses (X) (X) - (X)

Profit in Associate (45% of associate profit after tax) X -

Profit before tax X X - X


Audit work:

Inspect share certificate to verify the % of shares owned by company.

Inspect directors register and contract to verify their power to affect policy

making decisions.


Audit Question [June2010 Q1] IAS28

Grissom Co

This is a non-trading parent company, which wholly owns three subsidiaries –

Willows Co, Hodges Co and Brass Co, all of which are involved with the core

manufacturing and marketing operations of the group. This year, the directors

decided to diversify the group’s activities in order to reduce risk exposure.

Non-controlling interests representing long-term investments have been made in

two companies – an internet-based travel agent, and a chain of pet shops. In the

consolidated statement of financial position, these investments are accounted for as

associates, as Grissom Co is able to exert significant influence over the companies.

Required:

Evaluate the principal audit risks to be considered in your planning of the final audit

of the consolidated financial statements for the year ending 30 June 2010.

Answer to [june2010 Q1] IAS28

Grissom Co

Non-controlling interests

Two companies have been accounted for as associate.

According to IAS 28 investment in associate if Grissom co can demonstrate it has significant

influence over those two companies then they should be accounted for as associate using

equity method otherwise they should be accounted for as simple investments.

There is a risk that Grissom Co has wrongly classified those companies as associate but rather

they should be simple investment resulting in non-current assets being misstated and profit

being overstated because income from associate is recognized.


Chapter2 Q7: 18, Financial instruments IAS32,37,39 IFRS9

Accounting issues:

Financial instrument :

Any contract that gives rise to both a financial asset of one entity and a financial

liability or equity instrument of another entity.

Financial asset:

This is a contract if a party is holding then it can give benefit to the holder.

Financial liability:

This is a contract if a party is holding then it will deliver cash to other party or

cost us something when exchanging financial instrument.

Eg, Debt; redeemable preference shares.

Equity instrument

Something not for cash or any other assets but they are settled in shares.

Eg, Shares; irredeemable preference shares.

Summary:

Financial assets Financial liabilities/

Equity instrument

Examples

Initial recognition Become party to contract

Initial measurement Price-discount-issue cost

Subsequent

measurement*

Based on 2 tests Based on intention

*Subsequent measurement:

Financial assets Financial liabilities

Debt Equity Debt/Equity

Amortized cost Business model test(hold not sell)

CCC test (simple cash flow)

No All others

FVTPL All others Held for

trading

Held for trading

FVTOCI No Not held

for trading*

no

Note:

*If the equity is not for trading then at initial recognition company can make an

irrecoverable election that classifies this under “FVTOCI” only with dividend

income in P/L. And this is sometimes known as “strategic equity”-buying shares


in order to acquire the entire company in the future.

*Financial asset tests:

NO

yes

NO

yes

Financial liability test (base on intention)

Keep Trade

Business model test

(Hold it till maturity?)

Contractual cash flow

characteristic(CCC) test

(does debt contain principle and

interest only?)

Amortized

Cost

FVTPL

Intention

Amortized

Cost

FV


Accounting Treatment:

1, Financial Asset

Amortized cost

Years Opening

balance

Interest

(at effective interest

rate)

Outstanding Installment

(repayment)

Closing

balance

DR financial asset

CR I/S(interest

receivable)

DR cash

CR financial asset

FVTPL

Gains/losses goes into I/S.

2, Financial liability(not held for trading)

Amortized cost (OIOIC)

Years Opening

balance

Interest

(at effective interest

rate)

Outstanding Installment

(payment)

Closing

balance

DR I/S(interest

payable)

CR financial liability

DR financial liability

CR cash


Compound financial instrument (IAS 32)

Convertible debt

Treatment:

Inception:

: PV of future cash flow

(use effective interest rate

on comparable bond if

there’s no conversion)

: value of the future

conversion

As a balancing figure

Or (total value-debt-issue

costs from debt +

equity pro-rata)

Subsequent:

Debt element using amortized cost.

Financial instrument impairment (IAS 39)

Under IAS 39, impairment of financial instrument applies to financial assets

carried at amortized cost.

What we do is to look for indicators of impairment.

If there’s Objective evidence that event has occurred(not happen in the

future);

The impairment expense can be estimated reliably.

Then we should recognize an impairment loss to the I/S.

Convertible

debt

Debt element

Equity element


Disclosure about financial instrument (IFRS 7)

We are required to disclose (significance and risks)

1, Information about significance of financial instrument;

SOFP:

Financial performance and position for each class financial instrument

I/S:

Separate disclosures for each class of financial instrument;

If financial instrument is not carried at FVTPL then disclose interest

expense on that;

Disclose any impairment losses.

Other information:

Information about the nature of financial instrument in detail;

Accounting policy of how to treat those financial instrument;

Fair value of financial instrument(IFRS 13): how to determine and its

value;

Its cash flow relating to the financial instrument.

2, Information about risks of financial instrument.

Qualitative of risks:

Risk exposure- risks included and what would happen?

Risk management-how to manage the risks?

Quantitative of risks:

Data about exposure

Credit risk-collateral and the quality of it

Liquidity risk-how to manage this risk?(risk of default on payment

of interest?)

Market risks-market prices change? (fair value changes?)


Audit work:

Perform analytical procedures by assessing valuation model used to verify

its reasonableness.

Inspect disclosures about each financial instrument such as market risk

disclosure about changes in fair value to verify its completeness.

Agree value of financial instrument to specialist working papers.

Inspect financial instrument contract to verify it’s in line with auditors’

business understanding.

Perform analytical procedures relating to experience, reputation and the

way experts determine the value for financial instrument to ensure they are

competent to do the work.


Audit question [Q17] IAS32,39 IFRS7

To help cash flows in a year of expansion, the company raised finance by issuing

debentures which are potentially convertible into equity on maturity in 2015.

To manage the risk associated with overseas expansion, in October 2009, the

company entered for the first time into several forward exchange contracts

which end in February 2010. The contracts were acquired at no cost to Papaya

Co and are categorised as financial assets at fair value.

Required:

Assess the risks of material misstatement to be addressed when planning the

final audit for the year ending 31 December 2009.

Answer:

1. Debentures:

Company has convertible debentures.

According to IAS 32 financial instruments at the inception of the convertible

debenture, it should be split between debt and equity element. The debt

element would be the present value of future cash flow and equity element

would be the balancing figure.

There is a risk that a spit is not done properly resulting in misstatement in the

debt and equity element and profit in statement of profit or loss because of the

misstatement in finance cost.

2. Forward contracts:

This is as financial assets at fair value through profit or loss.

According to IFRS9 financial instrument this should be recognized at fair value.

There is a risk that this transaction is not recognized at all or they might be

measured wrongly resulting in assets or liabilities in the statement of financial

position, income/expense in the statement of profit or loss being misstated.

According to IFRS 7 financial instruments disclosures about the significance and

risks relating to forward contract must be made.

There is a risk of under disclosure per IFRS7 as well.


Audit question:[DEC2011 Q3(b)] Financial instruments(relating to 3rd

party work)

Spruce Co

Spruce Co is also involved in energy production. It has a trading division which

manages a portfolio of complex financial instruments such as derivatives. The

portfolio is material to the financial statements. Due to the specialist nature of these

financial instruments, an auditor’s expert was engaged to assist in obtaining

sufficient appropriate audit evidence relating to the fair value of the financial

instruments. The objectivity, capabilities and competence of the expert were

confirmed prior to their engagement.

Required:

Explain the procedures that should be performed in evaluating the adequacy of the

auditor’s expert’s work.

(5 marks)

Answer to DEC2011 Q3(b):

Review the auditor’s expert’s working papers and reports to ensure that the

work meets the objectives of the audit.

Evaluate the appropriateness of models used by the expert to determine fair

value.

Compare the findings of the expert with results produced by management,

eg compare the fair values determined by the expert with those determined

by management.

Reperform any calculations contained in the expert’s working papers, eg

recalculate movements in fair value on the derivatives.

Agree figures used in calculations to supporting documentation, eg contracts

relating to derivative financial instruments.


Chapter2 Q7: 19,IAS33 Earnings Per share

Accounting issues:

Earnings per share(EPS) is important because it’s one of the ratios to measure

public company’s profitability.

EPS means how much earnings that a share of company may earn. If EPS=10,

this means that for every share within a company then it can earn $10.

EPS is very easy to be understood by non-financial investors and it’s very simple

as well.

The next question is how we can calculate EPS?

Basic EPS is calculated as:

PAT-irredeemable preference share dividend*

Weighted average number of ordinary shares

* irredeemable preference share dividend means dividend in this year only not

cumulative figure.

When trying to calculate basic EPS you should be aware of any changes in

capital structures, eg, bonus issue and right issue. Say if a bonus issue happens

in the middle of the year then the EPS would fall in the second half of the year

because of an increase in number of shares but no increase in profit. So it’s

unfair on EPS in the year it happens so we should then pretend the bonus issue

happened ALL this year and ALL last year.

Same as right issue. Say if a right issue happens in the middle of the year then

EPS would fall in the second half of the year because of an increase in number

of shares but there’s not an increase in profit as it should have been because we

know the right issue is the issue of shares at a discount hence it will decrease its

profit a little bit so EPS may fall. So it’s unfair on EPS in the year it happens so

we should then pretend the bonus issue happened ALL this year and ALL last

year.

So how can we pretend to do this? Well, we calculate “Bonus Fraction” for this

year and “Inverted Bonus Fraction” for last year. The key to this is to make

information comparable.

Bonus Fraction for Bonus issue:

Shares we have

Shares we had

Bonus Fraction for right issue:

MV

TERP


But basic EPS does not consider when a company may try to issue some

convertible loan notes where an investor may convert this into shares and hence

increase the number of shares in the future and also company may save interest

expenses as well.

Also this does not consider when a company gives out share options then at

some point in the future when an investor takes up the share options which may

increase the number of shares in the future.

In order to address this problem, we need to calculate “diluted EPS”.

Comparable with basic EPS.

Diluted EPS is to show to shareholders that the EPS of the company may fall in

the future. There are two clues we can find this: convertible loan and share

options.

Diluted EPS is calculated as:

Basic EPS+ interest saved on convertible loan note

Number of ordinary shares+ new shares converted or taken up

Since we know how to calculate the basic and diluted EPS, the next

question is “Is EPS flawless”?

Well, the answer is certainly NO!

There are some limitations I would like to discuss with you.

1, We can’t compare the EPS companies to companies because they have

different accounting policies, estimates which may result in different profit

figure and also different capital structure changes during the year resulting in

different number of shares as well.

2, EPS is based on profit so you can argue that it may be subject to manipulation

by company by just manipulating the accounting policy and estimates.

3, EPS is based on past information not the future one.

4, If you look at the denominator you will find the number of shares can be

manipulated as well if a company has got loads of cash in the year and then the

company can buy back shares in the share market which means the shares falls

and hence EPS may increases as a result.

5, Although company calculates diluted EPS to give a sign for potential impact in

the future resulting from certain activities to the users but its calculation is

based on current earnings so to a certain extent it’s not a reliable measure for


users as well.

Listed companies must, on the face of the Income Statement present:

Basic EPS

Diluted EPS.

Audit work:

1 Recalculate basic EPS and diluted EPS.

2 Ensure any necessary restatements of prior year EPS have been done, and

suitably disclosed.


Audit question [june2009 Q5 Pluto] IAS 33: (Ajusted)

You are the partner responsible for performing an engagement quality control

review on the audit of Pluto Co, a listed company. You are currently reviewing

the engagement partner’s proposed audit report on the financial statements of

Pluto Co for the year ended 31 March 2009. During the year the company has

undergone significant reorganization, involving the discontinuance of two major

business segments. Extracts of the proposed audit report are shown below:

Emphasis of matter paragraph

The directors have decided not to disclose the Earnings per Share for 2009, as

they feel that the figure is materially distorted by significant discontinued

operations in the year. Our opinion is not qualified in respect of this matter.

Required:

1, Does Pluto Do something wrong?

2, Is it correct to quote a breach in IAS33 EPS in the emphasis of matter paragraph?

Answer:

1. yes it has done something wrong because for listed companies EPS, Diluted

EPS and its comparatives should be disclosed in the note of the financial

statement to make information comparable.

2. no it’s not correct because auditor would include significant uncertainty about

going concern status of the company in the emphasis of matter paragraph and

a failure to disclose the PES, diluted EPS and its comparatives would just be a

material misstatement and it’s nothing to do with significant uncertainty about

going concern status of Pluto.


Chapter2 Q7: 21,IAS 36 Impairment of Assets

Accounting issues:

Impairment means decrease. According to prudence concept we cannot

overstate the asset value. And in order to ensure that amount is prudent we can

use a test called impairment test.

The question is when do we do the impairment test and how can we do

impairment test?

When there are Indications of impairment at the reporting date

Internal:

-Asset obsolete or damage;

-Operating losses for the current period;

-Loss of key employees;

-Reconstructions.

External:

-Adverse change in the commercial environment(decrease demand for the asset)

To determine value in use of the asset we calculate the present value of the

future cash flow relating to this asset. And the discount rate used would be

depend on company’s industry specific knowledge, like using weighted average

cost of capital or project specific discount rate etc.

To determine the net realizable value we take fair value(selling price)-costs to

sell this asset.

And the higher of the above two would be the recoverable amount.

Impairment reversal:

We need to reverse the revaluation reserve we have recognized first and the

remaining amount would be the impairment expenses.


Audit work:

Inspect a copy of correspondence to verify impairment indicator exists.

Inspect asset condition to determine whether it would need further

impairment.

Enquire with management to verify their Future intentions to use or to sell

the asset and this forms a basis for recoverable amount.

Inspect management representation that an impairment test has been

carried out.

Inspect draft sales agreements for impairment review evidence.

Inspect cash flow projections relating to value in use.

Inspect management account after the reporting date of company results to

confirm an impairment review is necessary. (for CGU)

Review management’s impairment review to establish the reasonableness of

value in use by examining its discount factor used.


the assumption regarding the future cash inflow, ie, in line with sales

revenue growth.


Audit question: [Q] impairment IAS36

You are the manager responsible for the audit of Aspersion, a limited liability

company, which mainly provides national cargo services with a small fleet of

aircraft. The draft accounts for the year ended 30 September 2008 show profit

before taxation of $2.7 million (2007 – $2.2 million) and total assets of $10.4

million (2007 – $9.8 million).

(b) Aspersion owns two light aircraft which were purchased in 2005 to provide

business passenger flights to a small island under a three year service contract.

It is now known that the contract will not be renewed when it expires at the end

of March 2009. The aircraft, which cost $450,000 each, are being depreciated

over fifteen years. (7 marks)

Required: comment on the matters that you would consider and the audit

evidence you should find.


Answer: (only 7 points required)

(i)Matters to consider:

Materiality

The depreciated value of aircraft is $720,000($900,000/15 X3) and it’s 7% of

total assets and it’s material to the statement fo financial position.

Accounting

According to IAS36 impairment of assets an impairment test would be carried

out if there’s indicator that asset would be impaired. And here for Aspersion

because the contract would not be renewed any more so this would be

impairment indicator. Management should carry out an impairment test

comparing carrying value of asset with its recoverable amount and the

recoverable amount would be determined using the higher of value in use and

net realizable value of the asset.

If an impairment loss is recognized auditor would need to determine whether it

would be material to the financial statement by calculating its materiality.


If the impairment loss is material to financial statement and hasn't been

recognized by management or has been recognized wrongly then auditor would

need to qualify their audit opinion with an except for due to material

misstatement.

(ii)Audit evidence

A copy of the service contract and any correspondence to verify contract

would not be renewed.

Aircraft inspection result to ascertain its condition and determine whether it

would need further impairment.

Notes of enquiries of management to verify their Future intentions to use or

to sell the asset and this forms a basis for recoverable amount.

Management representation that an impairment test has been carried out.

Draft sales agreements for impairment review evidence.

Cash flow projections relating to value in use.


Audit question [DEC2010 Q3 Clooney]impairment IAS36

Clooney Co is one of the world’s leading leisure travel providers, operating

under several brand names to sell package holidays. The company catered for

more than 10 million customers in the last 12 months. Draft figures for the year

ended 30 September 2010 show revenue of $3,200 million, profit before tax of

$150 million, and total assets of $4,100 million. Clooney Co’s executives earn a

bonus based on the profit before tax of the company.

You are the manager responsible for the audit of Clooney Co. The final audit is

nearing completion, and the following points have been noted by the audit

senior for your attention:

One part of the company’s activities, operating under the Shelly’s Cruises brand,

provides cruise holidays. Due to economic recession, the revenue of the Shelly’s

Cruises business segment has fallen by 25% this year, and profit before tax has

fallen by 35%. Shelly’s Cruises contributed $640 million to total revenue in the

year to 30 September 2010, and has identifiable assets of $235 million,

including several large cruise liners. The Shelly’s Cruises brand is not recognized

as an intangible asset, as it has been internally generated.

Required:

Comment on the matters that you should consider, and state the audit evidence

you should expect to find in your review of the audit working papers for the year

ended September 2010 in respect of: Shelly’s Cruises

(7 marks)


Answer to DEC2010 Q3(b)


Accounting

According to IAS36 impairment of assets there’s an indicator suggesting the

brand would be impaired, ie, due to economic recession. So an impairment

review should be performed by management by comparing carrying value of

brand and recoverable amount from the higher of value in use and fair value

minus costs to sell.

Materiality

It accounts for 20% of revenue($640m/43200m) and 5.7% of total assets

($235m/$4,100m) and so it’s material to statement of profit or loss and



If the impairment test is not done by management then auditors should issue an

except for qualification regarding this.

(ii) Evidence

Review management account after the reporting date of Shelly company

detailing the performance of Shelly to confirm an impairment review is

necessary.

Obtain a management representation stating performance of Shelly is bad

impairment review has been done.


value in use by examining its discount factor used.


the assumption regarding the future cash inflow, ie, in line with sales

revenue growth.


Chapter2 Q7: 22,IAS 37 Provisions, Contingent liabilities

and Contingent Assets

Accounting Issues:

1, Provision:

A provision is an uncertain future obligation that the business may or may not

have to settle.

You can only recognize the provision if these 3 criteria are met: (mnemonics:

POR)

P: probable that resources will be transferred to settle the liability(asset/other

resources);

O: present obligation whether it’s legal (law) or constructive (published

information) from past event;

R: reliable estimate of the amount of payment can be made.

Double entry:

DR Relevant expense a/c (Statement of comprehensive income)

CR Provision (Statement of financial position)

Disclosure: (to show how the opening provision may be reconciled

to the closing provision)

Opening provision $55m

Provision $20m

Closing provision $75m

2, contingent liabilities

A contingent liability exists when:

Situation1:

A possible obligation that arises from past events and existence will only be

confirmed by the occurrence or non-occurrence of one or more uncertain future

events not wholly within the control of the entity.

Situation2:

A present obligation that arises from past events but it fails criteria P and R

(above) of a provision.

Disclosure:

1, nature of contingent liability

2, likely financial effect

3, uncertainty of the amount and timing


3, contingent assets

A contingent asset arises from probable future income.

Situation:

It is a probable/possible asset that arises from past events whose existence in

confirmed by the occurrence or non occurrence of uncertain future events not

wholly within the control of the entity.

If it becomes virtually certain(>95%) that the company can receive the asset

rather than just a contingent asset so that they can recognize the asset in the

financial statements rather than disclose it.

Disclosure: (when it’s probable)

1, nature of contingent liability

2, likely financial effect

To sum up:

Audit work:

1. Use general analytical procedures to compare provision recorded year on

year to verify its reasonableness.

2. Use “CCTRAIN”

Claims- correspondence with customer – obligation

Correspondence -with layer-determine whether provision, contingent liability

would be needed.

Terms of contract- company’s obligation

Representation/recalculate provision-there are no further expenses needed to

provide for-determine the exact amount of

expenses and liability.

Insurance company- to verify if any reimbursement can be obtained by

company and this will form the basis for the amount

recognized as liability.

News-obligation

Liability (outflow)

Asset

(inflow)

Probable(>50%) Provide (provision) Disclose

Possible(20%-50%) Disclose Ignore

Remote(<20%) Ignore Ignore


Audit question [ DEC2007 Q1(b)] provision

One customer, Sawyer Co, communicated in November 2007, via its lawyers with

Island Co, claiming damages for injuries suffered by a drilling machine operator

whose arm was severely injured when a machine malfunctioned. Kate Shannon, the

chief executive officer of Island Co, has told you that the claim is being ignored as it

is generally known that Sawyer Co has a poor health and safety record, and thus the

accident was their fault. Two orders which were placed by Sawyer Co in October

2007 have been cancelled.

All machines are supplied carrying a one year warranty. A warranty provision is

recognised on the balance sheet at $2·5 million (2006 – $2·4 million). Kate Shannon

estimates the cost of repairing defective machinery reported by customers, and this

estimate forms the basis of the provision.

Required:

Explain the principal audit procedures to be performed during the final audit in

respect of the estimated warranty provision in the balance sheet of Island Co as at

30 November 2007.

(5 marks)


Answer to [DEC2007 Q1(b)] provision

Inspect correspondence with customer to understand the claims made by them at the

year end.

Inspect correspondence with lawyer to determine the possibility that company can win

the case if customers sue the company and this will form the basis for company to

recognize a provision or disclose as a contingent liability.

Inspect the terms of contract to understand the obligation of Island Co.

Recalculate the warranty provision.

Inspect the written representation that there are no further repairmen of assets apart

from $2.5m in the statement of financial position to determine there are no other

provision needs to be provided for or contingent liability disclosed.

Enquire with management to determine advice given by company and if company said

they would bear the compensation costs then this would help determining the full

provision amounts to be provided for or contingent liability amount to be disclosed.

Inspect insurance contract to determine whether company can get compensation

reimbursement from insurance company and if yes then this would reduce the liability

that company needs to provide for.

Inspect the news regarding this claim by customer to determine company’s liability

regarding this issue.

General Analytical procedures:

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

verify its reasonableness.

Perform analytical procedures to verify assumptions used are consistent with the

auditors’ understanding of the business


Chapter2 Q7: 23,IAS38 Intangible Assets

Accounting issues:

Intangible assets are something you can’t touch, ie, without physical substance.

Things like Goodwill, Patents, Brands / trademarks, Copyrights and customer

lists etc.

You can recognize the intangible assets as a non-current asset in the SOFP if

they are externally generated, ie, you purchase them and they have a fair value

for this.

You cannot recognize the intangible assets as a non-current asset in the SOFP if

they are internally generated, ie, you can’t reliably measure their value is

because even though they engage an expert to put a value onto the asset but

everybody has different opinion on the assets as well.

An exception for this is the development costs.*

Initial recognition:

Identifiable: You purchase it and you’ve got a contract.

Asset definition: Control by company- for human assets which are not

controllable by business.

Also it’s probable that future economic benefit will flow into

entity.

Cost: Can be reliably measured.


Amortize it over its useful life using straight line method.

Double entry:

DR Amortisation expense (Statement of comprehensive income)

CR Accumulated amortisation (Statement of financial position)


*Exception

Research and development costs (R&D)

Research expenses: this means that you search for the internet and other

information to see whether the plan is workable. So it should be expensed to I/S

not capitalize as asset because it’s not probable that this can help company

generate into future economic benefit.

Development costs: when company sees that the plan is workable then it starts

to invest money into developing the asset ,eg, design and test for the product.

Then if the development costs meets the following criteria then it should be

capitalized as an intangible asset.

(mnemonic: USER:TIM)

The asset can be used or sold

Economic benefit will be probable to flow into entity

Enough resource to complete the process

The process is technically feasible

There’s management intention to complete the process

The costs of this can be measured reliably.


Audit work for other intangible assets:

Agree cost of intangible to purchase documentation

Agree cash outflow relating to this intangible asset to cash book or bank statement.

Inspect the purchase documentation relating to this intangible asset to verify the

rights of intangible assets actually belong to the company.

Audit work relating to reaseach&development costs:

Inspect detailed business plan to determine how company would use this asset.

Inspect customer order if company is to sell the asset.

Inspect cash flow projections to verify if there is enough cash flow to carry out

the development process.

Inspect statement of cash flow to verify there is enough cash balance within

company to support the development process.

Inspect the overdraft facility to ensure there are enough resources to complete

the development process.

Inspect result of scientific tests relating to this asset to verify it’s technically

feasible.

Inspect management representation to ensure company has an intention to

complete the development process.

Inspect invoices relating to this project to confirm related expenses can be

measured reliably by company.


Audit question IAS 38 [ june2008 Q5] Blod

An internally generated brand name has been included in the statement of

financial position at a fair value of $10million. Audit working papers show that

the matter was discussed with the financial controller, who stated that the $10

million represents the present value of future cash flows estimated to be

generated by the brand name. The member of the audit team who completed

the work programme on intangible assets has noted that this treatment appears

to be in breach of IAS 38 Intangible Assets, and that the management refuses to

derecognize the asset.

Required:

From the information provided above, recommend the matters which should be

included as ‘findings from the audit’ in your report to those charged with

governance, and explain the reason for their inclusion.

(7 marks)


Answer:

Materiality

This is 13% of total asset ($10m/$78m) and it’s material to the statement of

financial position.


Although company can use the brand to generate into future economic benefit and

it seems to fulfill the asset definition.

But an internally generated brand name is not identifiable and therefore cannot be

recognize as an intangible asset in the statement of financial position.

Reason to notice to those charged with governance

It can give management an opportunity to correct that material misstatement

before a qualified opinion is given.

Those charged with governance, ie, audit committee should co-operate with

external auditor to require management to correct that material misstatement.

External auditor should tell audit committee why a potential qualification of audit

opinion would be given due to a breach in IAS38 intangible assets and state its

materiality as well to the financial statement.

If management still refuses to correct that material misstatement then auditor

needs to modify his audit report by issuing an except for qualification audit opinion

due to material misstatement in the financial statement.


Audit question [ DEC2011 Q1] IAS 38

Maple & Co

A significant amount has been invested in the new website, which is seen as a

major strategic development for the company. The website has generated

minimal sales since its launch last month, and advertising campaigns are

currently being conducted to promote the site.

Required:

Identify and explain the principal audit risks to be considered in planning the

final audit

Answer:

Company has developed the website.

According to IAS38 intangible assets the development cost would be capitalized

if it fulfills certain criteria and one of them is company can use this website to

generate into future economic benefit and given this website has generated

minimum sales so it can’t be capitalized.

There is a risk that company has capitalized this development costs and hence

overstating the asset within statement of financial position and understating

expense in the statement of profit or loss.


Chapter2 Q7: 24, IAS40 Investment Property

Accounting issues:

Classification of investment property if it fulfills the following criteria:

Investment purpose Earns capital gain or let it out to earn rental income and if

not: Use by company: IAS 16; held for sale: IAS2

Complete Asset has been completed and if not, IAS 16 until it’s finished

Empty The asset is not occupied by the business and if not: IAS16.

Or if lessee leases property from lessor but from a group’s

perspective this is not an investment property

And they should be recognize at cost initially.


Fair value model (widely used)

Get the fair value:

From Price

From Similar asset within the area

From Value from institution for similar assets

From Discount future cash flow

Then any gain/losses should be recognized into the Income statement.

Gain: DR Investment property(NCA)

CR I/S

Loss: DR I/S

CR investment property(NCA)

Disclosures:

Fair value model

An entity that adopts this must also disclose a reconciliation of the carrying

amount of the investment property at the beginning and end of the period.

Opening IP value 100

Increase 50

Closing IP value 150


Audit work:

General assets procedures:

Inspect purchase document of investment property to verify the cost of each building. And

because the property was acquired this year then the price shouldn't be too far away from

that as at the year-end so any big differences between the two would imply a misstatement

exists.

Inspect purchase document of investment property to ensure it belongs to company.

Inspect investment property physically to determine condition of the properties supporting

the valuation.

Far value procedures:

Audit procedures should focus on the appraisal of the work of the expert valuer. Procedures

could include the following:

Inspect the written instructions Co provided to the valuer to get an understanding about the

scope of their work.

Perform analytical procedures to evaluate assumptions used by valuer in the report are in line

with auditor’s business understanding.

Inspect valuer’s method used to determine fair value and ensure it’s consistent with by

IAS40.

Perform analytical procedures by reviewing forecast rental income from properties as an

evidence for valuation.

Inspect the date of the valuation report and ensure it’s close to the Co financial statement

year end so that fair value used would be reasonable.

Inspect any subsequent events, eg, sale of investment property after the year end and this

would provide evidence for property valuation, eg, using fair value in the contract price.


Audit question [DEC2008 Q3] IAS40

You are the manager responsible for the audit of Poppy Co, a manufacturing

company with a year ended 31 October 2008. In the last year, several investment

properties have been purchased to utilize surplus funds and to provide rental

income. The properties have been revalued at the year-end in accordance with IAS

40 Investment Property, they are recognized on the statement of financial position

at a fair value of $8 million, and the total assets of Poppy Co are $160 million at 31

October 2008. An external valuer has been used to provide the fair value for each

property.

Required:

(i) Recommend the enquiries to be made in respect of the external valuer,

before placing any reliance on their work, and explain the reason for the

enquiries; (7 marks)

(ii) Identify and explain the principal audit procedures to be performed on

the valuation of the investment properties.

(6 marks)


Answer to [ DEC2008 Q3]Investment property:

(i)

Competence

Is the valuer a member of a recognised professional body such as institute of registered

surveyors?

Does the valuer have any necessary licence to carry out valuations for companies?

How much experience does the valuer have in providing valuations of the investment

properties held by Poppy Co?

Is there any evidence of the reputation of the valuer, e.g. recommendations from other

companies to provide such service?

Objectivity

Does the valuer have any financial benefit in Poppy Co, e.g. shares held in the company?

Does the valuer have any personal relationship with any director or employee of Poppy

Co?

Is the fee paid for the valuation service reasonable and a market based price?


(ii) Audit procedures

General assets procedures:

Inspect purchase document of investment property to verify the cost of each building. And

because the property was acquired this year then the price shouldn't be too far away from

that as at the year end so any big differences between the two would imply a misstatement

exists.

Inspect purchase document of investment property to ensure it belongs to company.

Inspect investment property physically to determine condition of the properties supporting

the valuation.

Far value procedures:

Audit procedures should focus on the appraisal of the work of the expert valuer. Procedures

could include the following:

Inspect the written instructions Co provided to the valuer to get an understanding about the

scope of their work.

Perform analytical procedures to evaluate assumptions used by valuer in the report are in line

with auditor’s business understanding.

Inspect valuer’s method used to determine fair value and ensure it’s consistent with by

IAS40.

Perform analytical procedures by reviewing forecast rental income from properties as an

evidence for valuation.

Inspect the date of the valuation report and ensure it’s close to the Co financial statement

year end so that fair value used would be reasonable.

Inspect any subsequent events, eg, sale of investment property after the year end and this

would provide evidence for property valuation, eg, using fair value in the contract price.


Chapter2 Q7: 25, IFRS2 Share-based Payment

Accounting issues:

Share based payment really covers a lot of areas.

Senario1: If you are going to purchase something but you are not paying cash

but instead you are paying in shares or share options and you can use IFRS2.

Senario2: If you are going to give some incentive to the management of your

company saying to them if you work for me for the next 10 years then I will give

you shares/share options then you can also use IFRS2 to account for it.

The issue with senario1 is about measurement of the value. Because you are

going to pay in shares/options and if you can establish the fair value of the item

you bought(usually in selling price) then you should use the fair value of the

item you bought otherwise you can use the fair value of the shares.

The issue with senario2 is about recognition and measurement of the expense.

If you think about it that you are trying to give incentive to management by

offering them shares at the end of 5(say) years they have worked for you, the

shares you are going to give to them actually cost you nothing because you’re

just giving shares to them so does the company have to recognize the related

expense to the financial statement?

Well, IFRS2 says because management has worked for the company and the

company is going to give shares usually at a low price to the management but

otherwise they could trade it in the stock market at a higher price so company

should recognize an expense relating to it.

Some companies may also argue that recognizing the share based payment

expense will double hit the EPS because as expenses are recognized and shares

are issued then EPS will be twice lower. But as long as management has

provided the service for you and you earn the revenue then you should

recognize the expense and also you are going to give them shares and of course

you have to take them into account into the FS as well for PRUDENCE concept.


The question is how can we measure the expense?

Step1: identify the type of scheme. Pay (settle) in shares or cash?

Step2: follow the formula:

Obligation= number of rights expected to vest X FV X timing ratio

Obligation

The total expense we should recognize at the end of the vesting period.

There may be changes in the expense we recognize each year because of our

estimates and any changes in them would be a change in accounting estimate

and this would be accounted for under IAS8 by just using prospective adjusting

method. In order words, just provide for it.

number of rights expected to vest:

number of people left the company+no of people expected to leave next year

Fair value (FV)

If it’s settled in shares then FV should use the value at grant date because it has

been written into the contract.

If it’s settled in cash which means the company will pay cash to the employees

based on the future share price. So if the share price at the end of the vesting

period(the end that employee has worked for the company)is $50m then CR

liability 50m. so the Fair value here will be the FV of options at the end of each

year.

Timing ratio=year end / vesting period


Audit work:

Agree the following calculation by management to the contract:

– Number of employees

– Number of options granted per employee

– Grant date of the share options

– Vesting period for the scheme

– Required performance conditions attached to the options

Recalculate the share based payment expense to ensure its accuracy.

Review a forecast of employee turnover rates during the vesting period to verify its

reasonableness and this would help determine total number of share options granted.

Inspect written representation from management to confirm assumptions used in the

calculation are reasonable.

Agree fair value of share options to specialist’s report and calculation.

Agree that the fair value calculated is at the grant date if this is share options.

Agree that the fair value calculated is at the each year end if this is share appreciation

right.


Audit question [ DEC2008 Q1(b)(i)] IFRS2 share based payment:

Note2: significant items included in operating expenses:

2008($m) 2007($m)

Share-based payment expense(i) 138 -

Damaged property repair expenses(ii) 100 -

(i) In June 2008 Bluebell Co granted 50 million share options to executives and

employees of the company. The cost of the share option scheme is being

recognised over the three year vesting period of the scheme. It is currently

assumed that all of the options will vest and the expense is calculated on that

basis. Bluebell Co operates in a tax jurisdiction in which no deferred tax

consequences arise from share-based payment schemes.

(b) Describe the principal audit procedures to be carried out in respect

of the following:

(i) The measurement of the share-based payment expense;

(6 marks)


Answer to DEC2008 Q1(b)(i)

Agree the following calculation by management to the contract:

– Number of employees

– Number of options granted per employee

– Grant date of the share options

– Vesting period for the scheme

– Required performance conditions attached to the options

Recalculate the share based payment expense to ensure its accuracy.

Review a forecast of employee turnover rates during the vesting period to verify its

reasonableness and this would help determine total number of share options granted.

Inspect written representation from management to confirm assumptions used in the

calculation are reasonable.

Agree fair value of share options to specialist’s report and calculation.

Agree that the fair value calculated is at the grant date because this is share options not

share appreciation rights.


Chapter2 Q7: 26, IFRS5 Non-current Assets Held for Sale and

Discontinued Operations

Accounting issues:

Non-current assets held for sale:

When the non-current asset within your company is about to be sold to the 3rd

party maybe because its falling in value then if some criteria are fulfilled then

you can reclassify this non-current asset into current asset as “NCA HFS and

discontinued operations” under IFRS5.

Classification:

The idea behind the criteria is that you should prove that this sale is probable:

Selling purposes by management

Available for sale under current condition

Locate a buyer actively

Expected to complete within 12 months from the year end

If the above criteria are proved then company can reclassify the non-current

asset into non-current asset held for sale under current asset.


1, no depreciation or amortization (because we are not consuming the asset any

more-not for continued use but for sale.)

2, further impairment losses

DR I/S

CR non-current asset held for sale


Discontinued operations

A discontinued operation is an operation if it’s closed or sold during the year or

held for sale at the year end.

A discontinued operation should:

1, Dispose of or plan to dispose of a separate major line of business or

geographical area of operations;

(Major line of business: eg, financial service industry; supermarket.

geographical area: Canada division)

2, A subsidiary acquired exclusively with a view to resale.

Note: it should be subject to impairment as well same as above. But the key to

discontinued operations is about “DISCLOSURE”. (to help users predict future

performance based on continuous operations.)

Disclosure:

Net cash flow detailing operating, investing and financing activities.

Single line in the statement of comprehensive income showing post tax profit or

loss on discontinued operation.

Analysis of the profit or loss above in the note detailing how to arrive this figure

showing detailed:

Revenue $1,000

expense $50

Pre-tax profit $950

Income tax

Current tax

Deferred tax

($15)

($25)

Gains/losses on measurement to

NRV


Audit work:

For assets / operations that have been disposed of:

Agree proceeds to sales documentation and bank statements.

Recalculate any gain or loss on disposal and ensure separately disclosed in

the financial statements.

Verify date on sales documentation to prove asset was sold before year end.

For assets / operations “held for sale”:

Inspect Board Minutes to confirm intention to sell.

Inspect correspondence with agent to confirm company is actively trying to

sell the asset.

If company has advertised the asset for sale, inspect advertising

documentation.

Obtain management representation to confirm Board’s intention to sell.

Inspect correspondence between company and any interested parties

regarding the sale.

If company has made any announcements regarding the plan to sell, inspect

copies and agree date before year end.

Assess asset / operation for impairment, as a plan to sell often indicates

asset/ operation is not performing as well as company.


Audit question1 IFRS 5 [ DEC2007(a) ]

Alpha Co, a listed company, permanently closed several factories in May 2007,

with all costs of closure finalised and paid in August 2007. The factories all

produced the same item, which contributed 10% of Alpha Co’s total revenue for

the year ended 30 September 2007 (2006 – 23%). The closure has been

discussed accurately and fully in the chairman’s statement and Directors’

Report. However, the closure is not mentioned in the notes to the financial

statements, nor separately disclosed on the financial statements. The audit

senior has proposed an unmodified audit opinion for Alpha Co as the matter has

been fully addressed in the chairman’s statement and Directors’ Report.

Required:

Evaluate whether the audit senior’s proposed audit report is

appropriate, and where you disagree with the proposed report,

recommend the amendment necessary to the audit report of:

(i) Alpha Co; (6 marks)


Answer to [ DEC2007(a) ] IFRS 5

Auditor’s reports

Alpha


According to IFRS5 non-current assets held for sale and discontinued operations

closure of factories at the year-end should be disclosed in the financial

statements as discontinued operations.

General disclosure would include:

Profit after tax of the discontinued operations

Fair value of the discontinued operations.

Separate disclosure would include:

If product lines of the business would be closed and they are in separate areas

or they are separate products then they should be separately disclosed.

Materiality

This is material to statement of profit or loss because it accounts for 10% of

total revenue

Auditor’s opinion is not correct given this is a material misstatement in the

fisnancial statement and hence an except for qualification of audit opinion would

be given due to material misstatement.

A basis of qualification audit opinion would need to be placed before the actual

opinion paragraph and it needs to detail the reasons why qualification audit

opinion would be given due to a breach of IFRS5.


Audit question2 [june2011 Q1a]IFRS 5

The second issue concerns one of Bill Co’s specialist divisions, which trades under

the name ‘Treasured Homes’ and which deals exclusively in the redevelopment of

non-industrial historic buildings such as castles and forts. These buildings are

usually acquired as uninhabitable ruins, and are then developed into luxury

residences for wealthy individuals. The management of Bill Co decided last week to

sell this division, as although it is profitable, it generates a lower margin than other

business divisions. ‘Treasured Homes’ operates separately from the rest of the

business, and generates approximately 15% of the total revenue of the company. In

a board minute dated 1 June 2011, it was noted that ‘interest has already been

expressed in this division from a potential buyer, and it is hoped that sale

negotiations will soon commence, leading to sale in August 2011. There is a specific

office building and some other tangible assets that will be sold as part of the deal.

These assets are recorded at $7·6 million in the financial statements. No

redundancies will be necessary as employees’ contracts will transfer to the new

owners.’

Required:

I am asking you to prepare briefing notes, for my use, in which you explain the

matters that should be considered in relation to the treatment of these two issues in

the financial statements, and also explain the risk of material misstatement relating

to them. I also want you to recommend the planned audit procedures that should be

performed in order to address those risks.

(8 marks)


Answer to [June2011 Q1(a)] IFRS 5

Only 8 points required

Materiality

“Treasured Homes” is material to the group because it represents 8% of total

assets of the financial statements.

Accounting

A non-current asset held for sale is recognized if management has an intention

to sell the asset; asset is available for sale immediately; company locates a

buyer actively and the sale would be expected to complete within 12months

after the Financial statement year end.

Because a buyer is interested in buying it and a sale is expected to begin in

August 2011. Asset is complete and management is going to sell that to the

customer so it can be classified as a non-current asset held for sale.

As per IFRS5 the asset should be separately disclosed measuring at the lower of

carrying value and net realizable value and the asset is not depreciated any

more.

It’s likely that “treasured homes” meet the definition of discontinued operation

because it operates separately from the normal business operation and because

it accounts for 15% of total revenue so it’s a major line of business.

Risk of material misstatement

There is a risk that the classification of non-current asset held for sale is not

made leading to overstatement of non-current asset and understatement of

current asset in the statement of financial position. Also misstatement in the

expenses as well if depreciation continues to be charged.

There is a risk that separate disclosure for the discontinued operation is not

made.


Audit procedures

Obtain a management representation confirming management is planning

to sell the asset.

Inspect board minutes for evidence that management are planning to sell

the asset.

Inspect the asset physically to verify it’s available for sale.

Inspect the legal correspondence with potential buyer to confirm company is

actively locating a buyer.

Obtain management representation to confirm the sale would be completed

within the next 12months after the financial statement year end.

Confirm that separate disclosure of discontinued operation has been made in

the statement of financial position, statement of profit or loss, and

statement of cash flows.

Confirm that depreciation has not been charged as required by IFRS 5.


Chapter2 Q7: 27, IFRS8 Operating Segments

Accounting issues:

This area typically applies only to listed companies.

The aim of the IFRS8 is to give more information to the users of FS to make their

economic decision.

Think about it in this way, if you have a company which is operating in many

industries such as retail, mineral, financial services & education etc. If there’s a

rise in price due to increase in transportation fees then which industry will be

mostly affected?

Well to some extent, the retail industry will be mostly affected and the financial

service and education will be least affected. So when investors try to invest their

money into these industries they want to know these segments(companies in

different industries) are operating effectively so we come to IFRS8.

Another example would be if a company has many subsidiaries all round the

world such as in Asia, America, Canada, Singapore etc. and if you want to invest

your money into these companies say in China and you want to know whether

the company operating in China will be good and maybe you will then take into

account of political reasons etc.

So IFRS8 here just gives us some guidance of when trying to show the results of

different companies, how to do that?


Firstly, we should decide whether this is an operating segment?

An operating segment would have the following features:

1, It has business activities earning revenue and incurring expenses.

2, The operating results will be reviewed by CEO to make economic decisions.

3, There’s separate financial information for each segments showing assets,

liabilities, revenue, expenses and profits etc.

Secondly, once it fulfills the definition of operating segment then you will need

to decide whether this would be reportable?

An operating segment would be reportable if:

It’s more than 10%of revenue, profits or assets of all segments;

If there’s a loss then we need to decide whether the loss is higher than the

higher of total profits and loss and if no then it doesn't fulfill this criteria.

Only one of the criteria needs to be fulfilled.

Thirdly, once the operating segments are classified but they do not add up to

75% in total then we need to break the other operating segments down in order

to make the total up to 75%.

If other operating segments doesn't fulfill the definition of operating segement

then we can bring them together if they have similar products/types of

customers/distribution methods or regulatory environment.

Fourthly, we need to decide how to disclose the operating segements.

Revenue, total assets&liabilities, interest income&expense, tax&depreciation

should be disclosed.

Audit work:

Agree segmental analysis to the totals reported in the Financial Statements.

Perform analytical procedure by comparing figures with prior year to ensure

consistency of presentation.

Agree this year’s analysis back to management accounts.


Audit question1 IFRS8 [ DEC2009 Q1(d)]

You are the manager responsible for the audit of Papaya Co, a listed company,

which operates a chain of supermarkets, with a year ending 31 December 2009.

There are three business segments operated by the company

– two segments are supermarket chains which operate under internally

generated brand names, and the third segment is a new financial services

division.

The first business segment comprises stores branded as ‘Papaya Mart’. This

segment makes up three-quarters of the supermarkets of the company, and are

large ‘out of town’ stores, located on retail parks on the edge of towns and cities.

These stores sell a wide variety of items, including food and drink, clothing,

household goods, and electrical appliances. In September 2009, the first

overseas Papaya Mart opened in Farland. This expansion was a huge drain on

cash resources, as it involved significant capital expenditure, as well as an

expensive advertising campaign to introduce the Papaya Mart brand in Farland.

The second business segment comprises the rest of the supermarkets, which

are much smaller stores, located in city centres, and branded as ‘Papaya

Express’. The Express stores offer a reduced range of products, focussing on

food and drink, especially ready meals and other convenience items.

The company also established a financial services division on 1 January 2009,

which offers loans, insurance services and credit cards to customers.

Required:

Assess the risks of material misstatement to be addressed when

planning the final audit for the year ending 31 December 2009,

producing your answer in the form of briefing notes to be used at the

audit planning meeting.


Answer to [ DEC2009 Q1(d)]IFRS8 Business segments

There are many operating segments.

According to IFRS8 operating segments for listed companies such as Papaya Co

the information relating to those operating segments should be disclosed in the

note of the financial statements.

There is a risk relating to non-disclosure of information relating to these

operating segments.


Chapter2 Q7 :28, IFRS10,11,12

Accounting issues:

IFRS 10 Consolidated Financial Statements

This is a result from the convergence of the FASB in USA and IASB.

IFRS 10 replaces the definition of control in IAS27 but the preparation of

separate financial statements in IAS27 remains unchanged and consolidation

process does not change per IFRS3.

The definition of control per IAS27: the power to govern financial and

operational policies of an entity to obtain benefit.

But the definition of control under IFRS10:

When investor is exposed or has rights to variable returns(profit/loss) from its

involvement with the investee and has the ability to affect those returns through

its power over the investee.

There are 3 steps to determine control and we use a mnemonic called “PAR”.

P: Power instrument:

voting rights and potential voting rights; power to appoint directors on the

board.

A: activities(relevant).

I like to think about relevant activities which are based on the purpose of the

organization. Such as if your company is going to manufacture high fashion

clothes then a relevant activity would be to determine the selling price of the

high fashion clothes in the whole market etc. An participation in preparation of

accounts for the company is just an irrelevant activity.

R: returns (either positive or negative)

The returns here could be positive or negative which means through the

direction of the activity within the company then the investor may be exposed to

or have right to profit or loss not necessarily benefit(profit.)

Also the returns are variable which means that if the company is doing a good

job so it earns a larger amount of profit then it will distribute larger amount of

dividend to shareholders and this is called variable which is against “fixed”.

Eg, a preference shareholder is just exposed to the fixed dividend received from

the company so it does not necessarily have control over the entity.


IFRS 11 Joint Arrangements

This is based on the concept of joint control.

Joint control just prevents any party who control the whole business.

Before setting up the joint control you need to have a look at whether the party

has control per IFRS10.

If yes then move on to see their agreements to establish whether there would

be an unanimous consent over the relevant activities by parties sharing control.

And if yes then you should decide whether this is a joint operation(JO) or joint

venture(JV). These are the two types of joint arrangements.

JOINT OPRATION (JO)

This means that parties do business together using their own assets and settling

their liabilities. The accounting for this follows the substance over form which

means the assets and liabilities remain in each parties’ FS and just a sharing of

revenue, expense, assets and liabilities.

JOINT VENTURE (JV)

Parties may set up a business together and put their assets and liabilities in then

the assets and liabilities belong to the business rather than belong to their own.

The accounting for this is to use equity accounting which means the growth of

business goes into the income statement and SOFP where it’s added to the cost.

IFRS 12 disclosures of interests in other entities

This is a new IFRS on disclosure of group relationships that requires the ultimate

parent to disclose all its relationship with other entities.

The parent company is required by IRS12 to list:

All of its subsidiaries and state the reason why it has control not significant

influence.

All of its associates and state the reasons why it has significant influence not

control.

All of its joint arrangements and state the reasons why it has joint controls.


Audit work:

Inspect their agreement to verify “joint control”.

Examine the term “control” by inspecting directors register and terms to verify

their power to govern policy making decision.

Inspect disclosure is appropriate as per IFRS12.


Audit question [Shire DEC2005] IFRS11 Joint Arrangements

In July 2008, Shire entered into an agreement to share in the future economic

benefits of an extensive oil pipeline.

Required:

Using the information provided, identify and explain the audit risks to

be addressed when planning the final audit of Shire Oil Co for the year

ending 31 December 20X8.

Answer:

The agreement to share in future profit seems to be a joint arrangement.

If there is joint control then we should decide whether this is joint operation or

joint venture.

If it’s joint operation then assets and liabilities should be recognized in each

parties financial statements.

If it’s joint venture then Shire should use equity accounting method.

There is a risk that the above accounting is wrong and hence financial

statements would be materially misstated.


Chapter2 Q7 :29, IFRS13 Fair Value Measurement

Accounting issues:

In this IFRS 13 we need to know

1, Definition of fair value:

The price that would be received to sell an asset or paid to transfer a liability

in an orderly transaction between market participants at the measurement

date.

Here, the price would be the exit price.

2, How to measure fair value

-For financial assets&non-financial assets, liability and equity

instrument, we use this hierarchy.

Level1: quoted price

If there is an active market then the market price from that

market on the measurement date should be used.

Level2: similar quoted price

If level one fails then level two requires that similar market data

should be used to establish the approximated market value.

Level3: unobservable inputs(management best estimate, eg, present

value)

If level one and two fails to determine the fair value then you can

use level three where you can use financial model to determine

fair value.

-For non-financial assets, we should use highest and best use value

Eg, to determine the fair value of land you need to consider which way

that the land may generate into a highest value. Either for industrial

use or residential use.


Audit work:

Inspect valuers’ working papers to verify methods used are in line with auditors’

understanding.

Enquire with management about controls over the estimation process when the

valuation for the items is complex as this will reduce the control risk.

Perform analytical procedures by comparing methods used for estimates with

prior years to ensure consistency.

Consider the use of an outside auditor’s expert to assess the estimate and the

assumptions on which it is based.

Obtain written representations from management that they believe the

assumptions behind their estimates to be reasonable.


Audit question [DEC2008 Q3(a)]fair value

(a) Financial statements often contain material balances recognised at fair value.

For auditors, this leads to additional audit risk.

Required:

Discuss this statement. (7 marks)

Answer to [ DEC2008 Q3]fair value

Inherent risk

This will increase the inherent risk because of its subjectivity in nature.

For example when determing the fair value for asset using disoucnting cash flow, lots of

discount rates would be used by management and it's subjective.

(For example when management tries to use fair value model for the asset they may

assess the market condition of that asset and the future intention of how to use that asset

to generate into future economic benefit and they can base on this to give a fair value to

the asset and this is subjective.)

This will increase the inherent risk because it’s subject to manipulation by management.

Management sometimes would use fair value model to value assets in order to overstate

its asset value to attempt window dressing.

This will increase the inherent risk because its complexity.

For example in IAS19 employee benefit when the actuary gives a fair value to the pension

asset or liability then the process is very complicated and it’s easy to make mistakes.

Control risk

This will increase control risk because sometimes fair value determination is beyond

company’s control.

For example when valuing the pension asset and liabilities it’s up to the actuary to value

them not company and hence any mistakes happened during the valuation process may

not be detected by the company internal control system.

Detection risk

This will increase detection risk because auditors may lack of knowledge when dealing

fair value.

For example if auditor has no knowledge about financial instrument then auditor may not

detect any errors within the fair value figure of financial asset and hence give a wrong

audit opinion.


Group audit

Accounting issues:

Based on single entity concept within the group there would be parent and

subsidiary. For associate which is outside the group.

Consolidated statement of financial position would be prepared showing assets,

liabilities which are based on definition of control whilst for equity which is based

on “ownership”.

When acquiring a subsidiary the excess amount of money paid would be

goodwill (positive-show in the non-current assets). If we spend less money than

its actual net assets then the difference would be bargain purchase which would

be presented in the consolidated statement of profit or loss and other

comprehensive income and retained earnings.

For associate we use equity accounting method.

For subsidiary we show the excess amount we paid as non-current asset.

Goodwill would be subject to impairment at each year end but not amortization.

Net assets should include deferred tax implication, ie, minus deferred tax

liability and add deferred tax asset back.

Audit work:

Look at the questions below.(the current examiner test this quite consistently.)


June2012 Q1(a(i+iii)): Group audit

You are a manager in Magpie & Co, responsible for the audit of the CS Group. An

extract from the permanent audit file describing the CS Group’s history and

operations is shown below:

Permanent file (extract) Crow Co was incorporated 100 years ago. It was founded

by Joseph Crow, who established a small pottery makingtableware such as dishes,

plates and cups. The products quickly grew popular, with one range of products

becominghighly sought after when it was used at a royal wedding. The company’s

products have retained their popularity overthe decades, and the Crow brand

enjoys a strong identity and good market share.

Ten years ago, Crow Co made its first acquisition by purchasing 100% of the share

capital of Starling Co. Both companies benefited from the newly formed CS Group,

as Starling Co itself had a strong brand name in the pottery market. The CS Group

has a history of steady profitability and stable management.

Crow Co and Starling Co have a financial year ending 31 July 2012, and your firm

has audited both companies for several years.

Acquisition of Canary Co

The most significant event for the CS Group this year was the acquisition of Canary

Co, which took place on 1 February 2012. Crow Co purchased all of Canary Co’s

equity shares for cash consideration of $125 million, and further contingent

consideration of $30 million will be paid on the third anniversary of the acquisition,

if the Group’s revenue grows by at least 8% per annum. Crow Co engaged an

external provider to perform due diligence on Canary Co, whose report indicated

that the fair value of Canary Co’s net assets was estimated to be $110 million at the

date of acquisition. Goodwill arising on the acquisition has been calculated as

follows:

$m

Fair value of consideration: 125

Cash consideration 30

Contingent consideration 155

Less: fair value of identifiable net assets acquired (110)

Goodwill 45

To help finance the acquisition, Crow Co issued loan stock at par on 31 January 2012,

raising cash of $100 million. The loan has a five-year term, and will be repaid at a

premium of $20 million. 5% interest is payable annually in arrears. It is Group

accounting policy to recognise financial liabilities at amortised cost.


Canary Co manufactures pottery figurines and ornaments. The company is

considered a good strategic fit to the Group, as its products are luxury items like

those of Crow Co and Starling Co, and its acquisition will enable the Group to

diversify into a different market. Approximately 30% of its sales are made online,

and it is hoped that online sales can soon be introduced for the rest of the Group’s

products. Canary Co has only ever operated as a single company, so this is the first

year that it is part of a group of companies.

Financial performance and position

The Group has performed well this year, with forecast consolidated revenue for the

year to 31 July 2012 of $135 million (2011 – $125 million), and profit before tax of

$8·5 million (2011 – $8·4 million). A breakdown of the Group’s forecast revenue and

profit is shown below:

Crow Co Starling Co Canary Co CS Group

$ million $ million $ million $ million

Revenue 69 50 16 135

Profit before

tax

3·5 3 2 8.5

Note: Canary Co’s results have been included from 1 February 2012 (date of

acquisition), and forecast up to 31 July 2012, the CS Group’s financial year end.

The forecast consolidated statement of financial position at 31 July 2012 recognises

total assets of $550 million.

Other matters

Starling Co received a grant of $35 million on 1 March 2012 in relation to

redevelopment of its main manufacturing site. The government is providing grants

to companies for capital expenditure on environmentally friendly assets. Starling Co

has spent $25 million of the amount received on solar panels which generate

electricity, and intends to spend the remaining $10 million on upgrading its

production and packaging lines.

On 1 January 2012, a new IT system was introduced to Crow Co and Starling Co,

with the aim of improving financial reporting controls and to standardise processes

across the two companies. Unfortunately, Starling Co’sfinance director left the

company last week.

Required:

(i) Identify and explain the implications of the acquisition of Canary Co for the audit

planning of the individual and consolidated financial statements of the CS Group; (8

marks)

(iii) Recommend the principal audit procedures to be performed in respect of the

goodwill initially recognized on the acquisition of Canary Co. (5 marks)


Answer to June2012 Q1(a)(i)+(iii)

(a)

(i)

Individual financial statement:

Auditors should consider the time to start their audit work to avoid any delay

in work because now it’s June2012 and the financial statement year end is

July2012 then it’s just 1 month away before auditors start their audit.

Auditors would need to consider performing professional clearance asking

previous auditors of Canary Co about any circumstances that may influence

its audit strategy and audit plan as this is an initial engagement.

Auditors would need to consider whether an expert would be used to obtain

sufficient and appropriate audit evidence relating to its sales revenue

because 30% of Canary Co sales are made online.

Auditors need to understand client’s company including understand its

internal control system because a new IT system was introduced to Crow Co

so auditor should assess whether there would be further internal control

weakness which may lead to a potential misstatement in its financial

statement.

Consolidated financial statements:

Auditors would need to consider extra work done on the transactions

occurred in July because Canary and Group have a different financial

statement year end.

Auditor should assess the new materiality because Canary has been newly

introduced into the group so the materiality for the group has changed.

Auditors should consider whether component would be significant

component and based on calculation revenue of Canary Co would account

for 11.9% of the group(16/135) and profit before tax would account for

23.5% of the group (2/8.5) so Canary would be a significant component of

the group.

Auditor should consider extra works to be done as well such as engaging an

expert auditing goodwill and auditors should ensure there enough time to

carry out the audit of the group.


(iii) (actions+document(what)+reasons(why/assertions))

Agree the cash consideration of $125m to bank statement and its cash book.

Obtain the breakdown of contingent consideration and recalculate it,eg,on a

discount basis to verify its accuracy.

Enquire with management of company about the likelihood of payment to

Canary co to verify its reasonableness in contingent consideration.

Inspect external expert report on the valuation of fair value of net assets at

acquisition to verify its accuracy.

Inspect the purchase document of Canary from management to verify this is

approval.


Stage 5 of audit flowchart

Review stage of audit

In this stage we will be going through:

1. audit findings

2. opening balance

3. subsequent events

4. other information

5. final analytical procedures

6. management representation


DEC2012 Q2 Audit findings

(a) You are a manager in Sambora& Co, responsible for the audit of the Jovi Group

(the Group), which is listed. The Group’s main activity is steel manufacturing and it

comprises a parent company and five subsidiaries. Sambora& Co currently audits all

components of the Group.

You are working on the audit of the Group’s financial statements for the year ended

30 June 2012. This morning the audit engagement partner left a note for you:

‘Hello

The audit senior has provided you with the draft consolidated financial statements

and accompanying notes which summarise the key audit findings and some

background information.

At the planning stage, materiality was initially determined to be $900,000, and was

calculated based on the assumption that the Jovi Group is a high risk client due to its

listed status. During the audit, a number of issues arose which meant that we

needed to revise the materiality level for the financial statements as a whole. The

revised level of materiality is now determined to be $700,000. One of the audit

juniors was unsure as to why the materiality level had been revised. There are two

matters you need to deal with:

(i) Explain why auditors may need to reassess materiality as the audit progresses.

(4 marks)

(ii) Assess the implications of the key audit findings for the completion of the audit.

Your assessment must consider whether the key audit findings indicate a risk of

material misstatement. Where the key audit findings refer to audit evidence, you

must also consider the adequacy of the audit evidence obtained, but you do not

need to recommend further specific procedures. (18 marks)

Thank you’

The Group’s draft consolidated financial statements, with notes referenced to key

audit findings, are shown below:


Draft consolidated statement of profit or loss and other comprehensive

income

Note 30June2012

Draft

$000

30June2011

Actual

$000

Revenue 1 98,795 103,100

Cost of sales (75,250) (74,560)

Gross profit 23,545 28,540

Operating expenses 2 (14,900) (17,500)

Operating profit 8,645 11,040

Share of profit of associate 1,010 900

Finance costs (380) (340)

Profit before tax 9,275 11,600

Taxation (3,200) (3,500)

Profit for the year 6,075 8,100

Other comprehensive income/expense for

the year, net of tax:

Gains on property revaluation 3 800 -

Actuarial losses on defined benefit plan 4 (1,100) (200)

Other comprehensive income/expense (300) (200)

Total comprehensive income for the year 5,775 7,900

Notes: Key audit findings –statement of profit or loss and other comprehensive

income

1. Revenue has been stable for all components of the Group with the exception of

one subsidiary, Copeland Co, which has recognised a 25% decrease in revenue.

2. Operating expenses for the year to June 2012 is shown net of a profit on a

property disposal of $2 million.

Our evidence includes agreeing the cash receipts to bank statement and sale

documentation, and we have confirmed that the property has been removed from

the non-current asset register. The audit junior noted when reviewing the sale

document, that there is an option to repurchase the property in five years time, but

did not discuss the matter with management.

3. The property revaluation relates to the Group’s head office. The audit team have

not obtained evidence on the revaluation, as the gain was immaterial based on the

initial calculation of materiality.

4. The actuarial loss is attributed to an unexpected stock market crash. The Group’s

pension plan is managed by Axle Co – a firm of independent fund managers who

maintain the necessary accounting records relating to the plan. Axle Co has supplied

written representation as to the value of the defined benefit plan’s assets and


liabilities at 30 June 2012. No other audit work has been performed other than to

agree the figure from the financial statements to supporting documentation

supplied by Axle Co.

Draft consolidated statement of financial position

30 June 2012

Draft

$’000

30 June 2011

Actual

$’000

Assets

Non-current assets

Property, plant and equipment 81,800 76,300

Goodwill 5 5,350 5,350

Investment in associate 6 4,230 4,230

Assets classified as held for sale 7 7,800 -

Current assets

Inventory 8,600 8,000

Receivables

8,540 7,800

Cash and cash equivalents 2,100 2,420

Total assets 118,420 104,100

Equity and liabilities

Equity

Share capital 12,500 12,500

Revaluation reserve 3,300 2,500

Retained earnings 33,600 29,400

Non-controlling interest 8 4,350 4,000

Total equity 53,750 48,400

Non-current liabilities

Defined benefit pension plan 10,820 9,250

Long-term borrowings 9 43,000 35,000

Deferred tax 1,950 1,350

Current liabilities

Trade payables 6,200 7,300

Provisions 2,700 2,800

Total liabilities 64,670 55,700

Total equity and liabilities 118,420 104,100


Notes: Key audit findings – statement of financial position

5. The goodwill relates to each of the subsidiaries in the Group. Management has

confirmed in writing that goodwill is stated correctly, and our other audit procedure

was to arithmetically check the impairment review conducted by management.

6. The associate is a 30% holding in James Co, purchased to provide investment

income. The audit team have not obtained evidence regarding the associate as

there is no movement in the amount recognised in the statement of financial

position.

7. The assets held for sale relate to a trading division of one of the subsidiaries,

which represents one third of that subsidiary’s net assets. The sale of the division

was announced in May 2012, and is expected to be complete by 31 December 2012.

Audit evidence obtained includes a review of the sales agreement and confirmation

from the buyer, obtained in July 2012, that the sale will take place.

8. Two of the Group’s subsidiaries are partly owned by shareholders external to the

Group.

9. A loan of $8 million was taken out in October 2011, carrying an interest rate of

2%, payable annually in arrears. The terms of the loan have been confirmed to

documentation provided by the bank.

Required:

Respond to the note from the audit engagement partner. (22 marks)

Note: The split of the mark allocation is shown within the partner’s note.

(22 marks)



(a) you can also talk about change in risk; change in internal control system;

outsourcing its ICS to 3rd party; departure of NEDs during the year like audit

committee collapse; fraud has been found during the audit etc.

(i)

The auditor shall revise materiality if they become aware of information

during the audit that would have caused the auditors to determine a

different level of materiality initially

During the audit, the auditor becomes aware of a matter which impacts on

the auditor’s understanding of the client’s business and which leads the

auditor to believe that the initial assessment of materiality was wrong and

must be revised. For example, the actual results of the audit client may turn

out to be quite different to the forecast results on which the initial level of

materiality was based.

There’s a change in the client’s circumstances may occur during the audit,

for example, a decision to dispose of a major part of the business. This again

would cause the auditor to consider if the previously determined level of

materiality were still appropriate.

If adjustments are made to the financial statements after the initial

assessment of materiality, then the materiality level would need to be

adjusted.

(b)

Operating expenses

The disposal of property involves a recognition from statement of financial

position of $2m but it’s given the right to repurchase at the end of the asset life

and this may imply that it’s not a sale but just a loan. So it may be accounted for

under IFRS9 financial instrument.

Further audit work will be needed to verify the substance of the transaction.

Revaluation

The audit evidence relating to this is not sufficient.

Because the materiality has been revised to $700,000 and this revaluation has

exceeded this figure so that further audit procedures relating to revaluation

would need to be carried out.


Actuarial losses

The audit evidence relating to this is not sufficient because auditors just rely on

the records of Alex Co which a service organization.

So auditors should also gain an understanding of this service organization and

perform other audit procedures to support its records.

Goodwill

The goodwill doesn't change but from the evidence of decline in sales revenue of

one subsidiary of 25% this may mean that there would be impairment in the

goodwill.

So auditors need to challenge the assumption made by management regarding

goodwill.

Associate

Associate in the statement of financial position remains unchanged but there is

profit from associate in the statement of profit or loss and this is unual and it

may imply that figures in the statement of financial position is wrong.

Auditors need to enquire with management for the accounting entry relating to

this to assess any potential mistakes.

Assets held for sale

Assets held for sale should be disclosed under current assets rather than

non-current assets in the statement of financial position.

The $7.8m is unclear about whether it would be just the asset or net of assets

and liabilities as a result of the assets held for sale and the IFRS5 requires there

should be a split between assets and liabilities not to net them off.

It seems that the assets held for sales meet the definition of discontinued

operation and so according to IFRS5 there should be a single line figure

disclosed on the face of the statement of profit or loss and other comprehensive

income about the post-tax profit or loss of the discontinued operation.

Further audit work should be done to ensure the above are corrected.

NCI

Non controlling interest has been disclosed properly under equity but in the

statement of profit or loss and other comprehensive income it hasn't disclosed

the profit after tax attributable to NCI and also total comprehensive income

attributable to NCI.

So auditors would discuss with management whether this will be made or not.


Loan

The finance cost accrued for the year should be $120,000($8X2%X9/12) but

there is just an increase in the finance costs in the statement of profit or loss and

other comprehensive income of $40,000 and this may imply that there would be

an understatement of the finance cost.

So auditors would need to review the notes regarding this to ensure its

accuracy.


Chapter 2 June2011 Q3 Opening balances (ISA510&ISA710)(b)

Your firm has been approached by Wexford Co to provide the annual audit. Wexford

Co operates a chain of bookshops across the country. The shops sell stationery such

as diaries and calendars, as well as new books.

The financial year will end on 31 July 2011, and this will be the first year that an

audit is required, as previously the company was exempt from audit due to its small

size.

(b) Wexford Co’s financial statements for the year ended 31 July 2010 included the

following balances:

Profit before tax $50,000

Inventory $25,000

Total assets $350,000

The inventory comprised stocks of books, diaries, calendars and greetings cards.

Required:

In relation to opening balances where the financial statements for the

prior period were not audited:

Explain the audit procedures required by ISA 510 Initial Audit

Engagements – Opening Balances, and recommend the specific audit

procedures to be applied to Wexford Co’s opening balance of inventory.

(8 marks)


Answer to Q June2011 Q3:

(b)

Genera procedures:

Auditor shall read the most recent financial statements for information

relevant to opening balances, including disclosures.

Auditor shall obtain sufficient appropriate evidence about whether the

opening balances contain misstatements that materially affect the current

year’s financial statements by determining whether the prior period’s closing

balances have been correctly brought forward.

The auditor should determine whether the opening balances reflect the

application of appropriate accounting policies.

Auditor shall obtain sufficient appropriate evidence about whether the

accounting policies reflected in the opening balances have been consistently

applied in the current period’s financial statements, and that any changes in

accounting policies have been accounted for under IAS8.

Specific procedures:

Auditor should inspect records of any inventory counts held at the prior

period year end, 31 July 2010, to confirm the quantity of items held in

inventory agrees to accounting records.

Auditor should Observe an inventory count at the current period year end,

31 July 2011, and reconciliation of closing inventory quantities back to

opening inventory quantities

Auditor should inspect management accounts for evidence of any inventory

items written off in the current financial period to identify any obsolete

inventory.

Auditor should discuss with management regarding any slow moving items

of inventory which were included in opening inventory.


Chapter2 :DEC2010 Q2 Newman & Co(C) [ISA720 other information]

(c) You have a trainee accountant assigned to you, who has read the notes taken at

your meeting with Ali Monroe. She is unsure of the implications of the charitable

donations being disclosed as a different figure in the financial statements compared

with the other information published in the annual report:

Disclosure note in the financial statement is $9m while in the sustainability report

this is $10m.

Required:

(i) Explain the responsibility of the auditor in relation to other information

published with the financial statements; and

(ii) Recommend the action to be taken by Newman & Co if the figure

relating to charitable donations in the other information is not amended.

(8 marks)



(i)

Auditors should read the other information and compare to financial statements to

establish whether financial statements are misstated or other information

paragraph is misstated.

If the financial statements are materially misstated and management refuses to

correct the material misstatement then auditors should qualify his audit opinion.

If financial statements are correct but the other information paragraph is wrong

then auditors should modify his audit report by adding another matter paragraph.

If any of these material misstatements are not corrected by management then

auditors should think about withdraw from the engagement letter but they need

to seek legal advice first.

(ii)

Auditors should perform audit procedures to obtain sufficient and appropriate

audit evidence suggesting the $9m in the financial statements is correct.

If $9m is correct then auditors should present the audit work result to

management telling them the $10m in the sustainability report is wrong.

If the management refuses to change the disclosure paragraph then auditors

should add other matter paragraph after the actual opinion paragraph telling

shareholders that there is a material inconsistency between financial statements

and the non financial information paragraph.

If management refuses to change the disclosure paragraph then auditors should

need to reconsider the integrity of management and review its management

representation again and where necessary resign as an auditor.


Stage 6 Audit report

Critique Style:

Chapter 2 June2012 Q5(b)

(b) Snipe Co has in place a defined benefit pension plan for its employees. An

actuarial valuation on 31 January 2012 indicated that the plan is in deficit by $10·5

million. The deficit is not recognised in the statement of financial position. An

extract from the draft audit report is given below:

Auditor’s opinion

In our opinion, because of the significance of the matter discussed below, the

financial statements do not give a true and fair view of the financial position of Snipe

Co as at 31 January 2012, and of its financial performance and cash flows for the

year then ended in accordance with International Financial Reporting Standards.

Explanation of adverse opinion in relation to pension

The financial statements do not include the company’s pension plan. This deliberate

omission contravenes accepted accounting practice and means that the accounts

are not properly prepared.

Required:

Critically appraise the extract from the proposed audit report of Snipe Co

for the year ended 31 January 2012.

Note: you are NOT required to re-draft the extract of the audit report. (7 marks)

(15 marks)


Answer to June2012 Q5(b):

The title for the paragraphs are not correct.

Firstly, explanation of adverse opinion in relation to pension should be “basis of

adverse opinion” .

And this should be placed before “opinion” paragraph.

“Auditors’ opinion” should be “opinion” paragraph.

The matter is not quantified. The paragraph should clearly state the amount

of $10·5 million, and state that this is material to the financial statements.

The paragraph does not say whether the pension plan is in surplus or deficit,

i.e. whether it is an asset or a liability which is omitted from the financial

statements.

There is no description of the impact of this omission on the financial

statements. Wording such as ‘if the deficit had been recognised, total

liabilities would increase by $10·5 million.

No reference is made to the relevant accounting standard IAS 19 Employee

Benefits. Reference should be made in order to help users’ understanding of

the breach of accounting standards that has been made.

The use of the word ‘deliberate’ when describing the omission of the pension

plan is not professional and the plan may have been omitted in error and an

adjustment to the financial statements may have been suggested by the

audit firm and is being considered by management.

It is unlikely that this issue alone would be sufficient to give rise to an

adverse opinion so ax except for qualification should be issued because this

is just material misstatement not pervasive.


Matter to be considered style:

Chapter 2 June2011 Q5 Nassau Group

You are the manager responsible for the audit of the Nassau Group, which

comprises a parent company and six subsidiaries. The audit of all individual

companies’ financial statements is almost complete, and you are currently carrying

out the audit of the consolidated financial statements. One of the subsidiaries,

Exuma Co, is audited by another firm, Jalousie & Co. Your firm has fulfilled the

necessary requirements of ISA 600 Special Considerations– Audits of Group

Financial Statements (Including the Work of Component Auditors) and is satisfied as

to the competence and independence of Jalousie & Co.

You have received from Jalousie & Co the draft audit report on ExumaCo’s financial

statements, an extract from which is shown below:

‘Basis for Qualified Opinion (extract)

The company is facing financial damages of $2 million in respect of an on-going

court case, more fully explained in note 12 to the financial statements. Management

has not recognised a provision but has disclosed the situation as a contingent

liability. Under International Financial Reporting Standards, a provision should be

made if there is an obligation as a result of a past event, a probable outflow of

economic benefit, and a reliable estimate can be made. Audit evidence concludes

that these criteria have been met, and it is our opinion that a provision of $2 million

should be recognised. Accordingly, net profit and shareholders’ equity would have

been reduced by $2 million if the provision had been recognised.

Qualified Opinion (extract)

In our opinion, except for effects of the matter described in the Basis for Qualified

Opinion paragraph, the financial statements give a true and fair view of the financial

position of Exuma Co as at 31 March 2011...’

An extract of Note 12 to ExumaCo’s financial statements is shown below:

Note 12 (extract)

The company is the subject of a court case concerning an alleged breach of planning

regulations. The plaintiff is claiming compensation of $2 million. The management

of Exuma Co, after seeking legal advice, believe that there is only a 20% chance of

a successful claim being made against the company.


Figures extracted from the draft financial statements for the year ending 31 March

2011 are as follows:

Nassau Group Exuma Co

$million $million

Profit before tax 20 4

Total assets 85 20

Required:

Identify and explain the matters that should be considered, and actions

that should be taken by the group audit engagement team, in forming an

opinion on the consolidated financial statements of the Nassau Group.

(10 marks)



Matters to consider

Significant component

A significant component is defined as a component identified by the group audit

engagement team that is of individual significance to the group. Exuma Co

meets the definition of a significant component because it contributes 20% of

group profit before tax, and 23·5% of group total assets. Exuma Co is therefore

material to the group financial statements.

Materiality

The legal case involves a claim of $2 million. This is material to the Exuma Co

financial statements as it is 50% of profit before tax, and 10% of total assets.

This is also material to the group financial statements because it’s 10% of group

profit before tax, and 2·4% of group total assets.

Qualified opinion

An except for qualification opinion is issued by auditors because they believe

that the cash outflow for this is probable rather than possible and as long as

there is enough audit evidence shows this is the case then this opinion is

appropriate.

Group auditors

Because the individual financials statements are material to the group and so

Jalousie&Co’s work should be carefully reviewed by group audiotrs.

The matters should be discussed with the group engagement audit team as well

as those changed with governance about the impact on the group audit opinion

as a result of this matter.

If there’s correct amendment in the Exuma Co financial statement then there

would be unqualified audit opinion issued to that financial statement.

If ExumaCo’s financial statements are not amended, an adjustment could be

made on consolidation of the group financial statements to include the

provision.So opinion on ExumaCo’s financial statements would be qualified, but

the group audit opinion would not be qualified as the matter causing the

material misstatement has been corrected.

If no adjustment is made, either to ExumaCo’s financial statements, or as a

consolidation adjustment in the group financial statements, and if the group

engagement partner disagrees with this accounting treatment, then the group

audit opinion should be qualified due to a material misstatement.


Actions

Auditors should inspect copy of the actual claim showing the $2 million claimed

against the company.

Auditors should inspecta written representation from management detailing

management’s reason for believing that there is no probable cash outflow.

The group engagement partner may consider engaging an external expert to

provide an opinion as to the probability of the court case going against Exuma

Co given the subjective nature of this matter.(ISA600 further procedures)


Non Audit Engagement Services

When talking about the assurance engagement it can be:

1. Audit engagement (6 stages)

2. Audit related services (which doesn’t require a detailed standard to perform

the work)

* Review engagement including interim financial information; prospective financial

information and due diligence review.

* agree upon procedure including forensic investigation and due diligence

investigation

* Compilation service just to prepare the account for client or doing tax

computation for client

3. other assurance engagement including social and environmental audit(verifying

KPIs.)


Interim financial information DEC2012 Q5(b)

(b) You are also responsible for the audit of Squire Co, a listed company, and

you are completing the review of its interim financial statements for the six

months ended 31 October 2012. Squire Co is a car manufacturer, and

historically has offered a three-year warranty on cars sold. The financial

statements for the year ended 30 April 2012 included a warranty provision of

$1·5 million and recognised total assets of $27·5 million. You are aware that

on 1 July 2012, due to cost cutting measures, Squire Co stopped offering

warranties on cars sold. The interim financial statements for the six months

ended 31 October 2012 do not recognise any warranty provision.

Total assets are $30 million at 31 October 2012.

Required:

Assess the matters that should be considered in forming a conclusion on Squire

Co’s interim financial statements, and the implications for the review report.

(6 marks)


Answer to DEC2012 Q5(b):

Matters to be considered:

General:

Reviews on interim financial statement for Squire Co are based on analytical

procedures and enquiry.

The IAS 37 provisions, contingent liabilities and contingent assets should be

applied both on annual financial statements and interim financial statements

here.

Materiality:

Warranty provision is 5.5% of total assets($1.5m/$27.5m) and hence it’s

material to the financial statements.

Accounting:

After 1 July 2012 there is no obligation for Squire to provide warranties on cars to

customers but Squire has a liability for customers before 1 July 2012 and so

Squire should recognize expenses and liability for those customers and here it’s

financial statements would understate liability and expenses.

Implications:

Before qualifying the conclusion auditor should communicate this to management

or audit committee to require an adjustment.

If this is not made then auditors should modified his/her conclusion like” Based on

our review, with the exception of the matter described in the previous paragraph,

nothing has come to our attention that causes us to believe that the

accompanying interim financial information does not give a true and fair view.”

Before qualification of opinion auditors should include the reasons about

qualification in the basis of opinion paragraph which is before the actual opinion

paragraph.

Auditors would also consider whether to resign as an auditor for both review

engagement and audit engagement if the above adjustments are not made.


Prospective financial information Chapter 2 June2012 Q2(a)

(a) You are a manager in Lapwing & Co. One of your audit clients is Hawk Co which

operates commercial real estate properties typically comprising several floors of

retail units and leisure facilities such as cinemas and health clubs, which are rented

out to provide rental income.

Your firm has just been approached to provide an additional engagement for Hawk

Co, to review and provide a report on the company’s business plan, including

forecast financial statements for the 12-month period to 31 May 2013. Hawk Co is

in the process of negotiating a new bank loan of $30 million and the report on the

business plan is at the request of the bank. It is anticipated that the loan would be

advanced in August 2012 and would carry an interest rate of 4%. The report would

be provided by your firm’s business advisory department and a second partner

review will be conducted which will reduce any threat to objectivity to an acceptable

level.

Extracts from the forecast financial statements included in the business plan are

given below:

Statement of profit or loss (extract)

Note FORECAST 12

months to 31

May 2013

$000

UNAUDITED

12 months to

31 May 2012

$000

Revenue 25,000 20,600

Operating expenses (16,550) (14,420)

Operating profit 8,450 6,180

Profit on disposal of Beak Retail 1 4,720 -

Finance costs (2,650) (1,690)

Profit before tax 10,520 4,490


Statement of financial position

FORECAST

31 May 2013

$’000

UNAUDITED

31 May 2012

$’000

Assets

Non-current assets

Property, plant and equipment 2 330,150 293,000

Current assets

Inventory 500 450

Receivables

3,600 3,300

Cash and cash equivalents 2,250 3,750

Total assets 6,350 7,500

Equity and liabilities

Equity

Share capital 105,000 100,000

Retained earnings 93,400 92,600

Total equity 198,400 192,600

Non-current liabilities

Long-term borrowings 2 82,500 52,500

Deferred tax 50,000 50,000

Current liabilities

Trade payables 5,600 5,400

Total liabilities 138,100 107,900

Total equity and liabilities 336,500 300,500

Notes:

1. Beak Retail is a retail park which is underperforming. Its sale is currently being

negotiated, and is expected to take place in September 2012.

2. Hawk Co is planning to invest the cash raised from the bank loan in a new retail

and leisure park which is being developed jointly with another company, Kestrel

Co.


Required:

In respect of the engagement to provide a report on Hawk Co’s business

plan:

(i) Identify and explain the matters that should be considered in agreeing

the terms of the engagement; and

Note: You are NOT required to consider ethical threats to objectivity. (6 marks)

(ii) Recommend the procedures that should be performed in order to

examine and report on the forecast financial statements of Hawk Co for the

year to 31 May 2013. (13 marks)


Answer to June2012 Q2(a)

(a) you can add other points such as time to finish, time to build up knowledge,

fees calculation, report to whom, follow which standards etc.

Management’s responsibilities

It should set out management’s responsibilities for the preparation of the

business plan and forecast financial statements, including all assumptions used,

and for providing the auditor with all relevant information and source data used

in developing the assumptions. This is to clarify the roles of management and of

Lapwing & Co, and reduce the scope for any misunderstanding.

The intended use of the business plan and report

It should be confirmed that the report will be provided to the bank and that it will

not be distributed or made available to other parties. This will establish the

potential liability of Lapwing & Co to third parties.

The period covered by the forecasts

This should be confirmed when agreeing the terms of the engagement, as

assumptions become vague as the length of the period covered increases, eg, it

should confirm whether a 12-month forecast period is sufficient for the bank’s

purposes.

The planned contents of the assurance report

It should confirm the planned elements of the report avoid any

misunderstanding with management. Eg, Lapwing & Co should clarify that their

report will contain a statement of negative assurance as to whether the

assumptions provide a reasonable basis for the prospective financial

information, and an opinion as to whether the prospective financial information

is properly prepared on the basis of the assumptions and is presented according

to the relevant financial reporting framework.


(b)

General procedures

Re-perform calculations to confirm the accuracy of the forecast financial

statements.

Agree the unaudited figures for the period to 31 May 2012 to management

accounts, and agree the cash figure to bank statement or bank

reconciliation.

Confirm the consistency of the accounting policies used in the preparation of

the forecast financial statements with those used in the last audited financial

statements.

Consider the accuracy of forecasts prepared in prior periods by comparing

with actual results and discuss with management the reasons for any

significant variances.

Forecasted statement of profit or loss

Discuss the reason for the 21·4% increase in revenue with management to

verify its reasonableness.

Discuss the reason for the increase in operating profit with management

from 30% to 33.8% to verify its reasonableness.

Request confirmation from the bank of the potential terms of the $30 million

loan being negotiated, to confirm the interest rate is at 4%.

Review relevant board minutes regarding the sale of BREAK RETAIL, to

obtain understanding of the likelihood of the sale, and the main terms of the

sale negotiation.

Forecasted statement of financial position

Agree the increase in property, plant and equipment to an authorised capital

expenditure budget.

Discuss the planned increase in equity with management to understand the

reason for any planned share issue,its date and the nature of the share issue,

ie, issue at full market price.

Review a forecast statement of changes in equity to ensure that movements

in retained earnings appear reasonable given forecasted profit is $10.52m

but there’s just an increase in retained earnings of $800,000 so there must

be a planned to pay out dividend.

Agree the increase in long-term borrowings to documentation relating to the

new loan.

Discuss the deferred tax liability with management to understand why no

movement on the balance is forecast given there’s a planned increase in

capital expenditure.


Due diligence review Chapter 2 June2008 Q2

Rosie Co is the parent company of an expanding group of companies. The group’s

main business activity is the manufacture of engine parts. In January 2008 the

acquisition of Dylan Co was completed, and the group is currently considering the

acquisition of Maxwell Co, a large company which would increase the group’s

operating facilities by around 40%. All subsidiaries are wholly owned. The group

structure is summarised below:

Rosie Co

Timber Co Ben Co Dylan Co

Acquired Jan 2001 Acquired July 2005 Acquired Jan 2008

You are an audit manager in Chien& Co, a firm of Chartered Certified Accountants,

and you are reviewing the working papers completed on the final audit of Rosie Co

and the Rosie Group for the year ended 31 January 2008. Your firm has audited all

current components of the group for several years, but the target company Maxwell

Co is audited by a different firm.

The management of Rosie Co has provided the audit team with some information

about Maxwell Co to aid business understanding, but little audit work is considered

necessary as the acquisition, if it goes ahead, will be after the audit report has been

issued. Information provided includes audited financial statements for the year

ended 31 January 2008, an organisational structure, several customer contracts,

and prospective financial information for the next two years. This seems to be all of

the information that the directors of Rosie Co have available. The finance director,

Leo Sabat is hoping that the other directors will agree that an externally provided

due diligence investigation should be carried out urgently, before any investment

decision is made, however the other directors feel this is not needed, as the financial

statements of Maxwell Co have already been audited. Leo has asked you to prepare

a report to explain to the other directors the purpose of due diligence, and the

difference between due diligence and an audit of financial statements, which will be

presented at the next board meeting.


Goodwill on the acquisition of Dylan Co is recognised in the consolidated statement

of financial position (balance sheet) at $750,000. The calculation provided by the

client is shown below:

$000

Cost of Investment:

Cash consideration 2,500

Deferred consideration payable 31 January 2009 1,500

Contingent consideration payable 31 January 2012 if Dylan Co’s revenue

grows 5% per annum

1,000

––––––

5,000

Net assets acquired (4,250)

––––––

Goodwill on acquisition 750

All of the figures in the schedule above are material to the financial statements of

Rosie Co and the Rosie Group.

Required:

(a) Prepare a report to Leo Sabat (the finance director), in which you

should:

(i) Describe the purpose, and evaluate the benefits of a due diligence

investigation to the potential purchaser of a company; and (10 marks)

(ii) Compare the scope of a due diligence investigation with that of an audit

of financial statements. (4 marks)

Note: requirement (a) includes 2 professional marks.


Answer to June2008 Q2

(a)

Report

To: finance director

From: auditor

Date: exam date

Subject: due diligence

Introduction:

The report details the objective and benefit of due diligence review as well as the

comparison between it and audit.

(i) purpose and benefit of due diligence

Management representation

By conducting such a due diligence investigation the management

representation can be reviewed for its reasonableness. Eg, if the management

representation said, “the company isn’t involved in the tax investigation” and by

conducting due diligence review we can subsequently find whether this

representation is true.

Information gathering

By conducting such a due diligence investigation and gathering enough

information as to whether or not to acquire the company any potential problems

can be revealed.

Reduce management involvement

By allowing external audit firm to do the service then the management may

save a lot of time by not checking the numbers themselves but focus more on

their core operation of the business.

Reveal operational problems

By conducting due diligence review operational issues such as high rate of

labour turnover can be revealed and it may help to form the decision by

company of whether or not going to acquire this company.

Increase confidence of investment decision

By conducting due diligence this will increase shareholders confidence and

investment decision to make subsequent acquisition easier.


Reveal assets and liabilities

By conducting due diligence it will reveal potential liability such as contingent

liability which may help company negotiate the price for the acquisition.

Also goodwill and other intangible assets are not recognized separately in the

financial statement but by conducting due diligence review the assets can be

revealed as well.

(ii) Comparison between due diligence investigation and audit

Time

Due diligence here relates to purchase another company so it may require it to

be completed as soon as possible.

The audit of financial statement may take a couple of months to complete.

Assurance

The due diligence review provides negative assurance or its’ just an agreed

upon procedures, ie, checking what client asks for.

Audit of financial statement would require positive assurance given and this

requires auditors should follow ISA to do the audit work.

Direction

Due diligence requires forward looking by identifying any potential problems

exist with the target company.

Audit of financial statement requires backwards looking to identify any material

misstatement in the financial statements.

Systems

Due diligence does not require auditors to test the client system.

Audit assurance service would require auditors to test client system because

this forms a basis of whether auditors would use system based approach to

audit or full substantive testing approach.

Conclusion

Since due diligence provides a lot of benefit so you can reasonably consider that

to happen before purchasing the target company.


Forensic audit （Chapter 2 DEC2008 Q2）

(a) Define the following terms:

(i) Forensic Accounting;

(ii) Forensic Investigation;

(iii) Forensic Auditing. (6 marks)

You are a manager in the forensic investigation department of your audit firm. The

directors of a local manufacturing company, Crocus Co, have contacted your

department regarding a suspected fraud, which has recently been discovered

operating in the company, and you have been asked to look into the matter further.

You have held a preliminary discussion with Gita Thrales, the finance director of

Crocus Co, the notes of this conversation are shown below:

Notes of discussion with Gita Thrales

Four months ago Crocus Co shut down one of its five factories, in response to

deteriorating market conditions, with all staff employed at the factory made

redundant on the date of closure.

While monitoring the monthly management accounts, Gita performs analytical

procedures on salary expenses. She found that the monthly total payroll expense

had reduced by 3% in the months following the factory closure – not as much as

expected, given that 20% of the total staff of the company had been made

redundant. Initial investigations performed last week by Gita revealed that many of

the employees who had been made redundant had actually remained on the payroll

records, and salary payments in respect of these individuals were still being made

every month, with all payments going into the same bank account. As soon as she

realised that there may be a fraud being conducted within the company, Gita

stopped any further payments in respect of the redundant employees. She

contacted our firm as she is unsure how to proceed, and would like our firm’s

specialist department to conduct an investigation.

Gita says that the senior accountant, Miles Rutland, has been absent from work

since she conducted her initial investigation last week, and it has been impossible to

contact him. Gita believes that he may have been involved with the suspected fraud.

Gita has asked whether your department would be able to provide a forensic

investigation, but is unsure what this would involve. Crocus Co is not an audit client

of your firm.


Required:

(b)

(i) Describe the objectives of a forensic investigation; and

(ii) Explain the steps involved in a forensic investigation into the payroll

fraud, including examples of procedures that could be used to gather

evidence.

(11 marks)

(c) Assess how the fundamental ethical principles of IFAC’s Code of Ethics

for Professional Accountants should be applied to the provision of a

forensic investigation service. (6 marks)

(23 marks)


Answer to Dec2008 Q2:

(a)

(i)

Forensic accounting

Forensic accounting uses investigative and auditing techniques to examine on

the client’s financial statements which would be used in court.

Forensic accounting includes both forensic investigation ad forensic auditing.

Forensic investigation

A forensic investigation is a process whereby a forensic accountant carries out

procedures to gather evidence.

This involves planning stage, testing stage, review stage and report produced.

Forensic auditing

Forensic auditing is the specific use of audit procedures within a forensic

investigation to gather evidence.

This could include performing analytical procedure to determine the amount of

an insurance claim.

(b)

(i)

Fraud happened

It should make sure that this is a fraud, ie, ghost employee not a mistake made

within company.

Obtain evidence

Forensic investigation should obtain sufficient and appropriate evidence

whether or not there are employees grouping together to commit the fraud.

Prosecute the perpetrator

This would involve interviewing with the suspected fraudster and if they are

proved to commit the fraud then company should prosecute them.

Quantify economic losses

The investigation should quantify the financial loss suffered by Crocus Co as a

result of the fraud which shows a detailed amount suffered by the firm.


(ii)

Type of fraud

Forensic investigation would firstly identify the types of fraud and in this case it’s

ghost employee happened, eg, employee who has left company but still getting

paid.

How the fraud happened

Forensic investigation would walk through the internal control system to see

how the fraud would have happened.

For example, there should be a control procedure to ensure that any

amendments made to payroll data must be approved by a senior manager and

it’s likely that this is breached.

Evidence gathering

The investigation needs to gather sufficient and appropriate evidence of a fraud

has happened, who committed the fraud and the economic losses as well.

For example forensic accountant would discuss with management relating to

the fraud.

Investigative skills

This is to establish how the controls that should have been operating in the

payroll system were breached.

Skills would include:

Review of authorisation of monthly payroll.

Interview with the suspect(s), with the aim of extracting a confession

Report produced

This summarisesthe number of perpetrators and the losses suffered by

company.

Expert witness

The investigator would likely be the expert witness to present the above findings

in court and they may be asked questions regarding the investigation

performed.

Advice

The investigator would give advice to company of how to avoid the same

problems happening in the future by improving its internal control system.


(C)

Professional behaiour

It’s likely that forensic investigation would be a matter of public interste and

much of the media are focusing on this so forensic accountant should have a

highly professional attitude towards this to avoid damanage the reputation of

firm.

Integrity

The forensic accountant should not lie to court and his client and should remain

highest integrity when carrying out the work.

Competence and due care

Forensic accountant should have cumulative knowledge in audit and in this area

to carry out the work and they should follow reconigsed standards to do the

work as well.

Confidentiality

During the court forensic accountant is required by the court to reveal

information discovered during the investigation.

But outside the court forensic accountant should remain faultless confidentiality

by not disclosing client’s information without its permission.

Objectivity

The outcome of the forensic investigation must be perceived as objective

because it forms part of the legal evidence presented at court.

The selfreview threat may arise because the investigation is likely to involve the

estimation of an amount (i.e. the loss) and then forensic accountant find out

whether this is true.


Social and environmental audit DEC2008 Q1(C)

A new internal auditor, Daisy Rosepetal, has recently joined Bluebell Co. She has

been asked by management to establish and to monitor a variety of social and

environmental Key Performance Indicators (KPIs). Daisy has no experience in this

area, and has asked you for some advice. It has been agreed with Bluebell Co’s

audit committee that you are to provide guidance to Daisy to help her in this part of

her role, and that this does not impair the objectivity of the audit.

Recommend EIGHT KPIs which could be used to monitor Bluebell Co’s

social and environmental performance, and outline the nature of evidence

that should be available to provide assurance on the accuracy of the KPIs

recommended. Your answer should be in the form of briefing notes to be

used at a meeting with Daisy Rosepetal. (12 marks)

Note: requirement (g) includes 4 professional marks.



Briefing note

To: Bluebell co

From: Auditor

Date: exam date

Subject: KPI

Introduction: This briefing note will detail eight KPI and nature of evidence

relating to KPIs.

KPIs Nature of evidence

Social-employees

% female employees accounts for total

number of staff

Personnel files will show this

Reduction in Staff turnover of 25% from

last year to this year

leavers’ documentation from payroll

records

Social – customers

Increase in Customer satisfaction rates

of 30% with service provided from last

year to this year

Surveys or questionnaires completed by

customers

Increase in Level of repeat bookings of

15% from last year to this year

Customer account details from the sales

system would indicate multiple

bookings.

Decrease in level of complaints by

customer by 20% from last year to this

year.

Management log book of complaints

received

Social –community

Increase in donation of 35% from last

year to this year expressed as

value/profit.

Cash book will show value of any

donations

Environment

35% decrease in water use from last

year to this year.

Comparison of utilities costs using

suppliers bills received.

35% decrease in carbon footprint from

last year to this year.

Board authorization of any payments

made for carbon footprint.

Conclusion:

It’s very important to quantify every KPIs measures and keep control over

them.


June2012 Q2(b)(ii): social and environmental audit

(b) You are also responsible for the audit of Osprey Co, which has a financial year

ended 31 May 2012. The audit engagement partner, Bill Kingfisher, sent you the

following email this morning:

To: Audit manager

From: Bill Kingfisher, audit engagement partner, Osprey Co

Regarding: Environmental incident

Hello

Osprey Co’s finance director called me yesterday to explain that unfortunately over

the last few weeks, one of its four factories leaked a small amount of toxic chemicals

into the atmosphere. The factory’s operations were halted immediately and a

decision has been taken to permanently close the site. Though this is a significant

event for the company and will result in relocation and some restructuring of

operations, it is not considered to be a threat to its going concern status. Costs of

closure of the factory have been estimated to be $1·25 million, which is expected to

be material to the financial statements, and a provision has been set up in respect

of these costs.

Osprey Co is keen to highlight its previous excellent record on socio-environmental

matters. Management is preparing a report to be published with the financial

statements which will describe the commitment of the company to

socio-environmental matters, and state its target of reducing environmental

damage caused by its operations. The report will contain a selection of targets and

key performance indicators to show performance in areas such as energy use, water

consumption and employee satisfaction. Our firm may be asked to provide an

assurance report on the key performance indicators.

I am asking you to prepare briefing notes for my use in which you:

(ii) Discuss the difficulties in measuring and reporting on environmental and social

performance.

(4 marks)

Thank you.


Answer to June2012 Q2(b) (ii):

(ii) Measuring and reporting on social and environmental performance

It is difficult to measure social and environmental performance for a number of

reasons.

Firstly, targets and KPIs are not always precisely defined. For example, Osprey

Co may state a target of reducing environmental damage caused by its

operations, but this is very vague.

Secondly, targets and KPIs may be difficult or impossible to quantify, with

Osprey Co’s planned KPI on employee satisfaction being a good example.

Thirdly, systems and controls are often not established well enough to allow

accurate measurement, and the measurement of socio-environmental matters

may not be based on reliable evidence. In Osprey Co it may not be possible to

quantify how much toxic chemical has been leaked from the factory.

Finally, It will also be difficult to make year on year comparisons for the same

company, as targets may change in response to business activities. For example,

if Osprey Co were to expand its operating, its energy and water use would

increase, making its performance on environmental matters look worse.


Chapter 2 DEC2010 Q2(b) social and environmental audit

(b) Recommend procedures that could be used to verify the following draft

KPIs:

(i) The number of serious accidents in the workplace; and

(ii) The average annual spend on training per employee.

(6 marks)

Answer to DEC2010 Q2(b)

(i) (only 3points required)

Review number and type of accidents in the workplace records held by

human resources department.

Review the accident log book for the location.

Discuss the definition of a ‘serious’ accident and establish criteria applied to

an accident to determine whether it is serious.

Review minutes of board meetings for discussions of any serious accidents.

(ii)

Review Eastwood Co’s approved training budget comparing to previous

years to ascertain the overall level of planned spending on training.

Agree significant components of the total training spend to supporting

documentation such as contracts and invoice with training providers.

Agree the total amount spent on training programmes to cash book and

bank statements.


Chapter3 Current Issues

In this session we will be going through:

1. Joint audit where 2 or more firms perform audit services to client’s company

and they would have same responsibility to the opinion.

2. Transnational audit where the audited financial statements would be used

by shareholders in the foreign country for raising money and legal purposes.

3. Audit guidance would include rules based to audit and if this is the case

auditors need to follow detailed rules in every situations with no judgment.

Another one would be principle based to audit where auditors follow the

regulatory framework to audit rather than detailed rules and hence auditors

would use their judgment in different situations for different clients.

4. Audit for small company would have its own advantages and

disadvantages. Advantages would be to utilize expertise to help business

growth by accepting advice from audit firm but the biggest disadvantage would

be it’s very expensive for the small audit firm to have such audit services.

5. How to increase the auditor’s independence? Solution would include things

like auditors’ rotation like key audit partners for one client should be rotated

every 7 years.

6. Auditor’s liability.

How auditor’s liability arises?

1.Auditors knows who use it and their plan. For example they know

shareholders would use the audit report to make their investment decision

so they are liable to shareholders. But if auditors don’t know who are going

to use their audit report and their plan then surely they are not liabile to

those guys.

2. Auditors have done a poor quality work(negligence).

3. Users of the audit report would lose money as a result of using the audit

report.

If the above criteria are fulfilled then auditors are liable to those ones.

Next question is how to minimize the liability?

They can use: Disclaimers; Professional indemnity insurance (PII); Joint audit;

Quality control.


Chapter3 June2009 Q2(d) transnational audit

The Dragon Group is a large group of companies operating in the furniture retail

trade. The group has expanded rapidly in the last three years, by acquiring several

subsidiaries each year. The management of the parent company, Dragon Co, a

listed company, has decided to put the audit of the group and all subsidiaries out to

tender, as the current audit firm is not seeking re-election. The financial year end of

the Dragon Group is 30 September 2009.

You are a senior manager in Unicorn & Co, a global firm of Chartered Certified

Accountants, with offices in over 150 countries across the world. Unicorn & Co has

been invited to tender for the Dragon Group audit (including the audit of all

subsidiaries). You manage a department within the firm which specialises in the

audit of retail companies, and you have been assigned the task of drafting the

tender document. You recently held a meeting with Edmund Jalousie, the group

finance director, in which you discussed the current group structure, recent

acquisitions, and the group’s plans for future expansion.

Meeting notes – Dragon Group

Group structure

The parent company owns 20 subsidiaries, all of which are wholly owned. Half of the subsidiaries

are located in the same country as the parent, and half overseas. Most of the foreign subsidiaries

report under the same financial reporting framework as Dragon Co, but several prepare financial

statements using local accounting rules.

Acquisitions during the year

Two companies were purchased in March 2009, both located in this country:

(i) Mermaid Co, a company which operates 20 furniture retail outlets. The audit opinion expressed

by the incumbent auditors on the financial statements for the year ended 30 September 2008 was

qualified by a disagreement over the non-disclosure of a contingent liability. The contingent liability

relates to a court case which is still on-going.

(ii) Minotaur Co, a large company, whose operations are distribution and warehousing. This

represents a diversification away from retail, and it is hoped that the Dragon Group will benefit from

significant economies of scale as a result of the acquisition.


Other matters

The acquisitive strategy of the group over the last few years has led to significant growth. Group

revenue has increased by 25% in the last three years, and is predicted to increase by a further 35%

in the next four years as the acquisition of more subsidiaries is planned. The Dragon Group has

raised finance for the acquisitions in the past by becoming listed on the stock exchanges of three

different countries. A new listing on a foreign stock exchange is planned for January 2010. For this

reason, management would like the group audit completed by 31 December 2009.

Required:

(d)

(i) Define ‘transnational audit’, and explain the relevance of the term to the audit of

the Dragon Group;

(3 marks)

(ii) Discuss TWO features of a transnational audit that may contribute to a high

level of audit risk in such an engagement.

(4 marks)


Answer to June2009 Q2 (d):

(d)

(i)

Definition:

Transnational audit is the audit of client’s financial statement which would be

relied on by investors outsider the home country for the purpose of raising

finance, investment or regulatory issues.

Relevance:

Because Dragon is seeking listed on the stock exchange and clearly its audited

financial statement would be used by investors outside the home country so this

is a transnational audit.

(ii)

Features:

Application of ISAs

For some countries they are using their own auditing standards and these may

be different from ISAs and hence when auditing those countries risks arises

because different rules exist, ie, ISA requires to gain an understanding of client

first to better identify risks within client’s company while local auditing

standards may not include this.

Corporate governance rules

In some countries there are very prescriptive corporate governance

requirements, which the auditor must consider as part of the audit process. In

this case the auditor may need to carry out extra work over and above local

requirements in order to ensure group wide compliance with the requirements

of the jurisdictions relevant to the financial statements.

However, in some countries there is very little corporate governance regulation

at all and controls are likely to be weaker than in other components of the group.

Control risk is therefore likely to differ between the various subsidiaries making

up the group.


Chapter3 DEC2009 Q4

As a result of the International Audit and Assurance Standards Board’s Clarity

Project, many revised and redrafted ISAs that have been issued will become

effective for audits of financial statements for periods beginning on or after 15

December 2009. One of the objectives of the Clarity Project is to clarify

mandatory requirements. This has been done by changing the wording used in

the ISAs to indicate requirements which are expected to be applied in all audits.

Some argue that this will introduce a more prescriptive (rules-based) approach

to auditing, and that a principles-based approach is more desirable.

Required:

(i) Contrast the prescriptive and the principles-based approaches to

auditing; and

(2 marks)

(ii) Outline the arguments for and against a prescriptive (rules-based)

approach to auditing.

(5 marks)



(i)

Prescriptive based to audit means auditor must follow detailed rules during the audit

in every situations.

Principle based to audit means auditors would follow a regulatory framework during

the audit and auditors would have a choice of how to apply the rules in different

situations.

(ii)

For:

Because rules based to audit then auditors must follow detailed rules and hence this

will improve clarity of auditing standards.

This will improve audit quality as well since auditors follow all of the rules during the

actual audit.

Against:

This will lead to over or under auditing because for small companies their

transactions are relatively simple and hence there is no need to carry out a variety

of procedures but just focus on those simple transactions. Under auditing means for

some business because auditors just follow the rules and they may ignore to

perform additional procedures to audit some more risky balances.

Lack of judgment in auditing would lower down the audit quality as well because the

rules are not applicable to every client.


June2008 Q2(c) Joint Audit

Maxwell Co is audited by Lead & Co, a firm of Chartered Certified Accountants. Leo

Sabat has enquired as to whether your firm would be prepared to conduct a joint

audit in cooperation with Lead & Co, on the future financial statements of Maxwell

Co if the acquisition goes ahead. Leo Sabat thinks that this would enable your firm

to improve group audit efficiency, without losing the cumulative experience that

Lead & Co has built up while acting as auditor to Maxwell Co.

Required:

Define ‘joint audit’, and assess the advantages and disadvantages of the audit of

Maxwell Co being conducted on a ‘joint basis’.

(7 marks)


Answer to June2008 Q2(c):

Definition:

This means two or more audit firms would have the same responsibility in giving the

audit opinion to the financial statements.

Advantages:

This will help two firms get together and build up knowledge of the new subsidiary

especially for the high risk areas they have identified before.

Two firms working together would mean resources would be shared and hence

make audit more efficient and audit opinion given with better quality.

Allowing two or more firms to work together and it should better complete the work

before the deadline.

Allowing two or more firms to work together and this would enable a new blood into

the audit meaning this will help auditors find out more risky areas by holding a

discussion among audit firms and hence increase the overall opinion given.

Disadvantages:

It’s more expensive for client to pay these two audit firms rather than just one.

Two audit firms would have different approaches to audit especially in materiality

determination, risk assessment and actual substantive procedures and hence it’s

difficult for them to work together effectively.

When professional negligence happens then both audit firms would suffer equal

liability and they may blame each other for negligence and making the litigation

process more complicated as a result.


Chapter3 Q5 DEC2010 Neeson&Co(b) Q4

(b) You have set up an internal discussion board, on which current issues are

debated by employees and partners of Neeson& Co. One posting to the board

concerned the compulsory rotation of audit firms, whereby it has been suggested in

the press that after a pre-determined period, an audit firm must resign from office,

to be replaced by a new audit provider.

Required:

(i) Explain the ethical threats created by a long association with an audit

client.

(3 marks)

(ii) Evaluate the advantages and disadvantages of compulsory audit firm

rotation.

(4 marks)

(20 marks)


Answer to Dec2010 Q4(b):

(i)

Familiarity threat would be created because of the long association with audit

client and this would be a threat to objectivity because auditors would lose

professional skepticism when doing the audit, ie, failure to challenge the client.

So key audit partners are required to be rotated every 7 years.

Self-interest threat may arise to objectivity because auditors may become

sympathetic to their client’s interest after the long association with client.

(ii)

Advantages:

It would eliminate the familiarity threat. By not only rotating the key partner,

but the entire audit firm, it is argued that the auditor’s independence is not

compromised, and that this adds credibility to auditors’ reports and to the

profession as a whole.

It can also be argued that clients would benefit from a ‘fresh pair of eyes’

after a number of years. A new audit fi rm can offer different insights from a

fresh point of view.

Disadvantages:

From the audit firm’s perspective, there will be a loss of fee income when

forced to resign as auditor.

Compulsory rotation undermines this accumulation of knowledge and

experience and hence new audit firm will have to spend more time into

auditing the client and hence it's more expensive to the client as well.


Chapter3 June2010 Q5(b) Auditors’ liability

(b) You are also responsible for providing direction to more junior members of the

audit department of your firm on technical matters. Several recent recruits have

asked for guidance in the area of auditor’s liability. They are keen to understand

how an audit firm can reduce its exposure to claims of negligence. They have also

heard that in some countries, it is possible to restrict liability by making a liability

limitation agreement with an audit client.

Required:

(i) Explain FOUR methods that may be used by an audit firm to reduce

exposure to litigation claims;

(4 marks)

(ii) Assess the potential implications for the profession, of audit firms

signing a liability limitation agreement with their audit clients. (6 marks)


Answer to June2010 Q5(b):

(b)

(i)

Disclaimers

audit firms can include a disclaimer paragraph in the audit report. This is an

attempt to restrict the duty of care of the audit firm to the shareholders of the

company, thereby attempting to restrict legal liability to that class of

shareholders.

Professional indemnity insurance (PII)

Auditors can buy the PII before providing the audit service in case something

goes wrong then company can reimburse the expense from insurance company.

Joint audit

By engaging two audit firms to do the audit because they have same

responsibility in giving the audit opinion so this reduce the risk exposure to

litigation claims if it happened.

Quality control

Firms must ensure they have sufficient quality control procedures to do the

audit and document the work, ie, staff would follow ISAs to do the work and so

this would reduce the risk to litigation cliam.

(ii)

Audit quality

Auditors could become less concerned with the quality of their work, in the

knowledge that if there was a claim against them, the financial consequences

are limited.

Value of the audit opinion

And once of the consequences would be users of the financial statements will

place less reliance on the audit opinion, resulting in less credible financial

statements.

Reduction on audit fees

Firms may be under pressure from clients to reduce their audit fees if the risk

exposure is reduced.

Reduce competition

The ability to set a cap on auditor’s liability could distort the audit market

because bigger audit firms may have the ability to set a high cap, which creates

a disadvantage to smaller audit firms.


Congratulations!

You have completed ACCA P7 Advanced Audit&Assurance(INT) study. I hope

you find this course useful to you both in Exams and Real life working as an

auditor.

Please go to revision phase now practicing more past exam questions with us

and the key to pass this paper is not only practicing them with us but also do

them under exam condition on your own and compare to our tutor’s answer.

Good luck with your future study.

Steve

p7 tuition study note dec2013

Documents

chapter2 q7

chapter2 q4

chapter2 q5

chapter2 q3

chapter2 q6

audit question dec2009

accounting estimates

accounting practise